MCO – Capital Light Compounder

Moody’s corporation is a credit rating, research and risk analysis firm. The company provides credit ratings and related research, data and analytics tools, quantitative credit risk measures, risk scoring software and credit portfolio management solutions and securities pricing software and valuation models.

Core driver 1 – A Sustainable Competitive Advantage

Moody’s benefits from significant bargaining power within its industry arising from a fragmented base of counterparties. Since 1975, the Securities and Exchange Commission (SEC) has limited competition in the market for credit ratings by designating only certain firms as “Nationally Recognized Statistical Rating Organizations” (NRSROs)…. effectively restricting competition to these appointed players. Post the mid-2000s, a number of additional agencies have been appointed (to reach ten in total) however there remains a distinct advantage in the big 3’s incumbency. Out of the newer appointed agencies, 3 are international, one is an insurance specialist and the other three are small and US based which leads to >95% combined market share for MCO, SPGI and Fitch. Arguably, the industry has been through the greatest regulatory stress test imaginable where CRA’s (credit rating agencies) played a significant hand in the financial crisis and after a considerable view, OECD and SEC hearing determined that the current industry structure was the most socially optimal, albeit with caveats around increased ratings transparency and significant fines.

State of competition

Credit rating agencies benefit from a unique agency problem whereby the regulator’s core objective is to ensure accurate credit ratings that protects the interests of consumer/ investors. As a result, the financial interests of issuers falls lower on the priority list which ultimately leads to strong pricing power for the ratings agencies. A study conducted by Milbourn and Becker (Harvard Business School) scrutinized the significant market share gains made by Fitch in the lead up to the financial crisis and found that increased competition for market share (particularly in structured products) led to a deterioration in ratings quality as quality was de-prioritized amongst CRAs. They find this through statistically significant ratings inflation compared over different periods, a fall in the correlation between bond yields and ratings and evidence of greater downgrade responses in equities, consistent with a lower bar being set for the ratings categories. This suggests reputation building activities should be prioritized/ rewarded over competition which is best achieved in an environment where the ratings agencies do not feel pressured to cater to issuers. As competition increases, the issuer has greater bargaining power, increasing the likelihood of “ratings shopping” or worse, CRA-led ratings inflation in a bid for market share. A disconnect exists whereby it is the most socially optimal outcome to promote a consolidated market structure on the ratings side as the CRA will feel less pressure to compromise their views in order to win business. This was compounded by the fact that the investment banks exerted greater market influence – a handful of securitisers made up at times 10% of market share in the structured products category which led to pressure on ratings agencies to offer favourable ratings.

Another study, this time primarily focused on Japan[1] found that an increase in Global CRAs’ market shares precedes a decline in credit ratings. This study then expanded to look at a range of 26 different credit markets and drew similar conclusions. For example, a one standard deviation in S&P’s regional market share was predicted to decrease the average corporate ratings by 0.644 and 1.339 notches in the U.S. and the other 26 developed markets, respectively.

Bargaining power of customers

Issuers individually make up a very insignificant portion of MCO’s revenue which limits their bargaining power. For example, if ATT (the largest global debt issuer) refinanced all $150bn debt in one year, it would be approximately a $60mn rev impact for MCO (1%.) This clearly exerts insufficient power to influence the credit rating delivered by the agencies and provides a desirable market structure for the regulator where long term reputation building incentives can supersede catering to customers. This power imbalance was broken in the lead up to the GFC in structured products whereby certain investment banks would comprise >10% market share in particular subcategories, making them powerful clients and ultimately contributing to a deterioration in ratings scrutiny. As discussed previously, this is a suboptimal social outcome for both the regulator and society in general. I.e. an environment where CRAs possess significant market power is seemingly the most socially optimal market structure, consistent with higher quality ratings.

