Apr 25, 2006
Donald S. Rubin
Thank you. Good morning and I thank everyone for joining us here for the McGraw-Hill Companies’ First Quarter 2006 Earnings Conference Call.
I’m Donald Rubin, Senior Vice President, Investor Relations for the McGraw-Hill Company. With me today are Harold McGraw, III, Chairman, President, and CEO; and Robert Bahash, Executive Vice President and Chief Financial Officer of the corporation.
This morning we issued a news release with our first quarter 2006 results. We trust you all had an opportunity to review the release.
If you need a copy of the release and financial schedules, they could be downloaded at www.McGraw-Hill.com/investor_relations. Before we begin, I need to provide certain cautionary remarks about forward-looking statements, except for historical information, the matters discussed in this teleconference may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 including projections, estimates, and descriptions of future events.
Any such statements are based on current expectations and current economic conditions and are subject to risks and uncertainties that may cause actual results to differ materially from results anticipated in these forward-looking statements. In this regard, we direct listeners to precautionary statements contained in our form 10-K, 10-Q, and other periodic reports filed with the US Securities & Exchange Commission.
We are aware that we do have some media representatives with us on the call; however, this call is for investors and we would ask that questions from the media be directed to Mr. C.
Weiss in our New York Office at area code 212-512-2247 subsequent to this call. Today’s update will last approximately an hour.
After our presentation, we will open the meeting to questions and answers. It’s now my pleasure to introduce the Chairman, President, and CEO of the McGraw-Hill Companies, Terry McGraw.
Harold McGraw
Okay, thank you Don and welcome to our review of the McGraw-Hill Companies’ First Quarter results and thank you all for joining us this morning. I’m Terry McGraw and as Don stated joining me for today’s conference call is Bob Bahash, Executive Vice President and Chief Financial Officer of the McGraw-Hill Company.
I’ll start today’s review by discussing the performance of our businesses and the outlook for the rest of 2006. Bob will then review our financial performance and expectations for the year, and of course after these presentations, as Don stated, we’ll go in any direction that anybody would like to go.
Okay, earlier this morning, we announced first quarter results. Revenue increased 10.9%, diluted earnings per share from continuing operations were $0.20, and that included a $0.04 for incremental stock-based compensation, that’s a part of the County Rule 123R, and that is on an annual basis, the $0.13 we talked about in expensing stock option.
What is new is that it also included another one-time charge of $0.04 for the elimination of the restoration stock option program. So, we are very encouraged by the start of this year and confident in the guidance provided two months ago.
Excluding the expensing of stock options, we still expect earnings per share of $2.36 to $2.41 in 2006, with more robust market opportunities taking shape next year, most notably in the K-12 education spade. We expect a return to double digit earnings growth in 2007.
The economy continues to look healthy. David Wyss, S&P’s Chief Accountant now expects GDP growth of 3.5% for the year, and that the Federal Reserve is nearly done tightening interest rates, another 25 basis point rate hike is anticipated when the Fed meets on May 10th.
Capital spending remains strong. State finances are in good shape, and that’s according to an update last month from the National Conference of State Legislatures.
Incidentally, that’s a pretty good website to monitor state activity. Most states are two-thirds of the way through their current fiscal year.
Revenue corrections are above original targets in 44 states, that of course is good news for education. With that let me now go to our operations and give you the current outlook in more detail.
Let’s begin with McGraw-Hill Education. The operating loss in a seasonally slow quarter for education was $97.1 million, and that includes an incremental $9.7 million for stock-based compensation and the one-time charge for the elimination of the restoration stock options.
As everyone following education knows, the first quarter is seasonally slow and represents only about 10% of the market’s annual sales. McGraw-Hill School Education Group produced an 18.5% revenue increase in 2005 and now faces tougher comparisons in 2006 in the elementary high school market, which at best could be flat or could be down as much as 4% after a 10.5% increase in the market last year.
That challenge was evident in the first quarter. Last year, the McGraw-Hill School Education Group reported a 12.6% increase in revenue in the first quarter.
This year revenue for the same period was off 1.1% to $146.5 million, a reduction of approximately 30% in the state new adoption challenges, the major factor in limiting this year’s potential. The two big adoptions this year are in the K-12 Science in Florida and the K-8 Social Studies in California.
The high schools in California are also buying social studies, but these sales will be reflected in the open territory results. In California, about 25% of the district’s reporting decisions by the end of March, we’re encouraged by the wining of some very important early adoptions in Fresno, San Bernardino, Ontario, Anaheim, and Glendale.
We’re also continuing to show strength at the high school level. In Florida, we expect a lead in the secondary market, which obviously is the biggest dollar volume opportunity in that state.
The strength in the secondary market will help offset a lackluster performance in the K-5 Florida Science adoption. Predicting the exact dollar volume of first year state new adoptions is never easy, and in both California and Florida we’re beginning to see a shift in purchasing plan.
It now looks like more buying may take place in the second year of the adoption than previously anticipated. California never buys 100% of adoption in the first year, so we had expected to see 70%-75% of the social studies adoption potential realized in 2006.
Now, it looks like California will achieve about 65% of the potential in year one, but it’s hard to tell. In Florida, six large districts have indicated that they may postpone buying science this year or do a partial purchase.
Again, it’s still too early to predict how that will turn out. Sales in open territories always develop later in the year, so it is clearly too early to predict developments there, although it’s going to be an important part of this year’s result.
We are aggressively going after sales in the open territories with important new products. Treasures is a Basal K-6 reading program that is aligned with No Child Left Behind and Reading First requirements.
Its competitiveness is enhanced by two related supplemental series designed to help with special room needs, Reading Triumphs for students that required intervention, and Treasure Chest for English-language learners. Last week, Treasures won awards from three professional design organizations for its evaluation component and promotional materials.
Innovative design and packaging are important in capturing the market’s attention, so the recognition that Treasures has achieved is very gratifying. Another important addition to our elementary list is Real Math.
