Should McGraw-Hill Investors Be Worried About the Lawsuit?

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McGraw-Hill (NYSE: MHFI) is supposed to be a large stable high-yield company, not a volatile stock in the middle of a controversy. Yet that is exactly where the company finds itself, erasing all of its 20% gains over the last year with a near 20% loss during the last two sessions. Therefore, what is it that’s moving this large and stable stock, and what could it mean for the stock long-term?

As a McGraw-Hill author, with a book released last week, I like to think that I have some perspective on this topic. Everyone knows that the publishing industry is on the decline thanks to e-books and changes to technology. However, McGraw-Hill is a company that has continued to perform fundamentally well due to the diversification of its business, including several segments. One of these segments is its rating agency, the S&P, which is currently facing significant pressure from the government.

What’s Going On?

On Monday, the WSJ reported that the Justice Department and state prosecutors intend to file civil charges against the S&P due to wrongdoing on behalf of the rating agency. Supposedly, the government is suing Standard & Poor due to its belief that the rating agency ignored its own standards to rate mortgage bonds that imploded during the financial crisis, which then cost investors billions. S&P has responded by saying that the suit would be “entirely without factual or legal merit” and denied any wrongdoing. The bottom line: The battle between the government and the S&P is setting itself up to be an Ackman-vs-Icahn like event, one that is striking fear into the heart of McGraw-Hill investors.

A Closer Look at the Lawsuit and its Merit

The DOJ submitted a 120 page lawsuit filled with emails, text messages, and documents to prove its case that the S&P (and McGraw-Hill) systematically downplayed the housing crisis to win business from Wall Street. The DOJ is now seeking $5 billion in losses from the S&P, or ultimately, McGraw-Hill. This would be catastrophic for McGraw-Hill, a company with cash of just $1.24 billion, annual net income of less than $1 billion, but does have retained earnings of $7.5 billion. If the government were to win its case it would cripple the company, making its recent 20% loss appropriate for the news. Therefore, I suppose the question is whether or not the DOJ has a basis for its lawsuit, if it will win, and why it’s choosing to chase the S&P now?

Here’s one for the conspiracy theorists: Why would the government be going after the S&P now? Why not in 2010 or in 2011 when it was fresh on our minds? Is it plausible that it “could” have taken four years to prepare the 120 page report, of course! However, the S&P did provide the U.S. with its very first downgrade of debt back in August of 2011 during the debt debates, and is believed to be considering further downgrades pending the outcome of the new debt limit talks. Therefore, it is possible that the government is sending the S&P a warning, because after all, why not go after Moody’s (NYSE: MCO)?

If the S&P is guilty of downplaying the financial crisis then so would other rating agencies such as Moody’s. Moody's traded lower with McGraw-Hill following this news, but investors seem to be discounting the possibility of Moody's connection if in fact this lawsuit materializes. This could be a bad situation for the ratings firm; it has just $4.6 billion in retained earnings but also has over $1.7 billion in debt. Therefore, the company does not have the leverage to weather the storm. When you really think about it, this lawsuit should be an industry-wide event for the rating space, not just one firm, if plausible. As this lawsuit progresses I am sure that the S&P will use this fact to their advantage, or perhaps the government will go after Moody’s as well. Either way, there is sure to be more to the story.

How Will it End?

According to an interview on CNBC with an attorney for S&P, the rating agency earned less than $20 million for its ratings during the housing crisis. He also made a very valid point in saying that the firm’s rating is nothing more than an opinion, one that is made from a systematic approach. Therefore, how can the government prove its case?

My belief is that the DOJ will never win this case, and that its only chance is to attack other rating agencies in the process, such as Moody’s. They simply cannot single out McGraw-Hill’s rating agency, and I am not just saying this because I work for the company, but rather the necessary proof is not present due to it being a system based on opinions. Also, during the time of the housing crisis there were analysts, economics, rating agencies, the Fed, etc. who were all trying to judge the complexity of the housing crisis. Seriously, you didn’t have to watch or read “Too Big to Fail” to know that the government dropped the ball during the housing crisis and completely misjudged its seriousness. Therefore, how can the DOJ target one firm among many? My belief is that they cannot and that McGraw-Hill is presenting a good opportunity due to this recent weakness, caused by the government’s game of revenge for the S&P’s downgrade in 2011.

BrianNichols has no position in any stocks mentioned. The Motley Fool recommends Moody's. The Motley Fool owns shares of The McGraw-Hill Companies. Try any of our Foolish newsletter services free 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 a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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