S&P Global Inc.
Q2 2012 Earnings Call Transcript

Published: 26 Jul 2012

[Operator:]

Good morning, and welcome to The McGraw-Hill Companies' Conference Call. I'd like to inform you that this call is being recorded for broadcast [Operator Instructions] To access the webcast and slides, go to www.mcgraw-hill.com and click on the link for the second quarter earnings webcast. [Operator Instructions] I would now like to introduce Mr. Chip Merritt, Vice President of Investor Relations for The McGraw-Hill Companies. Sir, you may begin.

[Robert S. Merritt:]

Good morning. We thank you for joining us this morning at The McGraw-Hill Companies' Second Quarter 2012 Earnings Call. I'm Chip Merritt, Vice President of Investor Relations. This morning, we issued a news release with our results. We trust you've all had a chance to review the release. If you need a copy of the release and financial schedules, they can be downloaded at www.mcgraw-hill.com. Once again, that's www.mcgraw-hill.com. In today's earnings release and during the conference call, we're providing adjusted financial information. This information is provided to enable investors to make meaningful comparisons of the corporation's operating performance between periods and to view the corporation's business from the same perspective as management's. The earnings release contains exhibits that reconcile the difference between the non-GAAP measures and the comparable financial measures calculated in accordance with U.S. GAAP. The results of the prior year quarter also reflect the reclassification of the Broadcasting Group as a discontinued operation. Before we begin, 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 other periodic reports filed with the U.S. Securities and Exchange Commission. We're aware that we do have some media representatives with us on the call today. However, this call is intended for investors, and we would ask that questions from the media be directed to Patti Rockenwagner in our New York office at [phone] subsequent to this call. Now I would like to turn the call over to Harold McGraw III, Chairman, President and CEO of McGraw-Hill Companies. Terry?

[Harold Whittlesey McGraw:]

Okay. Thank you very much, Chip, and good morning, everyone, and welcome to today's conference call. Joining me today on the conference call is Jack Callahan, our Chief Financial Officer. This morning, Jack and I will review our corporate results, provide an update on our Growth and Value Plan progress, provide a detailed look at the segment results that make up what will be McGraw-Hill Financial and McGraw-Hill Education, and then provide an outlook for the balance of the year. Three months ago, I was able to share record first quarter earnings. I couldn't be more pleased today to share with you our record second quarter earnings. What makes these results particularly noteworthy is that they occurred during a period of tremendous volatility in the debt markets as a result of European debt crisis and in a year in which we are experiencing the weakest state funding for textbooks in the past decade. To say the least, our employees are to be commended for delivering these results in today's very challenging global economic environment while simultaneously advancing the separation and implementing major cost reduction programs. During the second quarter, despite revenue that was modestly below a year ago, we delivered adjusted operating profit growth of 14% from both increased revenue in Commodities & Commercial, S&P Capital IQ, S&P Indices, as well as an acceleration of cost reductions that were realized during the quarter. Our recent aggressive share repurchase program amplified this growth. And we delivered 25% adjusted diluted earnings per share growth, and Jack will provide additional detail on that in just a moment. The primary focus of the company remains this

[John F. Callahan:]

