OREANDA-NEWS. Fitch Ratings has affirmed the Issuer Default Rating (IDR) for McGraw-Hill School Education Holdings, LLC (MHSE) at 'B' and the rating on the senior secured term loan at 'BB/RR1'. The Rating Outlook is Stable. MHSE is the K-12 educational content business of McGraw-Hill Education (MHE). A complete list of ratings follows at the end of this release.

The ratings reflect Fitch's belief that MHSE's current capital structure is not permanent and that the company would carry higher debt levels for additional equity returns or acquisitions. Fitch does not expect additional leveraging transactions in the near- to mid-term.

In March 2013, funds affiliated with Apollo Global Management, LLC (Apollo) acquired MHE, McGraw-Hill Companies Inc.'s global education business, for $2.4 billion. Apollo contributed $1.0 billion in cash to complete the acquisition. Since the acquisition, MHSE ($644 million) and MHGE Parent, LLC ($389 million), have returned an aggregate $1,033 million to Apollo, funded with a mixture of incremental debt and cash on hand. MHGE Parent, LLC, a sister subsidiary to MHSE, houses MHE's higher education publishing and solutions and professional and international education content and services businesses.

The term loan benefits from a first-priority lien on all non-asset-backed loan (ABL) collateral assets and a second lien on the ABL collateral assets. Between the two collateral groups, materially all MHSE's assets secure the term loans and the $150 million ABL facility in either a first-lien or second-lien position. The term loans are also guaranteed by the same subsidiaries that guarantee the ABL facility. The guarantors are MHSE's domestic wholly owned subsidiaries, which make up a material portion of MHSE's operations. McGraw-Hill School Education Intermediate Holdings also provides a guarantee.

The term loan amortizes 1% per annum and matures in 2019. There is no mandatory excess cash flow sweep. MHSE has an uncommitted option to increase the term loan by $75 million and may increase the term loans for a higher amount, limited by a net first lien leverage ratio of 2.5x for parity debt and a 4x limit for term loans junior to the secured term loans.

KEY RATING DRIVERS
MHSE is one of three leading K-12 educational content providers. Fitch believes that Pearson, Houghton Mifflin Harcourt (HMH) and MHSE hold more than 80% of the U.S. K-12 text book publishing market.

Fitch believes MHSE and its peers have endured a period of cyclical weakness and should benefit from strong adoption opportunities currently scheduled for 2017 and 2018. State and municipal revenues and education budgets are improving. In addition, the adoption of Common Core State Standards (CCSS) for English language arts and math has driven demand for new textbooks, educational materials and digital learning solutions.

Fitch expects MHSE to continue investing in its digital products, including through small bolt-on acquisitions. In addition, the company refocused its salesforce to better sell its digital products. These investments and salesforce initiatives allow MHSE to benefit from the rebound in the K-12 educational market. Fitch expects MHSE should be able to at least defend its existing market share and more likely grow it, especially in light of its success in recent adoptions in California and Texas.

Fitch's base case model assumes flat to slightly negative GAAP revenue growth in 2015 and 2016. However, digital revenues do not fully impact GAAP revenues in the then-current period and accrue in deferred revenues. Due to GAAP treatment of digital revenues, which are providing an increasing percentage of MHSE's total revenues, a growing portion of total annual cash revenues are deferred over an adoption's term. As Fitch expects digital revenues to continue to grow, GAAP revenues realized in a given year will eventually match cash revenues recognized in that year. To account for this timing differential, Fitch calculates leverage on a total debt to funds from operations (FFO) basis across the industry, with the change in deferred revenue included in the calculation of FFO. Fitch's base case demonstrates that the company can deliver lower GAAP revenue growth and still maintain current ratings.

Based on Fitch's base case, MHSE is expected to generate in the range of $100 million to $150 million in free cash flow (FCF before dividends) in 2015 and 2016. The ratings reflect Fitch's expectation that FCF will be dedicated towards dividends, acquisitions and organic investments in digital content and that most acquisitions will be small bolt-on acquisitions.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for the issuer include:
--GAAP revenue flat to slightly down in 2015 and 2016 as GAAP digital revenues are expected to somewhat offset minimal adoptions. In 2017 and 2018, large new adoption opportunities and associated digital offerings drive GAAP revenue growth in the mid-single digits.
--FFO is expected to range from $125 million to $200 million for the forecasted period;
--FFO adjusted leverage to be less than 2.0x throughout the rating forecast period.

RATING SENSITIVITIES
Rating Upgrade: Positive rating actions may be considered if a clear financial policy commensurate with a higher rating is communicated, which could include a leverage target and/or strategy as to shareholder policy in terms of return of capital. If MHSE publicly committed to a financial policy that reflected its current capital structure, the IDR could be considered in the 'BB' category context. Growth of FFO and FCF ahead of Fitch's expectations, which would likely demonstrate the company's ability to drive digital revenue growth and/or retake market share from its competitors, could also lead to positive rating momentum.

Rating Downgrade: Revenue declines on a cash basis in the low- to mid-single digits could result in rating pressures.

LIQUIDITY
Based on Fitch's base case, Fitch-calculated funds from operations adjusted leverage is expected to be approximately 2.0x at the end of 2015, and to decline through 2017.

As of Sept. 30, 2015, liquidity was supported by $212 million in cash and its undrawn $150 million ABL facility due in 2018. Fitch expects 2014 year-end cash balances of approximately $240 million and that MHSE will have sufficient liquidity to fund seasonal cash flow needs.

FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:

MHSE
--Long-term IDR at 'B';
--Senior secured term loan at 'BB/RR1';
The Rating Outlook is Stable.