This is a new skilled-based math program that employees the same instructional methodology as our highly successful Open Court Reading. Jamestown Reading Navigator is an online reading intervention program for secondary students, which is currently being piloted in more than 50 districts.
Two other new textbook programs are Reading with Purpose for middle school and Reader’s Choice for high school. In the testing market, our custom contract revenue increased in the first quarter due to additional work related to statewide assessment programs in Florida, Colorado, and New York.
The testing market is continuing to shift under the impact of No Child Left Behind Act. To meet the annual testing requirements that begins in this academic year, states are implementing more customized tests; as a result orders for the more profitable off-the-shelf tests are declining and our margins here are under pressure.
To meet this challenge, we are investing in technology to improve our efficiency in developing, delivering, and scoring custom assessments. Moving over to higher education, professional and international revenue in the first quarter increased 5.3%.
In the U.S. College and University market, two of our imprints, science, engineering, and math, as well humanities, social science, and languages got off to a good start.
This is an off-cycle year for the business and economics. So, as expected, sales were off modestly after strong performance last year.
We still anticipate approximately 5% growth in this market in 2006 and we expect to outperform it. Higher education products sold well in Asia and India.
We also benefited from solid sales performance in the Canadian school market when the government stepped up funding in two prominences, British Columbia and Ontario. We also had solid results in professional markets from our medical titles and from three titles that made national best seller lists, Chasing Daylight by my good friend, the late Gene O’Kelly, the Millionaire Maker, by Langemeier, and the Millionaire Real Estate agent by Keller.
They also continued to build on the recognition created over many years with Harrison’s Principles of Internal Medicine, the world’s best selling medical text, three new titles in dynamic specialties will extend the Harrison’s brand globally, Harrison’s Rheumatology by Dr. Anthony Fauci, Harrison’s Endocrinology by Dr.
Larry Jameson, and Harrison’s Neurology by Dr. Stephen Hauser.
Summing up then for the McGraw-Hill Education segment, very encouraging results in the secondary market, mixed results in the elementary market, good start in California social studies, strong performance in the secondary, especially Florida science. Testing is growing the top line, but the market shift towards customization is placing some pressure on margins.
Higher education shows promise, and we’re investing in technology to improve the efficiency. Okay, let’s move over to the Financial Services segment.
We had another very solid quarter in financial services. Revenue was up 9.6% and grew 13.7% on a non-GAAP basis, which excludes revenue last year of $33.5 million from corporate value consulting, which was divested at the end of September and excludes the current year’s revenue from Vista Research, which was acquired on April 1, 2005, and Crisil Limited where majority interest was acquired on June 1, 2005.
Operating profit grew by 13.1% and that included incremental expenses of $8.9 million for stock-based compensation and the one-time charge for the elimination of the restoration stock option program. The operating margin expanded to 41.9%, up from 40.7% for the same period last year.
That represents a healthy start to the year and the double digit top and bottom line growth that we projected. We benefitted once again from growth in structured finance, solid increases in both our domestic and international ratings, growth in the ratings products and services that are not linked to the new issue bond market or nontraditional products, growth in data and information products and services, growth in products and services related to our indexes.
In short, there were many contributors from a diversified portfolio. After the typically strong close in the fourth quarter last year, we pointed out that the pipeline for the first quarter of 2006 still looked very good to us and that was the case.
New issuance dollar volume in the US residential mortgage-backed securities market was up 11.3% in the first quarter this year versus the same period last year. Commercial mortgage-backed securities issuance was up 53.2%.
Asset-backed issuance was up 27.9. Collateralized debt obligations were up 75.4.
The total U.S. structured finance market was up 24.1%.
Public finance declined 25.7%, U.S. Corporate new issuance was up 22.1%, and that’s very encouraging.
The corporate market was also strong in Europe with first quarter issuance climbing 17.5%. It was driven by a merger and acquisition activity and some opportunistic financing in anticipation of interest rate increases by the European Central Bank.
Issuance in the European mortgage-backed securities market was up 9.5%. All our international regions, that would be Europe, Asia-Pacific Latin America, and Canada, showed increases in the first quarter.
After a strong finish last year, Europe grew more slowly in the first quarter. Nevertheless, international ratings produced just about 36% of ratings revenue in the first quarter, in line with the same period last year.
These figures are all based on reports from Securities Data Corporation, Harrison’s stock statistics, and S&P estimates. Standard and Poor’s is a leading provider of data and information to the securities industry.
These product lines had a strong first quarter. Securities information products such as RatingsDirect and RatingsXpress performed well.
The growing customer demand for fixed income data is another manifestation of the growth of our business and international market. The demand for securities information products was driven by growth in CUSIP issuance volume.
We issued 19,700 in the first quarter, an increase of 13.2% over last year, showing good strong demand. We continue to invest in our data and information platform adding functionality and data, a combination that enables us to win new customers.
At the end of the first quarter, we had more 1400 clients for Capital IQ products and services, up from 1000 just a few months ago. Exchange traded funds based on S&P index has attracted assets, driven mainly by iShares and SPDRs, S&P Depository Receipt.
Assets in these exchange traded funds increased 21.4%, $137.7 billion at the end of March versus the same period last year. We’re also benefiting from the increased adoption of the S&P Citigroup indexes for benchmarking in data.
In March, Lidex launched six new exchange traded funds based on the S&P Citigroup pure style indexes. Innovation in this market is a key to growth and we’ve been seeing some notable creativity in the first quarter.
S&P is also developing a new series of indiscreet focus indices called the S&P industry indices. In February, State Street Global Advisors launched three exchange traded funds based on these indexes.
15 more exchange traded funds based on these indices are now in development. The S&P Asia 50 futures contract was launched in mid February on Chicago Mercantile Exchange GLOBEX system and is starting to attract attention from traders.
In February, we officially launched a joint venture, the Standard and Poor’s CITIC Index Information Services Limited. The new company calculates and commercializes the S&P CITIC equity and bond indices for China.
