Is there life after reputational death? In the case of Moody’s Corporation (MCO, Financial), is there still a meaningful existence after being blamed by so many for causing the 2008 financial crisis?
Moody’s, you’ll recall, held a leading position among credit rating agencies, and critics by the thousands castigated it after many novel credit instruments imploded in 2008. Legislators, regulators and class-action lawyers – among others – have had this company in their sights for some five years now. Therefore, we ask if investors should even consider this stock now.
Image source: Moody's website
The answer is "yes." Despite the trouble it’s seen, Moody’s can boast a price (green line) and earnings (blue line) chart that would make many untroubled companies envious:
Moody’s Corporation came to our attention through its appearance on the Buffett Munger screener. Companies can only get through this screen by meeting several criteria used by the legendary Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) of Berkshire Hathaway (BRK.B, Financial). Most importantly, these companies need to demonstrate consistent earnings growth and at least fair valuation (defined by dividing P/E by the average 5 year EBITDA growth rate, or PEG).
History
1900: the company begins operations when John Moody publishes Moody's Manual of Industrial and Miscellaneous Securities
1906: competitor Standard Statistics founded
1907: after a market crash, Moody is forced to sell the Manual business (which by then was thriving)
1909: John Moody starts a new business – Moody's Analyses of Railroad Investments – analyzing railroad stocks and bonds and categorizing their quality with letter grades
1913: the new company expands its coverage to industrial companies and utilities; competitor Fitch Publishing Company founded
1914: Moody's Investors Service is incorporated; rating coverage expands to bonds issued by US cities and municipalities
1962: the company is acquired by Dun & Bradstreet (D & B)
1970s: ratings extended to the commercial paper market and to bank deposits; major rating agencies including Moody's begins the practice of charging issuers as well as investors for rating services
2000: D & B spins out Moody's Corporation; it goes public on the New York Stock Exchange as MCO
2007: the company splits into two operating divisions: Moody's Investors Service, the rating agency, and Moody's Analytics, which covers all other products
2008: as the financial crisis deepens, many investors, observers, and regulatory agencies allege ratings companies misled investors with their ratings of some mortgage-related securities
2013: the U.S. Department of Justice announces a $5 billion civil lawsuit again S&P (a McGraw-Hill subsidiary) but nothing against Moody’s; Moody’s and S&P (as well as banker Morgan Stanley) settle out of court with a group of investors who had been seeking $638 million in damages arising out of the 2008 financial crisis
History based on information provided by the company website, Investopedia, Wikipedia, and MarketWatch.
Moody’s business
For some of us, Moody’s is that rating company, but it has grown beyond just that line of business. In its 2013 10-K Report, it describes itself as a provider of five different types of services:
- credit ratings
- credit, capital markets and economic related research, data and analytical tools
- software solutions and related risk management services
- quantitative credit risk measures, financial services training and certification services
- outsourced research and analytical services to institutional customers.
Those services are covered by two reporting segments: Moody’s Investor Services (MIS) and Moody’s Analytics (MA):
Moody’s Investors Services: the best known (and infamous, in some eyes) part of the company; it provides credit ratings and research covering debt instruments and securities. It rates the debt of corporations and governments, generating information used by securities traders and investors. It describes its revenue model this way, "Revenue is derived from the originators and issuers of such transactions who use MIS ratings to support the distribution of their debt issues to investors." At the end of last year, it had ratings relationships with some 11,000 corporate issuers and 21,000 public finance issuers. It also monitors ratings on approximately 76,000 structured finance obligations.
Moody’s Analytics: software, advisory services and research for credit and economic analysis, and financial risk management. In this side of the business, the company provides financial analyses and risk management information for institutional investors (3,900 of them in 120 countries). Services include, "... in -depth research on major debt issuers, industry studies, commentary on topical credit related events and also provides economic research and credit data and analytical tools such as quantitative credit risk scores."
Revenue
In fiscal 2013, the corporation generated almost $3 billion in revenue. Slightly more than two-thirds of that came from MIS; the following excerpt from the 10-K Report breaks out the MIS revenue:
Moody’s Analytics brought in just under $1 billion, accounting for slightly less than one-third of revenue in 2013:
Geographically, the United States provided the most revenue:
Competition
In the MIS segment, Moody’s biggest competitor is Standard & Poor’s Ratings Services, a division of McGraw-Hill Financial (MHFI, Financial). In addition, many large investment organizations have their own, in-house research capabilities. Other competitors include Fitch Ratings (jointly owned by the Hearst Corporation and FIMALAC SA), Dominion Bond Rating Service, A.M. Best Company, Japan Credit Rating Agency Ltd., Kroll Bond Rating Agency Inc., Morningstar Inc. (MORN), and Egan-Jones Ratings Company.
Turning to the MA segment, competition comes from companies that include: Thomson Reuters (TRI), Bloomberg, S&P Capital IQ, Fitch Solutions, Dun & Bradstreet, IBM (IBM), Wolters Kluwer, Sungard, SAS, Fiserv, MSCI and Markit Group (competitive information from the MCO 10-K for 2013).
