Fitch Downgrades McGraw-Hill's IDR to 'A'; Ratings Placed on Watch Negative

Fri Aug 19, 2011 6:05pm EDT

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Fitch Downgrades McGraw-Hill's IDR to 'A'; Ratings Placed on Watch Negative

Fitch Ratings has downgraded The McGraw-Hill Companies, Inc.'s (McGraw-Hill), Issuer Default Rating (IDR) to 'A' from 'A+'. In addition, Fitch has placed the ratings on Rating Watch Negative. A full rating list is shown below.

The Rating Watch Negative and ratings reflect the following:

--The company is engaged in a strategic review of its portfolio and has publicly indicated its plan to announce significant actions in the second half of 2011. Fitch believes that leverage may increase as a result.

--This concern has been compounded by the disclosure of JANA Partners LLC (recognized as an activist investor) approximately 5% voting control over the company. While the 5% voting control is not a material holding, Fitch believes that the slow recovering stock price of the company may compel other potential investors to support aggressive strategic actions that could be detrimental to bondholders.

Fitch is providing the following observations on various strategic options McGraw-Hill could pursue as part of its review.

--Fitch estimates unadjusted gross leverage would be 1.0 times (x) under a scenario where the company spun-out McGraw-Hill Education and the Information and Media operating segments, and the senior unsecured bonds remained with both the McGraw-Hill Financial and Standard & Poor's segments (S&P). Assuming an appropriate post transaction financial policy, this scenario could potentially support the current ratings.

--While an unlikely scenario, Fitch estimates unadjusted gross leverage at approximately 1.5x if a spin-out of McGraw-Hill Financial, Education and the Information and Media operating segments occurred; leaving S&P to support the bonds. Assuming an appropriate post transaction financial policy, this scenario could lead to at least a potential one notch downgrade to the IDR.

--Fitch believes that the guarantee provided by Standard and Poor's Financial Services LLC (which operates most of S&P's U.S. business) to the $1.2 billion senior unsecured bonds, link the bonds to S&P. Therefore, Fitch believes divesting or spinning out S&P without the $1.2 billion bonds would be challenging (requiring 100% bondholder consent) and unlikely. This is based on Fitch's interpretation of the indenture documents.

--Given Fitch's belief that the bonds are tied to S&P and the size of S&P, 47% of EBITDA (and particularly S&P and MHP Financial combined, 67% of EBITDA), Fitch does not believe the disposition of substantially all of the assets clause found in the change of control definition would be triggered. Additionally if a change of control occurred it would still require a downgrade of the bonds into non-investment grade to trigger a change of control event. A change of control event would require an offer to buy back the bonds at 101%.

--The Rating Watch Negative reflects the uncertainty of the potential changes to strategic/management/financial policy the company may ultimately make and the potential for further rating downgrades. Fitch believes that any actions announced by McGraw-Hill will be in the context of remaining an investment grade rated issuer.

Other Rating Rationale Points:

--The ratings also incorporate several other overhangs on the credit profile which Fitch has previously commented on, namely regulatory and litigation related uncertainties

--The ratings reflect McGraw-Hill's diversity in its products and services, its historically consistent and conservative financial policies, and its prominent business franchises. In addition, the company's conservative balance sheet, coupled with its strong margins (EBITDA margins around 27%) and free cash flow characteristics, provided it with the capacity to weather the economic downturn.

--McGraw-Hill's School Education Group continues to endure pressure. Fitch expects that state budgets will continue to come under cyclical pressure and that any rebound in state and local economies will be slower than the general economy. The ratings reflect that the American Recovery & Reinvestment Act (ARRA) federal funds are expected to end in 2011. The ARRA provided approximately $80 billion in additional federal funds to offset the reduction of state spending on K-12 education. While there continues to be risk for further cuts in K-12 education funding, Fitch believes that a material portion of the cuts will be on teachers, supporting personnel and potential closings of schools.

--Education has historically been and continues to be a priority for the administration and federal law makers. Also, Fitch believes the adoption of the Common Core Standards by over 40 states should help drive new sales of textbooks and teaching materials (likely in a few years).

--The ratings are not dependent on a rebound in structured finance revenues. Fitch's model assumes that declines in certain high-margin, transaction-related revenue streams could be permanent.

Key Rating Drivers:

--As mentioned above, the ratings may be further downgraded and/or the Outlook stabilized, depending upon the resulting portfolio of assets and policies announced by the company.

--The ratings could be negatively affected if regulatory and litigation-related event risks accelerate or are combined with material operating or financial metric deterioration.

Liquidity and Leverage:

As of June 30, 2011, liquidity consists of cash and cash equivalents of $1.3 billion and full availability under its $1.2 billion commercial paper (CP) program (which are backed by McGraw-Hill's $1.2 billion bank credit facility due 2013). The company has ample cushion inside of the credit facilities' 4.0x indebtedness-to-cash flow ratio.

Free cash flow (FCF) at year-end 2010 was approximately $900 million compared to $770 million in 2009. June 2011 latest 12 months (LTM) FCF was $869 million.

Total gross debt stood at $1.2 billion as of June 2011 (the company was in a net cash position of approximately $100 million). Unadjusted gross leverage was 0.7x.

Fitch has taken the following rating actions:

--IDR downgraded to 'A' from 'A+';

--Senior unsecured downgraded to 'A' from 'A+';

Fitch also has the following ratings:

--Short-term IDR at 'F1';

--Commercial paper at 'F1'.

The ratings have been placed on Rating Watch Negative. The Outlook was previously Negative.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria & Related Research:

--'Corporate Rating Methodology' Aug. 12, 2011.

Applicable Criteria and Related Research:

Corporate Rating Methodology

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=647229

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Fitch Ratings
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