S&P Global - Earnings Call - Q1 2011

Transcript

Speaker 8

Morning and welcome to the McGraw Hill Companies' First Quarter 2011 Earnings Call. I'd like to inform you that the call is being recorded for broadcast and that all participants are in a listen-only mode. We will open the conference to questions and answers after the presentation, and instructions will follow at that time. To access the webcast and slides, go to www.mcgraw-hill.com and click on the link for the earnings announcement conference call. At the bottom of the webcast page are two links. If you are listening by telephone, please select the first link for slides only. For both slides and audio via webcast, select the Windows Media link. If you need any technical assistance, press star zero and I will assist you momentarily. I would now like to introduce Donald Rubin, Senior Vice President of Investor Relations for the McGraw Hill Companies. Sir, you may begin.

Speaker 7

Thank you. Good day to our worldwide audience. We thank everyone for joining us today for McGraw Hill's First Quarter 2011 earnings call. I'm Donald Rubin, Senior Vice President of Investor Relations for McGraw Hill Companies. With me today are Harold McGraw III, Chairman, President, and CEO, and Jack Callahan, Executive Vice President and Chief Financial Officer. This morning, the company issued a news release with First Quarter earnings results. We trust you all have had a copy and 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 is www.mcgraw-hill.com. In today's earnings release and during the conference call, we are providing adjusted revenue, free cash flow, and net cash information.

This information is provided to enable investors to make meaningful comparisons of the company's operating performance between periods and to view the company's business from the same perspective as management's. The earnings release contains exhibits that reconcile the differences between the non-GAAP measures and comparable financial measures calculated in accordance with US GAAP. 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 are aware that we do have some media representatives with us today on the call. However, this call is for investors, and we would ask that questions from the media be directed to Jason Feuchtwanger in our New York office at area code 212-512-3151 subsequent to this call. That's 212-512-3151. Today's update will last approximately an hour. After our presentations, the meeting will be open to questions and answers. It's now my pleasure to introduce Chairman, President, and CEO of McGraw Hill Companies, Harold McGraw.

Speaker 5

Okay. Thank you, Don, and good morning, everybody, and welcome to our conference call. As Don said, with me today is Jack Callahan, our Chief Financial Officer. We're going to review the First Quarter results and the outlook for McGraw Hill Companies for the rest of 2011. Following our presentations, Jack will discuss the key financials, and then we'll go to any questions or comments that anyone has. As we reported earlier this morning in our news release on the First Quarter results, a promising year is off to a good start. Earnings per share grew by 18.2% to $0.39 a share. Revenue grew by 7.7% to $1.3 billion. Our new segment, McGraw Hill Financial, is unlocking new value. Let's start today's call by reviewing the performance and the prospect, and begin with McGraw Hill Financial.

McGraw Hill Financial is off to a strong start, adding subscribers, 74% of the revenue comes from subscriptions, and growing in both international and domestic markets. In the First Quarter, revenue with the addition of markets.com increased by 16.2% and 11.9% without the acquisition. Operating profit grew by 35.3%. The operating margin expanded to 29.7%. McGraw Hill Financial is focused on integrating and evolving its capabilities into one scaled operation, offering global financial professionals our high-value content across all asset classes. We continue to make progress in leveraging our intellectual property across the new organization while growing individual businesses. This activity involves developing innovative and integrated solutions for clients to manage investment and trading strategies. Case in point, a new leveraged loan index for our benchmark group that was created in collaboration between two McGraw Hill Financial businesses, S&P Indices and S&P Leveraged Commentary and Data.

Designed to expand S&P's family of fixed income indices, the index became the basis of the first bank loan exchange-traded fund to hit the market. Assets under management in the new Invesco PowerShares leveraged loan ETF hit $70 million in the first month. This is just one of 32 new exchange-traded funds based on S&P indices that were introduced in the First Quarter of 2011. 18 of the new ETFs, by the way, were launched outside the United States. We now have 333 exchange-traded funds linked to S&P indices with $323 billion in assets under management. By the way, that's a 27% year-over-year increase. As this table illustrates, we maintain an active ETF pipeline to drive revenue growth. Besides driving revenue growth, these new ETFs have also diversified our product offering.

In 2006, 62% of assets under management in exchange-traded funds were tied to our largest ETF, and of course, that's the SPDR S&P 500. At the end of 2010, the percentage has dropped to 43%, reflecting the diversification of our ETF revenue across different asset classes and different geographies. Expect more collaboration and diversification. In the integrated desktop solutions group, subscriber demand for Capital IQ data, ratings content from the Global Credit Portal, and the addition of markets.com got the year off to a very strong start. Integration of markets.com is proceeding smoothly. You can now access the markets.com product via the Capital IQ platform. In the First Quarter, Capital IQ grew its client base to more than 3,600, and that's a 23% year-over-year increase.

