Thursday, October 27, 2011

Moody's, McGraw Hill Still Don't Rate

Remember the financial crisis? That was way back in 2008 when all that AAA-rated sub-prime mortgage backed debt turned out not to be worth as much as the ratings suggested. For that, we can tip our hats, in part, to Moody's (NYSE: MCO) and McGraw Hill (NYSE: MHP).

But recently, these paragons of corporate virtue are trying to boost their image. So they're getting tough. Most recently, in August McGraw-Hill's S&P decided to downgrade the U.S.'s credit rating. A move that had exactly the opposite effect as had been intended -- investors scrambled to buy the U.S. 10 year bond, driving its interest rate down 35%.

Before delving into their recent performance, it's worth thinking a moment about why a tip of the hat is due to the ratings agencies. Contrary to the popular refrain in 2008, there were plenty of people who saw disaster coming before the financial crisis. In December 2006, I recommended betting on a drop in the price of a big sub-prime mortgage lender, NovaStar (PK: NOVS) -- its stock has since lost 99.7% of its value -- plunging from $106 to $0.36.

And without ratings agencies, NovaStar and its peers would never have grown as much as they did. How so? As I wrote in August 2007, the rating agencies wrapped that financial toxic waste in gold. Moody's and S&P used data supplied by the investment banks that pooled sub-prime mortgages to compete with each other to win lucrative ratings business from those banks.

The winner of some $3 billion in ratings business for this toxic waste was the agency willing to supply a AAA rating on the increasingly low quality pools of mortgages so investors around the world would be cleared to buy them. And as good quality borrowers had all taken on as much debt as they could, the lower quality loans supplied by the likes of NovaStar were the only thing left to fill the pipeline.

Thursday, Moody's reported on how it's been doing in the wake of this disaster -- and it put in a mixed performance. It was expected to report EPS of 49 cents down 15% from the year before on $542.8 million in revenue, up 5.7%. Its actual revenue was $531.3 million for the quarter -- 2.2% below expectations and its EPS of 57 cents beat expectations by over 16%.

And Moody's gave an upbeat outlook -- its CEO noted, "we are reaffirming our 2011 EPS guidance of $2.38 to $2.48 and we expect to be at the upper end of the range."

Meanwhile, McGraw-Hill has decided that it does not like all the attention it got for its S&P unit during the downgrade episode. So it announced in September that it would spin out S&P. And that will mean giving up a strong financial performer. After all, S&P - newly dubbed McGraw-Hill Markets will have $4 billion in revenue while the publishing business - McGraw-Hill Education will have only $2.4 billion in revenue.

When McGraw-Hill reported its third quarter results, they disappointed analysts. It $365.6 million in net income was down 3.8% from the year before and it missed by two cents analysts' $1.23 forecast for earnings. Not only that but McGraw-Hill lowered its full-year profit forecast as sales from its textbook division dropped for a fourth quarter in a row, while its credit-ratings revenue fell along with a drop in corporate bond issuance.

So does this mean you should skip McGraw-Hill shares and buy Moody's? Unless you like overpaying, you should skip.
  • Moody's: Steady growth, good margins; expensive stock. Moody's sales have increased 13.1% in the past 12 months to $2.3 billion while net income jumped 26% to $618 million – yielding a whopping 27.6% net profit margin. Its PEG of 2.89 (where a PEG of 1.0 is considered fairly priced) is expensive on a P/E of 12.71 and expected earnings growth of 4.4% to $2.60 in 2012.
  • McGraw Hill: Slow growth, decent margins; expensive stock. McGraw-Hill's sales have inched up 3.6% in the past 12 months to $6.25 billion while net income jumped 13.4% to $852 million – yielding a 14% net profit margin. Its PEG of 1.23 is high on a P/E of 15.64 and expected earnings growth of 12.7% to $3.20 in 2012.
With the situation in Europe seemingly resolved -- the global ratings businesses of both companies could improve. In that case, McGraw-Hill looks like the least expensive way to invest in a possible business rebound. But I might wait until McGraw Hill Markets is separately traded. Meanwhile, Moody's valuation is too darned high.


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