S&P Global Inc.
Q3 2006 Earnings Call Transcript

Published: 19 Oct 2006

[Operator:]

Good morning and welcome to The McGraw-Hill Companies Third Quarter 2006 Earnings Call. At this time, I would like to inform you that the call is being recorded for broadcast, and that all participants are in a listen-only mode. At the request of the company, we will open the conference to questions and answers after the presentation, and instructions will follow at that time. To enhance the call for today’s participants, McGraw-Hill has made the presenter slides available on the Internet. To do that, go to http

[Donald Rubin:]

Thank you and good morning and thank everyone for joining us here at The McGraw-Hill Companies third quarter 2006 earnings conference call. I am Donald Rubin, Senior Vice President for Investor Relations of The McGraw-Hill Companies. With me today are Harold McGraw, III, Chairman, President, and CEO; and Robert Bahash, Executive Vice President and Chief Financial Officer of the corporation. This morning we issued a news release with our third quarter 2006 results. We trust you've all had a chance to review the release. If you need a copy of it and financial schedules, they can be downloaded at www.mcgraw-hill.com/investor_relations. Once again that's www.mcgraw-hill.com/investor_relations. Before we begin this morning, I need to provide certain cautionary remarks about forward-looking statements. Except for historical information, the matters discussed in the teleconference may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including projections, estimates and descriptions of future events. Any such statements are based on current expectations and current economic conditions and are subject to risks and uncertainties that may cause actual results to differ materially from results anticipated in these forward-looking statements. In this regard, we direct listeners to the cautionary statements contained in our Form 10-Ks, 10-Qs and the other periodic reports filed with the U.S. Securities and Exchange Commission. We are aware that we do have some media representatives with us on the call; however, this call is for investors, and we would ask that questions from the media be directed to Mr. Steve Weiss in our New York office at area code 212-512-2247 subsequent to this call. Today's update will last approximately an hour. After the presentations, we will open the meeting to questions and the answers. Now my pleasure to introduce the Chairman, President, and CEO of The McGraw-Hill Companies, Terry McGraw.

[Harold McGraw:]

Okay. Thank you very much, Don. And good morning everyone and thank you for joining us for a review today of The McGraw-Hill Companies third quarter results. As Don mentioned joining us on the conference call today is Bob Bahash, Executive Vice President and Chief Financial Officer of the company. And we will start today's call by reviewing the performance of our businesses and take a look at the outlook for the rest of the year. Then Bob Bahash will review our financial performance and also talk about expectations for completing the year 2006. And as Don said, afterwards as always we'll answer any questions and we can go in any direction that you'd like. Earlier this morning, we announced third quarter results. Diluted earnings per share increased 6% to $1.06 and that included $0.03 for incremental stock-based compensation and $0.03 for restructuring business operations. I'll chat about that in a moment a little bit more and Bob Bahash will also address that. Net income for the third quarter was $382.3 million and revenue rose to $2 billion for the quarter. As a result of this performance, we are again increasing our guidance for the year. Our previous earnings guidance called for earnings per share of $2.44 to $2.49 and that excluded the incremental impact of all stock-based compensation; that excluded $0.13 for the stock-based compensation and $0.04 for the one-time charge for the elimination of the restoration stock option program. Our new guidance for 2006 calls for earnings per share of $2.53 to $2.55 and that excludes again the incremental impact of all stock-based compensation and restructuring charges. The incremental impact at the stock-based compensation has been revised to $0.11 down from the estimate of $0.13 earlier this year, and as we have previously stated and for the full year 2007, we fully expect to achieve double-digit earnings growth. With that let's take a closer look at how we achieved our third quarter results and the steps that we are taking to prepare for 2007. Let's begin with The McGraw-Hill Education. In this year's softer market, we worked very hard to protect the bottom-line. Two major swing factors, more limited opportunities in 2006 after last year's robust growth, and stringent cost controls are reflected in the segment's third quarter results. Revenue decreased by 6.3%, operating profit declined by 7 and that includes $3.4 million for incremental stock-based compensation, but our operating margin at 33.1%, was virtually unchanged from last year's, which was 33.3%. That achievement reflects our determination to manage costs in a weaker state new adoption market this year. For the education segment in the third quarter, cost declined by 6% compared to last year and that’s after a pre-tax restructuring charge of $5.6 million primarily for the integration of our elementary and secondary basal publishing business, and $3.4 million for the incremental stock-based compensation expenses that I just mentioned a moment ago. We took a number of steps to manage cost in the third quarter. In anticipation of the restructuring of our basal publishing businesses, we sharply curtailed hiring, we also cut marketing and sampling costs in anticipation of this year's softer state new adoption market, and we also worked very hard to achieve a higher level of operational efficiency, the benefits of the new global transformation platform should be greater in periods of peak activity and they were in 2006. As we have pointed out, the year-to-year market shift is pronounced in The McGraw-Hill School Education Group. In 2005 The McGraw-Hill School Education Group increased third quarter revenue by 18.9% in a very strong market. One of the keys to last year's successes was an outstanding performance in Texas, which accounted for $46 million in third quarter new adoption revenue. There is no adoption this year in Texas and that clearly was an important factor in the 12% decline in third quarter revenue this year at The McGraw-Hill School Education Group. There were other factors as well. This is an off year in the state new adoption cycle; in 2006, it if off 30% or approximately $250 million, which obviously limits the potential. We also fell short of expectations with our elementary products in the Florida Science and the California Social Studies adoptions. We took only 4% of the elementary market in Florida and 15% of the market in California, but that’s not the whole story. Our secondary science programs took 39% of the Florida market, and they were also very successful in Alabama, New Mexico, Oklahoma and West Virginia. In California, we captured 32% of the middle school and 43% of the high school market for Social Studies. We successfully introduced Treasures; this is our new elementary reading program and designed in for this year in the open territory. Spotlight on Music, an elementary program was the market leader in the Indiana and Oregon. Our alternative basal math program, which is Everyday Mathematics, also demonstrated year-over-year growth with particular strength in the open territory. Still this is going to be a soft year in the school education business. Through eight months, industry sales were down six-tenths of 1% and that’s according to the Association of American Publishers (NYSE