Takeaways: Although Moody’s, along with the other ratings companies, may have taken a beating over its assessments, the business carries on. And, as we’ve seen, it carries on in a big way, providing substantial revenue and revenue growth. In addition, it’s growing the other side of its business as well, the Moody’s Analytics side, which serves the needs of institutional investors. Competition exists, but apparently not to the extent of beating down prices significantly.
Growth
Let’s start our consideration of growth with a look to the past. The following chart shows growth of EBITDA per share (blue line), and (because it is part of the financial sector) its book value per share (red line), along with the share price (green line) over the past decade and a half:
As we can see, management has grown the bottom line, but not steadily. We note that EBITDA took a beating after each of the last two market meltdowns.
Looking ahead, in its 3Q 2014 Investor Presentation, the company forecasts:
- Long-term revenue growth in the low double-digits % (on average)
- Long-term EPS growth in the mid-teens % (on average)
Takeaways: Overall, Moody’s has a good history of growing its bottom line; as noted, it has felt the effects of the two previous financial crises. Given that the American economy is expected to continue expanding for at least another couple of years, we would expect MCO to grow with it.
Management
President and Chief Financial Officer: Raymond W. McDaniel, Jr., age 56, has held the position since 2012. He previously served as president and chief operating officer and has held senior executive positions at the company since 1996.
Executive Vice President and Chief Financial Officer: Linda S. Huber, age 56, has served in these positions since 2005. She previously served in the same positions at U.S. Trust Company, as well as senior roles at Freeman & Co., PepsiCo (PEP, Financial), and as a captain in the U.S. Army.
Chairman of the Board, Henry A. McKinnell, age 71. Dr. McKinnell has served in senior management positions at Optimer Pharmaceuticals, Inc. (OPTR) and Pfizer Inc (PFE).
Board of Directors: Made up of Chairman McKinnell, CEO McDaniel, and seven independent directors. Areas of experience and expertise include manufacturing, retail, financial services, accounting, banking, South American banking, academia (finance), risk management, engineering, technology and financial consulting.
Takeaways: Senior managers have been with the company since before the financial crisis, and the board has a good range of exposure to different facets of the American economy. Not so much exposure to the international business, it appears.
Management information from the company’s website and board of directors information from Morningstar.com.
Ownership
Gurus: thirteen of the esteemed investors followed by GuruFocus hold positions in MCO. Biggest, by far, among them is Warren Buffett (Trades, Portfolio) of Berkshire Hathaway (BRK-B) with 24,669,778 shares (almost 12% of MCO’s shares outstanding). Others with more than a million shares are Chuck Akre (Trades, Portfolio), Lou Simpson (Trades, Portfolio), and Chris Davis (Trades, Portfolio).
Institutions: As the following graphic from nasdaq.com shows, institutional investors (which includes pension funds, mutual funds, banks, and insurance companies) own almost 91% of Moody’s:
Short interests: GuruFocus puts the shorts at 3.44%, well down from the levels it posted in 2010:
Insiders: CEO McDaniels has the biggest holding among insiders; data from Yahoo! Finance show him with 207,184 shares as of August 2014. Chairman McKinnell held 115,003 shares as of September 2014. Altogether, insiders own 1% of MCO’s shares, according to GuruFocus.
Takeaways: This is very much an institutional company, both in terms of what it does and its ownership. With more than 90% of shares in institutional hands (including 12% with Berkshire Hathaway), we would expect relatively stable pricing (barring another event on the same or greater scale than the recent financial crisis).
Moody’s by the Numbers
Takeaways: With the share price getting close to its 52 week high, the company has a capitalization of almost $21 billion. It pays a modest, but sustainable (25% payout) dividend. It ambitiously bought back shares in fiscal 2013 (and since then has bought back many more).
Financial Strength
The GuruFocus system assigns 7/10 and 9/10 ratings to Moody’s Financial Strength and Profitability & Growth, respectively.
As the chart shows, the system has concerns about the historical Cash to Debt ratio, which currently sits at 0.83 (a rating of 1.0 or higher means the company has enough cash to immediately pay off the debt). At 0.83, MCO is just below that threshold. Looking at net issuance of debt, we see this is apparently part of a pattern:
Debt also leads to another red flag, for Interest Coverage (again, in historical context). Interest Coverage reflects a company’s ability to carry debt, and is calculated by dividing Operating Income by Interest Expense. With a current Interest Coverage score of 12.69, Moody’s has enough operating income to pay its interest expense 12.60 times over. But, it attracts a red flag, historically, because the score has declined from a high of 25.94 in December 2007.
Cash flow: for the trailing twelve months (TTM) ended in Sepember 2014, free cash flow was $915 million; on a per share basis that worked out to $4.22. That puts it near the high end of a range set over the past 10 years:
One final GuruFocus five-year graphic may help us put the cash and debt issue into context (green bars for cash, red bars for debt):
Takeaways: While Moody’s does get red flags related to its debt and cash metrics, we view them with minimal concern. Cash flow is strong and debt levels are manageable.
