Good morning, and welcome to the McGraw Hill Company's Second Quarter 2010 Earnings Call. I'd like to inform you the call is being recorded for broadcast and that all participants are on a listen only mode. We will open the conference to To access the webcast and slides, go to www dotmcraw hill.com and click on the link for the earnings announcement conference call. At the bottom of the webcast page are 3 links. If you are listening by telephone, please select the first link for slides only.
For both slides and audio via webcast, select either Windows Media or Real Player. I'd now like to introduce Mr. Donald Rubin, Senior Vice President of Investor Relations for The McGraw Hill Companies. Sir, you may begin.
Thank you, and good morning. Pleased to have everyone joining us this morning for The McGraw Hill Company's 2nd quarter 2010 earnings call. I'm Donald Rubin, Senior Vice President, Investor Relations for the McGraw Hill Companies. With me this morning are Harold McGraw, III, Chairman, President and CEO and Robert Behash, Executive Vice President and Chief Financial Officer. This morning, the company issued a news release with results.
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www.mcgrawhill.com.
Once again, that's www.mcraw hill.com. Before we begin, I need to provide certain cautionary remarks about forward looking Statements. Except for historical information, the matters discussed in the teleconference may contain forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including projections, estimates and descriptions of In this regard, we direct listeners to cautionary statements contained in our Form 10ks, 10 Qs and other periodic reports filed with the U. S. Securities and Exchange Commission.
We're aware that we do have some media representatives with us today on the call. However, this call is for investors, and we would ask that you direct questions from the media to Mr. Jason Furschwanger In our New York office at 212-512-3151 subsequent to the call, 512-3151. Today's update will last approximately an hour. After our presentation, we will open the meeting to questions and answers.
It's now my pleasure to introduce the Chairman, President and CEO of The McGraw Hill Companies, Terry McGraw.
Okay. Thank you very much, Don, and good morning, everyone. And again, welcome to our review of the 2nd quarter earnings and our outlook for the year. With me today, as Don said, is Bob Behesh, Executive Vice President and Chief Financial Officer. I will review the 2nd quarter results And the guidance, Bob will then provide an in-depth look at our financials.
And after the formal presentation, again, as Don said, we'll be pleased to answer any questions or Take any comments that you have about the McGraw Hill Companies. Earlier this morning, we reported diluted earnings per share of $0.61 for the 2nd quarter and that's an increase of 17.3% compared to $0.52 Last year and of course that $0.52 last year included a total of $0.06 for a net restructuring charge and a loss on Revenue of $1,500,000,000 was up 0.6% for the 2nd quarter, but increased 2.7% if you In the current environment, regulatory and legal matters are clearly Top of mind issues with investors. So I will start this morning by reviewing developments in these areas and their impact on financial services, but let me Say at the offset or at the outset that regarding financial reform and legal issues, we are pleased, very pleased that this clarity on the new legal and regulatory landscape for credit rating agencies and that again is a welcome development. It reduces some of the uncertainty and gives us A clear picture of the way forward. From our vantage point, some things are now clear.
First, there were no surprises in the legislation. We've been at it 2nd, we have anticipated the key provisions becoming law for some time and third, the new legislation calls for greater In this period of change, Standard and Poor's has been investing in systems and processes and people to prepare us to Participants to compete effectively and to comply with regulations in all jurisdictions As well as being able to manage and mitigate risk. Now the key to meeting these regulatory requirements is S And over the past few years, S and P has continually strengthened its QCCR It uses formalized review procedures to oversee the integrity, quality and transparency of S That would include new and revised economic stress scenarios for the rating criteria to meeting emerging market and regulatory Expectations, in the compliance organization, there are now about 50 people helping to monitor that S and And finally, the risk control function is designed to assess various risks that could affect Securities. More global regulation is expected, but our investment in the QCCR framework in recent years has Created the foundation that S and P needs to implement the control and compliance functions. In short, Not only is S and P well positioned now to deal with the pending changes, it has a leverageable framework to deal With the new regulations, last year S and P spent about $63,000,000 for QCCR related items.
In 2010, Spending will increase by about $15,000,000 or up to about $78,000,000 At the beginning of the year, We said we expected a decline of about 100 basis points in the operating margin for Financial Services. Despite additional requirement that we have anticipated. Looking ahead, there will be some pressure on operating margins As we continue to deal with all the provisions of the new U. S. Legislation, new rule making by the SEC and regulations recently proposed by Canada and Hong Kong.
The new Dodd Frank Act will require more changes and let's go through some of those Ratings across the globe should continue to provide investors a common and transparent language and a fundamental credit risk benchmark across Sectors and geographies, independent analytical insight and transparency are the key to our value proposition. Another issue, The repeal of the Rule 436 gs. Under this rule, issuers of U. S. Public offerings Included the rating of a security in registration statements without triggering potential expert liability exposure For the credit rating agencies, in view of the new legal risks created by the repeal of 436 gs, S and P will not consent to the inclusion of its ratings and registration statement and prospectuses and in a new development as of yesterday By suspending Regulation AB requirements for 6 months, AB in the asset backed area, The SEC has given the market time to study potential solutions to the problem created by the repeal of 436 gs, But S and P will explore many mechanisms outside of registration statements to allow ratings to continue to be disseminated to the Debt markets.
As always, S and P ratings on new issues and presale reports are available at no charge To all market participants on our website and let me just give you those while we're at this point, simply log on www.standardandpoors.com/ New issues. And another www.standardandpoors, all oneword, dotcom/ Pre sales reports. Another issue is the repeal of the exception to regulation fair disclosure. Under this Issuers could share material non public information with rating agencies without violating Reg FD. There are other ways to The agency that knowingly or recklessly failed to conduct a reasonable investigation or obtain reasonable verification of the data they uses to determine a rating.
