Fitch Rates McGraw-Hill School Education Initial IDR 'B' and Term Loans 'BB/RR1'

NEW YORK--()--Fitch Ratings has assigned an initial Issuer Default Rating (IDR) of 'B' for McGraw-Hill School Education Holdings, LLC (MHSE) and assigned a 'BB/RR1' rating to the proposed senior secured term loans. The Rating Outlook is Stable. MHSE is the K-12 educational content and test assessment business of McGraw-Hill Education (MHE). A complete list of ratings follows at the end of this release.

Proceeds of the term loans, along with cash on the balance sheet, will be used to fund a $395 million dividend to the shareholders and cover transaction costs. Funds affiliated with Apollo Global Management (Apollo) acquired MHE for $2.4 billion in March of 2013. Apollo contributed $1 billion in cash to complete the acquisition, approximately 40% of the transaction value. The dividend would reduce the overall equity outlay by Apollo to approximately 25% (based on the $2.4 billion transaction value). The ratings reflect Fitch's belief that the current capital structure is not permanent and over the long term MHSE would carry higher levels of debt on its balance sheet, which may be used for further equity returns or acquisitions. However, Fitch does not expect additional leveraging transactions in the near to mid-term.

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

The term loans will amortize 1% per annum and mature in six years. There is no mandatory excess cash flow sweep. MHSE expects to have an uncommitted option to increase the term loans 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 proposed term loans.

KEY RATING DRIVERS

McGraw-Hill School Education Group (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 US K-12 text book publishing market.

Fitch believes MHSE and its peers have endured a period of cyclical weakness. 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 will drive demand for new textbook, educational materials and digital learning solutions. Fitch believes that the educational content providers will grow revenues organically starting in 2013/2014.

Fitch expects MHSE to continue investing in its digital products, including through acquisitions. In addition, the company has refocused its sales force to place it in a position to better sell its digital products. These investments and sales force initiatives should position MHSE to benefit in the rebound in the K-12 educational market. Fitch expects MHSE to at least defend its existing market share. Fitch's base case model assumes revenues growth in the low-single digits in 2014 and 2015. Fitch recognizes that there could be upside in 2015 revenue growth, supported by the expected California and Texas adoptions. Fitch's base case demonstrates that the company can deliver lower revenue growth and maintain current ratings.

Based on Fitch's base case, MHSE is expected to generate $75 to $100 million in FCF in 2013 and $50 to $75 million in 2014. The lower FCF in 2014 is driven by working capital swings and investments in product development due to the increased adoption/sale expectations. The ratings reflect Fitch's expectation that FCF will be dedicated towards acquisitions and organic investments. Fitch believes most acquisitions will be small tuck in acquisitions. Investments into adjacent K-12 educational markets may provide diversity away from highly cyclical state and local budgets.

MHSE did not provide audited financial statements. Audited combined financial statements for McGraw-Hill Education LLC were provided, which combined MHSE and McGraw-Hill's Global Education Holdings (MHGE). Unaudited break out of these two divisions were provided by management and used by Fitch to assign ratings. Upon the acquisition of MHE by Apollo, MHSE and MHGE were separated into two sister non-recourse subsidiaries of MHE.

LIQUIDITY, FCF AND LEVERAGE

Based on Fitch's base case, Fitch calculated FFO adjusted leverage is expected to be approximately 2.3x at the end of 2013, exceed 3x in 2014 and decline below 3x by 2015. Adjusting EBITDA for deferred revenue, one-time items and deducting plate expenditures, gross leverage is expected to range from 1.8x to 2.3x in 2013 and 2014.

As of Sept. 30, 2013, liquidity was supported by $269 million in cash (prior to the proposed dividend). The company also has its undrawn $150 million ABL facility due in 2018. Fitch expects 2013 year end cash balances of approximately $100 million (following the proposed dividend). Fitch believes MHSE will have sufficient liquidity to fund seasonal cash flow needs.

RECOVERY RATINGS ANALYSIS

MHSE'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. Given the strong recovery prospects, the $200 million senior secured term loan is notched up to 'BB/RR1'.

RATING SENSITIVITIES

Rating Upgrade: Long-term, meaningful diversification into international markets (through its royalty received from MHGE) and into new business initiatives could lead to positive rating actions. Also, growth of EBITDA 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 lead to positive rating momentum.

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

Fitch has assigned the following ratings:

MHSE

--Long-term IDR at 'B';

--Proposed senior secured term loans at 'BB/RR1';

The Rating Outlook is Stable.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria & Related Research:

--'Corporate Rating Methodology' (Aug. 8, 2012).

Applicable Criteria and Related Research:

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=810405

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Contacts

Fitch Ratings
Primary Analyst:
Rolando Larrondo, +1-212-908-9189
Director
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst:
David Peterson, +1-312-368-3177
Senior Director
or
Committee Chairperson:
Michael Weaver, +1-312-368-3156
Managing Director
or
Media Relations:
Brian Bertsch, New York, +1 212-908-0549
brian.bertsch@fitchratings.com

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Contacts

Fitch Ratings
Primary Analyst:
Rolando Larrondo, +1-212-908-9189
Director
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst:
David Peterson, +1-312-368-3177
Senior Director
or
Committee Chairperson:
Michael Weaver, +1-312-368-3156
Managing Director
or
Media Relations:
Brian Bertsch, New York, +1 212-908-0549
brian.bertsch@fitchratings.com