Might Want to Grab This One on the Dip

 | May 12, 2013 | 6:00 PM EDT  | Comments
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The Securities and Exchange Commission will host a Credit Ratings Roundtable in Washington next week -- and the noise this may generate could create a buying opportunity in McGraw Hill (MHP).

Back in February, the stock sold off sharply on news that the Justice Department and 17 attorney generals were suing the company's Standard & Poor's unit for issuing allegedly fraudulent ratings. The shares ultimately took a 27% slide. Since then, however, the shares have steadily rebounded, and are now within 5% of the $58.34 high they had previously reached.

Top competitor Moody's (MCO) was initially dragged down as well, but that stock has since recovered to 17% above its prior level. The company has comparatively tighter control over internal emails, so it has less exposure to legal claims -- which may explain its particularly strong rebound.

I still believe McGraw Hill faces serious exposure even despite the generally upward trend of market sentiment and lack of follow-on news, which may have helped investors to believe management's dismissive claims regarding the lawsuit. At the same time, McGraw Hill's attorneys have requested summary judgment to dismiss claims, which may move the story toward a key inflection point later this spring. That could either refocus investors on the still present risks or, alternatively, go a long way toward removing them entirely.

As for the SEC event, it has been largely designed to allow for public feedback on the Commission's earlier credit-rating report (PDF), which was itself mandated by the Franken amendment to the Dodd-Frank Act.

As expected, Senator Al Franken (D-Minn.) -- the industry's biggest Hill critic -- will not participate. But the first topic on tap is bound to be Franken's idea of creating a new SEC office to assign structured-finance ratings. The roster of 26 panelists will also discuss how to better address Franken's particular conflict-of-interest concerns -- encouraging more unsolicited ratings -- and the pointed question regarding whether the industry should be forced to change its issuer-pays business model.

This will create the obvious possibility for negative headlines, which could impact shares of McGraw Hill and Moody's. But I believe that, overall, the event will signal skepticism toward Franken and assigned ratings, and thus could be read as a neutral to positive for these stocks.

More intriguingly, the Roundtable will arrive just weeks after attorneys for McGraw Hill have asked a dismissal of the legal claims against it, and this comes quite soon after Mary Jo White's recent appointment as the new SEC chairman. So the Roundtable could ultimately become remembered either for further finessing the post-crash fervor for reforming the Community Reinvestment Act -- or, in the event of new variables, creating the scaffolding for worrisome new regulation.

The Upshot

My own view is that, barring a sharp change in the backdrop, the SEC will not move toward assigned ratings, nor will it push for shifts in the issuer-pays model. Instead, I believe it will favor bolstering rules that allow information-sharing to encourage unsolicited ratings -- the focus of the Roundtable's second panel. This should help to keep the CRA faithful in their pews. As far as the legal challenge is concerned, the industry's defenses have worked so far, and there's a decent chance they will do so again.

Even though some may believe McGraw Hill management is "betting the company" a bit here, they may also be able to settle the lawsuit, on terms still acceptable to stakeholders, if the case appears to gain traction.

After all, the AGs (also shorthand for "aspiring governors") seem mostly in it for the glory, and a share in the cash that a settlement might bring. At the same time, it appears the Justice Department is merely trying to satisfy the lust for financial-crisis "scalps" among the political left. It's unlikely that either is in it to create an existential threat for McGraw Hill. (Still, the Obama Administration, coming up on an election year, may well have weighed the optics of suing the agency that downgraded U.S. debt in 2011.)

Bottom line: Should McGraw Hill see any temporary softness next week, it could create a buying opportunity. The usual caveat here is that, as a political analyst, I don't make stock recommendations. Still, if you believe the ratings agencies' cash-cow model will ultimately be sustained, you may want to be prepared.

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