However, Mcgraw-Hill Companies Inc (NYSE:MHP)’s collection of wide-moat businesses will likely prove undervalued even if a large settlement is reached.
Unique collection of businesses
In addition to S&P, Mcgraw-Hill Companies Inc (NYSE:MHP) owns well-known brands like Capital IQ and J.D. Power. But S&P is the biggest contributor to profits, therefore it is the most important business to understand.
S&P is the top credit ratings provider worldwide — a position that is protected by regulations that discourage new entrants. The rating agency’s primary competitor is Moody’s Corporation (NYSE:MCO), which enjoys the same pricing power and stability that comes with a regulated oligopoly.
Although both S&P and Moody’s Corporation (NYSE:MCO) brands have been tarnished in the public eye due to wildly optimistic ratings during the credit boom, the agencies’ competitive position has not been altered one iota. Therefore, except for settlements with the Department of Justice, investors can expect both companies to continue earning high and stable profits for years to come.
After S&P, Mcgraw-Hill Companies Inc (NYSE:MHP)’s next most important asset is Capital IQ. Capital IQ’s primary competitor is FactSet Research Systems Inc. (NYSE:FDS). Although the two compete with Bloomberg and Reuters in some ways, as a rule, most institutional users have either Capital IQ or FactSet — or both.
FactSet Research Systems Inc. (NYSE:FDS) is a fast-growing recurring-revenue business. It is highly integrated into customers’ operations, which creates a sticky customer base. For instance, customers often use Excel spreadsheets set up specifically for FactSet Research Systems Inc. (NYSE:FDS) data; it is not a simple task to just switch everything over to Capital IQ.
Of course, Capital IQ enjoys the same benefits of recurring revenue and customer stickiness. This is what makes it such a valuable asset for McGraw-Hill.
Looking ahead
Mcgraw-Hill Companies Inc (NYSE:MHP) recently sold its education business to Apollo Global Management LLC (NYSE:APO) for $2.4 billion in cash. The cash enables the company to pay off short-term debt and accelerate share repurchases.
Although the company has never been aggressive when it comes to buying back shares, it has slowly and steadily lowered its share count in each of the last ten years. The extra cash on hand and lower short-term debt should allow the company to continue this practice in addition to increasing its dividend.
Furthermore, each of the company’s segments are growing at a high-single digit rate — and operating profits should follow a similar growth rate. Although the threat of a large settlement with the Department of Justice is real, the competitive position of the company has not been impaired. Therefore, investors can put aside short-term concerns in favor of looking at the bigger picture.
The big picture
I think the company will produce $1.2 billion in cash from operations during 2013, along with $200 million in capital expenditures. This leaves us with $1 billion in free cash flow during 2013 — or $3.60 per share.
The stock currently changes hands at around $50 per share, so $3.60 represents a 7.2% free cash flow yield. In the long run, I believe Mcgraw-Hill Companies Inc (NYSE:MHP) will grow free cash flow per share at a mid-single digit rate. Therefore, I expect investors who buy the stock today to earn a 10% to 12% annual rate of return on their investment.
The article Tarnished Brand but Untarnished Profits originally appeared on Fool.com and is written by Ted Cooper.
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