Undoubtedly, the new pleading standard will be tested at some point in the future. More litigation would obviously be burdensome and motions to dismiss may be more difficult to achieve, but we will be ready J. Muse:] Among other things, as I've already pointed out, S and P continues to make changes in It's business to improve its procedures and control processes, but don't lose sight of another crucial point. It is simply Ultimately, the current fraud liability standard still applies. That has not changed.
And let me be clear On this point, the new law changes what planets are required to allege in order to survive a motion to dismiss at the pleading stage, the law does not change what plaintiffs must ultimately prove to a judge or a Jury, in order for a credit rating agency to be held liable and that is the same federal securities broad liability standard to C. Butler:] On the litigation front, the outright dismissals of current cases now Since our last update on litigation, there have been 3 important decisions involving S and P, 2 involve a subprime And the third relates to S and P's index businesses and a grant of summary judgment that thwarts an on S and P's intellectual property rights. First, the Abu Dhabi subprime case and new rulings by Judge Schindlin Here on June 15, she emphatically denied class In denying the motion for class certification, the judge wrote, and I quote, defendants argue with considerable force certifying the proposed class. As defendants point out, this action is a collection of a relatively small number of sophisticated institutional investors That acquired 1 of 3 different categories of rated notes at different times pursuant to different internal requirements and after conducting different due diligence inquiries.
On July 20, she allowed the plaintiffs to reinstate 1 of 10 original claims against both the credit rating agencies and Morgan Stanley that she had previously dismissed with prejudice. In responding to the plaintiff's motion to amend their complaint, the judge concluded that she was mistaken in dismissing the aiding and abetting Fraud claims because they are related to the allegations of fraud, the one claim that has been allowed to proceed. There are 3 takeaways from the latest development. The first is that the decision does not affect the dismissal of the 9 claims, which were not based on fraud. The court, secondly, Has made no finding of fraud or aiding and abetting fraud.
At this early stage of the case, the court's ruling must be based I'm accepting the plaintiff's assertion as true until you get to a discovery dialogue. The third, The key issue here has not changed with the restoration of the aiding and abetting claim. The plaintiffs still must prove fraud And we remain very confident that neither claim can be sustained. The victory in the Illinois Circuit Court also was Judge William Menck ruled that index providers are entitled to protection against the misappropriation The International Securities Exchange, ISE, sought to offer options The judge observed, It bears noting that ISE unabashedly admits to attempt to create a competitive product, the ISC 250, which was an index highly correlated to the S After spending a large sum of money developing and promoting options on the ISC 250, ISC discontinued the Object, which has failed to garner significant trading volume, the court fails to understand how ISE's failure somehow It entitles it to profit from free the for free from the efforts, skills and reputation With that on some of the regulatory and the legal issues, I will leave that for now and Let's move on to the operations. Let's begin and let's take a look at the Financial Services operating results in the 2nd quarter and the prospects for the second half of the year.
Revenue at S and P Credit Market Services was up 0.1% as a surge in syndicated leveraged bank loan ratings helped offset continued softness in the Services. For the Q2 at Financial Services, revenue increased by 1.6%, operating profit declined by 4.2%. The operating margin was 38.7% compared to 41.0 percent last year, which reflected a pre tax loss of $13,800,000 from the divestiture of Vista Research and a pre tax net benefit of $400,000 from restructuring charges. The 2nd quarter started strongly and then softened in May June as doubts grew about the pace of the economic recovery and uncertainty developed European sovereigns and bank debt. In this environment, credit spreads for the investment and speculative grade bonds And again, when we talk about credit spreads, it's the excess interest rate over the treasury bonds, began to After reaching 2 year lows at the end of April, as this table shows, both the investment and speculative grade Composite spreads were on July 15 above their 5 year daily moving averages.
The 3 month LIBOR Rose to more than 0.5% and by the way that's the highest since the middle of 2,009. Although the volume of bank Loan ratings is still at the low end of its historical average. The market picked up substantially in the first half. As this chart The volume in syndicated leveraged bank loans, which are rated BBB We are lower, started climbing in the Q1 and accelerated in the Q2 of 2010. Bank loan activity was But refinancing requirements resulted in increased high yield debt issuance in Europe.
New issuance in the High yield market increased 15.3% globally in the 2nd quarter with gains in European issuance more than offsetting the And a key to the second half outlook is the wave of corporate debt coming due in the United States in the European markets. As these charts show, S and P estimates that U. S. And European debt maturities By dollar amounts, we'll grow steadily through 2014. Looking ahead, S and P expects companies to take advantage of increased investor to either amend credit agreements to extend maturities or refinance bank debt with longer dated high yield Credit spreads will be a factor for the level of issuance in the second half.
Stable or tightening spreads could spur some healthy issuance volume in the corporate sector. The outlook for public finance is mixed. Taxable bonds, including the new Build America bonds will probably drive Growth, although S and P expects traditional tax exempt issuance to decline in the second half. In structured finance, we may see a modest Pickup in activity. There may be slow rebirth of the commercial mortgage backed securities market in the second half.
That would be welcoming. In the near term, S and P expects to see REMIC activity continue in the U. S. Residential mortgage backed Regulations are digested. The SEC's Rule 17g5 became effective on June And the FDIC safe harbor rules, which are expected to take effect in September.
We also continue to monitor our Competitive position in the marketplace. In 2,009, excluding sovereign issuance, S and P rated Approximately 95% of the addressable debt issued in the United States. As this chart shows, S and P has performed consistent In the range for the last 6 years, in the European market, S and P rated 89% of the addressable market Last year, up from 83% in 2,008. It is also worth noting that at 1.8 Trillion, the rated European debt market with fewer but larger issues was actually bigger than the rated The first part about S and P's track record. S and P provides a range of ratings from AAA to CCC and if the initial credit Pinion meets the test of time.
You will see fewer defaults at the top of the scale and higher defaults at the lower End of the scale. S and P tracks these default rates with great care and recently updated the tables on the global corporate Cumulative default rates from 19.78 through 2,009. There is a lot of information on these two tables, which will appear in Our new investor fact book next month, but the key point is unmistakable. In both corporate and structured finance over long periods The higher the S and P rating, the fewer defaults have been experienced. That's the way it is supposed to be If S and P is doing its job properly.