[Robert Bahash:]

Hey thank you, Terry. I will begin this morning with a discussion of cash flow, which was stronger than expected in the third quarter. At the end of the second quarter, we projected a return to a net surplus cash position by the end of this year. But with cash flow stronger than we thought, we are ahead of schedule and actually reached net surplus cash position in the third quarter. Our net cash position is $74.3 million, consisting of debt of $235 million, which is primarily in commercial paper borrowings in the U.S., offset by approximately $310 million in foreign cash holdings. Given our strong cash flow, we'll probably pay down all commercial paper borrowings by the end of the year. Net interest expense was $7.5 million in the third quarter, compared to about $3 million for the same period last year. The increase resulted from more commercial paper borrowings at higher interest rates to fund the stepped up share repurchases compared with the prior year. Strong cash flow has enabled the company to reduce commercial paper borrowings during the quarter. And we now expect the full year interest expense to range from $17 million to $19 million. Now for share repurchases. We did not purchase any shares during the third quarter. During the first half of the year, we did acquire 26.1 million shares at a cost of $1.4 billion. We expect to buyback 2.3 million shares during the fourth quarter to achieve our previously-announced 28.4 million share target for this year. When we complete this purchase, 20 million shares will remain from the 45 million share repurchase program approved by the Board in January 2006. This program represents in total 12.1% of the corporation's outstanding 372.7 million shares as of the end of 2005. Share repurchases will benefit earnings per share this year by approximately $0.03 and is reflected in the earnings guidance that Terry discussed earlier. With the buyback and dividend programs, we have returned increasing amounts of cash back to our shareholders. In 2004, we returned over $630 million. In 2005, we ramped that up to over $920 million. And so far in 2006, we have returned nearly $1.6 billion. Together, these represent a return of more than $3.1 billion to our shareholders. The diluted weighted average shares outstanding for the third quarter of 2006 was 360.9 million shares, a 20.2 million share decrease compared to the third quarter of 2005 and a 4.6 million share decrease compared to the second quarter of this year. In the earnings release this morning, we reviewed the impact of restructuring a number of business operations in the third and fourth quarters. In the third quarter, the restructuring charge was $15.4 million or about $0.03 per share, primarily for employee severance in McGraw-Hill Education, information and media and at corporate. All told, we eliminated about 600 positions -- 400 at McGraw-Hill Education, 100 at information and media and 100 in our corporate business support areas. We will complete the restructuring this year in the fourth quarter. We anticipate an additional $0.03 restructuring charge in the fourth quarter for actions we contemplate but have not yet taken. The $16 million pre-tax restructuring charge in the fourth quarter relates primarily to vacating some facilities and eliminating another 100 positions in McGraw-Hill Education, information and media and at corporate. The fourth quarter action will bring our total restructuring charge for the year to $31.4 million or $0.06 per share primarily from the elimination of approximately 700 positions. Earlier this year, we reported we are transforming Sweets -- the McGraw-Hill construction group's popular building products database from a print catalogue to a fully integrated internet-based sales and marketing solution. This move has led to changes in our revenue recognition for the Sweets product sales. We estimated last year that the impact of the Sweets transformation would be $15 million or approximately $0.02 to $0.03 per share. We now expect the impact to be in the range of $24 million or approximately $0.04. We are increasing our estimate because all of the Sweets' customers have contracted to purchase a bundled product, consisting of both print and online editions. This swift migration from standalone print to bundled contracts was not anticipated in our earlier estimate. Accounting standards require us to recognize revenue for subscription products over the contract period, rather than solely in the fourth quarter, which was how we recognized Sweets revenue in the past, but only if the standalone print product was delivered to customers in December. We will cycle through this change in 2007. There is another change I want to bring to your attention. When the company began expensing stock options at the beginning of this year, we had expected an incremental charge of $0.13 per share as a result of this accounting change. However, as a result of lower than expected incremental stock-based compensation activity, the company now expects the full year incremental charge to be $0.11 per share. In the third quarter, the company incurred incremental stock-based compensation expense of $14.6 million or $0.03 per share, which brings us to a year-to-date incremental expense of $54.1 million or $0.09 per share. Now, let's take a look at our corporate expenses. In the third quarter, corporate expenses increased $11.9 million including 4.1 million of restructuring charges. The balance of the remaining increase is due primarily to increased compensation-related expenses. In 2006, we expect dilution of approximately $0.04 from the acquisitions made in 2004 and 2005. They will be approximately cash neutral. In 2007, we expect these acquisitions will be cash positive. The company did not make any material acquisitions or dispositions in the first nine months of 2006. The effective tax rate in the third quarter was 37.2%, and we continue to project this rate for the balance of the year. Let's take a look at capital expenditures, which include prepublication investments and purchases of property and equipment. In the third quarter, our prepublication investments were $64 million compared to $67 million for the same period last year. For 2006, our current estimate for pre-pub investments is approximately $300 million. This level of investment is driven mainly for products we are currently developing to realize significant opportunities in the el-hi market in 2007, 2008, and 2009. However, through continued efficiencies, technology, and global sourcing, we anticiapte a reduction in spending from our earlier projection of $315 million. Purchases of property and equipment were about $25 million in the third quarter compared to $29 million for the same period last year. We are decreasing our projection of capital expenditures for 2006 from $200 million to $150 million. We are making this change because of the delay in the timing of expenditures associated with the construction of our new data center and other expenditures related to the implementation of digital technology initiatives until 2007. Now for some non-cash items. In the third quarter, amortization of prepublication costs was $103 million compared to $99 million in the same period last year. We now expect $240 million for the full year, down slightly from our previous estimate of $250 million. Depreciation was $27 million in the third quarter compared to about $23 million in the same period last year. We continue to expect it to be about $130 million in 2006 reflecting the higher level of capital expenditures and a full year of depreciation of capital expenditures made in 2005. Amortization of intangibles was $12 million in the third quarter compared to $12.4 million in the same period last year, virtually flat. For 2006, we expect $50 million, up from $44.2 million in 2005. The increase is driven by 2005 acquisitions. Now, thanks and now back to Terry.

