Rating McGraw-Hill

CEO Terry McGraw kept a low profile as he built McGraw-Hill into a moneymaking machine. But that was before its Standard & Poor's subsidiary went from cash cow to a catalyst of the economic meltdown.

By William D. Cohan, contributor

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Harold 'Terry' McGraw III, across the street from Manhattan's McGraw-Hill building.
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Deven Sharma took over S&P last summer.

(Fortune Magazine) -- One warm day recently, a double-decker tourist bus barreled past Harold "Terry" McGraw III as he walked in front of the Manhattan skyscraper that is the world headquarters of the McGraw-Hill Cos. McGraw, the fourth generation of his family to run the company, heard the tour guide say, "And now we're coming up to the McGraw-Hill building."

McGraw thought to himself, "Hey, that's kind of cool. We're on the circuit. I didn't know that." Then he heard, "And sadly there are no McGraws alive today."

This unintended slight serves as a metaphor for Terry McGraw's 11 years running the company. Being the CEO of a media dynasty usually guarantees the scion at the helm two things: headlines and headaches. Just ask the Washington Post's Donald Graham or the New York Times' Arthur Ochs Sulzberger Jr. In contrast, Terry McGraw, 60, has traveled virtually incognito through the greatest scandal in McGraw-Hill's 121-year history.

The scandal has to do with Standard & Poor's, a McGraw-Hill subsidiary and one of the three major credit ratings agencies blamed in part for causing the current economic crisis.

In fact, the corruptness of S&P's business model - being paid fees by the same Wall Street banks that underwrite the securities S&P rates - is one of the few issues that the left and right agree on.

When the rating agencies' CEOs appeared before the House Oversight and Government Reform Committee last October, Jackie Speier (D-Calif.) called the agencies' conduct a "bone-chilling definition of corruption." Similarly, former congressman Christopher Shays (R-Conn.) said, "The ratings agencies are useless now. I think they have no brand."

Beyond loss of face, McGraw-Hill is also contending with investigations and litigation - lots of it. Some six states' attorneys general - including New York's Andrew Cuomo, Connecticut's Richard Blumenthal, and Ohio's former attorney general Marc Dann - have investigated S&P. (Ohio subsequently dropped the investigation.) "Everybody knows they don't get paid until the transaction gets a triple-A rating," Dann said in September 2007. (S&P has 12 ratings - from the highest, AAA, to the lowest, D - that it bestows on corporate and municipal debt based upon the assessed creditworthiness of the issuer. S&P also rates more exotic forms of debt.)

Then there are the private lawsuits: The Teamsters pension fund, a sizable McGraw-Hill shareholder, and the Boca Raton Firefighters and Police Pension Fund, the lead plaintiff in a large class-action lawsuit, have both sued McGraw-Hill, claiming that the company essentially misled investors through flawed debt ratings, helping to cause the collapse of the credit markets and drag down McGraw-Hill's stock with it.

In person, Terry McGraw does not come across as the "bone-chilling definition of corruption." He is a mild-mannered Connecticut patrician whose idea of leverage is going double or nothing on a putt at the Wee Burn Country Club in Darien. (He has a nine handicap.) He is married and has two children - a daughter, Megan, and a son, Harold Whittlesey-McGraw IV, who works for the privately held agribusiness Cargill. It is not hard to imagine McGraw as the affable local-TV weatherman he briefly was after college. Inside the buttoned-down McGraw-Hill corporate offices, the wags call the natty McGraw "he of the pocket square."

In the wake of the S&P scandal, restoring his family's good name has become the defining test of McGraw's leadership, and his ability to restore McGraw-Hill's credibility with investors will determine his legacy. Despite McGraw's best efforts to build a bulletproof balance sheet, investors have punished the company because of how highly correlated its revenues are to the financial sector.

Of McGraw-Hill's $6.4 billion in revenues last year, financial services - which includes S&P and Capital IQ (a data service) - accounted for $2.6 billion. Its school textbook business accounted for another $2.6 billion. The balance of the revenues - $1.2 billion - come from its media businesses, which include four television stations and Business Week (a Fortune competitor).

When it comes to profits, though, it is S&P that really moves the needle: More than $1 billion of the company's 2008 operating profit of $1.5 billion derived from financial services, down from $1.4 billion out of $1.8 billion in 2007. And lately that engine has been sputtering. The issuance of new corporate and government-debt securities fell through the floor in the fourth quarter of 2008, helping to reduce year-over-year revenue by 13% at S&P, where profit margins have historically been as high as 45%.

The downturn has afflicted McGraw-Hill's education and media holdings too. The growing fiscal deficits in 41 states have called into question how much can be spent on the textbooks that McGraw-Hill publishes. Ad spending is down as well. Revenue at the company's four television stations - augmented by record buys for political ads during 2008 - is looking bleak, while ad pages at Business Week have fallen 31.8% since 2005. (Fortune's dropped 22% during the same time frame.) Similar woes confront both Platt's, a McGraw-Hill division that publishes trade journals for the energy and metals markets, and J.D. Power & Associates, a provider of data on customer satisfaction.