In addition to defaults, S and P also looked at rating transition by conducting a comprehensive Review of credit ratings spanning the spectrum of corporate, government, structured finance debt. This report is entitled Default Transition and A Global Cross Asset Report Card of Ratings Performance in Times of Stress and that was published last month. This review demonstrated that ratings issued in the United States, Europe, Japan, Australia, for nearly all asset classes, generally performed as expected, with the exception of ratings on the U. S. Residential mortgage backed Securities and on collateralized debt obligations backed by structured finance collateral.
That is rated credits withstood the recent financial With results in line with expectations for the economic environment. In contrast, the performance of ratings for U. S. RMBS And below our expectations, Standard and Poor's performance review reaffirms 2 key attributes of rate. First, even during periods of economic stress, ratings have been and continue to be Reasonable predictors of the relative likelihoods of default or different credits.
In short, credits with higher ratings Generally experienced lower default rates. This trend held up across asset classes for the 3 stressful period of residential mortgage backed securities and CDOs during the recent crisis. 2nd, sectors other than RMBS and CDOs did not experience disproportionate downgrades relative to the degree of economic stress. Downgrades typically increase in all sectors during periods of stress, but apart from residential Mortgage backed securities and CDOs issued between 2,005 and 2,007, the pace was not exceptional. Earlier in this I mentioned the value of diversity that S and P Investment Services brings to our portfolio.
Nowhere is that more evident than in S and P indices, Which are providing greater access to more markets for more investors around the world. The team at S and P Indices is dedicated to finding new ways to grow the business. With the expiration of a 10 year exclusive agreement with Barclays, S and P has 8 new exchange traded funds targeting growth and value segments of the S and P 500 and growth and value and blend Segment of the S and P MidCap 400 and the S and P SmallCap 600. In May, S and P licensed 7 major European Exchange Traded Fund sponsors to create and list S and P 500 ETFs on major European exchanges for real time trading. In the spring, S and P
On the S and P
500, S and P will be adding new indices in commodities, fixed income, equities, strategy and customized others for its clients. The goal on index for every type So let's sum up for the Financial Services segment. New clarity on the regulatory And legal front, new requirements are manageable. Mid single digit revenue growth for the segment versus our previous estimate of high single digit growth due to Some anticipated softness in the market. With improvement in S and P Credit Market Services And this reflects infrastructure investments and compliance with new regulatory requirements.
All
right. Let's move on to McGraw Hill Education in the 2nd quarter, a strong performance in the U. S. Higher Education market and increases in the state new adoption market by the school education group were partially offset by declines in the open territory and the custom testing markets. As a result, McGraw Hill School Education Group's revenue declined by 4%, For this segment in the second quarter, revenue increased by 1.8%, but the gain in the U.
S. Higher education market had a substantial impact in the 2nd quarter on operating profit, which grew to $51,600,000 and an margin which increased to 9.1%. That compares to an operating profit for the Q2 $29,000,000 which included a pre tax restructuring charge of $11,600,000 and an operating margin of 3 point State budget pressures continue to be a factor in this year's elementary high school market. As we had expected, only the Spring adoption season progressed, it became clear that fewer California districts would be making new reading, literature or Activity has been limited in other states as well, including Georgia and Oklahoma. In view of these conditions, we are adjusting our estimates for 20 We are now expecting the state new adoption market to range from $825,000,000 to $875,000,000 and our previous forecasts That's been $875,000,000 to $925,000,000 We now look for the El Hai market, the market now to grow by 4% to 6%, down from our previous forecast of 6% to 7%.
The market's growth will come from the increase of nearly 70% in state new adoption sales, we still anticipate declines in both open territory sales and residual sales. The McGraw Hill School Group still to capture about 30% of the state new adoption business this year. The biggest opportunities, as we know, are in Texas, Florida and even despite the market shrinkage there, in California as well. In Texas, we are forecasting a capture rate We're winning 40% of the 6% to 8% math market, about 27% of the 9% through 12% market, but only 5% of the K-five market. In California, strong performances by our California Treasures program and Imagine It program should enable us to capture more than half the available dollars in the state For new K5 reading program, in smaller states, the McGraw Hill School Group expects to capture more than 40% of Mississippi's K-twelve science The school group has been strong historically in non academic subjects as well and this year is no exception.
We are seeing good capture rates The availability and the ultimate use of these funds are developments that we are tracking very carefully and we'll The massive stimulus program passed last year, now that was the American Recovery and Reinvestment Or ARRA has $11,500,000,000 available for distribution to the states budgets in the fiscal year that has just begun in most states. Last year, most of the Phase 1 funds were used to save teaching jobs and we believe that the same will be true on the Phase 2 funds this year, but the ARRA Stimulus legislation is also funding other programs that were released new dollars in 2010. Race to the Top Grants at $4,000,000,000 Common Core Assessment Grants at $350,000,000 and investing for innovation grants at 650 In addition, states are receiving school improvement grants from a 3.5 program funded by stimulus dollars and the U. S. Department of Education's current budget.
To date, 32 states And the District of Columbia have been approved for these grants, which are earmarked for low performing schools. For the McGraw Hill School These grant programs offer potential for both assessment and instructional materials. For example, all race to the top Proposals including formative testing so winning states will require these products and services. Our formative products Such as Acuity, Yearly Progress Pro and Writing Roadmap and our reporting services such as the Our network are naturals to meet the market's needs. At the same time, our research based instructional and intervention products such Number Worlds and Reading Mastery are proven solutions for turning around low performing schools.