[Harold McGraw:]

Okay. Thanks Bob, and as we came into 2006, we knew that we were facing from a market cycle standpoint, a weaker education market. And given that we are very pleased with the earnings performance across the board and the cost controls and the growth that we have been able to see, and we obviously are pleased to have the ability to raise our earnings guidance. And as we complete the year now, we start to focus on 2007 and beyond, we look forward to achieving that double-digit earnings growth and we fully expect to be able to do that. Let me turn it back to Don and then let's go in any direction anybody would like.

[Donald Rubin:]

Thank you. Just a couple of instructions for phone participants. (Operator Instructions). We will now get ready to take our first question.

[Operator:]

Thank you. The first question comes from Frederick Searby with JP Morgan. You may ask your question.

[Frederick Searby:]

Yes. Thanks. Terry could you give us some color on credit derivatives in terms of the growth rates in the U.S. and Europe and what percent of revenues they were for the quarter? And then just secondly, any thoughts on coming into a strong adoption year next year, what's going to prevent -- what looks like somewhat of a share loss in Florida, even though you had a nice, I guess, in the secondary market, can you just talk about your positioning from a share competitive perspective in the education el-hi. Thank you?

[Harold McGraw:]

Yeah. Thanks Fred. Yeah, in the structured finance market, obviously, it's been strong for the last several years and it's going to continue to be strong and then -- and the good part is that it continues to gain strength outside the United States. As we were saying in the -- in just some of the issuance numbers, the issuance for collateralized debt obligations, which is very large and a big area was up almost a 120% and it was up -- new issue dollar volume in Europe was up roughly 52%. So it's very, very strong. We continue to benefit obviously from the shift there. Now remember on the residential mortgage-backed securities market even though we are seeing year-over-year declines a little bit in the third and the fourth quarter, it is still very large. Overall, in 2006 in the residential mortgage-backed market, we sold $1.2 trillion of new issuance and that’s in the U.S. alone. So it is very large and it continues to grow very strong, and the residential mortgage-backed market in Europe is also doing -- is growing very nicely and is doing really well. So with that overall the structured finance market is strong and it's going to continue to stay strong. We will see the year-over-year comparisons of residential start to decline a little bit, actually for the full year. I expect it to be flat to probably even positive, given where we see the pipeline. On the commercial mortgage-backed market, you're going to see the continued strong increases that we have been seeing since last year. On the asset-backed, a little bit softer on the asset-backed, but again, the CDO market and the collateralized loan obligation market are going to continue strong. Fred, on the K-12 side, in terms of the state adoption markets for next year, again, 2007, 2008, 2009 are going to be really very, very good markets for the K-12 publishing business. Some of the major adoptions for next year, you're going to see California K-12 Science. You've got Florida with Health, K-12 Health, World Languages, Applied subjects. You've got Georgia with K-12 Math, Texas 6 to 12 Math, and then we start getting into major reading adoption, especially the Florida K-12 reading adoption in 2008. So the pipeline there is going to be strong, and it's going to be in the major disciplines. And we're pleased where we are this point, especially because on the reading side, Treasures, which we have launched this year, and really focused on the open territories is doing so well.

[Frederick Searby:]

Great, thanks a lot guys.

[Harold McGraw:]

Thanks Fred.

[Operator:]

Thank you. Our next question comes from Peter Appert with Goldman Sachs; you may ask your question.

[Peter Appert:]

Thanks you, good morning. Terry, or Bob, is it possible to quantify the cost savings you expect to achieve from the headcount reductions you've implemented, particularly, I am thinking about the education segment. And then related to that, I'm wondering if these cost reductions caused you to rethink the timing of your 20% margin target within the education unit, and maybe even, it implies there could be some upsides of that target.

[Harold McGraw:]

Okay, thanks Peter. Yeah, there is cost saving associated with all of the restructuring and some of the combination initiatives that we’ve taken, like the global transformation project, like the global resource management project and so forth. For the most part, the restructuring was associated with the combination of the elementary and secondary school operations. We’re very excited about that. This is something that is very new in the industry, and it gives us a lot of continuity and product development, and it gives us a higher level of focus in some of the sales and marketing areas. So, we’re pleased with that. But, again when we start talking about the margin improvement that we expect to see in 2007, '08 and '09, as we approach 2010, the GTP, the Global Resource Management, these restructurings are all about getting to a higher margin level. And so, from a target standpoint, I think we would leave it as where it is right now at 20%, but obviously we're going to be working very aggressively to be able to achieve that. After that as we become more online focused and as the market accepts more online participation, obviously, you are cutting 25% of your cost structure in terms of paper binding and printing and all of those kind of things. So, we'll see beyond 2010. We will work hard to get to the margin goal that we've got there.

