MCO - Moody's

[Guest Schwab711]

I'm kind of surprised there isn't a topic on Moody's already. It's down $5 today to ~$86 and 2015 earnings will likely come in between $4.40 - $4.60 or as low as 18.5x forward earnings. Looks pretty cheap at this point since we've seen the potential damage of lawsuits based of MHFI (~$1.5B in total for everything) which is more than covered by currently liquidity.

[Jurgis]

It looks like Buffett has been selling on and off 5%-10% of his position here and there. And it has been somewhat constant since 2009 - not a single big sale, but piecemeal. What do you think? It's very hard to understand why he's doing it this way. Of course, he made money by not dumping the whole position in 2009-2010, but he also lost money through the sales so far.

 

Or looking another way: why do you think you have a better handle on this than Buffett who has been a seller so far?

[Guest Schwab711]

I first bought Moody's in Feb-2013 and Buffett was already selling his stake at that point. At the time the fear was lawsuits of $5B+ against MHFI (and Moodys was excluded from them) and the fear of why Buffett was selling. Most research at the time feared revenue had peaked for awhile because there was a large decrease in derivative ratings. Since interest rates stayed so low for so long, there was a significant amount of debt issuance that made up for the lost derivatives business and the fear is/was this was a temporary spike in volume that will decline just as quickly and sharply when interest rates rise.

 

I personally thought Buffett was selling during and after the crisis because they had so many claims of poor ratings on MBS/derivatives/ect and he owns such a large % of the company (I'm still amazed FICO escaped untouched from public scrutiny). Thus, when folks started claiming that Moodys/S&P helped bring about the crisis, there was a possibility Buffett would either be tied to their outcomes (depending on outcome of lawsuits) or the general population would assume Buffett was somehow complicit with their wrongdoings (if there were any). I kind of think he just wanted to separate himself from the company since his stake was not large enough (relative to all of BRK) nor was there much future profit left to be worth the potential hassle or reputation hit. This is one of the situations where I have an advantage over Buffett in that my stake is small enough not to connect me with the actions of MCO nor does anyone care what I'm buying/holding.

 

Just because Buffett is selling does not change the fact that this is an incredible business model with a history of excellent operating performance. I sincerely doubt Buffett knows anything I don't and he certainly wouldn't be trading on that info if he did. In my opinion, most of Buffett's (or any large investors') actions are irrelevant to your investing decisions since he has $50b in net worth and is a well known personality in popular culture with different interests and incentives than the average shareholder. He may be acting because of things other than absolute expected returns. Copycat investing is nice, but nearly all of the time you are copying someone with different interests than your own.

[Jurgis]

You've got Buffett's endorsement: http://video.foxbusiness.com/v/4032461248001/buffett-on-coca-cola/?playlist_id=1866680862001#sp=show-clips

Congrats!  8)

 

I still wouldn't buy here, since I think the easy money has been made and it's not cheap here. Personally I won't pay 18x forward earnings even for a great business. But you might do well.

 

Good luck

[ItsAValueTrap]

(I'm still amazed FICO escaped untouched from public scrutiny).

 

Did FICO really do anything that was unethical?

 

Their credit scores aren't perfect.  (It may not even be possible to have a single number that accurately measures creditworthiness.)  Lenders generally understand that.

 

Their product is pretty good and they didn't deceive their clients about it.  They didn't have conflicts of interest.

 

The ratings intentionally gave out good ratings to please the people paying them (the underwriters).  FICO didn't do that.

[Guest Schwab711]

http://www.zacks.com/stock/news/183212/moodys-mco-tops-q2-earnings-and-revenue-estimates

 

Moody's had outstanding earnings, again. I think we are going to see earnings blow past FY projections of $4.60 (which assumes next 2 Qs come in below current estimates) and end up around $4.85-$4.90. They are currently have zero growth internationally due to global slowdowns. Any pickup in M&A, refinancing spree, or inflation is going to increase their earnings. Moody's is the optimal company in so many ways. It is cheap compared to V/MA, depending on your opinions of their business relative to payment transfers. Both earn revenue as a % of an inflating market.

[mankap]

Could not agree more. We have long way to go in the current business cycle.

With Greece settled, bond issuance should pick up in Europe in 3Q. 2015 M&A activity may surpass 2006 .

[Guest Schwab711]

Why I like Moody's more than S&P:

 

* S&P has better assets on the surface: S&P Ratings Services, Capital IQ, Platts, JD Power and Associates, SNL Finance (just purchased), and S&P/DOW Indexes.

