Buy a McGraw-Hill Break Up?
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McGraw-Hill (NYSE: MHFI) is set to break up into two companies -- McGraw-Hill Financial and McGraw-Hill Education -- by the end of the year.
McGraw-Hill Financial will consist of Standard & Poor's Ratings Services, S&P Capital IQ, S&P Indices, Platts (a commodity information provider), and Commercial Markets (J.D. Power, McGraw-Hill Construction, and Aviation Week).
McGraw-Hill Education will consist of the print and digital textbook and educational services businesses. The decision to break up the company was made to appease shareholders who believed the higher growth financial businesses were trading at the education business's slow-growth multiple. The idea being that once the companies split, the financial business will trade at its deserved higher multiple, and hence, the break up would create value for shareholders. However, after looking at a sum of the parts analysis, I am not sure much value will be created.
First, let us look at McGraw-Hill's business segments more closely. McGraw-Hill derives 44% of its operating income from S&P Ratings, 25% from Capital IQ and Indices, 11% from Commodities and Commercial, and 20% from McGraw-Hill Education. With McGraw-Hill expected to earn $3.70 a share next year, the above segments should produce earnings around $1.64, $0.92, $0.41, and $0.73 a share, respectively. Now we must look at what the market is willing to pay for earnings from each of these segments.
The education business is most comparable to the British educational book publisher Pearson (NYSE: PSO). Pearson, like McGraw-Hill Education, provides a wide array of both printed and digital education services. Because of the similarities in the businesses, I believe the market will pay the same multiple for each. Pearson's current multiple for next year's earnings is around 12.5, bringing the value of McGraw-Hill Education to around $9.25 a share.
S&P Ratings has an obvious comparison in Moody's (NYSE: MCO). With Moody's trading at just over 12 times 2013 earnings, we find the ratings business is worth around $20 a share. S&P Capital IQ and Indices can be compared to the business intelligence services provided by Thompson Reuters (NYSE: TRI). Since Thompson Reuters trades at just over 12.5 times forward earnings, we can assume the IQ and Indices businesses will be valued around $11.50 a share. Lastly, the Commodities and Commercial business lacks a publicly traded comparable company. However, since the business will only be around 14% of the future McGraw-Hill Financial company, it is fair to assume it will trade at the multiple dictated by the larger segments. In this case, the weighted forward price/earnings multiple of McGraw-Hill Financial is just under 12.5. Thus, the remaining business is valued at $5 a share.
The sum of the parts valuation above values the broken up McGraw-Hill company around $45.75, slightly higher than where the combined company currently trades. With Moody's and Thompson Reuters trading at similar forward price/earnings multiples as McGraw-Hill, it appears that shareholders were wrong to assume the education business is currently suppressing the multiple of its higher-growth financial business. For this reason, I do not believe one needs to own McGraw-Hill into the break up nor should one expect a big pop in shares after. However, after the break up, I would look to buy shares of McGraw Hill Financial as I believe S&P Ratings (as well as Moody's) are wide-moat businesses trading at valuations that assume debt issuances will remain at low levels going forward. And thanks to the break up, when the market becomes willing to pay up for these earnings McGraw-Hill Financial will no longer be held back by a slow-growth textbook business.
dtlly has no positions in the stocks mentioned above. The Motley Fool owns shares of The McGraw-Hill Companies. Motley Fool newsletter services recommend Moody's. 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. If you have questions about this post or the Fool’s blog network, click here for information.