September 12, 2011 / 8:07 PM / 6 years ago

HOW TO PLAY IT - Re-education of McGraw-Hill brings opportunity

THE ISSUE: McGraw-Hill Cos Inc. is planning to split itself into two public companies with one focusing on its credit rating business and the other on textbooks and educational products. Which company will be the better investment?

By Katya Wachtel

NEW YORK, Sept 12 (Reuters) - McGraw-Hill MHP.N, the publishing and information services conglomerate, is betting that two companies is better than one.

But investors, including some of the activist shareholders who are pushing for a break-up, should be aware that the earnings potential of two new companies being created by McGraw-Hill could be quite different.

Wall Street analysts and money managers say the company’s markets group, which will include the Standard & Poor’s ratings business, will tend to be the more consistent performer.

The markets business, with about $4 billion in revenue in 2011, won’t be weighed down by costs associated with McGraw-Hill’s more sleepy textbook and educational products group.

The education business, meanwhile, will have about $2.4 billion in revenue.

STANDARD & POOR‘S UNIT:

Following the split, the expectation is that the newly-minted markets company will garner new investor interest after shedding its weaker performing education unit. The markets company will be closer to a pureplay ratings agency, much like Moody’s Investors Service.

“We’re big believers in global growth so the financial piece looks like a real opportunity here,” said Timothy Ghriskey, chief investment officer at Solaris Asset Management, a investment firm that does not currently own any McGraw-Hill stock. Even before the split announcement, Ghriskey said his firm was looking at McGraw-Hill because of the strength of the ratings business.

Investors, for today at least, are certainly warming to the prospect of McGraw-Hill splitting up. In early afternoon trading on the New York Stock Exchange, the company’s shares rose 2.22 percent to $39.58, even as the broader market was trading in the red.

Douglas Arthur, an analyst at Evercore Partners in New York, which is advising on the deal, said the new markets business will have much stronger cash flow and operating margins than the education business.

“I’ve written for a long time that the education business has held back the growth profile of the company,” Arthur said.

EDUCATION BUSINESS:

The education business also could offer some opportunity to investors, but with a lot more risk. Analysts and investors said the challenge for the new education business will be finding ways to cut costs and increase revenues.

The new company’s big challenge will be finding a way for its textbook division to thrive in the age of electronic learning software and also deal with reduced spending state educational agencies.

McGraw-Hill’s digital strategy trails its competitors, according to an August research report from analysts at Stifel Nicolaus.

But if the new company can make the transition to the digital frontier, it may offer better upside returns than the new markets business.

“There aren’t many pureplay, publicly traded education companies, so there’s an opportunity for an investor or anyone in looking for exposure in that space,” said JPMorgan & Chase analyst Michael Meltz. “This [split] will free it up to spend capital however they want to.”

Terry McGraw, CEO of the company, said in an interview that the split will be good for recruiting a new chief executive for the education business.

“As a public company, the opportunity to get a very strong CEO to come in is going to be very good,” McGraw said.

BOTH ATTRACTIVE PLAYS:

Peter Appert, senior research analyst at Piper Jaffray & Co. and a long-time follower of McGraw-Hill, said both the markets group and education unit are both attractive investment plays.

“We believe there is opportunity for margin upside in both units although the market will likely take a ‘show-me’ attitude until we get more detail on cost reduction initiatives,” he wrote in a research note.

As an indication of potential margin leverage, Appert notes that S&P ratings’ 2010 actual margin -- before corporate overhead -- of 44.5 percent compares with Moody’s 46.2 percent and McGraw Hill’s Education’s margin of 14.8 percent compares with Pearson’s North American education margin of 17.8 percent.

All told, Appert said the steps the company outlined, including more aggressive stock buybacks and cost reduction efforts, “make strategic sense and will ultimately help close the gap between the current share price and our estimated $46 sum-of-parts asset value and $48 fundamental valuation.”

Reported by Katya Wachtel with additional reporting by David Henry and Sam Forgione; edited by Matthew Goldstein, Jennifer Ablan and Walden Siew

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