* Moody's is extremely focused with Moody's Ratings and Moody's Analytics

 

I found that S&P's other businesses, although very good in their own right, do not earn the same types of returns as Ratings/Analytics businesses so they are lowering the overall results. S&P's other businesses are not large enough to provide a protection of your investment if the NRSRO status were eliminated. Without a materially higher floor, I thought MCO's higher returns would be materially higher over the long run.

 

The 3rd article I included discusses the differences in rating methodology between S&P and Moody's. At both major banks I worked at, all credit ratings were quoted as Moody's unless the debt was only rated by S&P. It is a distinct cultural difference for banks to choose to think in terms of "probability of default" (PD) or "expected losses given default" (ELD). Although both are almost always used in any analysis, regardless of the depth, I thought it was telling that banks like Citi demanded their employees to consider what bankruptcy will look like and what recovery rates will be. With Moody's, this information is woven into the ratings and makes it a more relevant data point during decision-making.

 

I continue to hold MCO and it now comprises ~30% of my portfolio. My main reason for holding is due to my belief that credit ratings are more "important" to the financial system than the general public/media's representation would lead you to believe. Both Jurgis's initial response and the 6th article I cite are fairly well representative of the general consensus. However, after working at Citi, I'm not sure how the major banks (maybe ex-WFC, to be conservative) could operate without them! The ratings are quoted to customers, used to model Risk Capital and RWA, and are also used in nearly every proprietary model to determine credit quality and worthiness. They are core to Citi's business and can not easily be eliminated or replaced. Finally, it is the banks and major corporations themselves who generate MCO/MHFI's revenue and not the general public. When popular opinion wanted to remove the NRSRO designation in 2011, one of the reasons I was so heavily purchasing MCO was due to the severe polarization between how banks/insurance companies felt about the ratings agencies vs the average citizen who is almost fully removed from the financial system.

 

Current Valuation:

MCO is expected to earn ~$5.25 in FY16. I have them coming in higher, though current margins are a few hundred bps higher than the recent average. MCO is currently selling for between 20x-21x FY16 earnings, which is substantially lower than other high-quality names like TDG, MA, and V. I think MCO (and MHFI, to a lesser extent) is still incredible values at these levels.

 

Articles on NRSROs:

http://www.bloombergview.com/quicktake/rating-the-raters

http://www.cfr.org/financial-crises/credit-rating-controversy/p22328

http://blogs.reuters.com/felix-salmon/2011/08/09/the-difference-between-sp-and-moodys/

http://chartsbin.com/view/1178

http://business.financialpost.com/news/economy/sp-moodys-boosting-rating-fees-faster-than-inflation (from 2011 but shows pricing power - though I'm sure nearly everyone believed they had it)

http://www.governing.com/topics/finance/gov-credit-ratings-still-matter.html

 

https://punchcardblog.wordpress.com/moodys-the-perfect-company-for-investors/

[jeyfox]

Hi,

there is some european legislation which has been adopted (at the beginning of the year) in order to regulate the credit rating agencies (reporting on fees charged to the clients, setting up a European rating platform). There are also some RTS (regulatory technical standards) from the European banking authority (EBA)  which are trying to ask/make sure that banks do not rely mechanically on external ratings (Moody's and S&P). In other words, the EBA would like banks to rely more on their own ratings. In my opinion, it will take time to implement this. The moat is still strong. I would add that desintermediation is relatively low in Europe but if/when it picks up, external ratings will be useful.

Cheers!

Jeremy

No holdings in MCO.

[Guest Schwab711]

Hi,

there is some european legislation which has been adopted (at the beginning of the year) in order to regulate the credit rating agencies (reporting on fees charged to the clients, setting up a European rating platform). There are also some RTS (regulatory technical standards) from the European banking authority (EBA)  which are trying to ask/make sure that banks do not rely mechanically on external ratings (Moody's and S&P). In other words, the EBA would like banks to rely more on their own ratings. In my opinion, it will take time to implement this. The moat is still strong. I would add that desintermediation is relatively low in Europe but if/when it picks up, external ratings will be useful.

Cheers!

Jeremy

No holdings in MCO.

 

I saw that. I'm pretty sure they are also "suggesting" [though not enforcing] corps to "rotate" their rating agency. It's somewhat of an impractical request to have banks rely on their own rating since it's going to incentivize rate shopping to a much greater degree then the current system. The 2008 crisis did not expose some glaring hole in the NRSRO business model. Everyone in the financial industry has known about the possible conflict of interest for well over 50 years. It's the best business model when all things are considered, which is why I'm not worried about the rating agencies in the long-run. If you add more rating competition then we will go back to rate shopping, which is exactly why we have the NRSRO designation in the first place (see congressional notes from 1975 congress). I think the EU roadmap to reduce reliance on CRA ratings is more about reducing their reliance on US-based ratings then anything else. It's worth pointing out that what they are requesting is already being done by every major Euro financial institution.