The S&P Case-Schiller Metro Area-Home Price indices were announced in March creating a new way for investors to participate in the housing market without buying real estate. The indices are designed to be reliable, authoritative, and readily available measures of residential housing prices in the United States.
Future’s contracts based on these industries will begin trading shortly and again on the Chicago Mercantile Exchange and I can assure you there is more to come. As we look ahead to the second quarter, the pipeline for ratings look very healthy.
Sequentially, comparisons in dollar volume issuance levels for the structured market achieved in the first quarter this year and last year’s second quarter may be worth considering for a moment. As you can see in the chart, dollar volume issuance in the U.S.
structured market was $461.4 billion in the first quarter, a year-over-year increase of 24.1%. Last year in the second quarter, new issue dollar volume in the US structured market was $469.6 billion.
Later in the year comparisons will get tougher, but right now that pipeline still remains quite strong. For now, momentum in the U.S.
residential mortgage-backed market is carrying over into the second quarter and that pipeline is full. Mortgage rates remain within historical norms and are low enough to keep home purchases, home improvement, and debt consolidation markets active.
Subprime and affordability products are continuing to fuel our part of the market. We still expect the U.S.
residential mortgage market to cool off later in the year. The pipeline for the U.S.
commercial mortgage-backed securities appears very healthy, driven by improvement in commercial real estate fundamentals, investor demand for relative yields, and refinancing of maturing deals. Credit card activity increases in the student loans and a pickup in the auto securitization should keep the asset-backed market moving ahead as well.
U.S. CDO issuance looks also robust.
There may be more activity in public finance. Historically, the second quarter is one of the busiest periods in the municipal sector, although weakness in refunding activity may offset the pickup in new money volume, we’ll see.
We are fairly optimistic about continuing strength in the corporate market. This is a plus.
More debt financed merger and acquisition activity remains a wildcard. We remain optimistic about growth prospects in international markets, the pipeline in Europe is building, and the outlook is positive for the other region.
Finally, I want to update you on the regulatory outlook. We obviously continue to work with the Securities and Exchange Commission meeting with commissioners and key staff to complete work on the voluntary framework for the oversight of Nationally Recognized Statistical Rating Organizations NRSROs.
We also support the implementation of a more formal, transparent, and expedited designation process as reflected in the SECs proposed role, but without involving the SEC in a substance of the rating process. We also worked with the International Organization of Securities Commission that’s IOSCO on the codes and principles applicable to rating agencies.
S&P subsequently in October 2005 issued a code of practices and procedures, which is consistent with IOSCO’s code of fundamentals and that updates S&P’s 2004 code of practices and procedures. We continue to believe that any new or currently proposed legislation or regulation would not have a materially adverse effect on Standard and Poor’s financial condition or its operations.
So, summing up the financial service, we’re on track for another year of double digit top and bottom line growth excluding the impact of corporate value consulting and stock-based compensation, solid growth prospects in the international markets, growing sales in data and information, maintaining operating margins at least at last year’s level. Finally, let me turn to our information and media segment, revenues increased 29.9% or $52.1 million, in large part that includes $43.8 million from J.D.
Power and Associates. Operating profits declined by $3.1 million to $1.7 million, that reflects an incremental $7.6 million in expenses for stock-based compensation and the one-time charge for the elimination of the restoration stock option program and the impact of $5.3 million from the J.D.
Power and Associates acquisition. Our broadcasting group is off to a really terrific start.
Revenue for the first quarter increased 20.3% to $29.2 million. The Super Bowl on ABC, political advertising, and solid improvement in local and national time sales were all positive factors.
We’re seeing continued strength in the second quarter with pacing of 12% at the end of March. Revenue for the business-to-business group increased 31.4%, and again that’s mainly due to the acquisition of J.D.
Power and Associates. We are pleased with the progress of J.D.
Power and Associates since we acquired the company on April 1, 2005. J.D.
Power and Associates, one of the nation’s greatest brand and are providing a new direct link to consumers and pursue new collaborative opportunities with many of our leading brands including Business Week, Standard & Poor’s, McGraw-Hill Construction, and Platz, it will enhance growth prospects for our core business information platforms. We’ve been working very diligently on these collaborative projects and some promising new ventures will be introduced soon, and we’ll keep you posted there.
J.D. Power also is a solid business that is producing growth in both the global automotive and non-automotive market.
There is a very good pipeline business heading into the second quarter, and again for J.D. Power a little under a quarter of their revenues comes from outside the United States and two-thirds of that comes from the Asia-Pacific region, which is a very, very important region for all of our businesses in terms of growth opportunities.
Advertising pages in BusinessWeek's global edition were up 2.9% in the first quarter as measured by the Publishers Information Bureau. A growing percentage of advertisers are buying a combination of print and businessweek.com.
As a result, first quarter advertising revenue on businessweek.com was up 79.5%; that represents 12% of BusinessWeek’s ad revenue in the first quarter. The development of businessweek.com also represents a shift from a magazine-centric business.
The goal now is to leverage our editorial expertise, so each day we provide online users around the globe valuable insights on trends, important news, business and financial analysis, as well as services. We are also focused on cost at BusinessWeek.
We had shut down the international editions. They will now go to the online version and we’ve cut the circulation rate base to 900,000.
This month we also went from printing BusinessWeek in four plants to three, a step that also will increase operational efficiency. We will continue to move in this segment from a traditional publishing model serving readers and advertisers to one that provides news and information in text, audio/video format, data and analytics, workflow tools and services.
So, communities that we serve in business, energy, aerospace, defense, and construction can interact and transact business. That transformation is already well underway at McGraw-Hill Construction network.
We took the latest step last month with the transformation of Sweet, that’s a 100-year-old print product to a network for products for connecting 120,000 design and construction professionals in the network where they can access 20,000 CAD drawings, 3400 3-part specifications, and materials for more than 10,000 building products manufactures. In taking this step, we have created a new industry standard for researching, locating, comparing, specifying, and purchasing building products on the desktop.
