Fitch Affirms McGraw-Hill Global Ed's IDR at 'B+'& MHGE Parent PIK Notes at 'B-/RR6'
Proceeds from the note issuance will be used to pay a dividend to Apollo Global Management (Apollo), the sponsor. Funds affiliated with Apollo acquired McGraw-Hill Companies Inc.'s education business for \$2.4 billion in March of 2013. Apollo contributed \$1 billion in cash to complete the acquisition, approximately 40% of the transaction value. This dividend, along with the \$388 million dividend paid in July 2014, and the \$445 million and \$100 million dividends paid by McGraw-Hill School Education (MHSE) in December 2013 and December 2014, respectively, completely eliminates the overall cash outlay by Apollo. Upon Apollo's acquisition of the education business, MHSE and MHGE were separated into two sister non-recourse subsidiaries of MHE US Holdings, LLC. MHSE is not part of the credit profile of MHGE.
While Fitch did not previously model the proposed debt-funded dividend, the transaction is consistent with Fitch's expectations for private-equity-owned issuers. Fitch expects MHGE would prioritize free cash flow (FCF) towards debt reduction to follow the road to an IPO exit, particularly now that Apollo has received cash returns in excess of initial outlays. Following the proposed transaction, there is limited-to-no headroom within the current ratings for additional debt-funded transactions.
MHGE's operating results have performed in line with Fitch expectations. As of Dec. 31, 2014, MHGE has reduced debt by approximately \$175 million since the leveraged buyout (LBO), by a combination of mandatory and voluntary debt reduction. The ratings and Outlook are supported by the strong cash flow-generating characteristics of the company. Fitch calculates 2014 FCF at \$142 million and expects FCF to be \$100 million to \$150 million in 2015 and 2016.
MHGE Parent's senior unsecured notes are not guaranteed by MHGE or any of its subsidiaries (MHGE's debt benefits from subsidiary guarantees), and are structurally subordinate to MHGE's debt. The notes contain a contingent PIK option. The PIK may be exercised in the event that there is not sufficient cash available to MHGE Parent to cover interest payments (except for the first and last interest payment).
Fitch views the credit on a consolidated basis, since MHGE Parent has no operations and its only material asset is the indirect equity interest in MHGE. MHGE will be the primary source of funds to service MHGE Parent's debt. Pro forma for this transaction, Fitch calculates consolidated post-plate leverage to be 6.1x, up from 4.7x at Dec. 31, 2013, and FCF-to-adjusted debt to be 6.6%, down from 18.6% at Dec. 31, 2013. In 2013, FCF materially benefited from improved working capital efficiencies, elevating FCF metrics; Fitch expects relatively neutral working capital swings over the next few years.
Fitch expects consolidated leverage to decline over the next few years, driven by EBITDA growth (supported by low single-digit revenue growth and the benefits from efficiencies/cost reduction initiatives) and mandatory debt reduction at MHGE. Fitch expects gross leverage (based on Fitch's calculation) to be under 6x by year-end 2015. Any future leveraging transactions that drove Fitch calculated gross leverage over 6x would pressure the ratings.
Fitch notes that the PIK feature provides flexibility for the company in the event of weak cash flows. Cash flows to fund interest will be governed by the restricted payment (RP) covenants within the MHGE secured debt documents. However, based on Fitch's base case projection, there is sufficient liquidity and room within the RP basket to fund cash interest payments on the MHGE Parent notes. The MHGE RP basket provisions within the bond indentures include a cumulative 50% of net income basket (which includes various adjustments) and a general RP basket of \$75 million or 3% of total consolidated assets.
KEY RATING DRIVERS
The ratings reflect MHGE's business profile: 64% of revenues from higher education publishing/solutions, 10% from professional education content and services, and 26% from international sales of higher education and professional education materials. The higher education publishing market is dominated by Pearson, Cengage and MHGE. Fitch believes that collectively these three publishers make up approximately 75% market share. This scale provides meaningful advantages and creates barriers to entry for new publishers.
Fitch believes that there could be some near-term enrollment pressures due to continued enrollment declines at for-profit universities and the potential for federal student aid cuts, although Fitch believes MHGE's exposure to for-profit is limited relative to peers. Long-term, Fitch believes enrollment will continue to grow in the low single digits, as higher education degrees continue to be a necessity for many employers.
MHGE and its peers have continued to demonstrate pricing power over their products. Fitch believes this will continue, albeit at lower levels than historically. Textbook pricing increases are expected to slow down substantially and will likely be in the low single digits. Revenue growth will primarily come from the continued growth in sales of digital solution products and pricing increases associated with these digital products as they gain traction with professors.
The transition from physical education materials to digital products has been advancing at a materially faster pace relative to adoption at the K-12 education level. Fitch believes the transition will lead to a net benefit for the publishers over time. Publishers will have the opportunity to disintermediate used/rental textbook sellers, recapturing market share from these segments. Fitch expects print/digital margins to remain roughly the same, as both the discount of the digital textbook (relative to the printed textbook) and the investments made in the interactive user experience offset the elimination of the cost associated with manufacturing, warehousing, and shipping printed textbooks.
