In Part 9 of the 54 Part Dividend Aristocrats In Focus series, we will look into the growth prospects, valuation, and competitive advantage of financial ratings and research company McGraw-Hill Financial (MHFI, Financial). McGraw-Hill Financial has a 125-year history, and has paid increasing dividends for the last 41 years in a row. The company has benefited greatly from the split of McGraw-Hill Education from McGraw-Hill Financial in 2011. Splitting the company has allowed McGraw-Hill Financial to become a more focused and efficient organization. Since 2011, the company has rewarded shareholders through share repurchases, rising dividends, and strong growth both organically and through acquisitions. This article shows how the McGraw-Hill Financial has achieved its success over the last several years, where it is headed in the future, and if it is currently at fair value or not.
Business overview
McGraw-Hill Financial is organized into 4 lines of business: S&P Ratings, S&P Capital IQ, S&P DJ Indices, and Commodities & Commercial. The company’s S&P Ratings business is by far its largest, accounting for over 40% of revenue and 50% of operating profit in the first half of 2014. A complete breakdown of the company’s revenue and operating profit by business line is below:
Source: McGraw-Hill UBS Best of Americas Conference Presentation
The S&P Ratings line of business rates corporate and government debt, rates bank loans and provides corporate credit estimates. The business also provides credit surveillance, customer-relationship pricing programs and entity credit ratings. The company has rated an amazing $52 trillion of global debt in its history.
The company’s second-largest business line is its S&P Capital IQ Business. This business provides data feeds and enterprise solutions, credit ratings-related informational products, investment research products and advisory services for pricing and analytic analysis.
The S&P DJ Indices division generates revenue through licensing its name to investment products, through data subscriptions and custom indices and through creating OTC and custom derivative products. Finally, the Commodities and & Commercial division provides news, data, price assessments, consulting and custom research for the construction and automotive industry. The Commodities & Commercial business line operates primarily under the Platts, J.D. Power, and McGraw Hill Construction names.
Competitive advantages
McGraw-Hill Financial has managed to increase its dividend payments for 41 years by building a reputation as a trusted rating agency. McGraw-Hill Financial is one of the big 3 rating agencies, along with Moody’s (MCO, Financial) and Fitch Ratings. Together, the big 3 control about 95% of the financial debt rating industry globally. McGraw-Hill Financial’s S&P Rating division enjoys the high margins and low competition characteristic of an oligopolistic market. The S&P Ratings division maintained an operating margin north of 40% from 2009 through 2013. In addition, the company requires very little capital to maintain its operations. The ratings division spends about $40 million a year in capital expenditures and generated an operating profit of $958 million for the full year 2013. Capital expenditures are under 5% of operating profit for the company’s rating division. S&P Ratings possesses one of the most profitable business models anywhere. The company is very unlikely to lose its position as one of the top rating agencies globally as it is thoroughly entrenched. It would take an enormous amount of good will to be able to compete with the S&P Ratings division. Not only is the company’s competitive advantage in ratings highly profitable, it is extremely durable. It would be exceptionally difficult and costly to unseat S&P Ratings due to the company’s history, relationships, respect and goodwill.
McGraw-Hill finance has an even more profitable business unit than S&P Ratings. The S&P Dow Jones business unit has maintained operating margins over 50% since 2009. The business unit had capital expenditures of just $4 million for all of 2013 while generating operating profits of $266 million. The Dow Jones business line is truly exceptional in its ability to generate strong free cash flows. The unit capitalizes on the well established Dow Jones and S&P brand names to generate licensing revenue from expanding index and ETF products.
As a whole, McGraw-Hill Financial’s competitive advantage is based on trust and the respect that comes from being the industry standard. The company has a strong durable competitive advantage that is very likely to continue far into the future.