Our strategy is simply this, through workflow integration, and you will hear a lot of, through workflow integration, we will build even stronger ties to this community. Okay summing up with the information and media of solid start for broadcasting in an election year.
More progress at J.D. Power, improvement at business week, and businessweek.com, fundamental transformations are underway to create higher margin value-added products and services in the dot.com world, and that wraps up our review of operations.
Now before I move over to Bob for the financials, any review would be incomplete without noting some of the important decisions that we’ve been taking in recent months that will contribute to our performance in the future. To enhance our long-term growth prospects, we have restructured some of our operations at the end of 2005 and we eliminated approximately 500 positions.
That decision was announced in early January. We changed the leadership of the information and media segment, naming Glenn Goldberg as President.
We continue to refine the portfolio in information and media. In the first quarter, we divested two non-core businesses in energy.
Power Magazine, a monthly for the power generation industry and eSource, a subscription-based research service. We also sold a facility in Dubuque, Iowa which houses some of our higher education operations.
We’ll replace it with a new more efficient facility. To reduce future expenses, we eliminated our restoration stock option program, which was announced on March 30th.
There also will be a significant reduction in the number of stock options granted as part of our new long-term incentive program that we introduced this year. Now, we are emphasizing the use of restricted performance shares.
They will be earned over a three-year period for achieving earnings per share goals. We stepped up the share repurchase program and we increased the dividend.
Returning cash to shareholders due to the payment of dividends and share buybacks is an important measure of our commitment to producing total shareholder value. To take advantage of our scale and improve our productivity, we’re aggressively driving our global resource management program across the entire corporation as we build on our business process management capabilities.
This involves more than expanding our global network for print vendors. This is a very important initiative and we are beginning to benefit from it, but global resource management is a much broader concept than just offshore.
It means new opportunities to grow. It means looking across the company to take advantage of horizontal leveraging opportunities that were not possible several years ago.
By standardizing operations, workload tools, and support services, we’re in the process of creating greater operational efficiencies and enhance global capabilities. That’s why we said that we expect our profits to grow at a faster rate than revenues in the years ahead.
Okay, that completes the review of the operations from my standpoint. Let’s hear from Bob Bahash on the financials and those expectations.
Robert J. Bahash
Great, thank you Terry. In the first quarter, we repurchased 18.4 million shares at a cost of $994.5 million.
The total was comprised of 3.4 million shares that remained in the 2003 program plus 15 million shares authorized under the new share repurchase program the board approved in January. In the new program, the board approved the repurchase overtime of 45 million shares or 12.1% of the corporation’s outstanding shares of 372.7 million shares at the end of 2005.
The earning guidance for this year assumes a benefit of approximately $0.02 to $0.03 from the 2006 share repurchase program. The diluted weighted average shares outstanding for the first quarter of 2006 is 377.3 million shares, a 9.3 million share decrease compared to the first quarter of 2005 and a 5.2 million share decrease compared to the full year 2005.
Our cash position at the end of the first quarter was $180 million, a decline of $569 million from December 31, 2005. The decline is primarily the result of payments in the first quarter for share repurchase activity.
Of the 18.4 million shares the company acquired during the first quarter, we acquired 8.4 million shares of the company’s common stock from the holdings of the recently deceased William H. McGraw.
The shares were purchased at a discount of approximately 2.4% from the March 30, 2006 New York Stock Exchange closing price through a private transaction with Mr. McGraw’s estate.
This transaction settled on April 5, 2006 at an amount of $468.8 million, and as a result we are now in a debt position and I’ve issued commercial paper to fund this purchase. But, we were essentially debt free in the first quarter, and we therefore had net interest income instead of interest expense.
Net interest income was $2.5 million compared to $700,000 in interest expense a year ago. With the return to the commercial paper market, interest expense will increase in the second and third quarters.
By this fall, we expect to return to a surplus cash position. For 2006, we now expect approximately $14-million to $15 million in interest expense primarily attributable to rising interest rates.
As a result of FAS 123R, the company began expensing stock options in 2006. There is more of an impact in the first quarter of 2006 because of the residual expense from previous option grants that had not been yet adjusted.
As previously stated, we will incur an incremental $0.13 of expense in 2006 as a result of this accounting change, but the new program has changed, and as Terry mentioned, more towards restrictive stock and less towards stock options. Let me describe the impact of the new stock-based compensation program as well as the impact of the elimination of the company’s restoration stock option program.
In the first quarter of 2006, the company incurred incremental stock-based compensation expense of $48.4 million, which includes a one-time charge of $23.8 million from the elimination of the company’s restoration stock option program. This represents $0.04 for the incremental expensing of the new program I just referred to plus an additional $0.04 one-time charge for the elimination of the restoration program.
In terms of its impact on the segments, the McGraw-Hill Education’s first quarter stock-based compensation expense increased at $9.7 million and that includes the one-time charge of $4.2 million from the elimination of the program. Financial services first quarter stock-based compensation expense increased $8.9 million.
That includes a one-time charge of $2.1 million from the elimination of the restoration program. Information and media’s first quarter stock-based compensation expense increased $7.6 million, which includes a one-time charge of $2.7 million from the elimination of the program.
Finally with regard to the corporate area, corporates first quarter stock-based compensation expense increased $22.1 million, which covers both corporates and shared services personnel, and this expense includes the one-time charge of $14.7 million from the elimination of the company’s restoration stock option program. Now, let’s look at our corporate expenses.
Corporate expenses increased $17.7 million in the first quarter and of course we’re driven by increased stock-based compensation. Excluding the increase in stock-based comp, corporate expenses declined $4.4 million in the first quarter, and that was due primarily to the gain on the sale of the Dubuque, Iowa Office and Printing Facility.
Excluding incremental stock-based compensation, corporate expense is expected to increase only modestly in 2006. In 2006, we still expect dilution of $0.03 to $0.04 from the acquisitions made in 2004 and 2005.