Thank you, Terry. This morning, I want to provide additional detail on our consolidated results, including cash flow, and provide additional detail on the progress in one-time costs in the implementation of the Growth and Value Plan. Let me begin by discussing our consolidated results. Revenue decreased 1% year-over-year. However, it was more than offset by a 5% year-over-year decrease in overall adjusted expenses. The decrease in expenses was primarily the result of the Growth and Value Plan cost-reduction initiatives that began in the fourth quarter of 2011 and will continue into next year. As a result, consolidated adjusted operating profit increased 14% and consolidated adjusted operating margins increased over 300 basis points to 26.3%. Obviously, we are pleased with the progress thus far in margin expansion. To summarize the operating results Terry just reviewed, there was continued revenue growth at McGraw-Hill Financial of 5%, with margins that expanded 140 basis points, delivering strong adjusted operating profit growth of 9%. For McGraw-Hill Education, while there was a 12% decline in revenue, margins expanded 420 basis points based on the meaningful cost initiatives that began with the significant restructuring of the business in the fourth quarter of last year. Both businesses did benefit from a reduction in employee-related costs due to the realignment of our retirement programs. The share repurchase program remains an important aspect of the Growth and Value Plan, and the impact was evident again this quarter. Year-over-year, we reduced shares outstanding by 24 million shares. This amplified a 15% increase in adjusted net income to a 25% increase in adjusted diluted earnings per share or $0.85 per share. Since the beginning of 2011 through the second quarter of 2012, the company has repurchased nearly 36 million shares at a weighted average price of $42.05. This reduced shares outstanding by approximately 12%. Apart from the completion of the accelerated share repurchase program in April, no other shares were repurchased in the quarter. However, we do anticipate resuming share repurchases over the back half of the year, which will provide continued EPS leverage into next year. We continue to have a very strong balance sheet, with approximately $840 million in cash and short-term investments. Year-over-year, our free cash flow was down. This decrease was largely the result of a temporary acceleration of payments of approximately $100 million to the vendors associated with the transition to a new accounting system, as well as $65 million of cash outlays associated with the Growth and Value Plan. On a full year basis, we fully expect to deliver solid free cash flow. Our guidance of approximately $750 million, excluding cash outlays associated with the Growth and Value Plan, remains unchanged. Now let me provide some additional details around the execution of the Growth and Value Plan. During the quarter, we continue to make progress on our target of at least $100 million in run rate cost savings by the end of 2012. The actions taken over the last several quarters drove, in part, the cost reductions that were realized in the second quarter. Year-over-year, total adjusted expenses decreased 5%. As I mentioned earlier, one important component of this was the realignment of our U.S. pension plan that took effect on April 1. As we form 2 new companies, we need to separate several critical support operations that are currently shared. The next important round of cost savings will benefit from the realignment of these operations. We currently have 15 work streams underway to implement cost savings in the area of accounting, purchasing, information technology, human resources and real estate. We are already deep in the implementation of these plans, and we anticipate the realization of these cost reduction benefits by the time separation occurs in the latter part of this year. During the second quarter, we incurred $42 million of one-time Growth and Value Plan costs that we noted in this morning's press release. They include $19 million for professional fees, $15 million for deal fees and $8 million for severance. We anticipate that for the remainder of the year, we will incur an additional $80 million of one-time separation expenses necessary to implement the Growth and Value Plan. These one-time expenses are largely professional fees, as we need to support various consultants, business process and information technology firms and financial advisors. Please keep in mind, this is a working estimate. In addition, we anticipate that during 2012, we will continue to incur restructuring costs as part of our ongoing cost reduction initiatives. While the timing of these actions is still fluid, restructuring expense for 2012 could be up to approximately $65 million over the balance of the year. The Form 10 was filed several weeks ago and outlined many aspects of the separation. There are a few key financial items that I would like to draw your attention to. McGraw-Hill Financial will retain all of the outstanding long-term debt, as well as substantially all of the cash on hand at the time of the spin. Concurrent with the spin, we anticipate that McGraw-Hill Education will issue up to $600 million in new debt, likely a mix of bank term loans and public debt. McGraw-Hill Education will retain approximately $100 million of cash and issue a one-time dividend to McGraw-Hill Financial for up to $500 million. McGraw-Hill Education will also establish a revolving credit line. This, along with the $100 million of newly raised cash, should provide McGraw-Hill Education with ample liquidity to meet its business needs. Along with receiving the one-time dividend of up to $500 million, McGraw-Hill Financial will retain all of the pension liabilities, which are now largely frozen plans for both companies, as well as other selected liabilities, to simplify separation. In the spin, our goal is to provide the Education business with balance sheet flexibility to support its long-term growth potential. As we now look to the back half of the year, there are a couple items that I want to point out. First, as I mentioned earlier, we plan on resuming share repurchases. Our plan is to repurchase up to 500 million in the second half of the year. As always, share repurchases are subject to appropriate market conditions. Another item that I want to highlight is the financial impact of our new joint venture, S&P Dow Jones Indices. The transaction was closed at the end of June, and as such, our balance sheet reflects $792 million of additional net assets. It was closed on the last business day in the quarter, such that the income statement impact was negligible. We anticipate that by the end of the third quarter, the net income attributable to noncontrolling interest line on the income statement will become more prominent. Since we own 73% of the joint venture, we will consolidate the entire business in our income statement. 27% of the joint venture net income is then removed and recorded as net income attributable to noncontrolling interest. Obviously, we will review the impact of this exciting new venture with CME once there are operating results to review on the third quarter call. In closing, our outlook for the balance of 2012 remains positive. We are executing upon the Growth and Value Plan that we laid out late last year. At the same time, we delivered record first half adjusted earnings per share. While there is an inclination to raise guidance after such a strong first half, we need to be mindful that the third quarter, our largest of the year, is still ahead of us. This is the key quarter for McGraw-Hill Education as schools across the U.S. purchase the lion's share of educational materials for the upcoming school year. Therefore, we believe it is prudent to keep our guidance unchanged, with diluted adjusted earnings per share of $3.25 to $3.35, although based on the strong first half, we now anticipate being near the high end of that range. Our cost reduction efforts will continue, and we fully expect to deliver on our target of at least $100 million in run rate cost savings by the end of the year. Executing on all the aspects of the Growth and Value Plan remains our highest priority. And we continue to anticipate completing the separation into 2 powerful industry leaders, McGraw-Hill Education and McGraw-Hill Financial, by year-end. We are doing all the work to support a spin of McGraw-Hill Education by year-end. We are also evaluating other options to deliver shareholder value, including a potential sale. We will update the market as appropriate in the coming months. With that, thank you for joining the call this morning. And now let me turn the call back over to Chip Merritt to moderate the Q&A.