 

http://ec.europa.eu/finance/rating-agencies/docs/140512-fsb-eu-response_en.pdf

[valuefinder0525]

any buyers at these levels?

[marazul]

this thing usually trades at a big premium to the market. Now it is at less than 17x forward fcf. If we are not a top in the credit cycle, this is a great deal. I have been buying a lot. I have to say that sometimes mr. market is smart and knows what is coming. The market has to think the credit market is drying up, this price action is not random (at least I think).

[valuefinder0525]

anyone have anymore useful links or resources on this name? i am currently doing a deep dive. i would greatly appreciate it  :)

[bonkers]

http://www.marketwatch.com/story/icahn-sees-catastrophe-ahead-amid-zero-rates-junk-bonds-2015-09-29

 

I have not studied the company, but started to immediately think about the junk bond bubble. Is this large business for MCO? If yes, it may have been a substantial growth driver, has probably peaked, will crash, and cause big lawsuits - just like last financial crisis. ???

[Guest Schwab711]

http://www.marketwatch.com/story/icahn-sees-catastrophe-ahead-amid-zero-rates-junk-bonds-2015-09-29

 

I have not studied the company, but started to immediately think about the junk bond bubble. Is this large business for MCO? If yes, it may have been a substantial growth driver, has probably peaked, will crash, and cause big lawsuits - just like last financial crisis. ???

 

I don't think anything could come close to the risk created by >10% default rates of AAA paper. The late-80's junk bond meltdown did nothing but make Moody's/S&P more valuable. These bonds are junked rated for a reason. Earning may stall or slightly decline, but they will be significantly higher within 3-5 years. Moody's has a better research arm (even though it's less recognizable), a more accurate credit arm, and better capital allocation.

[fareastwarriors]

What Crisis? Big Ratings Firms Stronger Than Ever

 

S&P, Moody’s and Fitch issue more than 95% of global bond ratings, and profits are nearing all-time highs

 

http://www.wsj.com/articles/what-crisis-big-ratings-firms-stronger-than-ever-1457655084

[Liberty]

http://valueseekerinvestments.blogspot.ca/2016/03/moodys-corp-mco-106-page-slide-deck.html

 

https://drive.google.com/file/d/0BzG5iyelNfWfakxFV2xieEE5QWM/view?usp=sharing

[gjangal]

Anyone liking this as this price? I understand that there are a few concerns with growing revenue from this level (high yield debt issuance, cyclical concerns) . Around 85 seems a great price ( 15-17% pa).

[Guest notorious546]

this could be interesting.

[HJ]

While I very much agree with the bullish argument on the strength of the business model, let me just point to a couple of headwinds and make an argument that the current multiple, while not rich, is not obviously cheap either. 

 

Over the past 30 years, the business has benefitted from 2 big tail winds, 1) a massive decline of interest rate from the high teens in the late 70's / early 80's to close to zero today, which encourages all forms of debt financed activities, consumer and corporate, and 2) the disintermediation of regulated financial institutions (banks / insurance companies) by the ever more liquid capital market.  Both of these tail winds have arguably run their courses, and show signs of reversal.

 

Interest rate - one can argue rate will continue to stay low for the foreseeable future, but it likely won't go much lower.  Yes rates are negative in many places in the world, but it's not clear that negative rate encourages capital formation and a further expansion of debt.  If anything, it's quite possible the opposite is true.  Credit metrics that look reasonable at today's borrowing cost would look very stretched at significantly higher interest rate.  The society therefore can't and won't support as high a debt load as the one existing today.  This is sort of a longer term headwind even if one believes in the lower for longer thesis on rates.