Timing will vary for each of these programs, but Some revenues stemming from school improvement and investing in innovation grants could begin to show up by at least the 4th quarter. All this is developing as the states embrace common core standards for K-twelve math and for reading and language To date, 23 states have adopted the standards and more are expected to follow More than 40 states are expected to sign on by the end of this year, very important development. As a result of all this We expect to see an expansion of digital delivery systems for instructional materials, professional development and classroom level assessment, And we like these opportunities. In higher education, the digital opportunity is big and it's Our revenue in this space is growing at a double digit rate. The McGraw Hill Connect family of homework management and assessment program Are currently being used by 1,800,000 students and instructors.
And now by creating a partnership with Blackboard, We will dramatically increase the reach and ease of access for our suite of digital products on U. S. Campuses. As the We are off to a solid start this year in the U. S.
College and university market and with a And while a strong performance earlier in this year puts us in a good position, it is not necessarily a barometer of full year results. Those will be determined by the Heavy ordering season that we had just entered into. We have benefited so far this year from last Fall surge in enrollments, which carry through into the spring semester and why we think fall enrollments will continue at this Higher level, no further surge is projected. That is why we expect the market to grow by 5% to 7% despite the very strong In professional markets, digital products are also producing double digit growth. We now have 5,000 e books available and their sales accelerated last April following the introduction of the Apple iPad.
The e book is on its way to to e reading devices. Digital products are also growing rapidly in the business to business market. Here, the content is assessed on a platform that is updated with news feeds, augmented with video and rich with Searchable information and professionals required to remain current with developments in their fields. Our growing family of access Products offers a growing array of professional resources in medicine, engineering and business. So let's sum up for McGraw Hill Education, growth in key markets in 2010, 4% to 6% in the elementary high school market, 5% to 7% in the U.
S. College Segment revenue low single digit growth down from previous guidance of 6% to 7% growth given a more challenging LHAI The Information and Media segment, the growth of our Global Energy Information business, an increase in television and advertising And the continuing impact of the BusinessWeek divestiture were key to the segment's 2nd quarter performance. For the 2nd Quarter revenue declined by 5.1%, but excluding business, we grew by 7.4%. Operating profit It increased by $33,100,000 to $47,500,000 compared to $14,400,000 for the same period last year and by the way that included a pre tax restructuring charge of $4,000,000 The operating margin was 21.2% Compared to 6.1% for the same period last year, the business to business group's revenue declined by 7.8%, but excluding Business We grew by 5.6%. In volatile energy markets, the demand for Platts data and information product continues to produce solid growth, Both in the United States and in international markets, to keep its clients abreast of the changing marketplace, Platts is also introducing new The Bakken Shale formation in the Central U.
S. Is one of the most significant new sources of regional oil for our nation's refiners. In the 2nd quarter, Platts began publishing the world's first For Broadcasting, 2nd quarter revenue increased by 24% compared to the period last National, local and political time sales all contributed to the growth. A pickup in automotive And the contest for governor in that state. In the Q3, political advertising should again be strong.
There is an August 10 primary in Colorado and spending for the Senate race and propositions expected to be key drivers. Summing For the information and media, 2,009 sale of BusinessWeek is having a positive impact on revenue and operating margins. Revenue, Operating margin expect to rebound into the mid teens and therefore summing up overall now for McGraw Hill Companies, our previous earnings per diluted share guidance for $2.10 was $2.55 to 2.6 Due to the choppiness in some of our key markets, we now expect to finish the year at The lower end of that range. Okay. That concludes the review of our operations and various Let's turn it over now to Bob Behesh, our Chief Financial Officer and our other financial matters.
Bob?
Okay. Thank you, There should be no doubt about the strength and flexibility of the McGraw Hill Company's financial position as we enter the Q3. Free cash flow is building. There is no short term debt outstanding, no long term debt comes due until 2012 and in the second quarter we started We repurchased 6,500,000 shares for a total cost of 186 shares since the Q3 of 2008. 10,600,000 shares remain in the 2,007 program authorized by the Board of Directors.
Our diluted weighted average shares outstanding was 313,200,000 in the 2nd quarter, relatively flat Diluted weighted average shares outstanding declined 3,100,000 from the Q1, reflecting the weighted impact of 2nd quarter Fully diluted shares at the end of the quarter were approximately $310,000,000 We continue to be well capitalized With a net debt position as of June 30, $53,000,000 the shift to a net debt position from the end of the This quarter is driven primarily by funding for share repurchases. Cash and short term investments at the end of the quarter totaled 1.145 1,000,000,000 while gross debt was comprised of $1,198,000,000 in senior notes. Our debt is comprised entirely of long term And there is no commercial paper outstanding, again, as I mentioned earlier. The outlook for the free cash flow continues to improve. To calculate free cash We start with after tax cash from operations and deduct working capital, investments and dividends.
What's left is free cash flow, funds we can use to repurchase stocks, make acquisitions or pay down debt. In the first half of twenty ten, we generated free cash flow of $98,000,000 That's an improvement of $61,000,000 from the prior year due to improved operating results and the continuing focus on asset management. We now The improvement is driven by reduced capital investment projections and more favorable working capital than previously 2,009 full year free cash flow was $770,000,000 We generate the majority of our Free cash flow in the second half of the year because of the seasonality of our education business. Our guidance implies second half free cash flow, it will be roughly 5 $100,000,000 to $550,000,000 which is lower than the prior year due to increased investments and more challenging working capital comparisons during that second Regarding our U. S.
Pension plan, we still anticipate no funding requirements in 2010. We now expect an increase in pension expense growth, which represents expense growth excluding the 2,009 restructuring charges as well as the loss on the divestiture of Vista and the gain on the divestiture of BusinessWeek. So let's start now with Education. 2nd quarter adjusted expenses declined 1.8 In the first half, adjusted expenses declined 2.1%. At constant currencies, the first half decline is actually larger at 3.1 The segment benefited from savings from last year's strategy to combine our core Basal publishing operations with our alternative Basal on As Terry indicated, we now expect segment revenue growth in the low single digits versus our previous guidance of 6% to 7% increase.