Future growth prospects
The company’s strong competitive advantage generates significant cash flows, but is the business model scalable? The S&P Dow Jones business continues to grow on rising demand for low cost ETFs. The company generates licensing revenue from ETFs. ETFs continue to gain market share from actively managed mutual funds due to lower expense ratios. Rising demand for ETF products with brand names consumers trust has given the S&P Dow Jones line strong growth. The company grew revenues 27% for the full year 2013 in its S&P Dow Jones business unit. Revenue has grown an impressive (but more modest) 8% for the first half of 2014 versus the second half of 2014 for the S&P Dow Jones business unit. Growth has been spurred by increased ETF AUM, and partially offset by lower than derivative activity. Cash inflows to ETFs are expected to grow by about 11% throughout 2014 according to the Deutsche Bank Outlook for ETFs. During bull markets, ETF cash inflows will remain strong. I expect ETF AUM to continue gaining market share over mutual funds and propelling the S&P Dow Jones business unit’s growth. The unit will likely grow revenue in the high single digits or low double digits as long as the trend toward ETFs continues.
Source: McGraw-Hill Financial 2014 Investor Factbook
The growth driver for the company’s flagship S&P Ratings division is issuance of government and corporate debt globally. Debt issuance has been up significantly since the recession of 2009 due to extremely low interest rates throughout the world brought about artificially by central bank policies. Low interest rates will not and cannot last forever. When interest rates increase, we will likely see a sharp reduction in the amount of new debt issued each year as governments and businesses eschew higher debt payments. Of course, interest rates could stay low for 2 more decades before they go up. No one knows when they will change, and new debt will still be issued when they do change.
In the meantime, the S&P Rating business line is doing exceptionally well. The unit has realized revenue growth of 11% for the first half of 2014 compared to the first half of 2013. Margins increased as well, with segment operating profit rising 15% over the same period. The unit’s revenue grew 15% in 2012 and an additional 12% in 2013. The unit should continue to see low double-digit revenue growth as long as interest rates remain low and the economy avoids recession.
Dividend analysis
McGraw-Hill Financial currently has a dividend yield of 1.4%, below the S&P average dividend yield of about 1.9%. The company has a low payout ratio of just 34%. The company has grown its dividend payments at a 6% compound rate since spinning off its education division in 2009. The company’s dividend payments have grown at a slower rate than overall company growth. McGraw-Hill Financial certainly has room to grow its dividend payments by double digits due to fast overall company growth and its low payout ratio. The company’s management appears to be focused on organic growth and share repurchases rather than quick dividend growth, which is not necessarily bad but may turn away dividend growth investors.
The company is very shareholder friendly and uses its high free cash flows to repurchase shares. In 2012, McGraw-Hill Financial rewarded shareholders with a special dividend of $2.50 which is a good sign for shareholders as it shows that management of McGraw-Hill Financial is not afraid to give excess cash back to shareholders.
Valuation & final thoughts
McGraw-Hill Financial currently trades at a P/E ratio of nearly 25. For comparison, Moody’s has a P/E of 22. The company has traded for a P/E multiple under 18 for much of the last 5 years. The company appears overvalued based on its P/E multiple in comparison to Moody’s, to the S&P500, and to its historical P/E ratio which has traditionally been under 18. I believe a fair valuation ratio for McGraw-Hill Financial is 16 to 18 which is in line with its historical average reflects that the company has a strong competitive advantage but is affected by macroeconomic factors which the company cannot control.
Overall, McGraw-Hill Financial is a high quality business build around an extremely durable competitive advantage. The company appears overvalued at this time and has a below-average dividend yield coupled with a dividend growth rate that is significantly slower than overall company growth. Oddly for a Dividend Aristocrat, McGraw-Hill Financial is a better candidate for growth investors who have a favorable macroeconomic outlook than for dividend growth investors seeking current income and strong dividend growth. There are better Dividend Aristocrat investment opportunities available to dividend growth investors than McGraw-Hill Financial at this time. When the company’s P/E ratio falls it will make a more compelling investment.