Brand and Reputation

  1. Legislative barriers – minimum regulatory ratings requirements specify use of the ratings of particular rating agencies in the investment management contracts of some institutional fund managers and the investment guidelines of some fixed income mutual fund managers, pension plan sponsors, and endowment fund managers. This also applies to inclusion requirements in fixed income indices. Virtually no credit instrument goes unrated as mandated by the NRSRO and as a result, issuers are often essentially forced to use one of the big three players through legislative requirements.

  2. Diminishing returns of competition – Corporate issuers build a trust relationship with one or two CRAs but are unwilling to be rated by more due to the time and cost requirements of becoming rated. Naturally they will value the ratings most trusted by investors which tends to lead to industry concentration. It is not just the issuers that benefit from a consolidated CRA market but broader society…
    1. The reputation penalties for biased ratings are asymmetric as CRAs are penalized for optimistically biased ratings but not for pessimistically biased ratings
    1. When market share is high, the long-term reputation losses (i.e., foregone sales when inflated ratings are detected) are likely to be larger than the short-term gains from inflating ratings
    1. When Global CRAs have greater market power, the high economic rent strengthens their reputation-building incentives which in turn induces tighter rating standards.
    1. In contrast, when CRAs’ market power is lower, the conflicts of interest inherent in the issuer-pay model may dominate the reputation building incentives, leading to a looser rating to cater to issuers’ demand and grab business
  3. Network effect – it is nearly impossible to obtain clients without a track record for reliable ratings and such a track record is difficult to generate unless one first has clients. New ratings from new firms would effectively be ignored until they have sufficient scale which limits the probability of disruption. It can take multiple decades to build a reputation for quality given the long tenure of some rated debt instruments and the associated difficulty with evaluating ratings performance promptly.
  4. Proprietary risk assessment models – Homogenizing credit ratings has been considered in the past but was ultimately decided against as requiring standardized credit rating terminology may reduce incentives for credit rating agencies to improve their credit rating methodologies and surveillance procedures, leading to suboptimal societal outcomes.
    1. Most commenters in academic papers published and regulatory hearings after the GFC stated that it was neither feasible nor desirable to standardize credit rating terminology and market stress conditions or to require correspondences between ratings and default probabilities and loss expectations.
    1. Some of the commenters stated that standardization would lead to lower levels of competition and quality in the credit rating industry and would increase reliance on credit ratings.
    1. Economic forces driving performance are optimal for achieving the highest levels of ratings quality. This level of differentiation provides MCO and SPGI with a distinct advantage over newer competitors, benefitting from 100+ years of data and process refinement

Scale – MCO benefits from larger analytical staff to rate debt instruments, wider coverage of the debt capital markets and the ability to absorb regulatory costs which place it at an advantage over newer CRAs. The following graph details the number of credit analysts at each agency.

Switching costs

Issuers – An issuer that uses MCO instead of issuing unrated debt or using a rival agency will benefit in the form of interest savings as potential investors place greater faith in the processes of the incumbents with familiar brand names. Taking the $500mn bond detailed below and the associated $15mn in interest savings as an example illustrates the divergence in materiality for issuers. MCO would theoretically earn $200-$250k from ratings this bond assuming a revenue yield of ~0.045% which is about average for a corporate bond.  A 3-4% price increase pales in comparison to the $15mn in total interest expense that is being savedwhich underpins MCO’s significant pricing power.

Users/ investors – Ratings from a given CRA provide a common standard to interpret risk. Investors are unwilling to spend large time/money resources to interpret many different standards, all else equal, the larger the “installed base‟ of ratings from a given CRA, the greater the value to investors and the greater the barrier for new CRAs.

Core driver 2 – Attractive Operating profile

Moody’s has very desirable financial characteristics that underpins long term EPS in the low teens on average. The following snapshot is taken from a recent investor day. I will endeavor to go through the drivers of this EPS growth in this section.