They will be cash neutral. In 2007, we expect these acquisitions will be cash positive.
The effective tax rate in the first quarter was 37.2%. We expect to maintain that rate for the rest of the year and any federal state applying taxable changes or changes in the locational mix of our income.
Let’s now review capital expenditure which includes prepublication investments and purchases of property and equipment. Prepublication costs and prepublication amortization will strongly influence results in the education segment this year.
In the first quarter, our prepublication investments were $62 million compared to $49.2 million for the same period last year. For 2006, our current estimate for prepublication investments is approximately $315 million.
Now, this is driven mainly by the el-hi products which we are developing to realize significant opportunities in 2007 and subsequent years. However, through efficiencies, technology, and global sourcing, we anticipate a reduction in spending from our original projection that was $340 million.
Purchases of property and equipment were $11.6 million in the first quarter compared to $17.5 million for the same period last year. However, we do expect this to ramp up and for the full year we expect $200 million as compared to $120 million last year.
The increase is primarily driven by investments in the construction of a new data center, where construction will begin later this year, the new facility for McGraw-Hill Education in Iowa, and technology initiatives and financial services. Now for the non-cash items.
Amortization of prepublication costs was $22.5 million for the first quarter as compared to $25.2 million in the same period last year. We expect $250 million for 2006 as a result of new el-hi programs we are publishing this year.
Appreciation was $28 million for the first quarter compared to $25 million in the same period last year. We expect it to be $130 million in 2006 reflecting the higher level of capital expenditures in 2006 and also the full year of depreciation from capital expenditures made in 2005.
Amortization of intangibles was $12 million in the first quarter compared to $8 million in the same period last year. For 2006, we expect $50 million; the increase is driven by 2005 acquisitions.
Thank you, and now back to Terry.
Harold McGraw
Okay, thanks Bob and again this is the first quarter and it’s our traditionally very small quarter because of the fact the seasonality of education being more of a third quarter business, but still nonetheless, we are very encouraged by our start this year and we’re confident again in the guidance that we had given. With that, let me take it back to Don and to your questions.
Donald S. Rubin
Thank you Terry. Just a couple of instructions for our phone participants.
Please press “*” and “1” to indicate that you wish to enter the queue to ask a question. To cancel or withdraw your question simply press “*” and “2”.
If you’ve been listening through a speaker phone but would now like to ask a question, we ask that you lift your handset prior to pressing “*” and “1” and remain on the handset until your question has been answered. This will ensure good sound quality.
Now, we’re ready for the first question.
Operator
Thank you. Our first question comes from Peter Appert with Goldman Sachs, please go ahead.
Peter Appert with Goldman Sachs
Good morning. Terry, you’ve said some soft start for the science program in Florida at the K-5 level, any broader implications from that?
Harold McGraw
No, again science overall at the K-12 adoption is quite strong, middle and high school is doing exceptionally well. We are behind, though, on the K-5 side.
Essentially what we have done is customize a national edition for that market and we’re dealing with intervention and remedial side of it a little bit more. But, it’s softer than we would have liked and we’re gratified by the middle and high school levels where the bigger dollars are.
Peter Appert with Goldman Sachs
Is that a brand new program?
Harold McGraw
No.
Peter Appert with Goldman Sachs
Okay. Then, continuing on the education side, the seasonal loss took a big step up; you referenced this obviously in your comments.
I guess it’s somewhat surprising just in the context of this being a slower adoption year, I would have thought perhaps less pressure in terms of marketing expenses, does that cause you to rethink maybe the profit expectations on a full-year basis?
Harold McGraw
No, I think it’s going to be a challenging year, no question. We are very gratified where the treasures are.
At this point, all signs look quite promising, and of course that’s going to be in the open territories. As we get a little further into this year, we’ll have an understanding of what the open territory results are looking like, but we haven’t seen anything materially different that would change our expectations.
Other than that, we’re a little softer on the K-12 and science in Florida and we should do…again, it’s way too early to tell, but just from some of the districts that have already reported, in California we have good expectations there.
Peter Appert with Goldman Sachs
Okay, great. Last thing, maybe for Bob, the 8.4 million shares repurchased from William McGraw, that’s in the 18.4 correct?
Robert J. Bahash
That’s in the 18.4, that’s correct, but the actual cash outlay went in early April. So, of the $994 million that I mentioned that we spent, a portion of that expenditure actually occurred in the second quarter.
That’s why I mentioned that we moved to a commercial paper situation.
Peter Appert with Goldman Sachs
Okay, got it, thanks.
Operator
Thank you, our next question comes from Lisa Monaco with Morgan Stanley.
Lisa Monaco
Yes, Bob, could you just elaborate on the expectation for pre-pub cost in 2006? It looks like that number will come in lower than expected, and what can we think about that number for 2007?
Thanks.
Robert J. Bahash
Okay, with regard to the figure that I gave you, the early look that we had done, which was really developed back in the fall of last year was $340 million, and there were a number of programs for excellent opportunities in 2007 and beyond 2006, but as well as 2007-2008. As we looked at it closer, we saw opportunities to leverage certain capabilities across lines, but also as Terry mentioned earlier, we’ve been focussing an awful lot of about our sourcing, global sourcing, and our opportunities to lower those costs through a global sourcing initiative.
We’ve had this effort going on for a period of time. We’ve been doing global sourcing quite frankly, but we have an opportunity to really step this up with a number of partners that we’ve developed relationships with outside of the US.
So, as we continue to fine tune the investment, that’s why we reduced it from $340 million to $315 million. No, we’re not cutting back on the number of programs, but we just imply saw an opportunity lower the cost and provide the same type of quality products, but simply at a lower cost.
Lisa Monaco
Can you give us any color on a preliminary basis 2007 spend, upper or about the same level?