 

Disintermediation by the capital market - since the financial crisis, things have gone the opposite direction, with pressure to go further.  Private credits in most forms of consumer lending today have significantly less involvement from rating agencies.  Non-agency residential mortgage lending has been minimal since the crisis.  What little is done has been kept on bank's balance sheet for the most part with little involvement of rating agencies, rather than being securitized.  With the destruction of the non-government money market funds, there's not a lot of competition for bank balance sheet funding for most assets.  A lot of formerly capital market funded entities are converting themselves into banks, online or branch, with less rating demand for funding needs - Ally, Synchrony, Discover, Capital One, etc., etc.  The government has basically taken over student lending with no need for rating agency involvement.  Demand for rating service in all forms of consumer finance has diminished significantly.  For corporate lending / commercial real estate lending, ratings need have somewhat revived with the resurrection of the CLO market and CMBS market.  But those are now facing serious regulatory headwind in the form of risk retention requirement, which kicks in after this year.  Most estimates are for a meaningful reduction in activities in those areas.  The development of those 2 markets and the consumer finance industry in the past 30 years converted the aggregate balance sheet of the entire banking system in the US from one with little rating agency involvement (on balance sheet, privately credit scored and monitored) to one where the rating agency is everywhere (they rate the underlying corporate borrowers, rate the structures for RMBS, CMBS, CLO securities, and then rate the commercial paper that allow these assets to be funded through money market funds).  While neither the CLO nor the CMBS market will go away, regulation is putting pressure from many different directions to discourage these securitization activities.  How capital market will evolve from here, and how rating agencies will be involved in the future is anybody's guess.  They may be just as involved in the whole capital formation process as they are right now, but one can also easily envision a scenario where their roles will be significantly diminished. 

 

These are headwinds that the entire financial system is facing, which have kept a lid on valuation across the industry.  These businesses don't take credit risk, are capital light, and for now have a total strangle hold on how capital is formed.  They certainly deserve to trade to a significant premium to the risk bearing financial institutions.  But it seems like before a further multiple expansion beyond where we are, (call it 20x) today, can happen, the regulatory headwind need to first show some sign of having been absorbed by the industry, if not being reversed.

[Palantir]

The problem with this company is that it doesn't have an economic moat over its competitors. There is no secret sauce and this space may be ripe for disruption. It's business model is primarily driven by debt issuance which will probably shrink, so even if it looked cheap, you're getting in front of some major downwards revenue adjustments which seems like a dangerous place.

[LC]

Thanks for your thoughts HJ very insightful...I agree especially in terms of disintermediation. Gone are the days of billing fees at every step of the financing process between 5-10 parties, unless regulations change and I think that will be difficult

[gjangal]

HJ, Thank you for your comment. The way I am looking at this is that revenue growth for Moody's is a function of gdp growth, disintermediation and pricing power. I agree with you that the disintermediation tailwind in the US may be over, but in China , India and Europe the banks hold most of the loans. IMO the opening up of bond markets and securitization in China and India and the rest of the world should still be a tailwind. Moody's has a decent presence in both China and India.

 

Then there is inflation. Businesses like these can be a good hedge against inflation( when that happens). There is also some opportunity for margin expansion,  While this is not a home run kind of investment, IMO this can still compound investor money for some time to come and this stock has never been very cheap. Concerns would be If revenue growth slows down permanently to low single digits.

[Guest notorious546]

http://vintagevalueinvesting.com/a-unique-behind-the-scenes-look-into-warren-buffetts-investment-process/

 

BONDI: I understand, sir, that in 1999 and in February 2000, you invested in Dun and Bradstreet.

 

BUFFETT: That’s correct. I don’t have the dates, but that sounds right. Yes, sir.

 

BONDI: And am I correct, sir, in saying you made no purchases after Moody’s spun off from Dun and Bradstreet?

 

BUFFETT: I believe that’s correct.

 

BONDI: Okay. What kind of due diligence did you and your staff do when you first purchased Dun and Bradstreet in 1999 and then again in 2000?

 

BUFFETT: Yes. There is no staff. I make all the investment decisions, and I do all my own analysis. And basically it was an evaluation of both Dun and Bradstreet and Moody’s, but of the economics of their business. And I never met with anybody.

 

Dun and Bradstreet had a very good business, and Moody’s had an even better business. And basically, the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.

 

BONDI: Now, you’ve described the importance of quality management in your investing decisions and I know your mentor, Benjamin Graham – I happen to have read his book as well – has described the importance of management.

 

What attracted you to the management of Moody’s when you made your initial investments?

 

BUFFETT: I knew nothing about the management of Moody’s. I’ve also said many times in reports and elsewhere that when a management with reputation for brilliance gets hooked up with a business with a reputation for bad economics, it’s the reputation of the business that remains intact. If you’ve got a good enough business, if you have a monopoly newspaper, if you have a network television station (I’m talking of the past) you know, your idiot nephew could run it. And if you’ve got a really good business, it doesn’t make any difference.

 

I mean, it makes some difference maybe in capital allocation or something of the sort, but the extraordinary business does not require good management.