The Enterprise Solutions Group was formed to integrate multiple cross-asset datasets and to streamline the delivery of McGraw Hill Financial, S&P, and third-party data into one platform. That means, for example, introducing new integrated technologies such as application program interfaces or API to enable clients to more easily incorporate data directly into their systems and into their workflows. Easier access to more information is obviously good for business and allows for greater insight and transparency into the markets our customers serve. We continue to see demand for our data in both pre and post-trade markets. For example, Global Data Solutions continues to grow the number of clients who are buying multiple services instead of just one-off datasets, especially in global markets.

We are also pleased to report that in The Wall Street Journal's new annual survey of "the best analysts on the street," Standard & Poor's Equity Research leads the list of 86 firms with 10 winning analysts. The "best on the street" survey identifies the top five analysts in 44 sectors based only on stock picking skills. To be eligible, analysts generally had to follow at least five stocks in an industry group during the year. Nearly 7,000 analysts and more than 500 firms were surveyed. The Wall Street Journal Online announced the winners last week. The newspaper will publish the formal list on May 10th. S&P's Equity Research is an important resource for Market Scope Advisor, which is an online service for more than 80,000 financial advisors. Going forward, S&P Equity Research will be available on Enterprise Solutions and through our integrated desktop solutions group.

Clearly, McGraw Hill Financial is off to a very good start and is finding new ways to unlock value. Let's sum up then for McGraw Hill Financial. We expect double-digit revenue and operating profit growth this year, a combination of strong organic growth and the acquisitions of markets.com. Okay, let's move over to Standard & Poor’s. Powerful trends and record issuance in global bond markets were evident in Standard & Poor’s First Quarter top-line performance. Revenue grew by 10.4%, but operating profits increased by 0.8%, primarily because of timing issues, difficult expense comparisons, and a decline in structured finance. The operating margin was 43%. With year-over-year cost comparisons easing in subsequent quarters and favorable market trends expected to continue, we now anticipate that Standard & Poor’s operating profit will accelerate for the balance of the year.

That implies about 10% growth over the balance of the year to meet our current forecast of high single-digit operating profit growth for the full year. Let's start by reviewing the difference between the top and bottom line growth in the First Quarter. First, foreign exchange negatively impacted profits in Q1. While foreign exchange rates increased S&P revenue by $1.9 million, it reduced operating profit by $6.1 million. Excluding foreign exchange, revenue grew by 9.9% and operating profit increased by 4.1%. Second, the First Quarter represented S&P's most difficult expense comparison. Q1 2010 margins were 47%, the highest of the year, versus a full year 2010 adjusted margin of 44.5%. That record was achieved despite the fact that Q1 2010 was S&P's lowest revenue quarter of the year and lower than the First Quarter of 2011 by $42 million. Third, expense comparisons will become easier as the year progresses.

S&P has made significant investment in technology platforms and staff to deal with the new regulations of credit rating agencies. That's the QCCR program that you've heard us talk about. Again, QCCR stands for Quality, Criteria, Compliance, and Risk, which are managed independently of the ratings business. In 2010, we incurred incremental QCCR costs of $17 million with efforts focusing on the implementation of the European Union and Japanese requirements, which were effective towards the end of the year. As a result, this increase was almost entirely realized in the second half of 2010, making first-half comparisons particularly challenging. For 2011, we anticipate an incremental increase of $12 million-$15 million and expect the increase to be more evenly spread. In subsequent years, we expect QCCR costs to increase at a lower rate, level off, and possibly decline as new regulatory requirements subside.

Staffing increase, mostly at CRISIL in India, includes the acquisition of Pipal Research late in 2010. The factors that helped produce a strong close in the fourth quarter last year underpin our solid top-line growth in the First Quarter of 2011 and our prospects for the remainder of this year. Transaction revenue at Standard & Poor’s grew by 17.2% in the First Quarter as worldwide high-yield corporate bond issuance of $124.4 billion eclipsed the previous record of $121.1 billion set in the fourth quarter of 2010. A key contributor to this performance was European high-yield issuance, which grew by 95% to $36.3 billion in the First Quarter, and that's a new record too. A solid increase in investment-grade bonds and robust growth in bank loan ratings also contributed to our growth. As this table shows, refinancing was key to the high-yield volume.

According to the S&P Leveraged Commentary and Data Group, 64% of the proceeds were used for refinancing in the First Quarter. Coincidentally, refinancing activity also represented 64% of the high-yield bond volume last year. The rapidly growing leveraged loan market remains centered around what S&P calls the three Rs of leveraged lending: repricing, refinancing, and recapitalization. There is still unrealized potential in this market. S&P estimates that there are $5.6 trillion in bond and loan maturities coming due in the U.S. and Europe between 2011 and 2014. While some of the 2011 maturities have already been refinanced coming into this year, S&P estimated maturities in the range of $1.2 trillion-$1.5 trillion per year between 2011 and 2014. An improving economy, low default rates, and very low yields on less risky debt should keep investors focused on opportunities in the high-yield and leveraged loan markets all year.

In the search for yields, some investors are tuning out concerns about risk. We have seen deals oversubscribed for companies with B- ratings. The increased role of hedge funds in the high-yield market has also opened up a bigger market for CCC-rated debt. The search for yield will persist as interest rates remain low and spreads, the excess interest rate over Treasury bonds, remains high. As this table shows, the speculative-grade composite spread had tightened to 478 basis points at the end of the First Quarter. Both speculative-grade and investment-grade composite spreads at the end of the First Quarter were well below the five-year daily moving average. An increasing active M&A market should also contribute to growth in new issuance. With banks less willing or less able to lend, new borrowers will turn to the public debt markets.