Revenue Growth

The competitive dynamics discussed above underpin strong pricing power for MCO and I do not project this to change over my forecast horizon – forecasting 3-4% annually in line with history. Additionally, the environment over the next few years should broadly be supportive for issuance. The two largest uses of debt are refinancing (50%) and M&A (29%.) Although refinancing has been plentiful this year it has been primarily driven by IG whilst HY issuance is actually down and M&A has ground to a standstill. Over the next few years as economies reopen post the discovery of a vaccine, we will be in an environment of government rates at the effective lower bound, a return to GDP growth, unemployment improving, returning business/consumer confidence and corporate credit spreads decreasing. Moreover, the public debt financing pipeline is very strong over the next 5 years.

Although we have experienced 50-100 years of increasing debt globally (in most private/public settings) and as a result, system wide deleveraging is certainly a plausible risk, the medium term outlook appears supportive. My Moody’s Investor Services (MIS or the credit rating segment) revenue forecasts (between 6-7%) take this into account and are at the lower end of their long term guidance. Additionally, the disintermediation of credit markets offers a 2-3% tailwind as the benefits of publicly issued debt continue to outweigh bank loans. Increasing regulation of banks has weighed on profitability via increased regulatory costs, stringent capital requirements and less flexibility. As a consequence, the attractiveness of the rates they are able to provide in the form of bank loans coupled with tougher regulatory requirements has made direct balance sheet financing less attractive for all parties involved. These financial intermediaries are increasingly selling assets in public capital markets rather than retaining them on balance sheet. I expect the disintermediation of credit markets to continue given that issuer use of debt capital markets confers advantages in efficiency and capacity versus traditional banking systems, further assisted by the still-low interest rate environment and overall bank de-leveraging as they continue to move towards agency models rather than principal models. See Europe (left) and US (right) below for recent market share trends.

Operating Expenses

There is very little operating expenditure required to sustain MCO’s moat – as a services business there is very little R&D required and marketing costs are low due to the fantastic brand awareness MCO has selling to other businesses, testament to its enduring moat.

This highly scalable expense base has given rise to significant margin expansion over the past decade and I forecast this to continue with Moody’s Investor Services (MIS.) Note this segment accounts for ~80% of EBIT.

Capital Intensity

MCO is highly free cashflow generative and requires little incremental capital to grow, evidenced by the steady growth in sales/ net fixed assets and high levels of asset efficiency. This facilitates significant free cashflow generation. As a result of limited reinvestment opportunities within the core business, MCO is able deploy significant resources into its capital allocation waterfall, focusing on M&A, dividends and share repurchases instead.

Core driver 3 – Assessment of Management

Incentives

The management team is highly incentivized to deliver growth in operating income, with incentive linked pay comprising >90% of Ray McDaniel’s potential pay and 72% arising from equity linked compensation. Notably, Ray’s $1mn base is in line with key comp SPGI, below the peer set and has not moved since 2017, indicating a reasonable base package and lesser exuberance from the board. Management’s short term incentives also focus on strategic and operational goals by evaluating performance against the following objectives: (i) new sources of growth; (ii) quality assurance and controls; (iii) operating effectiveness and efficiency; (iv) people and culture; (v) risk management; and (vi) enabling technologies and capabilities. On balance, I am comfortable that the management team are focused on the correct objectives in the short term that will deliver sustained growth for the business.

LTIs are assessed on group adjusted EPS growth, MA sales growth (adjusted for M&A) and MIS ratings performance which seems like a solid proxy for creating shareholder value. This has arisen from the GFC fallout and it is encouraging for shareholders to know that the management team are incentivised to maintain ratings discipline and preserve the reputation of the MCO brand. Arguably, there is too much of a focus on EPS growth rather than metrics such as return on capital however, given the quality nature of the businesses fundamentals, I am less concerned with this.

