Sweet Revenge: Moody's Downgrades S&P, Two Years After S&P Downgraded Moody's
Just over two years ago, we reported that "The Farce Is Complete: S&P Downgrades Moody's To BBB+ From A-2", or in other words, one rating agency downgraded another rating agency, with the following rationale: "While we believe it is likely that the new pleading standard will lead to an increase in litigation-related costs at Moody's and therefore poses an element of risk, whether the new pleading standard may increase the likelihood of successful litigation against Moody's will be determined in the future by the courts.... Moody's management has stated that it plans to adapt its business practices in an effort to offset any potential new litigation-related costs associated with the legislation. Nevertheless, we believe that Moody's will likely face higher operating costs, lower margins, and increases in litigation-related event risk that we believe may present risks to the company's reputation." Well talk about irony, and of course role-reversal, now that it is not Warren Buffett's pet company Moody's (which is just as guilty as US-downgrading S&P was in rating financial toxic garbage as AAA), but S&P that was just sued by the DOJ and the kitchen sinks. And the last laugh - the piece de resistance as it were - sure enough, belongs to Moody's, which just downgraded S&P parent McGraw Hill.
Moody's Investors Service downgraded The McGraw-Hill Companies (McGraw-Hill) senior unsecured rating to Baa2 from A3, concluding the review for downgrade that was initiated on September 12, 2011. The downgrade reflects the loss of earnings and business diversity that will result from the expected completion of the $2.5 billion sale of McGraw-Hill Education (MHE) to investment funds managed by affiliates of Apollo Global Management, LLC (Apollo) as well as heightened litigation risks in light of the recent civil lawsuits filed against McGraw-Hill and its subsidiary Standard & Poor's Financial Services LLC (S&P) by the Department of Justice (DOJ) and various state attorneys general. McGraw-Hill's Prime-2 short-term rating for commercial paper is not affected. The rating outlook is negative.
McGraw-Hill has reclassified MHE to discontinued operations and expects the sale to Apollo to close in the first quarter. In the event that the Apollo transaction does not close as anticipated, we believe that McGraw-Hill would revert to its prior plan for a spin-off of MHE or would seek another buyer. Accordingly, the downgrade and Baa2 rating factors in the disposition of MHE, which will reduce the company's business diversity and cash flow generation. Moody's believes McGraw-Hill's nearly 10% increase in the dividend in January 2013 indicates the company will not cut the dividend upon completion of the MHE sale. The foregone MHE earnings and maintenance of the dividend will reduce McGraw-Hill's free cash flow.
McGraw-Hill has indicated that it will vigorously defend itself in ratings-related litigation, but has not ruled out settlements. However, adverse outcomes could have substantial negative implications for McGraw-Hill's credit profile. The Baa2 rating balances the company's history of prevailing in its legal defenses against the potentially substantial negative credit effects that could result from adverse litigation or settlement outcomes. In addition, the management focus and direct costs involved in defending litigation may be a persistent drag on the company's operations over the intermediate term.
McGraw-Hill's Baa2 senior unsecured rating and Prime-2 short-term rating for commercial paper reflect its sizable cash flow generated from good market positions in financial information and credit ratings, its conservative leverage profile, its narrowed business focus and potentially significant exposure to litigation related risks. Moody's estimates that 60-80% of ongoing revenue has cyclical aspects, with a mix of contractual revenue streams and transaction-dependent revenue. S&P, which is McGraw-Hill's largest operating division, has a strong global market position but is also exposed to regulatory-driven structural changes in the rating agency industry and to litigation risk. McGraw-Hill's conservative financial profile and the expected MHE net sale proceeds ($1.9 billion) provide some flexibility to manage these risks with gross debt-to-EBITDA leverage (in a low 2x range incorporating Moody's standard adjustments, the redeemable put related to the S&P/DJ JV, and the proposed MHE sale) among the lowest of media issuers rated globally by Moody's. Moody's anticipates McGraw-Hill will maintain a sizable cash balance, but also expects the company will utilize cash and projected free cash flow for acquisitions and continued high shareholder distributions.
The July 2013 expiration of McGraw-Hill's $1.2 billion revolver and the $457 million commercial paper borrowings at the end of 2012 create potential pressure on McGraw-Hill's near-term liquidity position. The company had $761 million of cash at the end of 2012, although a majority of the cash is outside the U.S. and repatriation would result in tax leakage. The company's cash holdings and Moody's projection for 2013 free cash flow in a $300 - $350 million range provide modest coverage of commercial paper borrowings. Moody's ratings anticipate that McGraw-Hill obtains a new revolving credit facility or extends the maturity of the existing facility. The company's liquidity position will improve meaningfully upon completion of the MHE sale as McGraw-Hill is expected to repay commercial paper borrowings with the net proceeds and maintain a sizable cash balance.
The negative rating outlook reflects the potential for additional adverse litigation and regulatory developments and the resulting uncertainty created for McGraw-Hill's operations and financial position.
An upgrade is unlikely in the foreseeable future given the ongoing litigation and regulatory risk. The rating outlook could be changed to stable if litigation and regulatory risk diminishes, provided that McGraw-Hill also maintains solid market positions in its businesses, a conservative leverage profile, good free cash flow, and a strong liquidity position.
A significant decline in operating performance and cash flow generation, substantial acquisitions or shareholder distributions, or a deterioration of the company's liquidity position could create downward rating pressure. Adverse litigation or regulatory developments could create material downward rating pressure.
* * *
Translation: never downgrade the US.