McGraw Hill Selling Jet Shows CEO’s Effort to Top Moody’s

By Matt Robinson

Doug Peterson sold his old boss’s jet not long after becoming chief executive officer in November, a move to cut expenses that help keep McGraw Hill Financial Inc. (MHFI) less profitable than rival Moody’s Corp. (MCO)
The $5 million annual savings aren’t the biggest concern for the 126-year-old company, however. It’s a $5 billion U.S. Justice Department lawsuit against McGraw Hill’s Standard & Poor’s unit claiming it accommodated issuers of mortgage bonds at the expense of investors before the 2008 financial crisis. S&P also faces a possible Securities and Exchange Commission penalty regarding 2011 ratings of commercial mortgage-backed securities.
McGraw Hill has staked its future on financial services after jettisoning its publishing business in March 2013. A guilty verdict or an admission of
wrongdoing in the Justice Department case would open the door to more lawsuits against a credit-rating business that accounted for 46 percent of the company’s revenue last year, said Jeffrey Manns, a law professor at George Washington University in Washington.
“If McGraw Hill admits that S&P’s ratings were not independent and objective and that the business side shaped ratings, that admission would be used against McGraw Hill in every subsequent case because it calls into question the business model of the rating agency,” Manns said. “It would tarnish the brand in a much deeper way than a financial settlement would.”

Reasonable Settlement

S&P has said it believes the lawsuit is retaliation for the company’s 2011 decision to downgrade the country’s credit rating.
“We’ve always been open to a reasonable settlement,” Peterson, 56, said in an Aug. 13 interview in his corner office in downtown Manhattan. It overlooks Governors Island, in New York Harbor, and is decorated with framed nature photos and a baseball bat autographed by the New York Yankees’ Ichiro Suzuki.
Peterson has experience smoothing things over with government officials. He led Citigroup Inc.’s efforts in 2004 to mend the New York-based lender’s relationship with Japan after regulators accused the bank of breaking the law.
While McGraw Hill and Justice Department attorneys exchange evidence in the pre-trial process known as discovery, Peterson is tackling the company’s fiscal challenges. To cut costs, symbolically if not deeply, Peterson sold the corporate jet, which will save about $5 million in annual operating costs, according to a person with knowledge of the transaction.

Devouring Perks

Peterson’s decision to fly commercial is a break from the 15-year reign of former CEO Harold “Terry” McGraw III. McGraw, who remains as chairman, bought the jet from the company for $20 million, according to a regulatory filing.
Peterson is “certainly not into glitz or devouring of the perks you see in some corporate structures,” said Richard Herring, a professor at the University of Pennsylvania’s Wharton School of Business, who’s known Peterson since the 1990s and serves with him on the Federal Deposit Insurance Corp.’s Systemic Resolution Advisory Committee.
Peterson has found more savings in real estate. McGraw Hill paid $60 million to terminate the lease five years early at its namesake building across the street from Rockefeller Center and the dancing Rockettes of Radio City Music Hall. The midtown Manhattan building features wood paneling and views out of full-length glass windows on the 49th floor, according to people who worked there. The executive team is joining their S&P ratings colleagues at cheaper digs on Water Street, where Peterson has his view of New York Harbor.

Aggressive Focus

“Let’s face it. Rockefeller Center is a more prestigious address than 55 Water Street, but they’re choosing the more cost-efficient route,” said Peter Appert, a San Francisco-based analyst for Piper Jaffray & Co. who’s been covering the company for more than two decades and recommends buying the shares. Since Peterson took over, McGraw Hill has “a more aggressive focus on improving profitability and improving margins and closing the margin gap” with Moody’s, he said.
Another way Peterson has moved to catch up is by winnowing layers of management. Under a plan implemented by S&P President Neeraj Sahai, the company is cutting its ratings workforce by about 6 percent by offering voluntary buyouts to as many as 100 U.S. employees with business titles of director and above.

