Fitch Rates McGraw-Hill Global Education's Sr Secured Notes 'BB/RR2'
by Business Wire
Fitch Ratings has assigned a 'BB/RR2' rating to the $1.05 billion proposed senior secured note offering, due 2021, of McGraw-Hill Global Education Holding LLC (MHGE) and McGraw-Hill Global Education Finance, Inc (MHGE Finance; co-issuer of the secured debt). Proceeds of the notes will be used to fund the acquisition of McGraw-Hill Education (MHE) by Apollo Group. A complete list of ratings follows at the end of this release.
Apollo Group will be acquiring the MHE unit for $2.4 billion. Apollo intends to finance the acquisition with $1.05 billion of senior secured notes, $560 million in senior secured term loans, a $240 million revolver (for liquidity purposes and will not be drawn on to fund the transaction), and $950 million in cash from Apollo.
The credit facility and the notes will be 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 will be 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 will be guaranteed by existing and future wholly-owned domestic subsidiaries of MHGE (subject to certain exceptions) and Holdings and MHE US Holdings, LLC, which is Holdings' parent and also holds the equity of the McGraw-Hill School Education Group.
None of the funding provided by this rated transaction will be used/attributed to the funding of the acquisition of McGraw-Hill's School Education Group (SEG; K-12 education unit). The SEG assets will be separated from MHGE. EBITDA was negative for the SEG segment for the year ended 2012. SEG will not provide any guarantee to MHGE or MHGE's rated instruments. In addition, MHGE will not provide any guarantees to the SEG segment.
Covenants for the senior secured notes include a 101% change of control put right in the event that more than 50% of the voting control of MHGE is held by a person or group, other than permitted holders (as defined); or a sale, lease, or transfer of all or substantially all the assets of MHGE and its subsidiaries to a person other than a permitted holder (as defined; includes sponsors). Additional debt is primarily limited by a 6.25x total indebtedness leverage ratio incurrence test. There are additional debt carve outs, including additional debt, in an amount that does not exceed the greater of $100 million or 5% of total MHGE assets by non-guarantor subsidiaries. Also, up to an additional $325 million in additional debt secured by the proposed collateral package may be issued ($2.2 billion limit less proposed financing of $1.9 billion). Additional secured debt (above the $2.2 billion limit) is limited by a secured indebtedness leverage incurrence test of 4.75x. Restricted payments (and restricted investments) are primarily limited by a cumulative credit basket (as defined; includes an accumulation of 50% of net income among other add backs). There is also a general restricted payment basket of the greater of 3% of total assets or $60 million.
Covenants for the credit facility are expected to include a net first lien leverage maximum of 7 times (x), if more than 20% of the revolver is drawn. Also, there are mandatory credit facility repayments including a 1% per annum term loan amortization and a 50% excess cash flow sweep (as defined) stepping down to 25% and 0% when the first lien leverage ratio reaches 1.5x and 0.75x respectively.
LIQUIDITY, FCF AND LEVERAGE
Based on MHGE's reported 2012 year end results, Fitch calculates post plate EBITDA of $334 million, resulting in pro forma leverage of 4.8x. Fitch post plate EBITDA does not add back certain adjustments made by the company, including adjusting for deferred revenue and cost savings expected in 2013. Based on Fitch's base case model, with revenues flat to down in the low single digits, Fitch expects leverage to remain near 5x in 2013 and decline in 2014 driven by absolute debt repayment and EBITDA growth.
The ratings reflect the strong FCF metrics of MHGE. Fitch estimates 2012 FCF of approximately $170 million. FCF to debt (pro forma for the transaction) in 2012 is estimated at 10%; Fitch projects approximately 9% in 2013. EBITDA to FCF conversion metrics is expected to be 45% over the next few years This is in part driven by the cost reduction initiatives, but absent these initiatives Fitch would expect FCF conversion to be around 40% or better.
The ratings reflect Fitch's expectation that FCF will be dedicated towards debt reduction and acquisitions. 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.
Post the transaction, Fitch expects liquidity to be supported by the company's proposed $240 million revolver due 2018 and pro forma cash balance of approximately $90 million.
KEY RATING DRIVERS
The ratings reflect MHGE's business profile: 61% of revenues from higher education publishing/solutions, 10% of revenues from professional education content and services, and 29% from international sales of higher education and professional education materials. The higher education publishing market is dominated primarily by Pearson, Cengage and MHGE. Collectively these three publishers make up 75% (according to Monument Information Resources; provided by the company), with MHGE holding a 17% market share. This scale provides meaningful advantages to these three publishers and creates barriers to entry for new publishers.
According to the National Center for Education Statistics U.S. student enrollment in higher education has grown nearly every year, for the last 50 years. There have been seven years where enrollment declined (including 2011), each time in the low single digits. Most recently, 2011 enrollment declined slightly, 0.1%. This has been driven by an approximately 3.1% decline in for-profit university enrollment and 0.2% declines in public universities. Non-profit private universities were up 1.9%. Fitch believes enrollment for 2012 was down in the low single digits.
Fitch believes that there could be some near-term enrollment pressures due to continued enrollment declines 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 materially slow down and will likely be in the low single digits. Revenue growth will primarily come from the continued growth in volume of digital solution products sold and pricing increases associated with these digital products as they gain traction with professors.
The transition from physical education materials to digital products has been advancing at a materially 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 dis-intermediate used/rental text book sellers, recapturing market share from these segments. Fitch expects print/digital margins to remain roughly the same, as the 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. Under Fitch base case model, Fitch expects the growth in digital solutions, custom publishing and eBooks to offset the traditional print revenue declines within the next two to three-years.
The ratings reflect cost savings identified by MHGE, approximately $86 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 MHPI within a conglomerate.
MHGE did not provide audited financial statements. Audited combined financial statements for McGraw-Hill Education LLC were provided, which combined MHGE and McGraw-Hill's School Education Group. Unaudited break out of these two divisions were provided by management and used by Fitch to assign ratings.
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 74%, which maps to the low end of its 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 the following ratings:
--Long-term IDR 'B+';
--Proposed senior secured credit facility (term loan and revolver) at 'BB/RR2';
--Proposed senior secured notes assigned at 'BB/RR2'.
--Long-term IDR 'B+'.
--Proposed senior secured credit facility (term loan and revolver) at 'BB/RR2' (co-issuer to MHGE's credit facility noted above);
--Proposed senior secured notes assigned at 'BB/RR2' (co-issuer to MHGE's secured notes noted above).
The Rating Outlook is Stable.
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
Applicable Criteria & Related Research:
--'Corporate Rating Methodology' (Aug. 8, 2012).
Applicable Criteria and Related Research
Corporate Rating Methodology