Robert J. Bahash
It’s really pretty early to be looking at that, but my first indication would be to say probably that level or a little bit lower, but what we hope to do is as we continue to refine and enhance our global sourcing capabilities to bring that number in a bit lower.
Lisa Monaco
Okay, and then just really quickly, is there any way to quantify the impact of the spillover effect from capital spending in first quarter.
Robert J. Bahash
There was some spillover both from product that was some sales that actually came in 2006 as well as certain sales that landed up being deferred because we didn’t have the appropriate freewill order to go out with those particular sales. The amount was in the range of $10 million.
Lisa Monaco
Okay, great thank you.
Operator
Thank you, our next question comes from Karl Choi with Merrill Lynch.
Karl Choi
Hi, good morning, a couple of questions. First one, just want to follow up to Peter’s question, do you expect your performance at el-hi this year to be in line with the industry performance?
And I’ll hold the next question.
Robert J. Bahash
For the el-hi market, we’re seeing after last year’s 10.5% market rate that we anticipate with the 30% reduction of state adoption that somewhere around flat-to-negative 4. It’s very hard to tell but I think it’s somewhere around there, and we’ll see.
We have to get a better gauge on open territories and completion of the social studies in California. But we’re encouraged with the overall science in Florida.
So, I think that we should be on it.
Karl Choi
Okay, second question is related to residential mortgage back. You mentioned that you expect it to cool off, can you give us a little bit better sense as to how you expect the whole year to pay out and what percentage of decline do you expect?
Robert J. Bahash
Just in terms of dollar volume, I mean it’s a big number. The residential mortgage back market just from comparison year over year, you keep thinking that this is going to slow down, the pipeline is full.
I did not expect the level that we’re at right now. We did expect commercial mortgage back to pick up early last year and it did, and that’s still quite strong.
But I have to believe, Karl, that year-over-year comparisons are going to at least be in the single digit level by the end of the year, but it’s still quite a strong market.
Karl Choi
Last question, I think there’s an upcoming vote on the elimination of the state report, how do you think that would pay out?
Robert J. Bahash
Well, you’ve got our proxy and we put our position on that one. It was a proposal to eliminate and go to the annual election of our directors.
We’re not in favor of that and we so stated the reasons why in that proxy. We’ll see tomorrow.
Karl Choi
Right, thank you.
Operator
Thank you, our next question from Frederick Searby with JP Morgan.
Frederick Searby
Thank you, Terry, a couple of questions. One, can you give us some OM in the quarter for S&P, how much was housing related of the rating revenues, RMBS, on equity loans?
And then, two, just a clarification, as you moved away from stock options, historically you looked a little high relative to the overall benchmark with the S&P in terms of percent of shares, how are you thinking of restricted stock, are you going to try and hold that to about 2% of shares outstanding or is it going to be more in line with the higher sort of 3%? Thank you.
Harold McGraw
On the latter question, Fred, it’s going to be lower than 2%. On the first question, what was the question…
Frederick Searby
We are trying to get a sense of how much of the entire revenues for S&P is tied into the housing market you know, you have equity loans including commercial mortgage back, you’re even stripping that out, but can you give us some sense?
Robert J. Bahash
We don’t take out those specifics, Fred; I mean the residential mortgage back markets for the last five years. We all know the numbers there and they’re been quite strong and they continue at that pace.
What we will see is a shift in leadership in some of the categories. One other thing that we wanted to see and what would be very much in keeping is that commercial would pick up, and that’s the part that we wanted to see and we’re seeing great leadership there.
But, the residential mortgage back is a big part, the structured finance market, and as we start to see more increases on CDOs and some of that involvement as residential slows down, it will picked up in other areas. Again, Fred, as you know, the structured finance market in the whole nation was securitization.
Nobody wants to hold on to paper. They’re going to securitize it and sell it back into the market, and this is a very favored vehicle for banks and other financial institutions to do.
So, there’s going to be no let up in the overall securitization market; what we’ll see is shift in leadership between some of the subcategories.
Frederick Searby
But, in your annual report I think your piece on McGraw-Hill, you forecasted 10-15% decline in RMBS and obviously no one has really a perfect outlook or forecast, but it’s going to make it much stronger that you’re not raising guidance overall for the year, is guidance just getting increasingly conservative or is something coming off relative to your expectations? Clearly it’s beaten so far, right?
Robert J. Bahash
You know, it’s really a question of timing Fred. We’ve given you the best thoughts that we have at this time and we want to be conservative about what we’re saying and to deliver on it.
But, it looks to me at this point that given the strength it may stay positive growth to the end of the year, and we would expect to see some year-over-year comparisons coming in.
Frederick Searby
Okay, thank you.
Operator
Thank you, your next question comes from Brian Shipman with UBS.
Brian Shipman
Thanks, good morning. There have been some amendments to the higher education act that have led to the Department of Education investigating the college publishing market.
It looks like there are two issues, I’m wondering if you could comment on the two. One is the unbundling of text books and the second is again the investigation into college textbook pricing.
I’m wondering if you could comment on those two issues, thanks.
Harold McGraw
Thank you Brian. First of all, we unbundled now…by the way, I think as far as Margaret Spellings as Secretary of Education and the leadership that they’re showing with the expansion of No Child Left Behind, it’s only a matter of time before we get into higher education.
They started pretty much on the Early Childhood and The Elementary and they graduated into the secondary market, and you’re going to see more and more emphasis on higher education. Again, in terms of overall American competitiveness and the types of skills and capabilities for workforce development is in question.
So, I think this is very welcoming and what we’ve designed to do is to help in every way we can to get a student in the right kind of skill sets and to be ably proficient, and therefore we think through a bundled approach there is more that we can do in supporting that student and supporting the instructor as well in terms of being able to get there. Now, if a college professor or if a community college wants to go in a different direction and wants components, we’ll go that way as well.
On the college textbook pricing issue, we’ve been very clear here. Again, if you’re taking a look at a proposition that’s trying to achieve a certain outcome, we’re going to do everything we possibly can to bring value to that overall proposition and price it accordingly.
