Fitch Affirms McGraw-Hill Global Education's IDR at 'B+'; Outlook Stable
NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the 'B+' Issuer Default Rating (IDR) of McGraw-Hill Global Education Holding LLC (MHGE) and McGraw-Hill Global Education Finance, Inc. (MHGE Finance; co-issuer of the secured debt). Fitch has also affirmed the senior secured debt ratings of 'BB/RR2'. The Rating Outlook is Stable. A full list of ratings can be found at the end of this release.
KEY RATING DRIVERS
The ratings reflect MHGE's business profile: 63% of revenues from higher education publishing/solutions, 10% of revenues from professional education content and services, and 27% from international sales of higher education, professional and primary 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 to these three publishers and creates barriers to entry for new publishers.
Fitch believes that there could be some near-term enrollment pressures due to continued enrollment pressures at for-profit universities and the potential for federal student aid cuts. 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 be in the low single digits. Revenue growth will primarily come from the continued growth in the volume of digital solution products sold and pricing increases associated with these digital products as they gain traction with professors.
The transition from printed education materials to digital products has been advancing at a faster pace relative to K-12 education level. Fitch believes that the transition will lead to a net benefit for the publishers over time. Publishers will have the opportunity to disintermediate used/rental text book 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 print 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 that this strategy is sound and can be successful. Fitch notes that adoption will be slow due to the slow to change nature of many professors.
Fitch expects traditional print revenues to continue to decline due to growth in eBooks, near-term cyclical pressures in enrollment, and delays by professors in adopting new editions. In 2013, these print declines were offset by growth in digital solutions, custom publishing and eBooks. Fitch does not expect a material acceleration in print declines and believes that the digital solutions, custom publishing and eBooks will continue to provide an offset for these print declines.
The ratings reflect cost savings identified by MHGE, approximately $80 million through 2015. Cost reductions include corporate and IT costs driven by headcount reductions and outsourcing. Fitch believes this is achievable given the historical ownership of MHGE within a conglomerate.
MHGE did not provide audited financial statements. Audited combined financial statements for McGraw-Hill Education LLC (MHE) were provided, which combined MHGE and McGraw-Hill's School Education Group (MHSE). 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 MHGE's reported September 2013 last 12 months (LTM) results, Fitch calculates post plate EBITDA of $291 million, resulting in gross leverage of 5.2x. Fitch post plate EBITDA 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 down in the low single digits, Fitch expects leverage to remain near 4.5x - 5.0x in 2013 and decline in 2014 driven mandatory debt repayment and EBITDA growth.
The ratings reflect the strong FCF metrics of MHGE. Fitch estimates September 2013 LTM free cash flow (FCF) of approximately $346 million. In 2013, FCF materially benefited from the improved working capital efficiencies. Fitch expects FCF to decline, however, remain healthy in the $50 million-$100 million range in 2014. As of September 2013 LTM, FCF to debt is estimated at 23%; Fitch projects 5%-10% in 2014. EBITDA to FCF conversion metrics are elevated in 2013 due to the working capital efficiencies and cost reduction initiatives, but absent these initiatives Fitch would expect FCF conversion to be around 35% or better.
The ratings reflect Fitch's expectation that FCF will be dedicated towards acquisitions and debt reduction. Fitch believes most acquisitions will be small tuck in acquisitions. While management has not stated a leverage target, Fitch believes that the private equity ownership is incentivized to reduce leverage in order to improve the prospects of an exit from its investment. Fitch does not expect additional leveraging transactions in the near to mid-term.
As of September 2013, liquidity was supported by $240 million revolver due 2018 and cash balance of $181 million.
The credit facility and the 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.
The 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's 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 notes are guaranteed by existing and future wholly owned domestic subsidiaries of MHGE (subject to certain exceptions).
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 $1.5 billion, using a 6x multiple and a post restructuring EBITDA of approximately $250 million. After deducting Fitch's standard 10% administrative claim, Fitch estimates recovery for the senior secured instruments of 77%, which maps within 71%-90% 'RR2' range. Issuance of additional secured debt could result in a one notch downgrade of the issue ratings.
Continued growth in digital revenues coupled with leverage of 4x or less (on Fitch-calculated basis) would likely lead to positive rating actions.
Mid to high-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) would pressure ratings.
Fitch has affirmed the following ratings:
--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+'.
The Rating Outlook is Stable.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria & Related Research:
--'Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage' (Aug. 5, 2013);
--'Credit Encyclo-Media VI: Fitch's Comprehensive Analysis of the U.S. Media & Entertainment Sector' (Sept. 19, 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage
Credit Encyclo-Media VI: Fitch's Comprehensive Analysis of the U.S. Media & Entertainment Sector