 

I’m not making any reference to Moody’s management, I don’t really know them. But if you own the only newspaper in town, up until the last five years or so, you have pricing power and you didn’t have to go to the office.

 

BONDI: And I’ve seen in many places where you’ve been referred to as a passive investor in Moody’s. Is that a fair characterization, and what sort of interactions and communications have you had with the board and with management at Moody’s?

 

BUFFETT: At the very start, there was a fellow named Cliff Alexander who was the chairman of Dun and Bradstreet while they were breaking it up.

 

I met him in connection with something else, years earlier; and so we had a lunch at one time. But he wasn’t really an operating manager. He was there sort of to oversee the breakup of the situation.

 

Since we really own stock in both Dun and Bradstreet and Moody’s when they got split up, I’ve never been in Moody’s office, I don’t think I’ve ever initiated a call to them. I would say that three or four times as part of a general road show, their CEO and the investor relations person would stop by and – and they think they have to do that. I have no interest in it basically, and I never requested a meeting. It just – it was part of what they thought investor relations were all about. And we don’t believe much in that.

 

BONDI: What about any board members? Have you pressed for the election of any board member to Moody’s –

 

BUFFETT: No, no –

 

BONDI: – board?

 

BUFFETT: – I have no interest in it.

 

BONDI: And we’ve talked about just verbal communications. Have you sent any letters or submitted any memos or ideas for strategy decisions at Moody’s?

 

BUFFETT: No.

 

BONDI: In –

 

BUFFETT: If I thought they needed me, I wouldn’t have bought the stock.

 

BONDI: In 2006, Moody’s began to repurchase its shares, buying back its shares that were outstanding, and they did so from 2006 to 2008, according to our records.

 

Why didn’t you sell back your shares to Moody’s at that time? I know subsequent in 2009 you sold some shares, but from ‘06 to ‘09, during the buyback, did you consider selling your shares back, and if so, why didn’t you?

 

BUFFETT: No, I thought they had an extraordinary business, and – you know, they still have an extraordinary business. It’s now subject to a different threat, which we’ll get into later, I’m sure.

 

But I made a mistake in that it got to very lofty heights and we didn’t sell – it didn’t make any difference if we were selling to them or selling in the market. But there are very few businesses that had the competitive position that Moody’s and Standard and Poor’s had. They both have the same position, essentially. There are very few businesses like that in the world. It’s a natural duopoly to some extent. Now, that may get changed, but it has historically been a natural duopoly, where anybody coming in and offering to cut their price in half had no chance of success. And there’s not many businesses where someone can come in and offer to cut the price in half and somebody doesn’t think about shifting. But that’s the nature of the ratings business. And it’s a naturally obtained one.

 

It’s assisted by the fact that the two of them became a standard for regulators and all of that, so it’s been assisted by the governmental actions over time. But it’s a natural duopoly.

 

WARREN BUFFETT AND INVESTMENT MODELS

 

BUFFETT: The rating agencies, they have models, and we all have models in our mind, you know, when we’re investing. But they’ve got them all worked out, with a lot of checklists and all of that sort of thing.

 

I don’t believe in those, myself.

 

All I can say is, I’ve got a model in my mind. Everybody has a model in their mind when they’re making investments.  But reliance on models, you know, work 98 percent of the time, but they never work 100 percent of the time. And everybody ought to realize that, that’s using them.

[Guest Schwab711]

I think MCO is cheap (again). This isn't deep value cheap, but I think they are currently earning well-below their "earnings power". Here's my quick summary of why MCO is better than SPGI and why it's cheap.

 

Below are some screen shots of the segment results for S&P and MCO. They both earn nearly identical revenue from their ratings segments, but MCO has 51.1% to 53.9% operating margin vs. S&P's 44%. Moody's Analytics earns just as much as S&P's CIQ and SNL, combined.

 

SPGI's market cap is almost exactly $10b greater than MCO's. That $10B basically buys you the DJIA Index royalties (~$400m/yr @ 8%-10% growth) and Platt's (I believe SPGI sold JD Power - so C&C operating profit will decline in 2016). SPGI has significantly lower margins in the apples-to-apples segments and you get to purchase the DJIA indices and Platt's at ~20x-25x (I'd have to do more work on JD Power).

 

MCO is selling at 20x 2016 earnings, which they have already guided lower on. Earnings will increase in 2016, despite reduced total issuance, HY issuance, and structured finance being well-below pre-recessionary levels. Record debt issuance is going to continue for decades and MCO is basically a small, high-margin royalty on the aggregate issuance, weighted by credit rating.

 

I think 5 years from now, Moody's EPS will be closer to $9-$10.