Despite the reduced revenue growth, we are maintaining our guidance of an unchanged adjusted operating margin as we now Our full year guidance implies that second half expense will be in the mid single digits driven by an increase in selling and marketing Because of the state adoption calendar as well as cycling through the phase out of the previously mentioned statewide custom contracts. Additionally, we 1st half expenses increased 8.5%. Expense increase was driven by increased salaries and Occupancy costs, mainly from our international hires and increased incentive compensation. For the full year 2010, we now expect expenses to increase roughly 7% to 8%, down slightly versus our previous guidance of roughly 9% to 10%. The expense growth is largely driven by continued investment in our fast growing businesses, the carryover impact of 2,000 and Our expense guidance assumes approximately $15,000,000 in additional costs related to our regulatory and compliance initiatives, which will occur mostly in the second half of the year.
As Terry indicated, there will be some pressure on operating margins as 19.4 percent respectively. The divestiture of BusinessWeek reduced 2nd quarter revenue by 20 $7,500,000 and expenses by $38,500,000 for a positive profit impact of roughly $11,000,000 in the quarter. For the first half, The divestiture of BusinessWeek reduced revenue by $55,000,000 and expenses by $78,000,000 for The segment also benefited from restructuring actions taken in 2,009. For the full year, Information Media will reflect savings from BusinessWeek divestiture of approximately $38,000,000 For 2010, reflecting primarily The divestiture of Business Week expenses are expected to decline in the low teens versus 2,009 adjusted expenses. Corporate expense in the second quarter was $37,600,000 an $8,300,000 increase versus the prior year.
The increase was primarily driven by increased Excess space, increased incentive compensation and growth in selected support functions. For the first half, corporate expense was 73,400,000 which is a $10,600,000 increase. For the full year, we expect to we continue to expect Corporate expense to increase about $25,000,000 to $30,000,000 and the primary reason for the increase is driven by the higher excess base for New York where we are expecting increases in the second half. Prepub investments were $30,000,000 in the second quarter, a decrease of $12,000,000 compared to the Q2 2,009. In first half, we invested $60,000,000 which is a $25,000,000 decrease.
The decline largely is largely due to Timing as we expect increased pre publication investments in the second half of the year. For 2010, we now expect pre But on the other hand, this investment is $30,000,000 less than our previous estimate of $225,000,000 to $235,000,000 reflecting the fact that with changes in state Investments are being delayed to better align with projected opportunities. In addition, we continue to benefit from combining our core operations with our alternative Basel and supplemental publishing operations. Purchases of property and equipment were 14 point 1,000,000 in the second quarter, a $6,000,000 increase versus the Q2 of last year. First half purchases of property These expenditures will be approximately $90,000,000 to $100,000,000 versus $68,500,000 in 2,009 and the increase Pre publication cost was $69,000,000 in the 2nd quarter, which is a $2,000,000 decrease versus last year.
In 2010, we continue to expect 2 $60,000,000 to $265,000,000 versus $270,000,000 last year. Depreciation was $26,000,000 in the The Q2 versus $29,000,000 the previous quarter last year. We continue to expect depreciation to be roughly 100 $15,000,000 versus $113,000,000 in 2,009. Amortization of intangibles was $13,000,000 for 2nd quarter of $20,000,000 for the first half and we expect for the full year about $40,000,000 Net interest expense was approximately $21,000,000 in the 2nd quarter compared to $18,500,000 in the same period last year and $22,000,000 in Q1 of 2010. We continue to expect full year interest to be roughly comparable to 2,009, which was $77,000,000 Regarding the company's effective tax rate, during the second quarter and the first Half of twenty ten was 36.4 percent, which was unchanged from 2,009 and that's what we expect to see for the full Our unearned revenue continues to grow ending the quarter at $1,100,000,000 which is up 4.2% from the prior At constant foreign currency exchange rates and excluding the impact of the divestiture of Business The growth was 7%.
Unearned revenue was impacted by a deferral of revenue at McGraw Hill School Education Group, where shipping will be completed in the 3rd quarter. Excluding this impact, unearned revenue would have grown at Approximately 3.5%. Financial Services continues to represent 73% of the corporation's total unearned Revenue. It grew in the low single digits as strong growth in ratings related information, S and P indices and Capital IQ offset declines at credit Ratings and Equity Research Products. For 2010, we continue to expect mid single digit growth in unearned revenue.
Thank you. And now back to Terry.
Okay. Thank you, Bob. All right. That completes the results for the Q2 and obviously for the first half of the year, as well as Guidance for the second half. And I have to say, we feel very confident about the results for the full year.
And again, Regarding some of the financial reform and legal issues, we're obviously pleased that this period of uncertainty is largely over. And with that, let me turn it over to Don Rubin, and he'll moderate our Q and A session.
Thank you, Terry. Just a couple of instructions for our phone participants. This will ensure good sound quality for everyone. We will now we're now prepared to take the first question.
Thank you. Our first question comes from Brian Shiffman, Jefferies. Your line is open.
Thank you. Good morning. I have a couple of questions actually. First with Standard and Poor's, how was relative issuance performance In June versus May and any impact on revenues and how is issuance trending so far in July relative To what you saw in late May June. And then still with Standard and Poor's, Terry, you alluded To watching the competitive position of S and P very closely, are you feeling something new on the competitive front?
And have you seen any Pat from Bloomberg's quantitative credit ratings feature yet. And then I have a question on textbooks. Thank you.
Okay. Hi, Brian. First of all, on the S and P issuance, whether you're talking corporate governance, munis, structured finance, The story for the 1st part of the year, as we all know, January through the end of April was very strong. And And quite frankly, we were a little surprised by it on that one. But again, what it did It led into a May, June, July period of softness and it was a lot Slower than we anticipated on that one, and we'll just have to see going forward.
I think it reflects a little bit of Fed Chairman Bernanke's comment, when he was talking about entering into sort of a summer lull of more modest We'll have to see.