[Robert S. Merritt:]

Thank you, Jack. [Operator Instructions] And now, operator, if you would, please, we'll take our first question.

[Operator:]

Our first question comes from William Bird with Lazard.

[William G. Bird:]

Just 2 questions. First, on a GAAP basis, how much of the $100 million in cost savings do you expect to fall in 2012? And second, about how much leverage are you comfortable with for McGraw-Hill Financial post-spin?

[Harold Whittlesey McGraw:]

Bill, first of all, in terms of the cost savings and in terms of being able to realize those savings, we will realize those cost savings in 2012. And again, not to be nebulous about it, but we're seeing at least $100 million. And we believe, as we go through all of the reductions and shared costs and all of those things as we go through the separation process, that there'll be more. But I think it's safe to say, at this point, at least $100 million is a good way to do it. Leverage...

[John F. Callahan:]

Sorry to interrupt. The -- on a run rate basis, absolutely, at least $100 million by the fourth quarter. In terms of actual flow through the P&L within 2012, I would say about 2/3 would flow within the P&L this year. And obviously, that $400 million would benefit both businesses as we go into next year. And again, that excludes the one-time impact of the costs that we highlighted today around the separation expenses.

[Harold Whittlesey McGraw:]

That's right. And that -- and again, at least $100 million. And also in terms of leverage, it's way too early to tell at this point. I mean, obviously, we've got a very clean balance sheet. And relative to organic growth projects, transactions, shares repurchased and things like that, we will have ample capability to do whatever we need to do on that part. So we have a very clean balance sheet.

[William G. Bird:]

And just to clarify on the cost saves, how much have you realized in the P&L year-to-date?

[John F. Callahan:]

Well, if I go back to my comment a minute ago, that we anticipate at least 2/3 to benefit the P&L within the full year. I would say a little less than half that has already been reflected in the P&L year-to-date.

[Harold Whittlesey McGraw:]

And given the conditions that we're facing at this point, obviously, in terms of some of the lower revenue growth and the higher profit growth, obviously, cost reductions are having a significant impact.

[John F. Callahan:]

And obviously, we're also benefiting from -- the Education business is obviously benefiting from the very significant cost restructuring they did in the fourth quarter, where we eliminated -- last year, we eliminated 10% of all positions. That, obviously, is also adding incremental benefits.

[William G. Bird:]

Could you also comment on just what you're seeing in terms of the Ratings pipeline right now?

[Harold Whittlesey McGraw:]

Yes. I mean, as we said, what we're seeing on the structured finance side, we're starting to see some pickup on the commercial and a little bit on the residential side. Obviously, the public finance market is quite strong. Bigger than that, Bill, is that you're looking at -- in terms of nonfinancial corporate securities over the next 5 years, you're looking at $46 trillion of refinancing and new monies on that part. So we're starting to see some pickup on that side. Obviously, investment grade is doing better than speculative grade, and that goes for both here in Europe and parts of Asia Pacific as well. But now, it will start to pick up, and we'll start to see more activity on that part. And the plus side is that we're seeing it on the structured finance area.

[Operator:]

Our next question comes from Peter Appert with Piper Jaffray.

[Peter P. Appert:]

So Terry, the cost growth slowed considerably at S&P in the second quarter, which helped you generate some pretty good margins in the context of a tough revenue environment. Should that pattern replay, you think, in the second half of the year?

[Harold Whittlesey McGraw:]

Well, I mean, you've got ongoing cost reduction in one area, but you're also rightsizing that a little bit. But the big area is the foreign exchange. And again, especially coming out of Europe, our revenues were impacted by foreign exchange. But also positively, the expense base is also affected that way. So we'll have to see how the currency markets play itself through, but we're obviously benefiting on the cost side with foreign exchange.

