Feb. 28 (Bloomberg) -- After 30-year-old Harold W. “Terry” McGraw III helped his father fend off a hostile takeover from American Express Co. more than three decades ago, McGraw-Hill Cos. shareholders were rewarded with an 11 percent annualized return through 2012.
No such good fortune is anticipated now after the U.S. government on Feb. 4 accused the company and its Standard & Poor’s credit-rating unit of fraud. The stock has dropped 20 percent, going from a premium to the market to a discount, and McGraw, now chief executive officer and the family patriarch, faces the firm’s worst crisis in its 125-year history.
“I’ve known three generations of McGraws and they all felt the same way: the firm is sacrosanct,” Joseph Dionne, Terry McGraw’s predecessor as CEO, said in a Feb. 21 telephone interview.
The lawsuit, which seeks as much as $5 billion in damages, or the equivalent of more than five years of profit, reduced the New York-based company’s market value by $3.2 billion and McGraw’s 1.56 percent stake by $54 million to $198.9 million through yesterday, according to data compiled by Bloomberg. The shares are trading today at $46.42 from $58.34 on Feb. 1 and credit-default swaps tied to its debt are near a 10-month high. Moody’s Investors Service cut rival McGraw-Hill’s credit rating by two levels to Baa2, or two steps above junk.
After this month’s rout, the worst since September 2009, the stock trades at 13.74 times earnings, down from 17.16 before the lawsuit was filed and below the average 14.96 for the S&P 500.
“This is his family legacy on the line,” Jeffrey Manns, an associate professor of law at George Washington University in Washington, said of McGraw in a Feb. 13 telephone interview. “He’s gambled his financial future on the future of S&P, and he has more of a stake in the resolution of this litigation than any other party.”
The company, which declined to make the 64-year-old McGraw available for an interview, said in a Feb. 5 statement that the lawsuit is without merit. The government didn’t sue Moody’s or Fitch Ratings. Jason Feuchtwanger, a McGraw-Hill spokesman, said in an e-mail that the company expects to prevail against the claims and forecasts 2013 will be “another strong year.”
McGraw, speaking on a conference call with analysts and reporters Feb. 12, after S&P reported its highest revenue since at least 2009, said executives “will vigorously defend our company, as we have successfully defended against more than 40 other financial crisis-related cases.”
Investors have spurned firms hit with federal lawsuits. After paying a $550 million fine to settle charges from the U.S. Securities and Exchange Commission that it misled investors on sales of collateralized debt obligations, Goldman Sachs Group Inc. has yet to recover its market value, which fell to $73.5 billion yesterday from more than $100 billion before it was sued in April 2010.
McGraw-Hill dates back to 1888, when James H. McGraw acquired The American Journal of Railway Appliances, according to the company’s website. He later merged his book-publishing department with John A. Hill’s, creating the McGraw-Hill Book Co.
Terry McGraw, who graduated from Tufts University in Medford, Massachusetts, and has an MBA from the University of Pennsylvania’s Wharton School of Business, took a leave of absence in 1979 from GTE Corp., now part of Verizon Communications Inc., when he was brought in to defend the family legacy from American Express, Dionne said.
He joined his brother Robert as they rallied around the late Harold W. McGraw Jr. while he beat back James D. Robinson III’s charge-card issuer. Bringing in his sons showed the family’s concern, “not only about the company, but all the people in the company,” Dionne said.
McGraw-Hill warded off its unwanted suitor in part by claiming one of its own directors violated his fiduciary duty, according to Dionne, who retired in 1998 after 15 years as CEO and more than 30 years at the company. The McGraw-Hill director was employed by American Express when it was planning the bid, he said.
“The McGraws were astonished that American Express would try to acquire a company that didn’t want to be acquired,” Martin Lipton, a founding partner of law firm Wachtell, Lipton, Rosen & Katz who represented the company at the time, said in a telephone interview on Feb. 19. “You have to recognize that in 1979 while there had been some hostile takeover attempts, there were virtually none in which a major established company went after another major established company.”
McGraw formally joined the company in 1980, holding a variety of jobs that included publisher of Aviation Week and Space Technology magazine and head of the financial services division that included S&P.
He was named CEO in 1998, and transformed the company from a publisher into a financial services firm dominated by S&P, the world’s biggest credit-rater, which his father had bought in 1966. He cast off publications from Chemical Engineering to Modern Plastics to Businessweek, which was purchased in 2009 by Bloomberg LP, the parent of Bloomberg News.