We continue to move ahead without much help from the public or the structured finance markets. Public finance issuance fell by 52% in the First Quarter. The decline is largely attributed to the expiration of the Build America bond program at the end of 2010. It may take some time for the public finance market to show year-over-year growth. The structured finance market was mixed, soft in the United States and more active in Europe. Even with the decline in structured finance surveillance due to the defaults and maturing deals, non-transaction revenue grew by 6.3% to $266.6 million and represented 60.2% of S&P's total revenue in the First Quarter. Non-transaction revenue now includes a royalty of $15.2 million, which McGraw Hill Financial pays for the right to use and distribute S&P's content.

Increased revenue from CRISIL, our majority-owned company in India, and non-issue-based analytical services also helped offset the decline in structured finance. We confidently expect S&P's non-transaction revenue to continue growing in 2011. Earlier, I reviewed the costs of creating our QCCR framework to deal with regulations. We expect more regulations this year. There will be some new rules from the Securities and Exchange Commission to implement requirements mandated by the Dodd-Frank Act. New rules have been passed in Hong Kong, and we anticipate new regulations from Canada and Singapore. Many of them incorporate European Union requirements in an effort to meet EU equivalence requirements for the endorsement and compliance with IOSCO Model Code of Conduct for rating agencies. That's the Security Commissioners out of Madrid. We are also working with regulators and market participants on the implementation of new rules for credit ratings in the European Union relating to endorsement.

The bottom line, S&P has implemented a sound and effective control framework to accommodate compliance with additional regulatory requirements. We continue to make progress on the legal front. To date, 20 of our motions to dismiss have been granted in their entirety. Eight more lawsuits have been voluntarily withdrawn. It's also worth noting that five of the dismissed cases involved fraud charges. As we have said all along, we continue to believe the legal risk is low. In the Calpers case, a hearing has been set for August 23rd on whether the plaintiff can demonstrate that it has substantial evidence to support each element of its claim and if there is a probability of success on the merits of its claim. The burden shifted to Calpers after the court granted our motion that the complaint fails under a California statute protecting speech made in the public interest.

Discovery continues in the Abu Dhabi case. In the Anschutz case, a New York court dismissed the plaintiff's claim of negligent misrepresentation in regard to the securities issued by Merrill Lynch. In the California federal court, the same claim involving securities issued by Deutsche Bank survived a motion to dismiss. We have asked the California judge to permit us to seek an appeal of this decision to the United States Court of Appeals for the Ninth Circuit in view of the clear conflict with the New York federal court's dismissal ruling. Overseas, we have submitted our final brief in the Parmalat case and now await a ruling. Last week, a German court dismissed another lawsuit relating to S&P's layman's ratings, recognizing that ratings disseminated globally from our US ratings business should not subject S&P to lawsuits in Germany without a specific connection to that nation.

Let's sum up then for Standard & Poor’s. Legal risk remains low. Regulatory issues are manageable. High single-digit revenue growth for 2011. Operating profit will accelerate for the balance of the year and grow in the high single digits for the full year. With that, let's go on to McGraw Hill Education. For McGraw Hill Education, in the First Quarter, revenue decreased by 4.6%. The operating loss increased by 22.2%, and that was reflecting the revenue decline and ramped-up investment for digital infrastructure that will position us for future growth. Given the seasonality of the education market, we recognize that the First Quarter results are a small fraction of the year and certainly are not indicative of what's ahead for 2011. In the elementary high school market, First Quarter sales are mainly orders for replacement copies. In higher education, the sales mainly reflect last year's adoptions.

In both markets, the First Quarter through mid-May is the major selling season for this summer's orders. Our sales force is in the field and working hard to ensure success in the seasonally important third quarter. There is something different about the First Quarter this year. It is simply this: the robust double-digit growth, particularly in higher education and the professional markets. Digital products and services are the harbinger of change that is coming in the education market. No one can be sure when the tipping point will occur, but we cannot sit back and wait for it to arrive. Our investment in digital capabilities and capacity builds on McGraw Hill Education's continued success in the marketplace.

It positions us to meet the growing demand for our digitally delivered products that is already evident in testing in K-12 and higher education and in professional markets, and it will support the launch of a broad array of new digital products that are now in our pipeline. The heightened investment in digital products reflects the opportunity created by our market's increasing capacity to utilize wholly digital products delivered online, whether through numerous sites that McGraw Hill operates, sites maintained by educational entities ranging from individual public schools in the U.S. to major colleges and universities around the world, or sites operated by third-party providers such as Amazon. For two decades, McGraw Hill Education has been able to supply significant content in digital form, owing to ongoing investments in the transformation of our internal publishing processes.