Nevertheless, Terry McGraw remains upbeat about McGraw-Hill's prospects. "Once we get through this [credit crunch], then we'll be fine," he said in a rare interview at the company's New York headquarters, in a conference room decorated with landscape paintings by William Elston. He thinks it is only a matter of time before the stock market wakes up to the company's sound fundamentals: Free cash flow is expected to be around $450 million in 2009, and net debt a mere $800 million, none of which matures until 2012 and one-third of which is due in 2037. (Both Moody's and Fitch rate McGraw-Hill's debt an A.) Nevertheless, the company's stock, which was trading around $45 per share before Lehman Brothers filed for bankruptcy on Sept. 15, 2008, fell by half after that event. It has since come back up and was trading at $24 per share in mid-April. Debt issuance - and the ratings that accompany it - has picked up a bit in the first quarter of 2009 as well.

"Our numbers were all solid," McGraw said. "The balance sheet is solid. Free cash flow is still there. We're profitable and doing well." McGraw also points out that the company has been paying a dividend since 1937 and has been increasing that dividend every year for the last 36. Chatting about the company's figures is easy for Terry. What is a tougher exercise is discussing where he was during S&P's transformation from reliable rating agency to panderer of toxic assets.

***

Growing up, Terry never aspired to be the CEO of the company. As a teenager, he genuinely believed he would be playing linebacker or guard for the Green Bay Packers. During the 1960s the Packers apparently encouraged high schools to send tapes of their outstanding players, on the off chance that there was a rare talent among them. While at the Salisbury School, McGraw was one of the four players identified on the film the Connecticut boarding school sent to the Packers. "We were really feeling good," he said. "But the Packers rated us as being three years behind the average entering freshman. I can't tell you how deflating that was."

His first foray into the family business did not go well either. One summer during college, before he headed off to be a camp counselor, he decided he wanted to see what it would be like to be a salesman at McGraw-Hill. He spent three weeks working for the top salesman at the company and came up with the idea of asking travel agents to sell a foreign-language translation product that McGraw-Hill produced. The veteran McGraw-Hill salesman told McGraw the product would not sell well in the travel agencies, but McGraw insisted anyway. "I went, 'Charlie, you're the best. I think it'll work,'" McGraw remembers. "He said, 'Fine, okay. Let's put together a list of all the travel agencies in New York City on this one. We'll put together this kit, and good luck.' About 21/2 weeks later, guess what? Doesn't work. So I'm back to being camp counselor."

After graduating from Tufts and getting an MBA at Wharton, McGraw went to work at GTE (a telephone company that is now part of Verizon), revamping its pension plans. His career path changed when American Express (AXP, Fortune 500), led by James D. Robinson III, launched a $34-a-share, $830 million hostile takeover of -McGraw-Hill. The year was 1979, and Terry took a three-month leave of absence to help his father, Harold McGraw Jr. (then CEO), fend off the takeover.

American Express's offer represented a 30% premium to McGraw-Hill's prevailing stock price at the time. American Express raised its offer to $40 per share a few weeks later. But from the start, the McGraws by and large viewed the American Express offer as an unwelcome act of corporate aggression, especially since Roger H. Morley, the president of American Express, was on McGraw-Hill's board of directors. Charges of corporate espionage, betrayal, and immorality were flung far and wide as McGraw-Hill hunkered down to fight American Express. "This was a violation of the worst order," Terry McGraw says of the way that a McGraw-Hill director encouraged his boss at American Express to launch the hostile bid.

McGraw-Hill repeatedly rejected the American Express offers, and it won. This style of takeover defense came to be known as Scorched Earth, and the McGraws were one of the early adopters of the tactic at a time when the rules on the M&A battlefield were changing rapidly. The term of art, Scorched Earth, describes the willingness of shareholders and management to do whatever it takes to fend off a hostile takeover. It meant accusing American Express of being an inappropriate steward of the First Amendment issues supposedly so near and dear to McGraw-Hill.

"The conclusion obviously was," McGraw explained, as if back in the moment, speaking directly to James Robinson, "If McGraw-Hill were to sell itself, you wouldn't be the one we would sell to. We don't care for your approach, and we'll fight you." The defense worked, and American Express slunk away empty-handed. A year later McGraw left GTE for good and came to McGraw-Hill. His father retired as president and CEO in 1983 and was replaced by longtime McGraw-Hill executive Joseph Dionne - a neighbor of the elder McGraw's in New Canaan - who ran the company for the next 15 years. In 1998 the board selected Terry McGraw as CEO. His younger brother Robert left the company not long after that. (Robert is now the chief executive officer of Averdale International, an investment and consulting company.)

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