Focusing on the faster-growing ratings business helped McGraw-Hill recover from the recession, sending its shares to a five-year high of $58.62 on Feb. 1. The shares have gained 139 percent since April 1998, compared with a 35 percent rise in the S&P 500 index, Bloomberg data show. Named chairman in 2000, McGraw earned $1.4 million in salary in 2011 and $8.7 million including stock options in total compensation for the year.
“I give Terry a high grade,” Peter Appert, an analyst for Piper Jaffray & Co., who’s been covering the company for at least 20 years, said in a telephone interview on Feb. 14. “Even acknowledging some of the volatility we’ve seen in the stock recently, this has been a very rewarding stock over the course of his tenure as CEO.”
After completing the sale of its education division for $2.5 billion to Apollo Global Management LLC., McGraw-Hill will be more reliant than ever on revenue from Wall Street and companies selling securities graded by S&P while leaving it with the most cash in six years, Bloomberg data show.
“With the education business going nowhere and acting as a drag on the company, he made what had to be a very tough decision because that was the family business.” Ed Atorino, a media analyst at Benchmark Co. in New York who forecasts McGraw-Hill stock will outperform its peers over the next six to 12 months, said in a telephone interview Feb. 14. “Under his leadership, McGraw-Hill has really moved forward.”
The moves also contributed to the company’s biggest challenge since the American Express takeover attempt as the Justice Department alleges S&P inflated grades on mortgage-backed securities to win business, helping trigger the worst financial crisis since the Great Depression.
The S&P unit’s designation as a Nationally Recognized Statistical Rating Organization by the SEC has benefited the company. Some investors are required to buy only securities rated by an NRSRO to meet regulatory requirements. S&P, Moody’s and Fitch were the first to obtain the license in 1975, and by 2011 provided 96 percent of all grades in the debt market, a November SEC report found.
That imprimatur became more valuable during the early and mid-2000s as easy credit led Wall Street firms to package record amounts of subprime mortgages and other assets into bonds, and companies ramped up borrowing.
S&P rated more than $2.8 trillion of residential mortgage-backed securities and about $1.2 trillion of CDOs from September 2004 through October 2007, according to the Justice Department complaint filed in federal court in Los Angeles.
At the height of the structured finance boom in 2007, McGraw-Hill reported record revenue of $6.77 billion, a 46 percent increase from 2001, with its financial services division responsible for 75 percent of operating income, Bloomberg data show. The stock price soared from $24.35 to as high as $72.50, with the 206 percent gain beating the S&P 500’s 58.4 percent rise.
When the U.S. housing boom collapsed, the world’s largest banks reported $2.1 trillion in losses and writedowns. Frozen credit markets triggered the worst financial crisis since the Great Depression and cost 8.8 million people their jobs.
Securities that S&P and Moody’s rated AAA and helped Wall Street firms structure defaulted within months.
S&P, Moody’s and Fitch were “key enablers of the financial meltdown,” the Financial Crisis Inquiry Commission, created by Congress with a 10-member bipartisan board, said in its January 2011 report. “This crisis could not have happened without the rating agencies.”
The commission’s report also blamed the crisis on lenders’ irresponsible and sometimes fraudulent practices; regulators’ inattention and overconfidence; and the recklessness of borrowers and investors.
“The fact is that S&P’s ratings were based on the same subprime mortgage data available to the rest of the market -- including U.S. government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained,” McGraw-Hill’s Feuchtwanger wrote in the e-mail.
The ratings business is starting to make a comeback, with corporate bond sales from the U.S. to Europe and Asia climbing 20.4 percent to a record $3.97 trillion last year, according to Bloomberg data. Yields on the debt from the most creditworthy to the riskiest borrowers plummeted to an all-time low of 3.24 percent on Dec. 28, according to the Bank of America Merrill Lynch Global Corporate & High Yield index.
S&P had sales of $2.03 billion last year, the most since at least 2009, Bloomberg data show. The unit accounted for 45 percent of McGraw-Hill’s revenue and 56 percent of operating income in 2012, according to the data.
McGraw-Hill faces lawsuits from 16 states and the District of Columbia in addition to the federal case, which may not go to trial for “two to three years,” Kenneth Vittor, the company’s chief counsel, said on the conference call Feb. 12.
For McGraw, whose board hasn’t named a successor, fighting the government will help determine his legacy.
“This is much more than a job for him; it’s his heritage,” Kathryn Wylde, president and chief executive officer of Partnership for New York City, a nonprofit organization of the city’s business leaders, where McGraw has served as a board member for a dozen years, said in a telephone interview Feb. 19. “The impact and implications of these accusations are more difficult than if you were a hired-hand CEO.”
The Justice Department case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Santa Ana).
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