That transformation is now complete, enabling us to pour content into a variety of formats, print or digital, as indicated by market demands. These investments are already enhancing our opportunities for 2011 and beyond. New and forthcoming digital products from McGraw Hill Education represent a new generation of digital resources, a far cry from the static PDF versions of print books. They feature the interactivity and audio-visual capabilities of digital media that a critical mass of customers now have the bandwidth to access and to fully utilize. Our new products are designed to differentiate us from others and genuinely enhance the teaching and learning experience. In the K-12 market, there are the recent releases of Cinch Math and Cinch Science, full curriculum basal instructional materials delivered online. We are the only publisher to offer comprehensive all-digital programs in these subjects.

In the testing market, the shift to online testing and all-digital reporting is a growing trend. With Acuity, our leading product in the formative assessment market, students can be tested online using paper and pencil or with handheld response devices. Increasingly, schools are choosing the online option. In higher education, we have McGraw Hill Connect, the industry's most advanced homework management platform for students, and Create, a digital publishing system that allows instructors to build customized e-books for their courses. We have the highly sophisticated computer-adaptive tutoring programs, LearnSmart and ALEKS. For several years now, all of our frontlist higher education titles have been available for purchase as e-books from a wide variety of vendors and for a wide range of e-reading devices. In professional markets, we are seeing steady increases in the number of subscribers, domestic and international, for our digital resource sites in medicine, engineering, and business.

More than 6,000 of our professional titles are currently available as e-books, and we are introducing a line of enhanced e-books featuring embedded audio and video content. Our product line of downloadable applications for mobile devices is also going strong in the professional market. We offer more than 150 apps for business, medical, technical, and educational test preparation, and another 75 apps will be added this year. The growth of digital products clearly requires technology systems, robust platforms that guarantee product performance. That is a second factor in our increased investments. As the delivery of digital content has shifted away from CD-ROMs and local servers to the internet, it is imperative for online providers to ensure reliable accessibility and functionality 24/7. That's why we recently made a substantial investment in the creation of a state-of-the-art digital hosting and support center, which is paying off in increased product reliability.

With the higher usage we are experiencing for current products and with many new projects in the pipeline, including the expansion of online testing, we will be making incremental investments in infrastructure and utilizing the cloud to ensure our capacity as well as our ability to provide the necessary levels of expert customer support. We expect our digital products and services to produce another solid year of growth in 2011. As the second quarter selling season progresses, we are monitoring district adoption activity levels, state funding developments, and buying patterns across our markets. We think the LI market is stabilizing. The state new adoption market could still meet or exceed 2010 levels. That depends to a great extent on the Texas legislature and how it funds instructional materials.

We probably won't know much about which programs will be funded and for how much until sometime in May, maybe towards the end of May. We are currently also very carefully watching North Carolina. There's a reading and literature adoption that was recently called for purchase this year, but here again, the funding has not been approved, and we're waiting for that. There are signs of pent-up demand in the open territory, which is very pleasing, but it's still early days in this market and too soon to make a forecast. In the US college and university market, we still believe the market will grow between 4% and 6%. Enrollments are expected to show modest growth after the surge in the last two years. In 2011, we will begin to see the benefits of our Blackboard connection.

It's hard to overstate the value of offering students and instructors a single point of access to content and study tools through Blackboard's learning management system. Earlier this month, we expanded what began as a domestic arrangement with Blackboard to international markets as well. Let's sum up. Our expectation for the education market: flat to minimal growth in the elementary high school market, 4% to 6% growth in the US higher education market. For McGraw Hill Education in 2011, revenue growth in the low single digits, a decline in operating profit driven by investments, especially for digital developments. The decrease could range from mid-single digits to high single digits. Finally, let's review McGraw Hill Information & Media. In 2010, this segment substantially improved its operating margin. At that time, we said the improvement was not a one-year phenomenon. We said the new level was sustainable.

In the First Quarter, Information & Media started delivering on that promise of sustainability. With revenue growth of 10.3%, the operating margin improved to 16.4%, up from 13.5% for the same period last year. We are benefiting from the growth in key markets. What is less well recognized is that our business-to-business group is now primarily a subscription business delivered digitally. Currently, more than 70% of the B2B group's revenue is digital. Revenue for the B2B group increased by 10.3% in the First Quarter, fueled by growth at Platts, J.D. Power, and the acquisition of Ventech Energy in January. Platts has a strong position in the data, price discovery, and market news across many commodities, including oil, natural gas, coal, metals, petrochemicals, nuclear, and electricity. Acquiring Ventech Energy is Platts' latest step to expand its capabilities in core markets.

As this graph illustrates, Ventech, with its expertise in natural gas, adds to Platts' capabilities in three key areas along its value chain. The goal is to embed our news and prices in the trader's workflow and provide new analytical capabilities. The growing demand for oil and the uncertainty of supplies create energy price volatility and new clients for the entire range of Platts' products and services. That was evident again in Platts' First Quarter performance. J.D. Power also grew globally, benefiting from the recovery in domestic and international auto markets. The growth was not limited to the automotive market. J.D. Power also showed gains in healthcare, financial services, and in insurance markets. J.D. Power expects continued recovery in the worldwide automotive markets. J.D. Power now forecasts 7% growth this year in global light vehicle sales and 20% growth in the United States.