Valuation
The Buffett Munger screener at GuruFocus looks for, "...high quality business at undervalued or fair-valued prices." The latter criteria, undervalued or fair valued, is calculated in the screener by dividing the P/E by the average 5-year EBITDA growth rate. The result is known as the PEPG or PEG ratio – in other words, it links current share price and earnings with how fast the company has grown its EBITDA (EBITDA is "more normalized" than EPS).
At the close of trading on Wednesday, November 26, MCO had a valuation of 1.21, which puts it at the low end of the fair valuation range (0.00 to 0.99 is undervalued, 1.00 to 1.99 is fair valued, and 2.00 or higher constitutes overvalued). We also note Moody’s PEG ratio ranks higher than 92% of the 1,121 other companies in the Global Business Services sector.
The other key criterion for making it through the Buffett Munger screener is predictability, or the ability to consistently generate revenue and earnings. On that metric, MCO sits high; it enjoys a 5-Star rating, making it one of just 83 stocks, among the many thousands traded on North American stock exchanges, that reach that threshold.
Backtesting by GuruFocus found that 5-Star stocks appreciate, and appreciate consistently – they average a gain of 12.1% per year. In addition, their odds of slipping back are low; on average, just 3% of 5-Star stocks are still in a loss position if held for 10 years.
And, investors will want share price appreciation from MCO. As the following excerpt from the GuruFocus Summary page shows, the company’s dividends and share buyback ratio are modest:
Takeaways: As a Buffett Munger stock, the current Moody’s price comes in as fair value; combined with a very high predictability rating it comes in as a good buy for investors looking for capital appreciation.
Opportunities and risks
As we saw in the Growth section, the company has optimistic growth projections. It bases those projections on four growth drivers, or broad trends:
More debt market issuances because of global GDP growth; as we’ve seen with other ambitious companies, there are opportunities abroad, particularly in the emerging economies of India and China.
Disintermediation of credit markets, leading to more issuances, as well as demand for new products and services (disintermediation refers to cutting out financial intermediaries, such as banks and brokerage houses, between the users of funds and the suppliers of funds – for example, a pension fund investing directly in a private equity deal.
Growth of Moody’s Analytics because of the expansion of bank and insurance risk regulatory requirements; since the financial crisis of the last decade, much new legislation and thousands of new regulations have been put in place in the United States and other countries.
Better prices because of higher business volume and a more profitable mix of products/services; given that there are relatively few companies that can do what Moody’s does-an oligopoly-it has opportunities to increase margins as demand for its products increases. At the same time, a growing book of business means it has the luxury of putting less emphasis on products/services with smaller margins.
Risks
While the increased regulatory scrutiny of other companies benefits Moody’s, it is itself under increased scrutiny. And considering the finger pointing at ratings companies like Moody’s, it faces, in its words, "...complex, continually evolving and have tended to become more stringent over time." As a consequence it faces a number of significant risks and uncertainties.
Because of the tough economic circumstances over the past half dozen years, the market value of some debt related instruments has gone down and default rates have gone up. That’s led to more legal issues, some of which involve Moody’s ratings. As a result it faces not only specific lawsuits, but also class actions and government investigations.
International operations open the doors to many opportunities, but also increase exposure to a host of risks, including currency exchange, economic uncertainty and political machinations.
New products or technologies from competitors could undermine its current business model, because of cost advantages or customer preferences.
In the Opportunities section above, we noted it expects to get better prices; but at the same time, it does face pricing pressures from competitors in some areas. As it notes in its 10-K for 2013, "There is intense price competition in the credit rating, research, credit risk management markets, outsourced research and analytical services and financial training and certification services."
Outlook
In the near future, Wall Street estimates from morningstar.com put this year’s mean and median EPS at $4.04, an increase of 12.2% and 2015’s mean and median EPS at $4.62, an increase of 14.4%.
For the longer-term, Moody’s has indicated it expects to grow its revenue in the low double-digits (say 10% to 13%) and its earnings per share in the mid-teens (say 13% to 17%).
While the company still has not put all of its financial crisis troubles behind it, it does seem reasonable that it will meet these targets through the next five to ten years.
Conclusion
So there is life after reputational death, and in Moody’s case, lots of life. Earnings and EBITDA have grown strongly since the financial crisis, and we see no reason why they should not continue to grow in the short and long term. The company itself says it expects to grow earnings per share in the mid-teen percentages.
A couple of issues give us pause about MCO stock: first, will any more shoes drop as a result of government investigations or shareholder litigation? Second, we’ve seen many disruptive technologies shake the financial sector in the past two decades; will ranother one undermine Moody’s big breadwinner, the ratings business?
Tipping the balance to the positive side is the ownership profile: significant positions taken by the gurus, by institutional investors, and by CEO McDaniels give us confidence. As we’ve seen, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) are believers, and we can be, too.