[Peter Appert:]

Right, but no specific estimates in terms of the dollar magnitude of the costs you are taking out in the context to these specific cuts?

[Harold McGraw:]

No, and not at this point. We will be able to do that as we go forward, but obviously we are looking at a very good 2007 and the double-digit earnings guidance and we've taken the opportunity to make sure that we are in a good position to do that. So, the cost savings are obviously a factor in doing that and why we took the actions that we've taken.

[Peter Appert:]

All right, okay. Just one follow-up, I think Bob mentioned or you mentioned, Terry, that you would cut marketing and sampling costs in the Education segment this year. Is there any risk associated with cutting the marketing expense in terms of implications for your share performance next year?

[Harold McGraw:]

No, I mean, it really has to do with the fact that there is -- the schedule is so light for 2006 that we were able to obviously save on the variable costs associated with the lower schedule. So, as we see the demand pick up coming into next year, those variable expenses obviously come back in all of that, but with a higher revenue the better return, on that one. But, again we were just being able to take advantage of really good cost savings. I would also add one other thing, Peter. It's also the efficiencies here, in terms of how we look at the whole production and design process and how we have been be able to save cost there by doing some outsourcing and doing some pickup on that side, and we will continue to look at that. That’s coming out of not only global transformation, but also the global resource management capability.

[Robert Bahash:]

Peter, in addition to Terry's comments here, when he talked about the fourth quarter, we are seeing a step up clearly in some of our sales and marketing promotion costs because of the big opportunities in 2007. So, that’s another factor entering into what our forecast is looking at the fourth quarter to really help to ensure the sales objectives that we have for 2007.

[Peter Appert:]

Got it. Thank you.

[Harold McGraw:]

Thanks Peter.

[Operator:]

Thank you. Our next question comes from Brian Shipman with UBS. You may ask your question.

[Brian Shipman:]

Thanks. Good morning. Couple of questions. First Bob, could you tell us what the Financial Services division operating profit growth was, excluding CVC? Second, Terry, I was wondering if you could give us a better idea as to your expectations for revenue growth from the Schools Education Group in the fourth quarter? Is it going to be worse -- given the comparisons, is it going to be worse than what we saw in the third quarter or better or comparable? And then I may have a follow-up. Thanks.

[Robert Bahash:]

Okay. Just getting that specific information excluding CVC, I will have it for you in just a moment.

[Brian Shipman:]

Okay.

[Harold McGraw:]

On that revenue growth in the fourth quarter, remember in the fourth quarter for education it's much more of a higher education market. The only reason that we had such strong growth in the fourth quarter of 2005 was because of the timing associated with the Texas spending on that one. Usually you don’t see that kind of K-12 spent in the fourth quarter. So for the Higher Education Group, which is doing quite well, my sense is that you are going to see better revenue growth because of that but it's going to be less on the K-12 side.

[Brian Shipman:]

Okay.

[Robert Bahash:]

With regard to third quarter revenue growth, revenue growth excluding CVC from previous year was almost 18%, 17.9%

[Brian Shipman:]

Right, and the operating profit, I'm sorry that’s actually what I was after.

[Robert Bahash:]

Okay, operating profit was in excess of 20%.

[Brian Shipman:]

Okay. And then, Terry, one other follow-up, if you will, please. If I recall, you ran into trouble a few years ago in Florida again, I believe, on the math side. Can you talk more about McGraw's positioning in Florida please? Is there some kind of legacy issue going on there that’s affecting your performance?

[Harold McGraw:]

No, I mean, again the middle school and the secondary school, which are under the Glencoe imprint have -- are clearly number one. I mean they are so strong in all of that and our problem has been on the elementary side. Now one of the -- and here again, remember now we are talking programs and bigger programs, the issue this year and with the elementary science program had to do with the state-specific guidelines. They wanted a very detailed state-specific program. Now what you've got to look at very carefully here is the cost benefit of developing a program that would be so state-specific that it might not get you any kind of return. We made a conscious decision coming out of North Carolina with this science program that did so well -- we made a conscious decision to make it state-specific to Florida, but only to a point on that one. And in hindsight that was a decision that did not bode well for us on it. But we did overall, on Science, for example in Florida we did very well but that was because we had such huge performances in the middle school and the secondary school on that side.

[Brian Shipman:]

Okay thanks Terry.

[Harold McGraw:]

Thank you Brian.

[Operator:]

Thank you. Our next question comes from Lisa Monaco with Morgan Stanley. You may ask your question.

[Lisa Monaco:]

Hi, yes, on the amortization of pre-pub costs you could give us a number for '07and then I have a follow-up.

[Robert Bahash:]

Yeah actually it's bit early because we are not even into the budgeting process for 2007, but clearly it's going to be a higher number because we have increased our spending. So, it's hard to predict at this point of time what it's going to be, Lisa, but there is no question it's going to be a higher number because of the additional ramp up in spending with regard to the significant programs that will be released, but we will have that for you probably by the next call, clearly.

[Harold McGraw:]

And just to add on to that Lisa again, you know, remember with these larger programs especially in reading and math, these are -- it takes 2, 2.5 years to develop these programs, so we are really finishing up now on the costs for 2007, and we are really working on 2008-2009 product on that one. So you will see that continue to ramp up a little.