We have to see what the effect
of some of the economic recovery and some of the effect that that's Going to have on business investment and what that means then for issuance. But right now, it's pretty soft. And again, the charts In the slides that show that, we're not going to anticipate stronger issuance at this If it comes, it will obviously offset any additional costs and should improve margins, but We'll just stay tuned at this point on that one. Competitive issues, Brian, on S and P, no, I mean, again, When you talk about the extensiveness globally of providing credit rating It is a huge undertaking. We carry some 1300 analysts around the world that are They're providing all of these kind of functions.
And so for new entrants, that's a big We're hearing on the fringe of a lot of different people that would like to get involved or be a part of or something like that, but we're not seeing anything From a competitive standpoint, that concerns us from that one. On the textbook side, Brian, what was the question?
Yes, I guess, we're entering the most important time of the year. Q3 is, call it, well, just it's the important Quarter. So you've touched your textbook forecast several times this year. As we enter the most important quarter, what are you seeing currently that gives you confidence in this
Well, as we know, the countercyclicality, especially in higher education And professional to an economic recovery is there. More people have gone back to school, more people are staying longer, And therefore, we're entering into a period that I think should be very advantageous for us. We will see, But it also gives us a lot of upside in terms of some of the new things we're doing. Very pleased with the Online learning platforms like McGraw Hill Connect, it is doing extremely well, Especially at the community college level, and so that part is good. Also what we're seeing is increased In the educational services area, these are online learning platforms that are very targeted toward professional skills In places like India and China, where to get certain jobs, you have to have certain skill sets and we can rifle shoot in with online learning And we're seeing a lot of success in that as well.
So I mean, I think it's a good situation At this point, we just have to stay tuned. On the K-twelve side, it really is going to depend on some of the Recovery Act federal stimulus, there is $11,500,000,000 That is scheduled for spending in 2010. Certainly, I think teacher jobs are part of it. But I think also we ought to see some very, very important support in some of the key states. We'll see.
The higher end is going to clearly be the winner of the year.
Thank you, Terry.
Thanks, Brian.
Our next question comes from Sloane Bolen, Goldman Sachs. You I ask your question?
Hi, good morning. Just to start off a little bit on the regulatory front. Just first on the legal liability, it's clear that there's some concern with attaching ratings to certain issues and now we've gotten the Next month kind of cleanup from the SEC on regards to the ABS. Could you just talk about your strategy going forward with regard to that new legal liability? And then kind of as a secondary follow-up to that, just your thoughts on the SEC study, I guess the replacement for the frankenbill and study on the conflict of interest.
Okay. Sloane, on the legal liability side, The outcome was better than what we were Hearing even a year ago on this one. As you know, in terms of the pleading standards, we were taking a look at Fraud and then you're talking about gross negligence and then dropping down to a negligence level and all have locations on intent and so forth. Where we are is just a little bit lower than the fraud level that We saw originally in the Credit Rating Agency Reform Act of 'six. So It's very livable.
What we've always been concerned about It's clarification of some of the language. When you talk about a reasonable investigation, what's the definition of Understandably and recklessly, what constitutes that? And I think what we're seeing here It is a sort of dust settling period with the SEC, and I think yesterday's pronouncement of suspending AB Suspending AB requirements for 6 months is really, okay, we've got to get our arms around all of this, We got to clarify certain language and we've got to put things in place that does no harm and all that. So we're actually Satisfied with where that is. And regardless, we think that we are in a good position to deal with that.
As far as conflicts of interest and questions about The business model or things like that, we feel quite good. I mean, again, it's what you're trying to solve If you're trying to solve the equation for higher transparency, which is a good thing, then you're going to go with the issuer pay model. And you just got to make sure, because we disseminate all the information free around the world, so you got higher Transparency. What you just got to make sure and obviously being regulated that your compliance systems and your Firewalls and all of that is very, very pronounced and clearly articulated. And that is exactly what the new overhaul reform bill articulates that they're going to be Expecting those compliance systems and the like, and we're working with various regulators to make sure they understand Our compliance systems and that they are in all of that.
So that's what anything. So I don't see anything at this point in either the business model or And any potential conflicts of interest that would surface.
Okay. And just switching gears, just a quick question on the publishing side. Terry, you had Double digit revenue growth I think from the digital side of the business. Can you maybe elaborate on the partnership with And how that may scale that opportunity, just how quickly the opportunity sets growing with the advent of the iPad, whatever else?
Yes. Thanks, Glenn. I mean, we're very excited about that. Obviously, they distribute to 70%, 80% of all U. S.
Colleges and universities. And so with a platform like McGraw Hill Connect, we see for them and we see for us acceleration And the bigger issue here and the more important one is the role that digital is playing, Especially in higher education, in terms of being able to expand to a larger student audience as well as getting into the professional training And areas. So the digital growth is good, but it's in keeping with the transformation that's taking place
We have
a question from Craig Huber, Access 3 42. You may ask your question.
Yes. Good morning, Terry. Can you hear me?
Yes, Greg.
Yes, good morning. If I heard you right, I believe you said The Elhigh market you thought would grow 4% to 6% this year, the college market would grow 5% to 7%. Is that correct?
That's correct, Craig.
Yes. And then I believe you said you thought your Education segment revenues would grow 1% to 2%. Can you just talk about the differences there why your overall Like grow 1% to 2%.
No. Well, we said low single digits on that one. 1% to 2% would be a little low On that one. Yes, no, I mean, I just think that on the K-twelve space, we're all watching it real time. And we've witnessed some upside surprises in California that we didn't expect and then some downside there.
We've also seen some of the Smaller states, Oklahoma, for example, that cut back. But overall, We're still seeing a pretty good number. Now we dropped the new state adoption number to 8.25 to 8.75, down from 8.75 This is in Florida and the market share numbers there. So it is fluid. We have to see What the federal stimulus and the Recovery Act dollars as we were saying, dollars 11,500,000,000 It's been sent to the states and obviously a variety of uses, but we feel pretty Confident that instructional materials and testing materials are going to be a part of that.
