Dividend Aristocrats Part 9 of 52: McGraw Hill Financial Inc (MHFI) by Sure Dividend

You may be more familiar with McGraw Hill Financial (MHFI) by its very widely used (at least in investment circles) S&P brand.

Not only is McGraw Hill Financial a Dividend Aristocrat – but the company actually created the Dividend Aristocrats Index.

McGraw Hill was created in 1917 with the merging of the McGraw Publishing Company and the Hill Publishing Company.  In 1957, the company introduced the S&P 500.  Today, McGraw Hill Financial has a market cap of over $25 billion.

In 2011, McGraw Hill announced that it would split its financial and education businesses.  The split was completed in 2013 when Apollo Global management purchased the education side of the business for $2.5 billion.

Business Overview

McGraw Hill Financial is organized into 4 business segments:

  • S&P Ratings
  • S&P Capital IQ
  • S&P DJ Indices
  • Commodities & Commercial

The image below gives a graphical overview of the size of each business segment

McGraw Hill Financial

Source:  McGraw Hill Financial Barclays Presentation, slide 5

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’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 indexes, 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 Advantage Analysis

McGraw Hill Financial has paid increasing dividends for 42 consecutive years.  The company is the leading index fund provider and the leading rating agency.  It is very apparent that McGraw Hill Financial has a strong competitive advantage.

McGraw Hill Financial is one of the big 3 rating agencies, along with Moody’s (MCO) and Fitch Ratings.  Together, the big 3 control about 95% of the financial debt rating industry globally.  Oligopolistic markets are characterized by high margins.  Click here to see another oligopolistic Dividend Aristocrat.

McGraw Hill Financial’s S&P Rating division has generated over half of McGraw Hill Financial’s profits over the first 6 months of fiscal 2015.  The rating division has maintained operating margins north of 40% since 2011.

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.  It would take an enormous amount of goodwill to be able to even compete with S&P Ratings.  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 Financial has an even higher margin business unit than S&P Ratings.  The S&P Dow Jones business unit has maintained operating margins over 50% since 2011.  The unit capitalizes on the well established Dow Jones and S&P brand names to generate licensing revenue from expanding index and ETF products.  Again, the S&P and Dow brands are very strong and durable.

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

McGraw Hill Financial has 2 primary growth drivers:

  • Growing popularity of index funds
  • Low interest rates driving increased debt issuance

McGraw Hill Financial generates licensing revenue from ETFs with the S&P and Dow brand names.  ETFs continue to gain market share from actively managed mutual funds due to lower expense ratios which typically result in better performance.

From the first 6 months of 2014 through the first 6 months of 2015, the S&P Dow Jones segment saw revenue grow 7% and operating income increase 10%.  Interestingly, the S&P 500 was up 6% over the same period.  Most of the company’s ETF licensing growth was a result of market gains.

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 operating income in the high single digits or low double digits as long as the trend toward ETFs continues.

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.

Risks & Expected Total Returns

McGraw Hill Financial will likely see steep earnings declines during the next large recession.  The company’s S&P Dow Jones segment in particular will suffer as investors reduce their exposure to equities resulting in lower assets under management for ETFs.

Recessions and economic slowdowns will also hut the company’s flagship ratings segment.  Debt issuances tend to slow during bear markets as growth projects are put on hold (meaning less financing is needed) and banks and other financial institutions are less willing to lend.

In addition, McGraw Hill Financial is also exposed to interest rate risk.  Low interest rates will not and cannot last forever.  When interest rates increase, debt issuance will slow and the company’s ratings profits will decline.

Over the last several years, McGraw Hill Financial has managed to realize compound 20%+ earnings-per-share growth.  This exceptional growth is from a confluence of low interest rates and a strong bull market.

Over full economic cycles, the company will likely grow earnings-per-share at around 10% a year.  This growth combined with the company’s current dividend yield of 1.4% gives investors an expected annual total return of around 11.4%.

Valuation & Final Thoughts

McGraw-Hill Financial currently trades at a price-to-earnings ratio of 21.8 (using adjusted earnings).  The company is likely trading around the high end of fair value given its slightly above-average expected total returns.

There are two simple facts that make me hesitant about adding to or initiating a position in McGraw Hill Financial:

  1. It is very likely the company will see its earning and price-to-earnings ratio fall significantly during a bear market
  2. There will always be another bear market

Simply put, now is not an especially opportune time to purchase McGraw Hill Financial.  When another bear market comes around, McGraw Hill Financial will likely be a much more attractive purchase.

McGraw Hill Financial is a high quality business build around an extremely durable competitive advantage.  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.

Due to the company’s above average price-to-earnings ratio and below average dividend yield, McGraw Hill financial does not currently rank well using The 8 Rules of Dividend Investing.