Again, if somebody wants them unbundled, then we can go in that component as well. I think one of the issues also is that this is a very exciting market.
When you talk about global higher education, you’re talking about some 90 million students worldwide, and the global spend is about $300 billion. The growth rate in that enrollment, just given a lot of the economic growth activity and the requirements there, it’s given about 300 million students, maybe more on that one.
So, the opportunity here is absolutely huge, but when you’re dealing with certain countries that literally can’t afford to do certain things, then we have to try and repackage and do things in a way that will be attractive to those markets. One of the reasons that we’re very strong on the trade front is in the enforcement of intellectual property rights.
You have to take a look at piracy rates when you get outside the United States. At a certain price point, the pirates are going to copy those kind of materials and as countries begin to protect intellectual property better and live up to those obligations, then obviously we’re going to be able to value proposition bundle more completely to help them in that sense.
So, it’s a huge opportunity and we welcome this and explain how we go about doing things, but it’s about outcomes and I think Margaret Spellings has done a terrific job and bringing the spotlight to it.
Brian Shipman
Do you have any sense of timetable at this stage for the investigation?
Harold McGraw
I really don’t. They haven’t made it clear at this point, but we’re available and we look forward to it.
Brian Shipman
Okay, thank you Terry.
Operator
Thank you, our next question comes from Brandon Dobell with Credit Suisse.
Brandon Dobell with Credit Suisse
Thanks. Maybe Terry if you could address this issue of customization from two perspectives; one from the testing but also from taking national programming and customizing those down to a state level.
I guess I want to get a better idea of how big of an impact does this have on the operating margins in education and do you see that sustaining for a quarter, for a year, at what point can you start to round the corner on that issue? Then, from a textbook perspective, maybe talk a little bit about how the customization process might work where you’re customizing more programs for state…I know there was a move a couple of years ago for states where that even small states wanted to have their own programs versus just becoming an-off-the-shelf thing, and is there any correlation there between the pullback in pre-pub spending and how do you guys look at customizing national programs?
Harold McGraw
Terrific, thanks Brandon. This is going to be a huge and this is going to be an essential business; it is now.
If you go back 15 or 20 years, educational testing was a nice to have kind of business. There was no mandate in terms of state testing or district testing or like.
It was pretty much left up to state educational commissioners to decide what they wanted to be able to do. Therefore, where we excelled was on the high end, high stakes summative type tests.
What has taken place with the mandatory testing environment is the opening up of the low stakes passing, the formative side, where teachers, principals, district leaders want to know right now how well we’re doing, where we’re going, where we need intervention, remedial, all of those kind…such that when they get to the high stake they’re better prepared to be able to do it. So, the educational testing opportunity is going to be big.
Now, what’s changed? Clearly, when you get into formative in the low state, people want customized tests to their state standards, and therefore it requires you to be able to have the capability to develop those kinds of tests in a short period of time.
Number two, speed. Educators today don’t want to the educational results three months later or in a longer period in terms of some of the high states; they want it yesterday.
So now the system that was designed in a large part for the high stakes summative type testing has to be retrofitted to a much more facile and customized where speed is a requirement, and these additional new work flow tools are going to become very important in terms of being able to accomplish that. So, what we have done is a massive effort to reconfigure and to get ahead of the game.
This is something that all educational test players are going to have to do. When you start seeing that there are problems here and there about testing, scoring problems or things like that, what you’re seeing is the system going as fast as it possibly can with the existing legacy structure, and therefore you have to quickly be able to re-tool to be able to work in that speedier customized environment, and that’s exactly what we’re doing.
There is some investment in there for pre-pub for that. In large part, it’s not a technology problem as it is a management issue, in terms of being able to get around it.
Most states are going to want to in terms of scoring do some of that scoring and capability in their state, so that they can recoup some of the investments they’re making in the mandatory testing. So, we are broadening out our scoring capabilities, but from a technology standpoint we’re going to be able to ramp up and be able to do very well in this space.
This is a very important market.
Brandon Dobell with Credit Suisse
Okay, so it sounds like it’s more of a near-term buildup perhaps of infrastructure that people and/or technology and local markets to get there versus a structural margin difference between the tests…overtime shouldn’t you be able to kind of capture the same type of margins with these tests, probably charge more than you could for a basic off-the-shelf test?
Harold McGraw
Let’s see Brandon, probably lower. Bob you want to…
Robert J. Bahash
Yeah, I think just intuitively, Brandon, when you’re producing a test as we used to with CAT, etc., that particular test, that same test could be sold nationally, you could leverage that development capability more broadly. So, as you’re working now in more of a customization mode on a safe basis, the margins would naturally be a bit lower.
I think the point that Terry has mentioned is we’re doing an awful lot of work in looking at not just technology but we’re looking at the process and putting in the appropriate workflow tools to be able to leverage as much as possible the development capabilities that we have to the extent possible where you can leverage some of the items or questions that they referred to outside of a particular state, which we’re doing that as well. So, we’re trying to do everything we can to speed the process, to leverage our workflow tools, to streamline the process as much as we can, but clearly when you’re customizing, it’s going to be naturally a bit of a lower margin and what would have been a very an attractive situation where you’re selling the same test in literally 50 different states, but clearly this is a very attractive marketplace.
Harold McGraw
Yeah, and I think the other thing, Brandon, is that now that all 50 states have academic standards we’re going to start to a coalescing around the most important standards, and you’re going to see some commonality there, and that would be very beneficial in being able to develop some of the formative testing.
Brandon Dobell with Credit Suisse
Okay, thanks a lot.
Operator
Thank you, our next question comes from Michael Meltz of Bear Stearns.
Michael Meltz
Thank you, two quick questions for Bob. You mentioned there was a sale of the higher ed building there, what did that contribute in the quarter?
And secondly, your annual guidance for buybacks, what’s the current thinking on buybacks going forward? And I have one followup.