So that's why we say 4% to 6% rather than the 6% 7% that we see. And if it improves and we see that stimulus having an effect and some of The race to the top fund, we'll come back to you on it. But I think given some of the softness we've seen, I think 4% to 6% is a responsible number. I'd love to see it higher.
Craig, also influencing our growth rate Our planned phase out of a number of the statewide custom contracts at CTV in California, Florida and So that's a planned phase out, which will reduce our revenue. But on the other hand, CTV, although we'll be showing Lower revenue for the year, we're still very excited about the growth opportunities for our formative programs with Acuity.
Yes. And as Bob Same. The shift there, Craig, is obviously away from the summative and to the formative testing. And the formative testing is a Bigger, broader market and we're very pleased with Acuity and how that's been received.
And then also, Are you still assuming open territories residual sales as the whole market sort of down mid single digits?
Yes, we're assuming That the open territory sales will decline around 3%. We're still holding to that and the residual sales more at the high Single digits simply because of the much larger new adoption calendar, there's less need for replacement of product.
Yes. And that could shift A little bit with the Recovery Act funds, but we want to see that before we change that.
And then we shift over if we could to your S and P ratings business, the transaction revenues there. Can you just give us a little better thought of what you guys are thinking in In terms of the outlook here for transaction revenues for the back part of the year, do you have an anticipation of when it might pick up significantly in these very low levels right now? Do you have I think maturity next year.
Do
you think we're
going to pull forward into the Q4 here?
Well, I'd love to be able to tell you, Craig, that it's going to be wildly up, But it's all a function of the economic recovery and access to business investment And Capital Markets, right now, as we watch spreads, The spreads have widened in all that. What we need to see is those spreads neutralize Or go lower, and that would be more issuance on that part. It's really just Very unclear. I can only tell you that as strong as the pipeline was for the 1st 4 months of the year, it's been pretty anemic For the last 3 months. And again, we need to see business investment And I'll pick up.
One last question, if I could. You talked about $15,000,000 incremental regulatory compliance costs this year. What is your preliminary thought for what that number could be for next year?
We're playing with that now. Obviously, as there's still unclarity, for example, at the SEC on Certain things and we're working with them in terms of interpretation of certain things and what potential cause for staffing or Those kind of things would be largely the systems part It's pretty much complete. We have as I was saying, we spent $63,000,000 last year And on the regulatory and compliance systems, this year, it's going to probably be around 78. Could it be a little higher? It could on that one.
But a lot of the one Time costs associated with the systems part are done. And so you're talking about the smaller, more incremental part. We'll be giving out that information as we go. But I think it's I mean growth in that It's going to be very modest, if at all, but we'll see.
Great. Thank you.
Our next question comes from Peter Appert, Piper Jaffray. You may ask your
question. Thanks. Terry, I'm wondering in the context of the increased litigation risk and Compliance fees you face at S and P, how are you thinking about fee structures? How do you institute any increases in fees? Or are you anticipating any increases in fees?
Well, any fee increases depending upon the category and whatever are all modest On that, again, risk mitigation situations for legal Expenses, we've got all of that in place at this point. The part that's encouraging, Peter, is obviously that 15 of the lawsuits have been dismissed, 5 more Have been just withdrawn and this is the trend that we expect. It's just taken so long to get judgments. I mean, the amount of litigation is in this system overall. It's pretty high and getting judge time is difficult, but we're pleased with You know the direction that's taken.
And we want to see that part continue. And so I don't see from On the pleading standards or any of the new reform things, I don't see anything overly onerous At this point, so again, I think that we have a pretty good situation. We'll continue to monitor And I think that we'll be in okay shape.
But you don't feel that you might be justified in raising fees a little more aggressively than you have in recent In context of the incremental cost you're faced with?
No, I mean, I think that obviously Well, given the current situation, we're fine in all of that. Now hypotheticals We could go down a lot of pads on that. Would we pass along some of the costs? Sure, In all of that, but I think we're on a pretty good path and in a pretty good situation and we're handling it as it Now obviously, the part that pleases us the most is the fact that when you still have the regulatory Reform bill out there and all the headline risk and all of those kind of things, the uncertainty levels We're pretty high. What we're doing is we're moving from a world of uncertainty to one that is more certain And that's good.
And I think the SEC pronounced me yesterday about sort of a 6 month moratorium, especially With the AB requirement, it's a good sign that the dust is settling and we now have to get after managing the So at this point, we feel pretty good about it.
Where do you think the margins go, Terry, at S and P over the Several years, do you think you can sustain them at the 2010 levels?
Well, again, we have to See what the additional costs are. The majority of the cost, the one time costs have already been taken in In terms of compliance systems and all of those kind of things. So we want to we're still studying on what some of the ramifications of some of the new rules might Yes, especially on staffing and things like that. But if there is pressure On margins, we think they're going to be very modest at this point. So once the one time costs And your run rate has already been adjusted on that part.
That And if revenue through new issuance picks up, that should all go straight to the bottom line and that would be But we're being cautious at this point with revenue And transaction direction because we just got to see a little bit more in terms of how this recovery takes place. But what we're focused Would be the revenue side, because the ongoing costs are have already been Justin, the one time cause will subside and then that should have a better situation.
Okay. And then just last thing, Bob, what kind of repurchase
activity should we anticipate in the
second half? I'm Purchase activity should we anticipate in the second half?
We will continue to report on a quarterly basis, Peter, how we're doing on the repurchase program. I think the important thing is to indicate, 1, we began the program. We do have 10,100,000 Shares remaining and we're in a very strong cash position. So without going into a forecast, I think the key is that we began the program and We didn't begin it to stop it. So not to forecast where we're going to be, but we began the program.
How about more generally in terms of the 10 point 1, is there would you like to complete that within some certain timeframe?