410 Percent

Shares climbed to a record $84.70 on June 11 after rallying 43 percent last year. McGraw Hill has gained 6.7 percent this year with dividends reinvested, trailing Moody’s 19.8 percent rise.
Under former CEO McGraw, the stock advanced 410 percent from April 1998 through the end of October. That compares with the 110 percent increase in the S&P 500 index (SPX) during the same period.
Part of the reason for the outperformance is the growing demand for credit ratings. McGraw Hill’s S&P unit has posted four straight years of increasing revenue as the Federal Reserve holds interest rates near record lows, encouraging companies to tap debt markets and boosting the need for credit opinions.
While Fed policy and the sale of its education unit have helped lift McGraw Hill’s operating margin to 36.1 percent, its highest in at least a decade, the company still trails the 47.1 percent of 105-year-old Moody’s, according to data compiled by Bloomberg. That makes Moody’s the 14th-most profitable company by that measure in the S&P 500. McGraw Hill is No. 42, according to the data.

Legal Defense

One expense that keeps S&P’s profit margin narrower than Moody’s is the cost of preparing a legal defense, Peterson said in a July 29 conference call with equity analysts.
McGraw Hill’s businesses are more diverse than its main competitor. Its other divisions include S&P Dow Jones Indices, which licenses benchmarks, and S&P Capital IQ, a financial data provider. Sales from those units have climbed about 7 percent in the last year. The company sold its education unit for $2.4 billion to Apollo Global Management LLC in March 2013 under former CEO McGraw.
Peterson, who joined S&P’s Ratings Services as president in 2011, has added executives from outside the company. They include former Citigroup colleague and now S&P president Sahai and incoming general counsel Lucy Fato, who joined last month from Marsh & McLennan Cos. (MMC) Fato succeeds Kenneth Vittor, who’s retiring after leading the company’s legal strategy since 1995.
Peterson is “a little more in control of the management team, more of a head man” than his predecessor, said Edward Atorino, a New York-based analyst at Benchmark Co., who’s been covering the company for more than 20 years and recommends holding the shares. “Terry was more of delegator.”

Unify Cultures

The company’s 17,000 employees are still getting used to the change. During a retreat in Miami earlier this year for 150 business leaders, a survey showed employees were hesitant to speak their minds, according to a person who attended the meeting.
“We’re trying to unify the cultures because the cultures in the company were not all the same,” Peterson said in the interview in his office. “We want an open environment, open dialogue. The more people that feel like they can speak up, the better you are in the long run.”
Peterson grew up in Santa Fe, New Mexico. He said he worked multiple jobs, including selling popcorn and snow cones at a local rodeo. He received a master’s degree from the Wharton School with the idea of traveling abroad. Peterson was hired by Citigroup, where he spent the next 25 years working for the lender around the world, including in Argentina and Costa Rica.

Remorseful Bank

Former Citigroup CEO Chuck Prince sent Peterson to Japan in 2004 to mend relationships with investors and regulators after the lender failed to prevent money laundering, among other violations. The probe forced Citigroup to close its private bank. Prince himself traveled to Tokyo, where he and Peterson apologized to regulators and bowed in a gesture of remorse.
“He was very instrumental in repairing the situation, more quickly than otherwise,” said Motoatsu Sakurai, president of the Japan Society in New York and former CEO of Mitsubishi International Corp. “He is different than the usual image of an American executive, who make quick decisions and sooner or later rethink whatever he made mistakes on.”
The S&P ratings unit is facing more regulatory scrutiny after the SEC told the company in July it may seek an enforcement action tied to six commercial mortgage-backed securities it rated in 2011. The SEC may pursue options such as a cease-and-desist order, civil money penalties or a suspension or revocation of the firm’s ratings accreditation, according to a regulatory filing.

Biggest Liability

The Justice Department lawsuit, filed in February 2013, is the company’s biggest potential liability. The government is seeking almost five years of profit. A trial could start in autumn 2015 unless the two sides settle first.
“The government doesn’t want to put S&P out of business, but they do want to take a healthy bite out of them,” said Peter J. Henning, a professor at Wayne State University Law School in Detroit and a former Justice Department attorney. “A new CEO comes in and says, ‘Find a dollar figure that can resolve this.’”