Alignment of interests

The stock ownership guidelines outlined by the board are intended to balance an officer’s need for portfolio diversification with the Company’s desire for officers to hold an ownership level sufficient to assure stockholders of the individual’s commitment to value creation. The current ownership level multiples are: (i) six times base salary for the CEO, (ii) three times base salary for the remaining NEOs, as well as all direct reports of the CEO who receive performance shares. The management team has persistently sold shares over the past 5 years which could potentially be a concern however I am relatively comfortable with their commitment to the business. Ray McDaniel owns $78mn in stock while the CFO owns $15mn which is 13x their prescribed minimum holding requirements. All executive members (excluding the current CFO) have been with the business at least 10 years which reinforces the strategic consistency that had led to terrific execution from MCO across the past decade. Ray has been CEO since 2005 while both divisional presidents have been with their divisions since the 1990’s. This highlights the strong internal promotion opportunities and consistent corporate culture that MCO have established. If history can be used as a guide, shareholders can be confident of steady, long term decisions made by the management team with a deep understanding credit markets and the Moody’s business model.

Capital Allocation

Moody’s have shown a strict discipline across acquisitions in the past 20 years despite having made 41 acquisitions since 2002. Nearly all of these have occurred in the Moody’s Analytics business (20%) of earnings to expand their risk, data and analytics solution. The vast majority of these acquisitions have been bolt ons faced on additional functionality and only 5 have been valued at greater than $200mn AUD. There is a strong desire for new adjacencies that are complimentary to Moody’s existing businesses and a preference for recurring revenue coupled with low capital intensity. MCO targets >10% annual cash return yield within 3-5 years, EPS accretive by year 3, IRR above MCO’s cost of capital and cash payback within 7-9 years. It is easy for businesses to pay lip services to these requirements however, MCO’s track record validates their acquisition requirements. A summary of the multiples paid across all material deals is provided in the table below.

It is challenging to assess these deals in aggregate with limited data so I will focus on the most significant. On August 10, 2017, a subsidiary of the Company acquired 100% of Bureau van Dijk Electronic Publishing B.V., a global provider of KYC, compliance and financial crime, data aggregation (particularly M&A), credit and financial risk, supply chain understanding/risk. This furthers MCO’s expansion into private company data & analytics and provides the core business with a holistic data set in covering credit markets. The cash payment of $3,542 million valued BvD at 20x forward EBITDA of $180mn. The business has accelerated form a 9% revenue growth rate in the ten years preceding the acquisition to a 16% CAGR in the 3 years since and, if purchased at the same price 2 years later would be trading on 14x EBITDA. It is still early on in the assessment of this acquisition but the signs are positive for what was their largest ever acquisition (triple the size of the 2nd largest and 8x the size of their 3rd largest.) The management team are excited about the opportunities within KYC (from both Bureau van Dijk and Reis their second largest acquisition) which they see growing at 18% per year from a $150mn revenue contribution to $300mn by 2023.

The easiest way to evaluate the organic performance of the other 40 acquisitions they have made in Moody’s analytics is to observe the strong organic growth they have generated net of churn as per the below chart. They have executed well and the Moody’s analytics business continues to grow at 10% organically driven by 8% upgrades/mix, 6% new sales and 4% churn.

MCO’s track record for redistribution capital back to shareholders is equally sound. MCO has consistently paid a dividend with a payout ratio of 25-30%. More impressively, Ray McDaniel (who remains the current CEO) invested heavily and counter cyclically during the GFC. Buying back $1.7bn in stock in 2007 when the stock was trading below 10x EBIT generated substantial returns for shareholders and showed excellent foresight despite significant public concern around the state of the industry. Note that this is still a record for stock bought back for the business. MCO has continued to deploy excess cash in the last ten years into share repurchases, even as the stock has become increasingly expensive. I am comfortable with this as the stock has traded at or below the market multiple for the majority of this time which I believe is not warranted given the quality of the business relative to the average stock.

Valuation analysis

Moody’s has traded below a market multiple (EV/EBIT) for the bulk of the decade. This was understandable initially given concerns regarding future regulation and the structure of the industry however, regulatory filings from the SEC and OECD reveal renewed confidence in the existing mechanisms for governing the rating agencies. Notably, MCO trades below the current market multiple which I believe is grossly undervalued given the strong moat, excellent track record and first class corporate culture.