Robert J. Bahash
Okay, first with regard of the sale of Dubuque facility, which is a combination of an office and printing facility that we acquired when we did our swap going back quite a number of years ago, there was a gain on that sale. In addition, there was a modest gain from a disposition in 2005.
The net between the two was a benefit of about $0.50 on a year-to-year basis. So, we are basically saying what it was, there was a modest gain last year, gain this year, it was in that incremental benefit this year of about $0.50.
With regard to the share buyback, as I’ve stated, we have reached our limit, but this would be something that would be addressed and discussed by Terry with the board at our meeting tomorrow.
Harold McGraw
And to update you, Michael, the board and our directors’ decision and we will be discussing that and I think the likelihood is that we’ll have a little bit more runway here.
Michael Meltz
But your $0.02 to $0.03 in guidance, that’s already done, is what you’re saying?
Robert J. Bahash
Yeah, that $0.02 or $0.03 guidance is done. We had plans in the original budget to accelerate and front load most of the share buyback.
We completed it a little bit earlier than we thought, only by a couple of months. So, we’re still within the same $0.02 to $0.03 guidance.
Michael Meltz
Got it, okay, and just one quick question on education, Terry, your comment about the sort of dynamic in adoption sort of a shift to year two, if tax receipts are running above schedule, my understanding is the variant isn’t that big, but I’m just wondering what is causing that shift?
Harold McGraw
I think that it’s all about accountability. You’ve got a lot of very anxious people wanting to make sure that their educational spend is delivering the results for them and so I think district by district you’re seeing some wavering on some people’s part to see how other people are doing with certain programs on that one; that’s all.
Some states normally will only purchase three-quarters of that adoption and hold it over for the remaining year. but, at this point, it’s really a question of the timing and just based on what we’re seeing at this point, it’s just a guesstimate at this point that it might be a little bit lower in the first year and a little higher in the second year, but we’ll see on that one, and as soon as we have some information on that we’ll give it to you.
Michael Meltz
Okay, and on S&P ratings, my understanding is you have pretty broad-based strength right now, is there anything weaker than you had expected looking relative to a couple of months ago, the outlook for any particular asset class?
Harold McGraw
No, not really. You know, we were talking about the public finance market that is still up, and again that’s because in a large part the states are in a much healthier situation.
The tough side is on the corporates, with corporates up about 22%, that’s pretty good. We want to start to see a stronger number there.
We have to see what the effect is on interest rates. You know, most people have this one in done with May 10th, and we will see.
You still have commodity prices in general that are quite high, and it looks like they may stay high, and who knows what Chairman Bernanke is going to consider on that part. But at this point, the consensus is that that’s pretty much done and therefore seeing strength on the corporate side is very encouraging.
Michael Meltz
Great, thank you.
Operator
Our next question comes from John Janedis with Banc of America.
John Janedis
Thank you, this one is a followup. The customization side and the margin pressure, is that a bad impact in your longer term segment goals of 20%?
Thanks.
Robert J. Bahash
John, at this point, the 20% margins would include the improvements that we expect in the assessment and reporting area, and again what we’re talking about now is not just the testing component, it’s all capabilities here. One of the things that we did when we acquired Grow Networks was to build out on the reporting capabilities such that once you get the result, then what is it that you need to do to be able to hop on that situation, and that part is something that we think is going to be an essential part in the overall equation.
So, no, it’s part of the 20% and that’s the goal.
John Janedis
Great, thank you.
Operator
Thank you, our next question comes from David Ferguson with Lehman Brothers.
David Ferguson
Hi, thanks all of my questions have been answered, thank you.
Operator
Thank you, our final question comes from Hart Brailey with Deutsche Bank.
Hart Brailey
Yeah, hi, two questions, I suppose these have been asked, I got cut off a bit earlier. The first one is just the potential adoptions in California and Florida, can you just quantify that in total, so what would the worst case be there and is that enough to change your view on the overall el-hi market, the flat guidance for the market?
And the second one was in the release, in higher ed business, you talked about the shift of the sales from traditional bookstores to online; I guess that has obvious working capital indications for your business, but can you just talk also about the implications for how the new book markets develop if students are by default increasingly looking online for books, how concerned are you about that sort of facilitating growth of the used book market?
Harold McGraw
Okay thanks, Hart. First of all, the adoptions in Florida and California, again it’s too early to give projections on total capture rates.
We’re very encouraged in Florida with science that the middle and the high school levels were disappointed with some of our K-5 Science program, but overall if you take a look at the K-12 space, we will do very well. I think it’s too early to say whether we’ll be number one in all of that.
But at this point, we’re looking for a very strong show.
Hart Brailey
Yeah, I was more thinking about where you were talking about the actual spend in the market from this year into 2007…
Robert J. Bahash
Yeah, and it was timing in both cases, Hart. Traditionally, California as we said, and in some cases Florida, they do not purchase 100% in the first year, and it can be 75% or 80%, and based on what we’re seeing from some of the districts at this point, we’re guessing that it might be lower than 75%, but it’s all about timing and some districts are a little bit slower than others.
So, we have a better handle on that by the time we get into June on that part. On the higher ed side, in the used book market, we’ve suffered with 30% of used book market here in the United States and we’re seeing it pick up in Europe on that part.
But again, in terms of going online and the transformation that’s going to take place, if you’ve got 90 million students in higher ed in the world today going to 300 million and you’ve got 20,000 colleges and universities that are almost saturated, I mean they’re not going to be able to pick this up, so where is that coming from? I guess that’s coming from the private sector, we’re betting on that, in the four profit sectors, and it is going to be online.
So, you’re going to see over the years a stronger transformation to an online environment and in that kind of environment you’re going to be able to do things cheaper, you’re going to be able to price differently, and you’re going to eliminate the used book market.
Mark Brailey
Okay, thank you.
Operator
Thank you, that concludes this morning’s call. On behalf of the McGraw-Hill company, we thank you for participating and wish you a good day.