[Lisa Monaco:]

And is there any way to give us some color -- not to harp on this, but in terms of the margins for next year, any general yield for el-hi, what percentage of the current costs that you would recognize in that given year are for the programs, which you will realize revenue for that given year and what -- and generally what percentage is for forward years?

[Robert Bahash:]

In a major release year for any given program, you are going to have a higher cost element relating to that release, combination of sampling costs, free with order costs depending upon the type of program and of course your amortization costs. In the K-12 space we amortize our cost generally over five years, some of the digits. So a major piece of your amortization goes out in that very first year. So there is a frontloading of costs in one sense -- of course frontloading and revenue as well, but it does have a margin impact. You have very significant benefits as you go out into the future years -- you are getting nice benefits in that year, but very nice benefits as you go out because your cost structure is lower, you have residual revenue coming in without sampling free with order costs as well.

[Lisa Monaco:]

Okay. And then just two unrelated questions. Is there any way for you to give us a little bit more color on what the revenue growth performance for JD Power was and what I guess the profit growth was? And secondly if you could just elaborate again on what's driving the strength in the bank loan issuance, and I think you mentioned that the strength continued into 4Q, what's holding that up? Thanks?

[Harold McGraw:]

Well, Lisa, the acquisitions that we completed in 2005 are all doing really well. We talked about Capital IQ, we've talked about -- well we actually didn’t talk about CRISIL in India. They're doing exceptionally well on that one, but the JD Power, we don’t give out specific unit information on that one. But those acquisitions and JD Power are exceeding the base plan that we had for them. They're doing really well, and they’re doing well because -- JD Power now is doing well because of what we were talking about with the non-automotive side. The automotive side is doing exceptionally well and you'd expect that. But the non-automotive areas especially in financial services including insurance and brokerage, is doing very well, and we expect that to continue. The global part is also quite exciting. As we’ve said, all the roads go online, all roads go to Asia, and the Asia-Pacific region increasingly becomes a more and more important for us, and two-thirds of their non-U.S. growth is coming out of that region. And we expect that to continue as well. And then the bank loan market, again, bank loan market is again a big piece of our non-traditional net ratings activities, activities not tied to the new issuance market and it is now up getting close to 24% of total ratings revenue, and we expect that to continue.

[Lisa Monaco:]

Okay, thanks.

[Harold McGraw:]

Yeah.

[Operator:]

Thank you. Our next question comes from Michael Meltz with Bear Stearns. You may ask your question.

[Michael Meltz:]

Great. Thank you. Two quick questions on Information and Media. Bob, I saw on one of the slides, you've got a benefit in the quarter, and can you just talk a little bit about that and quantify that? And then secondly, the Sweets -- just so I understand the Sweets migration, I understand the concept, I just thought it would have been impacting you all year already. And now it sounds like you are saying it is more an '07 event. Can you just talk a little bit about that and then I have a follow-up?

[Robert Bahash:]

Okay. Let me deal with the Sweets item first. The product previously that we used to produce was a book that came out once a year, a collection of marketing promotion pieces for a number of major building suppliers. This product would be sold during the course of the year. The advertising and promotional types of material and such would be bound and put together during the fourth quarter and the product would be shipped in December. So, it was a fourth quarter event, revenue recognition event. That’s how it always had been historically. No difference in previous years. As we went into this year when we gave you guidance earlier clearly with the web many of these suppliers have their own website, so they would question -- is a single bound book really the right way to spend some of their marketing dollars as -- well right now they have a very robust website. What we have tried to communicate to these individuals is that there is a tremendous opportunity, not only part of the sweets.com offering here, but also to be part of the construction network. With their web-based product offerings as we have a package not only would they be reaching their particular customers that they want to reach, the builders, the architects, but those individuals would then be able to put -- input that data into their specifications as they are bidding on particular sites. So, there is a greater connection to not only accessing the information, but also specifying that information with a particular building project. So, when we entered into the year, we thought there would be a different mixture of individuals purchasing either just the electronic product, individuals purchasing the print product or a bundled product. What we've found and we are very pleased to see this is that virtually every customer wanted the electronic product in addition to the print product. So as a result it is just simply -- is a revenue recognition issue. The customer penetration that we had thought we were going reach in the beginning of the year is about exactly where we are, It's just that the mix of revenue is going to be much more recognized over a 12-month period than a split between some being recognized in the fourth quarter of this year and the balance being recognized more broadly. So that is why we have increased the estimate from $15 million to $24 million. On the other item, it is just simply a business item that was in dispute and we reversed the reserve. And I don’t really want to get into the specifics of it, but it was a large enough in terms of an impact on the quarter that we wanted to point it out to you.

[Michael Meltz:]

How big was that?

[Robert Bahash:]

The net impact of that was $8 million.

[Michael Meltz:]

Is that solely at the EBIT line or is that in revenues as well?

[Robert Bahash:]

Both, revenue and EBIT line.

[Michael Meltz:]

Okay. Two quick ones. At S&P on the index side, do you expect any benefit from the Chicago Exchange mergers and then I have one follow-up there.

[Harold McGraw:]

No, I think it's very exciting. I think we are going to see a lot of activity in terms of exchanges and the coordination of exchanges doing more together. And I think that it makes for bigger markets and it gives us more opportunity to work with them. We have a terrific relationship with both and I see no -- I see nothing that would create an impediment for us, I look at it just the other way. It’s a way to extend those relationships. But we are going to see that again throughout Europe and Asia as well, as you see more cooperation between exchanges and combinations that way.