A pickup in automotive time sales and increased retransmission revenue contributed to McGraw Hill Broadcasting's 10.2% increase in First Quarter revenue. Therefore, summing up for Information & Media, revenue growth in the mid-single digits, adjusted operating profit growth in the mid-single digits as well. Wrapping up then for McGraw Hill Companies overall, we are obviously very pleased with the solid start to the year, but the First Quarter is seasonally small. We continue to maintain our guidance of diluted earnings per share of $2.79-$2.89. With that and our fourth segment, let me turn it over now to Jack Callahan, our Chief Financial Officer, for some added financial guidance. Jack?

Speaker 2

Thank you, Terry. Good morning to everyone on the call this morning. It is a pleasure to review with you a strong start to 2011. Today, I will focus on our robust cash outlook and strong financial position, capital allocation, and a couple of corporate items. We continue to expect another year of strong cash flow. Before dividends, we expect to generate cash flow greater than $1 billion. After dividends, free cash flow is projected to be in excess of $700 million. We expect to generate this strong free cash flow despite increased capital investments. For 2011, we continue to expect pre-publication investment of roughly $200 million-$225 million, or approximately a $50 million-$75 million increase versus 2010, which was an unusually low year. Capital expenditures are projected to be up to $150 million, driven in part by increased digital and technology investments.

This compares to $115 million in 2010. We are extremely well capitalized, with net cash and short-term investments at quarter end of approximately $100 million. Cash and short-term investments at the end of the quarter totaled $1.3 billion, while gross debt was comprised of approximately $1.2 billion in long-term unsecured senior notes. No commercial paper is outstanding. Turning to capital allocation, we spent $250 million in total on acquisitions and share repurchases in the First Quarter, which were the primary drivers of the $250 million decline in cash and short-term investments from year end. We spent $126 million on acquisitions, the most notable being the Ventech Energy acquisition, which, as Terry discussed, is now part of Platts in the Information & Media segment. In Q1, recent acquisitions accelerated revenue growth by approximately 150 basis points, while the profit impact was modestly dilutive. We also actively repurchased shares in the quarter.

We repurchased 3.3 million shares for approximately $124 million, averaging $37.44 per share. A step up in share repurchases this year versus our initial guidance is under consideration given our cash position and a reduced cash commitment for acquisitions now that the previously announced Opus transaction has been withdrawn. As a reminder, there are 5.1 million shares remaining in the current 2007 program. To further increase buybacks, a new program would need consideration and formal authorization by the Board of Directors. Going forward, our robust free cash flow and strong balance sheet enable us to selectively add attractive, strategically relevant businesses like Ventech to the McGraw Hill portfolio while continuing to return cash to shareholders via share repurchases subject to market conditions. Now finally, let me address some corporate items. Corporate expense was $34 million in the quarter and decreased by 4% or $1.5 million from the prior year.

2011 expense benefited from a decline in real estate costs as well as tight cost control. For the full year, we expect corporate expense to increase in the mid-single-digit range versus 2010, adjusted to corporate expense of $164 million. The 2010 expense excludes the one-time charge of $15.6 million related to sub-leasing excess space in the company's New York facilities. Net interest expense was $19 million in the First Quarter, a modest decline of $3 million versus prior year. We still expect full-year interest to be largely comparable to 2010, which was $82 million. Our effective tax rate was 36.4% in the First Quarter, flat versus last year. Net income attributable to non-controlling interest was $4.2 million, largely driven by Crystal.

Our diluted weighted average shares outstanding for the quarter was 309.6 million, a 6.7 million decrease from the prior year, and a 0.7 million decrease from the fourth quarter 2010. The decline is due primarily to share repurchases, which more than offset equity-related awards. In closing, I appreciate all the hard work from our associates across McGraw Hill Companies to deliver a solid start to 2011, and we appear to be on track for a good year. Now, let me turn the call back over to Donald Rubin for the Q&A session. Don.

Speaker 7

Thank you, Jack. Just a couple of instructions for our phone participants. Please press star one to indicate that you wish to enter the queue to ask a question. To cancel or withdraw your question, simply press star two. If you've been listening through a speakerphone but would now like to ask a question, we ask that you lift your handset prior to pressing star one and remain on the handset until your question has been answered. This will ensure good sound quality for everyone. We're now ready for the first question.

Speaker 8

Thank you. Our first question today is from William Bird with Lazard. Your line is now open.

Speaker 6

Thank you. Terry, I was wondering if you could just elaborate a little bit more on what you're seeing in the S&P pipeline. Your outlook for higher ed seems to be at odds with the recent declines you've seen. I was just wondering what you expect to drive growth in that subsegment. Thank you.

Speaker 5

Yeah, thanks. Yeah, the S&P pipeline continues to be strong. Obviously, the structured finance side is soft, especially here in the United States. Although we're seeing some activity in asset-backed deals, and we expect a pickup in the commercial mortgage-backed market, the residential mortgage-backed market obviously remains very low. Where we are starting to see some structured activity is in Europe, and that's starting to pick up. Again, the corporate market, sovereign market, the muni market is off as conditions exist state by state and city. Also, Bill, we're seeing a lot in the high-yield market and a little bit in the CLO market. From a pipeline standpoint, it's quite good. We were pleased with the 10.4% revenue increase, and we expect that to continue into the rest of the year.