The discount MCO trades at is even more stark when assessed relative to comparable firms. MCO has generated 8% revenue growth in the past decade, in line with peers and 9% EBITDA growth vs. comparables at 10%. More importantly, the confidence an investor can have in the sustainability of future revenue growth is higher due to the strong barriers to entry MCO has relative to peers in more competitive data provision services.

Through my DCF approach and comps I arrive at a target price of $339 which presents 21% upside to the current price. The opportunity for long term compounding earnings growth and significant capital returns should provide a foundation for Moody’s to outperform the index, hopefully for many years to come.

Risks

In the aftermath of the GFC, congress passed the Credit Rating Agency Reform Act of 2006, allowing the SEC to regulate the internal processes, record-keeping and certain business practices of CRAs. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, commonly referred to as Dodd-Frank, further grew the regulatory powers of the SEC including the requirement of a disclosure of credit rating methodologies. This process was one of the greater stress tests possible for the industry and in my view, renders any further wholesale changes unlikely given that the current system was forensically reviewed by a wide range of government agencies. Potential considerations included:

  • A subscriber pays model – Noting that(1) Most financial gatekeepers – auditors, law firms, investment banks – operate under a similar model under which the issuer pays their fees; and (2) A “subscriber pays” model may be doomed to failure by the “public goods” nature of ratings. Because the rating agency cannot effectively prevent the communication of its ratings to non-paying investors once it discloses its ratings to its clients, it cannot capture the full value of the financial information that it creates. If this were to occur, CRAs would become far less resourced from a talent and financial standpoint and as a result the industry is unlikely to achieve the best outcomes under a subscriber pays model.
  • Curbing employee compensation – the asymmetric risk profile of credit ratings makes this approach hard as it can take years before ratings quality is determined and can be assessed.
  • Negligence based payments – has been implemented although there is limited scope for punishments to fit the crime as it would bankrupt the ratings agencies.
  • Govt appointed agencies – may lead to inferior ratings quality. First, governmental agencies cannot pay the same salaries or incentive compensation to analysts as firms in the private sector, with the consequence that a “public” rating agency might have to rely on inferior personnel. Second and more importantly, serious doubt exists that a “public” rating agency could give a negative (or “junk”) rating to an important or politically-favoured local firm or publicly rated issuer.
  • Reducing their licensing power – they do not enjoy the same publicly appointed designation in Europe as they do in the US and it translates to increased competition which as previously discussed, is not the desire of the regulator or the most optimal outcome for society.
  • Homogenization of ratings – This was considered although it was determined it would ultimately lead to lower levels of differentiation between CRAs and as a result, increasing the probability of price as a differentiator for rating services. Any actions that increase the bargaining power of the issuer and potentially greater price competition
  • Increased disclosure/transparency requirements – implemented

After a thorough review of regulatory filings, it appears as though the current system (focused on less competition, not more) is the most effective for achieving the regulators goals. It is a politically sensitive industry and as a result, regulation must be constantly monitored however, the benign environment of the next ten years should provide a base level of confidence that the current industry structure should remain relatively stable.

The two other risks are systematic de-leveraging weighing on volume growth and technological obsolescence. Increases in leverage have been a theme of nearly all markets (public and private) over the past 50 and 100 years which may reverse as the leverage in the system builds to arguably unsustainable levels. I have taken this into account with long term revenue growth in MIS below the HSD long term management forecasts and not explicitly assuming 2-4% increases in volumes arising from GDP growth. Technological obsolesce is a risk as big data disrupts many industries. Again, one must remain vigilant when evaluating this risk but I would highlight that if an individual or firm were to discover an autonomous solution for accurately pricing credit risk, it is unlikely that it would be donated to a regulator to ensure more accurate credit ratings… rather the prospective investor would utilise this service to accrue wealth far more effectively! Additionally, SPGI and MCO are arguably in a far stronger position to develop such a system with greater than 100 years of credit data to draw on.

On balance, I think the risks are more than discounted in the price whereby MCO trades below the market and comps multiple and recommend buying MCO.


[1] Market Power and Credit Rating Standards: Global Evidence; Hung, Kraft, Wang and Yu