[Michael Meltz:]

And last question, do you expect any impact near term on your education business from this Reading First situation?

[Harold McGraw:]

No, and again I'm not sure what you know about it or whatever, but some of the comments that we were steering Reading First dollars by having access to expert panels and all, that is all nonsense. The fact of the matter is, is that we've got an extremely successful program and that’s the Open Court phonics-based reading program coming out of The McGraw-Hill Learning Group, which is our No Child Left Behind group and if some people have competitive problems with that, so be it. But just because you have an extremely successful program, I get a little exercised on that one. We'll compete in the market on merit and we'll stay with that.

[Michael Meltz:]

Okay thank you.

[Operator:]

Thank you. Our next question comes from Brandon Dobell with Credit Suisse. You may ask your question.

[Brandon Dobell:]

Hi. Terry, maybe you could just give us a little color on the S&P business in the U.S. versus internationally. Any major or significant differences in margins between the two geographies? And I guess in particular in terms of pricing on similar types of deals, so structure or CDO in Europe or Asia for example versus the US, any differences there? And then Bob, also on S&P, you also mentioned little bit of timing of expenses of that being an issue here in Q3, I wondered if we could get an the order of magnitude on what that might have been? And then I have one follow-up. Thanks.

[Harold McGraw:]

Yes, Brandon on the structured finance market here and in Europe, again the trend is what's important. As the structured market is the securitized world, gains increasing acceptance, most institutional investors are looking for that kind of product, financial institutions like it a lot, obviously because they are offloading that risk. And so, you are going to see that trend just absolutely continue, and you are going to see more growth outside the United States as that ramps-up. It's a more sophisticated market in one sense here in the United States because we have been at it longer and that trend is going to continue as we get to Europe. But also in the Japan and the rest of the Asia-Pacific region, even in Latin America, even Mexico, we are seeing some nice representation there, especially in the housing market. But it really hasn’t quite, when you start talking about margins, the revenue growth is going to be very strong on the non U.S. side. When you start talking about margins, it's really a question of size and scale. As you start to build up that size and scale, the margins are going to obviously increase on that one. So, in parts of Europe you have got very competitive margins, very competitive pricing to the United States. As you go in to certain other markets, newer markets, it's a ramp-up on that one. But eventually there will be no difference in terms of the pricing and the margin expectation that way. It's really a size and scale as you ramp up.

[Robert Bahash:]

Brandon, can you elaborate on your question about the expense timing, what area were you talking about?

[Brandon Dobell:]

I think it's within S&P, it sounded like that was some of the driver for the year-over-year margin change, want to get a sense of if it was material or then if we should expect those expenses to show up in Q4, or if it was pushed from Q2 into Q3, just trying to get a better sense of kind of what you guys meant there?

[Robert Bahash:]

Okay, there is nothing significant there. The only thing I can tell you is that just like the other segments, the S&P the Financial Services segment, is looking at efficiencies, looking at offshoring, outsourcing for a number of different initiatives. They are focusing on more of the captive approach to offshoring versus the other segments using third parties because of the relationships that they currently have with Capital IQ as well as CRISIL. Capital IQ leveraging some of the data information, the data type collection opportunities, they are creating initiatives for them; CRISIL, more from a standpoint of the analytic support. So, there are activities going on there, some timing of expenses in terms of where those things may be ramping up, but nothing of any significance here, Brandon.

[Harold McGraw:]

And I would just add, Brandon, that when you exclude the $33 million from CVC, which we divested last year, revenue growth was up 17.9% and that’s what's driving us.

[Brandon Dobell:]

Then one final one, with the stock now at kind of a year/all-time high, maybe your perspective or philosophy on continued share repurchases, is that the best use for capital, given what the stock continues to do -- I just want to get your thoughts on how you think about the value of buying stocks or when it make the most sense?

[Harold McGraw:]

Yeah, well, you know, again, that’s an ongoing judgment call and how does one use your free cash flow and between dividends and share repurchases, acquisitions, organic growth. We will continue to be looking hard at tuck-in acquisitions that will support either a platform that exists or creates a platform and component acquisitions that strengthen a platform, and we will continue on that. The problem I have, Brandon, is that with a lot of the excess liquidity still in the market, you know, you see some people that are looking for really high returns and taking enormous risks to get them, I don’t think this is a great environment to be paying four or five times revenues, you know, for some of these acquisitions. So, I think we will see an improved environment as we get into the latter part of 2007 and 2008, and I'm just not going to seek some of those very, very high valuations, that doesn’t make sense, we will never get a return on that one. So, we focus a lot in this kind of environment on organic growth, and again, given the strength of the markets that we have and the expectations we have for '07 and beyond, we are focusing really hard on being able to satisfy those kinds of needs. And we will continue to make that -- analyze all of those kind of things, but we think the stock repurchase program and the return that we've given back to the shareholder, we think that’s been a very, very good program for us and we like it.

[Brandon Dobell:]

Great, thanks a lot.

[Operator:]

Thank you. Your next question comes from Karl Choi with Merrill Lynch. You may ask your question.

[Karl Choi:]

Hi, good morning, a couple of questions here. The first one is I wonder if you can talk about whether -- going back to Florida for a second, whether you are seeing an increase in demand for customization from different states, and if so, whether that would have an impact on how you compete in margin overall and I have a follow-up question.

[Harold McGraw:]

Okay. In terms of mass customization, help me with that, Karl --

[Karl Choi:]

In terms of customization of specific programs, are you seeing an increase in demand and as a result does that have an impact on your margins overall over a longer period of time?

