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That $5 billion lawsuit against S&P? No problem

September 20, 2013: 5:00 AM ET

The U.S. government is suing the ratings agency for fraud in its pre-crisis ratings, but investors are pooh-poohing the threat.

By Craig Giammona

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FORTUNE -- The market doesn't seem too concerned about the federal government's fraud lawsuit against Standard and Poor's Ratings Services. The Department of Justice is seeking $5 billion in damages, claiming that S&P helped cause billions in investor losses during the financial crisis by inflating ratings on mortgage-backed securities and collateralized debt obligations to curry favor with issuers.

News of the suit initially spooked investors and sent shares of parent company McGraw Hill Financial (MHFI) tumbling. In the seven months since then, however, S&P's shares have soared nearly 50%.

After dropping from $58 on Feb. 1 to $45 on Feb. 5, the day after DOJ filed its case, McGraw Hill's stock price has been trading at post-crisis highs around $65. S&P is by far the most important business for McGraw Hill, generating nearly 71% of its $1.2 billion in profit last year. In the quarter that ended June 30, revenue was up 24% for S&P and came in at a record $599 million, beating a previous mark set in 2007, the company said.

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"There's just a lot of headline risk," says Manav Patnaik, a research analyst at Barclays. "It's not something I see having any meaningful effect in the near term. Two years down the road, when this thing [the lawsuit] develops further and we get a better idea where it's headed, you could argue you should be worried about it. But outside of that it doesn't affect the running of the business."

Initial settlement talks between McGraw Hill and the government broke down over the Feds' reported demand for an admission of wrongdoing and a $1 billion fine. McGraw Hill had $1.9 billion in cash at the end of 2012 and could weather a significant financial settlement, assuming the company doesn't admit fraud, analysts say. (A fraud admission could expose the company to more liability from private suits.) McGraw Hill has said the case is without merit and noted that its pre-crash ratings were objective and consistent with those of other market participants.

But the company has lost at least one legal skirmish so far: In July a judge ruled against the company's effort to dismiss the case on the grounds that S&P's statements about the integrity of its reports were mere "puffery," and that investors would not rely on such statements. Earlier this month, the company took an aggressive legal tack, accusing the Feds of filing the suit as retribution for S&P's decision to strip the U.S. of its AAA credit rating in 2011. (Moody's (MCO), for example, was not sued by the U.S., despite issuing pre-crisis ratings similar to S&P's.)

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Analysts and investors note that it's difficult to anticipate how the lawsuit will play out, but they point out that McGraw Hill's stock started its climb above $60 once market observers had a chance to examine the details of the case. The perception is that the government's case is weak and that the worst case scenario for McGraw Hill is a cash settlement that could cut into profits but won't derail the business.

"It's very difficult to predict the future actions of either party, but with the financial strength of the McGraw Hill balance sheet with $2 billion in cash, they are more than likely comfortable with any fiscal penalty that may arrive before a court case," says David Reynolds, an analyst at Jefferies.

There were calls to change the securities rating system after the financial crisis, but the basic structure remains, with S&P and Moody's paid to issue ratings of securities being sold by its clients. Like McGraw Hill, Moody's has made a steep climb in the past seven months and now trades above $70. Both companies have a forward price/earnings ratio of 18.

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In addition to S&P, McGraw Hill also operates the S&P 500 (SPX) and Dow Jones Industrial Average (INDU) indices, J.D. Power and Associates, McGraw Construction, S&P Capital IQ and Platts, a commodities information firm. McGraw Hill completed the sale of its textbook publishing business, McGraw Hill Education, to Apollo Management for $2.5 billion earlier this year and recently unloaded Aviation Week as part of its drive to focus on its strength in the financial information sector.

"McGraw Hill Financial demonstrated its commitment to shareholders by selling off non-core assets and returning its excess cash to shareholders," says Anthony Gennaro, portfolio manager of Oppenheimer's Main Street Select Fund, a $6.4 billion fund holding 2.5 million shares of McGraw Hill Financial. "We like McGraw Hill Financial because they own several high-growth, high-margin businesses such as Platts and the S&P indices businesses, which are mission critical to their users and are often misvalued or ignored by investors focused solely on S&P's rating business."

McGraw Hill started trading under a new ticker in May and Doug Peterson, who took over as president of the S&P ratings service in August 2011, will become McGraw Hill's new chief executive on Nov. 1, replacing Harold McGraw III. Peterson will become the third non-family chief executive in the company's history, which dates back to 1888.

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Peterson, a Citibank veteran credited with smoothing over that firm's issues with Japanese regulators in 2004, stabilized S&P at a tough time for McGraw Hill and the ratings service. S&P faced inquiries into its ratings of the securities at the heart of the financial crisis, while the parent company was under pressure from activist investors to split up. In 2011, profit dropped 6% at S&P, falling to $720 million, amid internal disagreement over changes to the company's ratings structure. Peterson led a significant turnaround of the business, and the rating service made $849 million for McGraw Hill in 2012. It's not clear who will run S&P once Peterson is formally promoted, but his knowledge of the company's most profitable business is another reason analysts think McGraw Hill is in a solid position.

"Doug is someone who comes in with deep domain knowledge," said William Bird, an analyst at Lazard Capital Markets. "I think he's been effective at striking a good balance between managing a business responsibility and commercializing a business."

The DOJ's fraud lawsuit remains the biggest long-term question surrounding McGraw Hill, with the potential to wipe out about five years worth of company profit. Still, even with S&P seemingly digging in for a long legal fight, it remains likely that the case will end with a settlement, legal experts say. Even if settlement talks don't pick up a steam, a trial is not likely until 2015.

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