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The company, and why I'm buying
McGraw-Hill operates in four different business units and serves a wide variety of customers:
S&P Ratings: The ratings business offers opinions about the riskiness of debt and other fixed-income instruments from all manner of organizations. It competes with Moody's (NYS: MCO) and Fitch, and to a lesser extent Dun & Bradstreet (NYS: DNB) .
S&P Capital IQ /S&P Indexes: This unit provides analytical tools and information for investment advisors and wealth managers, including its well-known Capital IQ database, which the Motley Fool, among many others, uses.
Commodities & Commercial: This division provides businesses with data and analysis on specific industries, such as automotive, aerospace, construction, and energy. Its brands include J.D. Power and Associates.
McGraw-Hill Education: This unit operates as an educational publisher for the elementary, high school, university, professional, and adult education markets. Here it competes with publishers such as Pearson (NYS: PSO) and Scholastic (NAS: SCHL) .
Those are very disparate businesses, so late last year the company decided to split in two, with the education division being spun off into a separate, publicly traded business. Its decision was "helped" by activist investor Jana Partners. The move will leave all the financial-related units with the parent.
In addition, the company has taken a number of steps to shore up its operations, including eliminating 10% of its education workforce, freezing its defined-benefit pension plan as of April 1, and purchasing an additional $500 million in stock last year. That repurchase brought total buybacks to $1.5 billion in 2011.
Currently, McGraw-Hill trades at a trailing free cash flow multiple of just 11, but I think that can increase following the spinoff. For me, the jewel here is the stand-alone financial business, which should be able to garner a higher multiple with its low-capital, high-cash-flow business, similar to Moody's. The spinoff is expected to be completed by the end of the year.
So tomorrow, I'll buy $1,000 of McGraw-Hill for the Special Situations portfolio.
Perhaps the most significant risk to this investment is potential changes in the regulatory environment. The ratings agencies Moody's and S&P were widely blamed for their shoddy analysis of risky loans in the lead-up to the housing debacle. While changes could occur, I think the government has been exceedingly willing to sweep everything under the rug and expect little to be done in this arena.
Along similar lines, another seize-up in the debt markets could hurt the company as debt issuance declines, so any major Euro flare-up could be worrisome, at least for the short term.
Educational spending could also be hit further, with the sluggish economy continuing to crimp state and local budgets. However, the economy is slowly improving, though it could still be several years before things return to normal. Moreover, this is the division that I'm less interested in, and unless it is priced quite cheaply on the spinoff, I don't expect to stick with it.
The spinoff of the education business creates a clear way to create value, and unlocks the lucrative financial business. We'll get further details on this transaction as the date approaches, but for now it makes sense to take an initial stake in the company and continue watching.
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At the time thisarticle was published Jim Royal, Ph.D., does not own shares in any company mentioned here.Motley Fool newsletter serviceshave recommended buying shares of Moody's. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy.
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