No, I'll go back to what I said originally that we would purchase the 17,100,000 shares over time without being specific, whether it was $18,100,000 shares over time without being specific whether it was to be done within 1 year or not, but we took a pretty big Slice of it, as you know, in the Q2. Okay.
Thank you.
Thanks, Peter.
We have
To clarify, Terry, when people ask about the pipeline and issuance activity, is it fair to you had said the pipeline had pulled back But isn't it fair to say the pipeline is still massive, it's just not clear when it comes to market? And then secondly, Bob, your guide we're talking about a slowdown in issuance, but I think the guidance there's a comparable issue. You grew S and P only grew 5% year Your guidance implies about the same amount of growth in the second half. Is that fair?
And then I have a follow-up.
Yes. I think with regard That particular question, we had very looking at the rating side of the house, as Terry pointed out earlier, very strong growth for the 1st 4 months of the year And a real slowdown in the last 2 months, very good performance from index services, Capital IQ continues We did have a slowdown in the equity research side of the house, which began in the effectively in the Q3 of So the comparables for that business will get better. We continue to expect our index services and Capital IQ to continue to grow. And a pickup in the latter half of the year, a little bit of a pickup on the issuance side within S That's how we kind of balance out to the levels that we have in the overall forecast.
Yes. And also, You're exactly right. In terms of the pipeline, there's an awful lot of conversation and activity. And the And activity and the question is, is when does it come to market. And so we just need to see some of that come to fruition, but yes, absolutely.
The number of people that are interested in raising those kind of funds is high. It's just that given the current situation, it's a little
Okay. And then a question for you on index. You mentioned a bunch of the new deals and over You've always mentioned the new launches, but I think the Vanguard deal, it could be one of your larger deals. Can you just talk about that in the context of if this is similar to the Barclays, Exov, if this is similar to the Barclays deal, is this really nicely Incremental in the second half or is it going to take a while to build up as you see it?
Well, I mean, no, incrementally it's doing exceptionally well Neil, on that one. And of course, Barclays in selling their operations to BlackRock, you've got BlackRock, you've got Vanguard, you've got State Street and those relationships are very strong and are growing at a very good rate. No, we're I mean, it's what a contrast. I mean, the S and P index business and the growth of exchange traded funds And the relationships that they take on with exchanges around the world is a great business. All right.
Thanks for your time.
Thanks.
Our next question comes from William Byrd, Bank of America Merrill Lynch. You may ask your question.
Good morning. Could you clarify what level of stock buybacks are in guidance? And can you just maybe Give us your point of view on whether you'd consider borrowing to buy back stock.
Okay. Bob?
The guidance really reflects Only what we have done, the 6,500,000 shares, Bill, that I indicated. And in response to a question earlier, We're not forecasting how much we will repurchase, simply that we have 10 point Just the shares over time. So we're not forecasting how much we're going to buy back this year or next Bill, but clearly we started off the program with a pretty good bite at it in the second quarter at 6,500,000 We are in just a modest as you know net debt position. Our cash flow forecast It's much stronger in the second half of the year. So we're clearly in a position where if we elect to continue to repurchase shares, we're in a very good position to Do that.
And Terry, earlier you talked a bit about some of the federal funding initiatives that could impact educational I just wanted to clarify, are those effects in effect in your numbers or could they be incremental to growth?
Those are obviously incremental. We can't count on anything. And so We're working state by state on the K-twelve side and we just anticipate of the 11 $500,000,000 earmarked for 2010 and out of the Recovery Act as plus the other grant That it's got to come. I mean, obviously, teachers are going to be a focus again of the administration, But it's got to come to materials and testing as well. We just don't have clarity on that.
And so we have not put that in our numbers and dependent upon what takes place, that would be And
do you have any sense of what that could boil down to in terms of spending on textbooks, for example?
Don't. It has to have some on that one, but until we We see the monies reach the state and the state's declaring What they're going to do, we just really can't assume on that part, but I think it's intuitive that It is going to have some impact and that would be good. Race to the top too, Bill. That has been very slow in terms of being approved. And Delaware and Tennessee are the 2 that have been approved.
But given the fact that by the end of this year, we'll have In probably 40 states that will be signing on for common standards and eligible for those Grant, that is a big, big shift. Currently, we have 32 states and the district has Approved for that, but that's a big shift. And obviously, the move to common standards is going to have a very positive effect on cost As well, if you don't have to do as many state specific kinds of materials.
Thank you.
Thanks.
Our next question comes from Doug Arthur, Evercore. You may ask your question.
Yes, great. I guess I'll cover something that hasn't been talked about. Any information in media in addition to obviously no business week and Anything else noteworthy going on there in the top line?
Well, Ian, Hi, Doug. The issues are, for example, on broadcasting, Given the political environment and all of that, political spending is really starting to pick up and it's picking up earlier Than we would have expected. And so that's one positive in the here and Now big issues are in Platts. Platts Doing exceptionally well. And their pricing and benchmark assessments are being picked up worldwide.
And actually, no, and Bob, correct me, I think it's a little bit over 60% of their revenue comes From outside the United States now?
That's right.
Yes. So I mean it's and it's growing at a very good rate. So those are 2 notables.
Okay, great. Thank you.
Thanks, Doug.
Our final question comes from Ed Aterino, Benchmark. Hi, Terry.
Yes, regarding the school outlook, is there any case that there could be some deferral here of spending another And may it show up in 2011 or is it sort of gone? No. I mean, that's hi, Ed. No, that's right exactly right. We have seen in places like Oklahoma deferrals.
And in every case, You keep hearing the words at a time later or whatever, but no, it can't be deferred forever And the one that we watch very carefully is the open territories And where some of the federal stimulus will go. But no, at this point, deferrals
That This concludes this morning's call. A PDF version of the presenter slides is available now for downloading from www.mcgraw hill.com. A replay of this call will be available in about 2 hours. On behalf of the McGraw Hill Companies, we thank you for participating and wish you a good day.