As far as higher ed goes, Bill, the move on the digital side is really helping us on that, not only in the professional side, but more importantly with McGraw Hill Connect and those capabilities. We're going to continue to push very aggressively on that. We will continue. It's a little early. The 4% to 6% I think is conservative. On that one, we'll see where we go with that and probably have a little better indication as we get closer to June on that part. It's solid on that part, and we expect it to be a good generator for us for the full year.

Speaker 2

Bill, in higher ed more specifically, I think on our last call we spoke to a little bit of weakness in our results as we ended 2010 and into the early part of 2011. We did see a bit of a pickup as we closed out Q1 in March, and early indications that April is off to a solid start. It looked like a bit of a rebound from the trends we had spoken to earlier.

Speaker 6

Great, thank you very much.

Speaker 8

Thank you. This question comes from Peter Appert from Piper Jaffray. You may ask your question.

Speaker 3

Thank you. Terry, the strength in the McGraw Hill Financial business is particularly impressive. Just a couple of questions on that. First, the margin of 29.7% you did in the First Quarter, do you think that's a reasonable run rate for the year? Secondly, as we think about the four segments, maybe you mentioned this and I didn't get it, but was there one particular product line or segment that drove the year-to-year strength that we saw in the First Quarter?

Speaker 5

Yeah. Again, thanks, Peter, because we're very pleased with the start with McGraw Hill Financial. We've known this for a little bit, and unlocking value is, I think, the right phrase here. We've seen good client attraction at Capital IQ. The efforts to integrate all of these businesses in terms of a horizontal platform are going very well. The integrated desk solutions business has been a source of strength for us. It's really been able to combine a lot of different data and to embed it into customer workflows that we're getting that kind of benefit. Obviously, on the index side, continued growth there. We're up to 333 exchange-traded funds based on S&P indices. One of the nice things is that we were talking about the diversification and the geographic distribution is broadening in all of that. We're very pleased with that.

I think that given some of the shifts that you're seeing in terms of the consolidation move, in terms of exchanges and the like, where exchanges are trying to differentiate themselves through product differentiation, it plays to our strength in all that. We're benefiting from that. We're very pleased with the strong start. As far as the margin is concerned, again, because of the royalty rate, it was probably a little artificial at the end of the fourth quarter in terms of where the margin was. We like where the margin is now on this one, and we think that we can do better on that one. We'll see as the year progresses.

Speaker 3

Terry, could I just sneak in one other question unrelated to that? On the education market, the pace of M&A activity has definitely picked up recently. Does McGraw Hill need to make acquisitions or step up spending to stay truly competitive in terms of these digital initiatives?

Speaker 5

You have to differentiate between acquisition and organic growth. Things like McGraw Hill Connect and Create, we've put an awful lot of effort into that digital transformation, and we're benefiting from that. When you start talking about different ways of being able to present content in various platforms, the arrangement that we entered into with Blackboard has helped us a lot that way. We've put a lot of effort into the testing side, and rather than acquiring capabilities, we built the Acuity platform that we're benefiting from now on the formative side. I mean, it's always a balance on that one. If there's a capability that is going to help you accelerate into a particular opportunity, okay. It's a balance between being able to develop that capability or whether you acquire that capability.

Again, in terms of the positioning that we've taken, it's been a combination of both, and we'll continue to watch that balance.

Speaker 2

Yeah, we're continuing to look very closely at those opportunities. I think the two things I would just add on Terry's comments are we just want to be sure that any of these acquisitions really help us accelerate our core strategy and moving forward, they're not distractions. Secondly, we want to be very disciplined when it comes to valuation. Some of these properties are quite rich.

Speaker 3

Great. Thank you.

Speaker 8

Thank you. This question is from Sloan Bolland from Goldman Sachs. You may ask your question.

Hi, good morning. Just a follow-on from Peter's question, just a little bit of trying to dig into what the cost on that digital expenditure is. If you could provide a little bit of granularity, you talked a little bit about digital hosting being one area of it, but maybe if you could kind of break out the buckets of where the spending is. If you could think about maybe just the longer term, what you guys are looking for in terms of return on that invested capital.

Speaker 5

Okay.

Speaker 2

Could you repeat the first part of the question again? I just want to be sure that I'm in the right place.

Sure, Jack. Just in terms of the different buckets for what types of on the digital investment side, you talked a little bit about digital hosting, how much of it's that versus how much of it's investment in the cloud. Just wanted to try and get a breakup because it seems like a big.

At least in the context of, let's say, the education segment, where obviously we have a great deal of work to extend out that digital portfolio. A good part of the, as you said, the year-on-year decline or the increased loss this year versus the quarter of last year was largely related to digital investments, largely in support of our higher ed and to some degree our professional business. I would also add there's also some investment from a hosting point of view as it relates to our online testing capability that we have too within education. Those are the primary drivers in the First Quarter. Going forward, we anticipate that we'll extend more broadly into the K-12 space as we start to move forward on the development of future programs.

