After Changing Focus, S&P; Parent McGraw-Hill Rates as Hot Stock

Pop quiz: Name a bond specialist with a hot stock.

Points if you answered McGraw-Hill Cos., the 110-year-old information and publishing concern whose major units include giant bond-rating agency Standard & Poor’s and financial magazine Business Week.

McGraw-Hill, which is also a leading provider of textbooks and other education materials, actually has been on a roll for the last five years. The New York-based company has churned out double-digit annual earnings growth during the period, and its stock has posted a total return (25% a year on average) that has outpaced Wall Street’s benchmark indicator--which happens to be the Standard & Poor’s 500 index.

And in just the last three weeks, the stock has surged an additional 18% in response to the company’s third-quarter results, which surpassed Wall Street forecasts. McGraw-Hill closed Friday at $89 a share, up 31 cents on the day, in composite trading on the New York Stock Exchange.

All of which paints a far different picture from several years ago, when McGraw-Hill was struggling with uneven earnings growth and a languishing stock price.

What happened? “Over the last five years, the company has changed its business mix,” said analyst Peter Appert of BT Alex. Brown. “Now, it has better profitability, more consistent growth and a higher valuation for the stock.”

Specifically, McGraw-Hill bought and sold divisions and made other strategic moves to bolster and broaden its S&P; and education lines, whose revenues come from service fees and product sales.

That, in turn, made McGraw-Hill less reliant on its publishing and broadcasting interests and their cyclical advertising revenues, which were subject to the vagaries of the U.S. economy and the financial markets.

“We were very concerned about the cyclicality of our earnings stream” at the time, McGraw-Hill President Harold “Terry” McGraw III, who also became chief executive this spring, said in a telephone interview.

At the same time, he said, McGraw-Hill realized that Standard & Poor’s was a business “under-leveraged and under-exploited.”

S&P;’s basic business is assigning investment ratings to bonds and other debt securities, a market where its archrival is Moody’s Inc., a unit of Dun & Bradstreet Corp. The ratings give investors a guide to a debt’s riskiness and thus help determine what interest rate the debt will carry.

But that business ebbs and flows with the number of new debt issues coming to market. So McGraw-Hill has been broadening the services S&P; provides and expanding them to foreign markets, to smooth out its revenue growth. “We got into new [rating] areas, like structured-finance, insurance, financial institutions and international,” McGraw said.

S&P; also now rates mutual funds, and it provides financial data and services about retailing, energy, commodities, real estate and investing--items it targets to customers in those specific industries.

The result: S&P; is now McGraw-Hill’s biggest profit center, accounting for 45% of its total operating earnings last year. That compares with 31% for education and 24% for its media group, which not only includes Business Week but Aviation Week & Space Technology magazine and four ABC network-affiliated television stations, including KGTV in San Diego and KERO-TV in Bakersfield.

Put another way, McGraw-Hill now counts on advertising sales for less than 15% of its total revenue, contrasted with 50% about 15 years ago.

To be sure, McGraw-Hill’s emphasis on S&P; in recent years was fortuitous because it dovetailed rallies in the financial markets, including a surge of new debt issues sparked by low interest rates. But in light of the markets’ recent volatility, some McGraw-Hill trackers are fretting that the company’s momentum could stall.

David Toung of Argus Research is one of two analysts who downgraded their ratings on McGraw-Hill recently, partly because he’s concerned that the volume of new debt issues is dropping off, which could slow S&P;’s sizzling growth.

“With the turmoil in the financial markets being what it is, along with the slowdown in new issues, that’s going to hurt revenue for Standard & Poor’s,” Toung said.

Appert agreed that S&P; “will grow at a slower rate in 1999 than you’ve seen in the last couple of years.” But that’s not as perilous for McGraw-Hill as it would have been a decade ago, he said.

That’s because S&P; also changed how it prices many of its products and services. In some cases, it no longer charges an issuer one fee for each new bond sale, but rather charges annual “surveillance fees” that are “based on the range of issues that the [issuing] company plans to place,” according to analyst Lauren Rich Fine of Merrill Lynch & Co. That also helps even out S&P;’s revenue.

In education, meanwhile, McGraw-Hill is a leading publisher of textbooks, tests, multimedia programs and other learning materials for all levels of schools and colleges nationwide. And that group is thriving right now.

The number of school-age children is growing, and demand from schools needing to replace their books is strong, analysts said. Also, states such as California are boosting the money spent on books and other learning materials.

“Regardless of what the economic conditions are, the funds are there for these [education] materials,” so the business is “recession resilient,” McGraw said.

McGraw-Hill’s third leg, its media group, has been less stellar of late. In the third quarter, its operating profit (exclusive of one-time items) rose only 4% and its revenue fell 6%.

The TV stations had lower earnings and revenue, partly because of lower ABC network ratings. Business Week’s ad pages, which have enjoyed substantial growth in recent years, were “virtually flat” in the third quarter compared with a year earlier, though the pages did yield somewhat higher earnings and revenue, McGraw-Hill said.

And in all of its divisions, McGraw-Hill has pushed to distribute its mountains of information digitally, not just on the printed page--and that’s also fueled the company’s gains, analysts said. Customers can now get its information and publications via fax, computer CD-ROMs or online through one of the 80 Internet sites McGraw-Hill has opened in recent years.

Appert credits much of that shift to the 50-year-old McGraw. The great-grandson of company co-founder James McGraw, he succeeded chairman Joseph Dionne as CEO in April, thus becoming the first McGraw to run the company since Dionne got the post 15 years ago.

Not that the McGraw family was ever far from the scene. James McGraw’s heirs together still own just less than 20% of the company, and the family’s net worth totals about $1.5 billion, according to Forbes magazine.

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McGraw-Hill’s Rise

McGraw-Hill’s stock has rallied on the strength of the company’s information service for the financial and education markets.

Friday: $89

At a Glance

Company: McGraw-Hill Cos.

Business: Information services, publishing, broadcasting

Headquarters: New York

Founded: 1888

Employees: 16,000

Annual revenue: $3.5 billion

Sourcew: Bloomberg News