Fitch recognizes the risk of digital piracy, given the age demographic of higher education, the current data speeds available on the internet, and the relative ease of finding a pirated text book. A mitigant to piracy risk is the development and selling of digital education solutions. The digital solutions incorporate homework and other supplemental materials that require a user's authentication. The company's strategy is to 'sell' these products to the professors, who then adopt this as required material for the course. Students then purchase the digital solution. This strategy has also been adopted by MHGE's peers. It will be vital for the industry to steer professors towards these digital solutions rather than a stand-alone eBook in order to defend against piracy. Fitch believes this strategy is sound and can be successful.
Fitch expects traditional print revenues to continue to decline due to the growth in eBooks, near-term cyclical pressures in enrollment, and delays by professors in adopting new editions.
LIQUIDITY, FCF AND LEVERAGE
As of Dec. 31, 2014, liquidity was supported by a \$240 million revolver due 2018 and a cash balance of \$232 million. Fitch calculates 2014 FCF of \$142 million. Fitch expects FCF to remain healthy in the \$100 million-\$150 million range in 2015. FCF-to-adjusted debt is calculated at 6.6%; Fitch projects 4%-7% over the next few years. In addition, Fitch expects EBITDA-to-FCF conversion to be around 25% or better (38% at FYE 2014).
The ratings reflect Fitch's expectation that FCF will be dedicated toward debt reduction at MHGE and to small tuck-in acquisitions.
Fitch calculates post-plate EBITDA of \$323 million, resulting in pro forma gross leverage of 6.1x. Fitch's calculation does not add back certain adjustments made by the company, including adjusting for deferred revenue and expected cost savings. Based on Fitch's base case model, with revenues flat to up in the low single digits, Fitch expects leverage to decline to under 6x by FYE 2015 and continue declining, driven by mandatory debt repayment and EBITDA growth.
MHGE's credit facility and its senior secured notes are pari passu with one another and benefit from a first priority lien on all material assets, including a pledge of the equity of domestic guarantor subsidiaries and 65% of the voting equity interest of first-tier foreign subsidiaries, subject to certain exceptions.
MHGE's credit facility is further secured by a pledge of the equity interest of MHGE held by its parent McGraw-Hill Global Education Intermediate Holding LLC (Holdings). While the secured notes do not benefit from the pledge of MHGE's equity by Holdings, Fitch believes the value of the security comes from the assets of MHGE and its subsidiaries (including the equity pledge of MHGE's subsidiaries).
Both the bank facility and the secured notes are guaranteed by existing and future wholly-owned domestic subsidiaries of MHGE (subject to certain exceptions).
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for the issuer include:
--GAAP Revenue flat to up in the low single digits,
--FCF of \$100 million-\$150 million in 2015,
--FCF-to-adjusted debt to remain 4%-7%,
--EBITDA-to-FCF conversion to be around 25% or better.
RECOVERY RATINGS ANALYSIS
MHGE's Recovery Ratings reflect Fitch's expectation that the enterprise value of the company and, thus, recovery rates for its creditors, will be maximized in a restructuring scenario (as a going concern) rather than a liquidation. Fitch estimates a distressed enterprise valuation of \$1.7 billion, using a 6.5x multiple and a post-restructuring EBITDA of approximately \$250 million. After deducting Fitch's standard 10% administrative claim, Fitch estimates recovery for MHGE's senior secured instruments of 88%, which maps to the 71%-90% 'RR2' range. The MHGE Parent notes (including the new \$100 million add-on) have no expected recovery, resulting in an 'RR6' and a rating two notches down from the IDR to 'B-'.
RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to a positive rating action include:
--Continued growth in digital revenues coupled with a financial policy that may include leverage of 4x or less (on a Fitch-calculated basis), along with a clear rationale for such a policy, would likely lead to positive rating actions.
Negative: Future developments that may, individually or collectively, lead to a negative rating action:
--Annual Fitch-calculated FCF of less than \$50 million;
--Gross Fitch-calculated post-plate leverage exceeding 6x on a sustainable basis, whether driven by operating results or a leveraging transaction;
--Mid-single-digit revenue declines, which may be driven by declines or no growth in digital products (caused by a lack of execution or adoption by professors).
Fitch has affirmed the following rating actions:
MHGE
--Long-term IDR at 'B+';
--Senior secured credit facility (term loan and revolver) at 'BB/RR2';
--Senior secured notes at 'BB/RR2'.
MHGE Finance (co-issuer to MHGE's secured term loan, revolver and notes listed above):
--Long-term IDR at 'B+';
MHGE Parent
--Long-term IDR at 'B+';
--Senior unsecured notes at 'B-/RR6'.
MHGE Parent Finance, Inc. (co-issuer to MHGE Parent's senior unsecured notes):
--Long-term IDR at 'B+'.
The Rating Outlook is Stable.
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