3 Not-So-Obvious Reasons To Own McGraw-Hill

By Will Ashworth | May 28, 2012 AAA
In an April article about the impending split of McGraw-Hill (NYSE:MHP) into two businesses, Investopedia's Ryan Fuhrmann discussed the reasons why it's a good idea to wait for the split to occur before buying either stock. His rationale is sound - the financial segment, which operates Standard & Poor's, will likely receive a valuation improvement once it splits from its educational cousin. However, that valuation improvement, Fuhrmann argues, has likely already been baked into its stock price and thus there is no advantage in buying its stock ahead of the split. It is hard to argue with his logic. Nonetheless, I believe there are three not-so-obvious reasons to own its stock. You can be the judge of who's right.

SEE: Efficient Market Hypothesis: Is The Stock Market Efficient?

Educational Spin-Off
When McGraw-Hill announced last September that it was splitting the company into two pieces to appease investors, it set in motion a series of events that will likely produce additional spinoffs in the future. The problem, institutional investors argue, is that McGraw-Hill is worth more broken into smaller pieces than it is as one or two publicly traded entities. Analysts valued the sum-of-its-parts at more than $50 last July when the public outcry first began. Given its 2012 earnings per share estimate of $3.25-$3.35, I would think that valuation is probably higher now.

The beauty of investing in spinoffs is that they generally outperform the parent. Several reasons exist for this phenomenon, but the biggest is that once it becomes an independent business and can set its own course, good things tend to happen, but usually not right away. Often spinoffs perform better in the second year than in the first because it takes time for plans to take hold, according to Joel Greenblatt.

Thus, an argument can be made that one shouldn't buy McGraw-Hill stock or that of the newly split company, like Fuhrmann contends, until both have traded for a while. The problem with this argument is that it's much like getting out of the market because you're scared of the volatility; you promise yourself you'll get back in once things calm down, but you never do. You either believe in the educational unit's ability to make money and grow, or you don't. No amount of timing is going to change that. Furthermore, history shows that once a split occurs, both divisions become potential takeover targets. If that happens, not buying before the split becomes an expensive mistake.

SEE: Parents And Spinoffs: When To Buy And When To Sell

Additional Spin-Offs
On the very last page of McGraw-Hill's "Growth and Value Plan" presentation from last September, you'll see that the financial business generates about 62% of overall revenue and about 80% of operating income. There's no debating the fact its financial businesses are the jewels in the crown. However, as institutional investors have rightly pointed out, more can be done to accurately reflect the value of the assets it has accumulated over the years. In 2011, its three financial segments - S&P Ratings, S&P Capital IQ/S&P Indices and Commodities & Commercial - generated revenue of $1.8 billion, $1.4 billion and $900 million respectively.

Right off the bat it seems to make sense that the ratings business be spun-off, if for no other reason than to maintain the appearance of independence. It is possible investors would view this move in a positive light from a regulatory standpoint and not just as a financial maneuver. Equifax (NYSE:EFX) trades for 2.7 times sales, which puts the potential value of the ratings business at $4.9 billion. Then you have the S&P Capital IQ and S&P Indices segment. A significant majority of its revenue is recurring in nature and very attractive to long-term investors.

Furthermore, it receives fees for ETFs linked to its indices. As ETFs grow in popularity, so too will its fees. Its margins aren't as high as the ratings business, but the future growth potential is much brighter. I would think investors would be clamoring to own its stock. Lastly, there is the commodities & commercial business, which includes J.D. Power and Associates and Platts, a leading provider of information for those operating in the natural resources business. Growing at a decent clip, I'm not sure why it couldn't have included this segment in the education spin-off. It certainly would help attract more investors. But now that the wheels are in motion, all three seem better on their own.

Barry Diller
What does Barry Diller have to do with McGraw-Hill? On Aug. 21, 2008, Diller split IAC/InterActive (Nasdaq:IACI) into five separate companies to provide focus to each of his businesses and value to shareholders. For each share of IAC/InterActive stock, you received a smaller fraction in HSN Inc. (Nasdaq:HSNI), Interval Leisure Group (Nasdaq:IILG), Tree.com (Nasdaq:TREE) and Ticketmaster. The ticket seller subsequently merged with Live Nation (NYSE:LYV). Add it all up, and the group of five stocks achieved a total return of 136%, compared to 19.3% for McGraw-Hill over the same period. I'm not a big fan of Barry Diller, but this move was a money-maker for shareholders.

SEE: The Merger - What To Do When Companies Converge

The Bottom Line
The last section about Barry Diller says it all. Management will get around to doing the right thing. In the meantime, I suggest you hang onto its stock if you already own it and buy some if you don't. The results of spin-offs don't lie.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

comments powered by Disqus
Related Analysis
  1. India Remains An Emerging Market Bright Spot
    Stock Analysis

    India Remains An Emerging Market Bright Spot

  2. Still More Gains Ahead For Semiconductor Makers
    Stock Analysis

    Still More Gains Ahead For Semiconductor Makers

  3. Unconventional Drilling Still Has Room To Boom
    Stock Analysis

    Unconventional Drilling Still Has Room To Boom

  4. Finding An Alternative With Currency ETFs
    Stock Analysis

    Finding An Alternative With Currency ETFs

  5. Commodities: Has Their Time Come Again?
    Stock Analysis

    Commodities: Has Their Time Come Again?

Trading Center