Speaker 5

Yeah, I think also, Sloan, that we're all watching the market activity very carefully. In many cases, digital or hybrid product is going to be critical in terms of being able to be successful in some of the adoptions. We are obviously watching Texas very carefully and also North Carolina, as I mentioned, in all of that. It's a little bit too early to tell here. Again, from the transformation aspect of costs associated with digital, you've got to be there on that one to be competitive in those kinds of adoption markets.

Okay. I'll follow up with that one. Just one more if I could. Terry, you talked a little bit about the drivers of the non-transaction revenues at S&P. Could you maybe just elaborate a little bit on what is driving that bigger pool?

When you're talking about the surveillance and the compliance side of this, you've got an awful lot of fees generated with the refinancing activities and the like. Those will continue to be very strong contributors. It's really having to do more with the annual fees associated with surveillance.

Okay. All right. Thank you, guys.

Speaker 8

Thank you. This question comes from Michael Meltz with JPMorgan. You may ask your question.

Speaker 1

Thank you. Two clarifications, then an actual question for you. You reiterated the EPS guidance for the year, and it sounds like through the presentation, you're basically reiterating everything you said back in February in terms of revenues and EBIT projections for the segments. Can you just clarify or do that as true?

Speaker 5

Yeah. Michael, I think that, you know, this is the First Quarter. It's the smallest quarter of the year. We're off to a really good start, and we're pleased with that. It's one quarter and the start of the year. I think the message really is that things are really in shape for a good year here. How good? We'll see as we get a little bit more market evidence, I think. It's shaping up very nicely. At this point, in terms of earnings guidance and the like, it's too early to make any changes that way. The $2.79-$2.89 is, as you say, a repeat from February. We'll see. Let's see where the strength in some of the issuance is. Let's see the continued strength in McGraw Hill Financial across the board. Let's see how Platts and J.D. Power continue.

I think by the time we get together in a couple of months, we'll have a better picture of the full year, and then we can talk about fine-tuning. Right now, it's just one quarter, start of the year. What's pleasing is that it's a good start and that everything is sort of falling in shape the way we were hoping it would. We'll just see how strong it gets.

Speaker 1

Okay. On Peter's question on M&A, the educational M&A, it sounds like from your response, and I don't want to put words in your mouth, but Terry, you said three times capabilities, Jack said discipline, and you don't want distractions. Is the inference that we should take that you are more focused on tuck-unders than larger transformational acquisitions?

Speaker 5

In terms of the opportunity, the market opportunity aspect of this thing, the digital transformation is critical. This is moving at a pace that is very rapid. If you don't have the internal capabilities, you just can't go shopping and buy a little of this and a little of that and overpay and go through all of the integration capabilities and the like. You have to have the internal capabilities to do that. What we have done is both in terms of staffing and in terms of platform capability, we have really put a lot of effort into building that core competency. That's why we've been able to develop McGraw Hill Connect, which is far and away a superior online product. Being able to scale it now even more is going to be very important. McGraw Hill Create is going to be important there.

What we did in terms of getting after administrative platforms is we entered into an exclusive arrangement with Blackboard to be able to accelerate that. As I was mentioning to Peter, the Acuity platform, that was homegrown. That was home-built. We're very pleased with obviously the formative testing market and where that takes us. It's always a balance on that one. Yes, we're looking for components and capability, but whatever it is that you do on that one, you have to have internally the core competencies to be able to grow it. That's the focus that we have taken, and how you get there really is a balance.

Speaker 1

Okay. My actual question, just to drill down a little bit further, and I know you went over this in the slides, the S&P ratings expenses or margin in the First Quarter. Can you just maybe explain again? I guess the EBIT growth was fairly or very light in Q1. The margin was disappointing in Q1. You mentioned compliance costs will decline in the second half year-over-year. I assume the international expansion costs are still in there. The higher markets acquisition costs are still.

Speaker 5

That's right.

Speaker 1

I'm sorry, the other pipeline is still in there. What else will be different? If revenue growth is similar the next few quarters, what else will be different in expenses?

Speaker 5

Yeah, I mean, again, these are all timing issues and factors on this. There are a couple of factors, and we were breaking them down for you. The QCCR program and the data infrastructure aspect has been a big part. Just making sure that our systems are as bulletproof as possible. We have focused a lot on that part, so that's a portion of it. We have investments in analytical resources, and this is U.S., outside the United States, India as well. You have the foreign exchange aspect, both the constant currency and the transaction side. We also had some one-time items from India. You have the real estate gains on one standpoint, and you have the pipeline acquisition on the other. We have broken it down.

What you're looking at in terms of revenue, you had an increase of revenue, and again, in a smaller quarter, $42 million in revenue. That got us the 10.4% revenue gain. In expenses, we had a $40 million increase as well. It's those factors, the categories that did that. We do not see that going forward. We feel very good about the full year profit picture. You will start to see in the second, third, and fourth quarter the profit margin there. We are talking about for the balance of the year, about 10%. That would get you to your low single digit. Now, if we start to see a pickup in some of the issuance, again, especially in the bank loan market in terms of some of the high-yield, in terms of some of the corporates, that will obviously benefit.