[Harold McGraw:]

No, I think -- really the part that impacted revenues from the elementary side was the lack of revenue on that one. The mass customization -- really, I would put it a little bit differently to you. You are going to see more bundling of capabilities because as people are really focused on performance, student achievement and school performance, and you are benchmarking them, you are going to have to provide more capabilities to be able to ensure that they are getting that kind of performance. Therefore you're going to see much more push in the online market, you are going to see more push in remedial, more push in intervention products for people that are falling behind. So, one of the things that we are excited about with the reorganization of our elementary and secondary market school operations, is the continuity. We think that in terms of being able to put together a more continuous product that takes into account a building process, especially in reading, especially in math is going to very important. Testing in Science takes place in 2007 and we are going to see more activity on that side as well but I think it's going to be important to have a continuous product there.

[Karl Choi:]

And second question is, you previously have stated that you expect operating income for your education division to fall by as much as 10% in fiscal '06, just wonder whether you have any update on that outlook either with or without restructuring costs?

[Robert Bahash:]

Yeah, we had indicated that we would have a decline in our profits in that range; we are still forecasting to be in that general zone.

[Karl Choi:]

And that is before or after the restructuring charges?

[Robert Bahash:]

That’s before.

[Karl Choi:]

And actually last question is to clarify the fourth quarter guidance of $0.53 to $0.54 that is before the restructuring charges as well, right?

[Robert Bahash:]

That’s correct. It’s before -- the $0.53 to $0.55 is similar to the forecast that Terry had given, $2.53 to $2.55 before the incremental stock-based compensation, both the $0.11 -- the revised $0.11 and the $0.04 reload as well as the restructuring charge that occurred in the third and fourth quarters.

[Karl Choi:]

Great. Thank you.

[Operator:]

Thank you. Our next question comes from Drew Crum with Stifel Nicolaus. You may ask your question.

[Drew Crum:]

Good morning everyone. Terry, my first question for you pertains to the mid-term elections that are coming. Any potential concerns at the state or Federal level, any changes to education policy as a result of that? And then secondly, maybe for Bob, it looks like you are recognizing some efficiencies as well as some timing issues in terms of your investment pre-pub and CapEx. How should we think about those in 2007 relative to your original guidance? Thanks.

[Harold McGraw:]

Drew, on the mid-term elections -- boy, I'd better stay out of that one in terms of forecasting it, but as it relates to No Child Left Behind, no -- no, I mean No Child Left Behind is bipartisan. One can always have issues as to we ought to have funded more, we ought to have put more weight on this versus that and whatever. The important thing is the Education Reform Movement in America is so strong and it is clearly underway. It has taken time for the No Child Left Behind to get into the states and get administered that way and it has taken time for the Department of Education as well on that one. But -- and but that would be expected with something as major as that. But you've got aligment now between Federal, state and local that you've never had before. The focus is all on performances against student acheivement and school performance, and therefore I see no retreat from that. In fact, we are going to be working with DOE for obviously reauthorizaton of No Child Left Behind for next year, and we are going to see more emphasis now on the secondary. I mean a lot of the early emphasis has been on the early childhood learning. Obviously, the urban markets and that push for reading in particular and then you saw it with the early reading and reading first areas. We are going to see the push in not only reading, but math and science in particular as we get into the middle and the secondary school, and you are going to see more emphasis placed on that -- teacher training and development as well. We are also going to start to see a lot more discussion about higher education and you are going to see something in the reauthorization bill on that as well on that one. But I see no reversal on education side of the momentum in terms of billing under reform movement.

[Robert Bahash:]

With regard to your question about pre-pub and CapEx, let me take pre-pub first. Clearly we are experiencing benefits from the efficiencies not only of the offshoring side, but we expect to generate efficiencies from the combination of McMillan and Glencoe, and let me talk about each one. We are using all the most current technologies in the development of products where it’s not necessarily a linear handoff, but a number of editorial individuals can be working on projects collectively together which is very, very helpful. Using off-shoring vendors to help us in the page layout, the digitization is helping us tremendously; and as we are going through we weren’t exactly certain how quickly and how deeply we would be penetrating this work effort with these individuals and that’s why quite frankly we have been coming down a little bit each quarter with regard to how much we were expecting to spend. So no question we are getting efficiencies and that will help us as we go out into the future. As I indicated earlier it is little bit -- it is really too soon to be forecasting what our pre-pub investments are for next year. All I can say to you that was -- they are clearly going to be lower than where we had originally thought they were going to be simply because of the efficiencies that have been proven and will continue to generate these operating efficiencies. I think also with regard to the Centers of Excellence being creative with School Solutions we will see clear efficiencies there in that development process. On the CapEx side that's more simply a timing thing. Next year should be a higher year, again, not know exactly how that will fall, but the development of the new data center to support the digital nature of our company is significant. That's underway. We are just, I think, probably being a little bit too aggressive in terms of how we were thinking we are going to proceed with that development in terms of the timing of expenditures. We -- the completion of the program in early 2008 is still on target, but the expenditure side is a little bit slower. So you will see bigger spending on that initiative in 2007. Little bit too early to call how much that is but it will be up there in that range probably in the 200 range.

[Drew Crum:]

Okay. Thanks guys.

[Robert Bahash:]

You bet.

[Operator:]

Thank you. Our next question comes from William Bird with Citigroup. You may ask your question.

