Catch This Spin-Off Before It's Too Late

In the educational book sector, McGraw-Hill (NYS: MHP) and Pearson (NYS: PSO) compete with the ferocity of a ruler-wielding schoolteacher. While McGraw-Hill benefits from its financial segment right now, by the end of the year the educational segment will be spun off into its own entity. Once it's out there wandering the corporate stacks, how will it measure up against the Pearsons of the world?

Breaking up is hard to do
Last year McGraw-Hill announced that it plans to split itself into two "pure-play" companies. McGraw-Hill Markets will focus on maintaining and growing the existing S&P Ratings business, Capital IQ, and the other financial services provided by McGraw-Hill. McGraw-Hill Education will contain, shockingly, the existing educational offerings from McGraw-Hill. The split will take place later this year, and stockholder compensation has not yet been determined.

We can look at the efficiencies of the two companies to better compare the soon-to-be educational spin-off and Pearson. McGraw-Hill has already stated that cost reductions and efficient operations will be key to both divisions' success. The company dropped 10% of its education-side staff last year in an attempt to grease its corporate machinery.

Is less more?
When we look at efficiency, it often makes sense to look at net margins. However, in this case, wildly different tax situations make it difficult to pin Pearson and McGraw down. Pearson is headquartered in the U.K. and last year paid a paltry 17% of its pre-tax income in taxes, while McGraw-Hill had to fork over 36%. Pearson also had deferred taxes that affected its 2011 payment.

Let's turn to operating margins to compare the companies' pre-tax positions. Last year McGraw-Hill's education segment had operating income of $320 million. This represented 14% of the segment's total revenue for the year. Pearson's education segments netted 584 million pounds in 2011, which accounted for 14.5% of its total revenue.

Well, those are pretty close
Since the two companies are so well-matched on the business operations side, we should instead think about which one will be a better stock. Pearson's stock includes the educational segments, a professional technology group, the Financial Times, and the Penguin publishing group. Right now the stock is trading at 9.3 times earnings.

McGraw-Hill currently contains the S&P Ratings business, the educational segment, Capital IQ (a stock information provider for professionals), and a business insights segment (which includes JD Power). McGraw-Hill is currently trading at 16.3 times earnings.

While both stocks provide a diverse set of businesses, McGraw-Hill also gives you the chance to invest in a spin-off stock.

Spin it -- let's begin it!
The McGraw-Hill split has been driven by activist investors at Jana Partners hedge fund and the Ontario Teachers' Pension Plan. As a result of the split, investors will have shares in both of the resulting companies. On one hand they will hold the quick-growing McGraw-Hill Markets businesses, including Capital IQ. That business has seen its subscription revenue increase 20% since 2009.

On the other hand they will hold the newly formed McGraw-Hill Education, a business which has focused on an increased operating margin over the past three years. As a result, operating income has grown 16% since 2009, even though revenue has dropped 4%. A fast grower and a margin-maximizer sound like good options to me.

A Fortune in the making?
Investors can only hope that McGraw-Hill will pull a Fortune Brands. When that company split itself into Beam (NYS: BEAM) and Fortune Brands Home & Security (NYS: FBHS) , it unleashed a wealth of value for investors. Since the split in 2011, Beam shares have risen more than 20%, while Home & Security shares are up almost 60%.

Both of those stocks also saw a glorious time window shortly after the split when share prices actually fell from the split price, allowing savvy investors to increase their stake at a discount. Immediately after the split, owners of the original stock decided to get out of the new spin-off company, resulting in a sell-off. At the same time, the market decided to pay less for the original issue, due to its decreased assets and revenue. If McGraw-Hill ends up in a similar place, there could be plenty of value to be had by taking the long view.

In short, while Pearson is a well-run company and by no means a bad play, I see McGraw-Hill as the better investment right now. With the benefit of an upcoming spin-off, stockholders could benefit from an increase on both sides of the aisle, which would compound their value growth. The education segment may take longer to realize its true value than the market segment, but with tightly run operations, I have no doubt it will eventually realize that value.

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At the time this article was published Fool contributorAndrew Marderdoesn't own in any of the stocks mentioned in this article. He is, however, considering a spin-off of himself as a pure-play layabout.Motley Fool newsletter services have recommended buying shares of Beam. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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