We should wait a little bit and see some of that results before we start projecting that. These are just more one-time hits into the First Quarter. We feel very good about the full year. Jack, you want to add anything to that?

Speaker 2

I would just add that a couple of these things are not necessarily new to the First Quarter. They're starting to be layered in last year. If you look at the margin sort of in the back half of 2010 for S&P, they're pretty much in line with the margins that we posted here in the First Quarter. I think as we work our way through these overlaps in the first half of 2011, we'll return to more solid profit growth beginning in the second quarter, and then I think more extensively in the back half of the year.

Speaker 1

Okay, thank you for your time.

Speaker 8

Thank you. This question comes from Craig Huber from Access 342. You may ask your question.

Speaker 9

Yes, good morning. I had a similar question on these costs for S&P. Maybe if I could just ask it a little bit differently here. This $40 million increase in S&P costs year-over-year, how much of that should we think of it's not going to repeat by the time we get to the second half of the year?

Speaker 5

Well.

Speaker 9

We need to break that out.

Speaker 5

Let me let Jack go through more specifically some of the numbers on this. Again, the two big pieces here really are the foreign exchange and also the QCCR. One of the things that we're going to speak, Craig, is that as you know, over the last three years, the investment that we have made in the overall QCCR has been significant. We knew that this was going to peak about now. That's why we came up with a forecast that in QCCR we saw a $10 million-$15 million incremental increase this year. We're taking a lot of that in the First Quarter on that one. The reason that we're very optimistic about the rest of the year is that those costs now significantly subside and are behind us. We'll benefit from that. Again, outside of the India situation, the acquisition there, it's additional investments.

Jack, do you want to give any more color on that?

Speaker 2

I think there's about two-thirds of this increase, I view it as it's sort of being worked into the run rate, that these costs started to be worked into the run rate back in the third quarter of last year. I think we lap that as we get into the back half. In Q1 itself, between currency and some other things, there's probably $10 million, $12 million of sort of one-time impacts that are now behind us.

Speaker 9

Okay. Can you speak about the issuance trends in Asia in the quarter and also the long-term opportunity there?

Speaker 5

The markets are still dominated, obviously, by more of the developed countries. What we're seeing, as you know, is the development of local bond markets literally around the world as there's less reliance on banks. What we're seeing is increased activity in those countries that have to GDP ratios and that are showing nice growth. Obviously, outside of the large developing countries, India, Brazil, and China, you're seeing activity in Malaysia, Korea, and Indonesia, a little bit in Thailand. We have invested significantly in terms of developing local relations in all of those markets. We will continue to see much more participation coming out of the Asian markets and especially out of the ASEAN groups in the years ahead. It's still a smaller portion, and therefore the growth rates are high because it's coming off a low basis. Those markets are going to be quite strong.

Speaker 9

Can you just discuss a little further about your outlook for structured finance for the remainder of the year, please?

Speaker 5

Yeah, I mean, what we're looking at, Craig, is obviously that there is more structured activity that we're seeing coming out of Europe than here. The asset-backed market never went away. I think that there was, given fear and uncertainty, I mean, I think there was less issuance. It never went away, and so that is pretty strong. What we're looking for domestically is probably a pickup in the commercial mortgage-backed market. I think it's going to be a while for the residential part of the market. Again, in terms of some of the collateralized loan obligations and things like that, I think it's an improving picture. I can't say that we're a return to pre-crisis conditions. I think over the next two, three years, whatever, you're going to see just a steady, momentous pickup in structured activity on that one.

I just think there's going to be obviously a lot less risk associated with it, and therefore less yield orientation. It's an improving situation, but slow.

Speaker 9

Great. Thank you.

Speaker 8

Thank you. We will now take our final question from Doug Arthur from Evercore. You may ask your question.

Speaker 4

Yeah. Terry, when you look ahead to the funding situation for the local school districts and states.

The third quarter ally market, you know, how big a role will the federal government play this year as opposed to last year? Is that up, down, flat, or how is it playing out?

Speaker 5

I think it's going to be more of the same. Obviously, we, like you, are watching very carefully how the federal government is implementing some of the Race to the Top funds and the like. There should be a federal improvement that way as more states are pushing for Common Core standards and the like. I mean, it's obviously a question mark. If you take people by their direct comments and words, the federal portion is going to be higher this year, but we got to see it. In some cases, you're seeing more implementation on the Race to the Top, and some people are still pending on that part. Places like Texas, for example, they're going to be fine on their own. We just have to make sure that they're going to do what they say they're going to do on that one.

I think the federal portion in 2011 should go up based on the comments and statements that have been made, but we got to see it.

Speaker 4

Great. Thanks.

Speaker 5

Thanks, Doug.

Speaker 8

Thank you. That concludes this morning's call. A PDF version of the presenter's slides is available now for downloading from www.mcgraw-hill.com. A replay of this call will be available in about two hours. Please note that a replay of this call, including question and answer, will be available.