[John F. Callahan:]

And Peter, I would just add that looking forward over the balance of the year, as Terry mentioned in his remarks, we have a tough expense overlap, particularly in the third quarter. So I'd be -- we're cautious as we look at the third quarter. But on a full year basis, we -- our anticipation is that the margins would remain 40% or better on a full year basis.

[Peter P. Appert:]

Okay, got it. And could I ask just 2 other questions, please? The S&P Dow Jones Index business, Jack, you mentioned this, I think, in your part of the call. I'm just trying to figure out, how big is the incremental contribution from that in the second half of the year? That's question one. And then question two, unrelated to that, Jack, you also mentioned the exploring the possible sale of the Education business. If you went that route, obviously, you'd be left with considerable cash balances. How would we -- how should we think about the potential use of that cash?

[John F. Callahan:]

Yes, 2 quick questions. I mean, for the JV over the balance of the year, from an earnings-per-share point of view, we think it'll be accretive $0.01 or $0.02. And on the third quarter call, once we actually have real operating results, we'll detail that much more than we can today. And then I'll be honest, we're very focused on trying to determine the right strategic path for the Education business spin or, potentially, sale or other option. Obviously, in a sale, we would have a fairly significant cash infusion. We haven't spent a lot of time, quite honestly, trying to sort out what we would do with that. Obviously, it's a high-class issue for us to consider. I would think you should expect some part of that would be consistent with our return of capital policy that we have as part of the Growth and Value Plan.

[Harold Whittlesey McGraw:]

And obviously, again, we're in a very, very sensitive period with the Education business because we have to make sure that we're prepared for the spin, and we are. And standing up the Education business as a stand-alone has taken all the attention on that part. Obviously, being responsive, as a public company, to every other interest as well, we are going through a process on that as well. But the most important part is that this is a 2012 event and that it is going to be a stand-alone business, and we have to make sure that -- in every possible way, that it is capable of being able to deliver on its strategic mission. Now in terms of, as Jack said, proceeds and everything else, you can look at the key components. It will definitely have some transaction component to it. It will definitely have some organic, especially as we continue to build out on areas like Platts and S&P Dow Jones Indices and things like that, and also the geographic expansion at Ratings on that, but also in terms of share repurchase as well.

[Operator:]

Our next question comes from Craig Huber with Huber Research Partners.

[Craig Huber:]

I have a very specific question first. On the transaction line in your Ratings business, given these various city bankruptcies of late, and I've noticed a number of downgrades out there as well over the last 6 months or so, an increasing number itself, how concerned are you about the public finance market out there? I know it's not going very strong now, given low rates and how we should accomplish year-over-year. But how concerned are you guys and your analysts that this could materially impact, if this continues, debt issuance on the U.S. finance?

[Harold Whittlesey McGraw:]

Yes, well, I mean, it's very strong for a very good reason. I mean, you've got so many states that are having difficulties, and as we were saying, non-transaction revenue represented 58% of the second quarter revenue in all of that. And again, that was a lot to do with the strengthening of the U.S. dollar. But we're not -- I mean, we're all concerned in terms of the lack of growth and some of the economic conditions and all of that. We're all influenced by that. But clearly, you're going to see more public finance issuance on that one, and it's a critical phase, and we're watching it very carefully. And again, from a creditworthiness standpoint, we will be extremely diligent in terms of stating exactly what we see.

[Craig Huber:]

But again, this pickup in city bankruptcies out there, you're not overly concerned of what that could do for debt issuance in the muni market for a period of time?

[Harold Whittlesey McGraw:]

No, we're not overly concerned.

[Craig Huber:]

Okay. And also, on the non-transaction line for the entire Ratings business, can you just talk about -- and I know it's up here 2% in the quarter, adjusting for currency, but just what your outlook is there in the back half of the year, and also about any potential price increases, what you're doing there?

[Harold Whittlesey McGraw:]

Yes, well, I mean, again, from our standpoint, and there would be modest price increases, but again, what you really have to focus on is the currency side of it. The strengthening U.S. dollar is obviously influencing it. But excluding the impact of foreign exchange rate, we see an increase in the non-transaction revenue.

[John F. Callahan:]

And I would -- our current forecast assumes sort of low single-digit growth in that area over the balance of the year. So obviously, to Terry's point, currency, and then, obviously, how active the markets are on the transaction side will drive the business for the next 6 months.