[William Bird:]

Yeah. Just a follow on related to pre-publication investment, it seems that your level of pre-pub investment has been lower than your competitor Pearson and the gap also seems to be widening. You mentioned offshoring as one explanation and some of the efficiencies you are gathering. Maybe you could talk a little bit about maybe some other things that might explain differences and what you would expect going forward? Thank you.

[Robert Bahash:]

We're using a number of very significant and very, very -- well, quite frankly, excellent workflow tools. We have been implementing a number of new technology initiatives in that process, and it has helped us tremendously. I really can't comment where our competitors are in the use of electronic workflow tools, or where they maybe on the offshoring side, but I can only talk from our standpoint that the editorial teams have done a great deal of work in this effort. This is not simply -- first of all we have been outsourcing this type of work for many, many years. So, the thought of outsourcing to a different location was not foreign to our individuals. We've had a number of individuals of the development side traveling to India, meeting with our vendors offshore, not just the vendors, but meeting with their colleagues that they’re going to be working with on a day-to-day basis. They are traveling here as well. We've gotten a high level of comfort and we have pushed more and more work in that direction. Again, I can't really comment where our competitors might be, but we see this as a very significant competitive advantage to permit us to do more of the customization work, a question that was raised earlier, where we can do a heck of a lot more on the customization side in the development of these programs, so we can be much, much -- hopefully create a competitive advantage for us versus several of our competitors.

[Harold McGraw:]

Yeah, and I'd only add to that Bill, that, a lot of this began early on with the global transformation project, but the whole global resource management capability; its not just an education, this is straight across the board, in terms of process improvement and efficiencies on that. We have launched a significant Six Sigma capability and that process has benefited us and I expect that to continue.

[William Bird:]

Just as a follow-on, Terry, you touched on uses of cash a little bit earlier. Was just wondering if you could just speak a little bit to your cash build and in the context of acquisitions and what kind of acquisition strategy you would expect to be following?

[Harold McGraw:]

Well, again as Bob indicated, we will be in a very good cash position by the end of the year and once again we will be thinking through the allocation of that. As far as acquisitions go -- again, we have to take a look at what valuations are. We have a very full pipeline and all of that. They are focused on the core growth areas. When he is talking about especially outside the United States, the continued development of the growth of the capital markets and the specifics within, we are looking very aggressively at building on those kinds of relationships. CRISIL was a good example and the follow-on acquisitions that CRISIL has been able to make, bring more transparency to that developing market. You are going to see more in the Asia-Pacific region. We are spending a lot of time there. You are seeing tremendous growth in the ASEAN base. We've got initiatives in Korea, Malaysia, Taiwan and obviously China on that one. So, you are going to see continued push on that part. On the education side, we are developing obviously very strong online development programs and we want to continue to focus on that, and anything that brings transparency via content to a particular market. We are looking at all of those.

[William Bird:]

Thank you.

[Harold McGraw:]

Yes.

[Operator:]

Thank you. We will now take our final question from Steven Barlow with Prudential Equity Group. You may ask your question.

[Steven Barlow:]

Thank you, two quick ones here. On the education side, you didn’t have some success on a couple of the states with a couple of the books. Does that mean that you have to go back to the drawing board, retool those books to get yourself in better position for the next couple of years of adoptions or is it just really a sales issue in that particular state and then you basically have fixed sales process in that state? Secondly, can you just talk a little bit about Capital IQ again? What is the number of people you have there versus when you started and an update really on the dilution or non-dilution of that for full year 2006?

[Harold McGraw:]

Okay. Steve first on the education side, no, it's not a product problem. The decision that we made in Florida on elementary science really was one to go with the national edition with some state specific and we didn’t go to a detailed level. Again, when you take a look at overall, we are right up at the top when you talk about the entire science or social studies in California for that matter. Again, in the Florida secondary market, we took a 39% share, 4% in the elementary and 39% in the secondary. So, it clearly -- it sounds it wasn't flawed product, I think it was the approach that we took towards state specific. Same thing in social studies; in California, it did very well. So, it's not -- from that stand point, it's not a product issue, and so there is no redesign that way. But what we will do with the new combination is we will be selling a more -- with more continuity a K-12 product that will build through the elementary into the middle school and into the secondary school market and I look forward to that. You'll see some design and implications associated with that as we go forward. On Capital IQ, Capital IQ remember now is a platform acquisition, and we have now catenated on to that platform Compustat and some other data components, and we will continue to build data components onto that platform. So when you take a look at the employment base there, it is obviously increased a lot but that’s also because of the growth of it. Capital IQ in terms of an acquisition, just looking apples-to-apples at its existing operation is way ahead of the acquisition plan that we had put together and is doing exceptionally well as the product is so well accepted in the market on that part. And we expect that to continue and you can expect that we are going to be very aggressive in developing additional data components for it.

[Robert Bahash:]

You asked about the headcount at Capital IQ, and Capital IQ I think specifically probably where you were going was with regard to our India headcount and that is right now approaching 1900 employees and this is growing, one because of Capital IQ and the roughly 40% growth in client penetration, but more importantly the leveraging across the S&P franchise to move more and more work into that particular business. So, as Terry points out not only is Capital IQ meeting and exceeding the particular targets that we have but across the board we are leveraging the capabilities of Capital IQ to help to reduce costs and hopefully grow revenues in other parts of the enterprise. So there is multiple benefits to the enterprise as a result of the Capital IQ acquisition.

[Steven Barlow:]

Thank you.

[Harold McGraw:]

Thanks Steve.

[Operator:]

That concludes this morning's call. On behalf of The McGraw-Hill Companies, we thank you for your participation and wish you a good day.