[Harold Whittlesey McGraw:]

Yes, that's right, low single-digit net modest increases.

[Craig Huber:]

And then, I'm sorry, back to this other question earlier with the Dow Jones Indices JV, can you ballpark the revenue impact or the positive impact? Or is it roughly say $20 million with you guys on a quarterly basis? Could you just ballpark it for us?

[John F. Callahan:]

I'd put it closer to $25 million plus.

[Craig Huber:]

Per quarter?

[John F. Callahan:]

Per quarter, yes. So for the balance of the year, somewhere between $50 million to $60 million.

[Craig Huber:]

Okay. My last question, please. On Education, could you just update us on your latest thoughts on the digital migration both on el-hi, as well as college, what you think it actually means to your profits, profit dollars, not margins, not revenues, with the actual profits at the end of the day, the dollar impact, please?

[Harold Whittlesey McGraw:]

Well, that -- I mean, that is where it's coming from. And it's happening very, very rapidly, and in particular, at the Higher Education level. As you know, with some of the transformation, with the Apple partnership and things like that, both Professional and Higher Education have significant title expansion in that area, and that will flow this year and next year to increases on the profitability. The K-12 area is still one that is -- it's very fragmented. We have pushed very hard on the high school market in terms of new title capabilities and the like. But again, because of state and local municipality economic conditions, it will remain fragmented. But the Higher Ed and the Professional side, it'll be a direct contribution.

[John F. Callahan:]

I'd squeeze in this point as an example. Obviously, it's much smaller because it's not Higher Ed. But the Professional business, while it's a small business, it's our most digitally advanced, and we have continued to build profitability in that business. So we have some experience in managing through this transition. It will obviously work differently in the Education markets, in Higher Ed or K-12 going forward, but we're working our way through that.

[Operator:]

Our next question comes from Doug Arthur with Evercore.

[Douglas M. Arthur:]

Yes, Terry, going back to S&P Ratings, and particularly focusing on transaction revenues, irrespective of the currency hit, I don't think I've ever seen a quarter where there was such a divergence between U.S. activity and particularly European, and I guess that's for the obvious reasons that we all read about every day. Do you -- how do you see that playing out, particularly in Europe, over the second half of the year? More of the same?

[Harold Whittlesey McGraw:]

I'd say you're probably right, Doug. It is more the same, although I think you'll start to see a little pickup in the structured finance area on that one, and we're looking to that. But again, the European environment is so difficult right now. I would say that it would probably be more of the same.

[Operator:]

We will now take our final question from David Reynolds with Jefferies.

[David Reynolds:]

David Reynolds here from Jefferies. I wondered if I could just ask a question about McGraw-Hill Education. Clearly, you're pursuing a variety of strategic options for the business going forward. Perhaps you could just share your expertise with us, really, with regard to how -- how do you think about valuation for businesses like McGraw-Hill Education?

[Harold Whittlesey McGraw:]

Well, first of all, if you take a look at the overall appetite and the need and the criticality of it, and the second one, take a look at the industry serving it on that part, McGraw-Hill Education is one of the most comprehensive and most powerful scaled capabilities and the like. As we're going through some very, very interesting changes in terms of the digital composition and how education is being focused on, both at the Higher Education and at the advanced level, as well as in the elementary, secondary school area, you're seeing some fundamental change taking place. Ours is, is that with McGraw-Hill Education, the digital transformation has to be accelerated. We have to continue to push aggressively on that. And as an industry, you're seeing that. I think that our capability and the team that we've got, we've been able to demonstrate making that kind of change more rapidly. And I think that judgment of anybody in the industry is going to be on their ability to develop a digital product very, very quickly and comprehensively.

[David Reynolds:]

And could I just follow that up? How critical do you believe is the internationalization of your Education business strategically going forward?

[Harold Whittlesey McGraw:]

I think it's very important, and especially when you're talking about emerging markets. 2/3 of world GDP growth is coming from something called emerging markets. And our ability to be able to interface with that, and in particular, on the Professional and Higher Ed side, it's going to be a big component of growth going forward.

[Operator:]

That concludes this morning's call. A PDF version of the presenters' slides is available now for downloading from www.mcgraw-hill.com. A replay of this call, including the Q&A session, will be available in about 2 hours. The replay will be maintained on McGraw-Hill's website for 12 months from today and for 1 month from today by telephone. On behalf of The McGraw-Hill Companies, we thank you for participating and wish you good day.