MCO - Moody's

[valuefinder0525]

Schwab and others, any thoughts on MCO vs SPGI?

 

http://valueseekerinvestments.blogspot.com/2016/03/moodys-mco-vs-mcgraw-hill-financial.html

[Guest Schwab711]

Schwab and others, any thoughts on MCO vs SPGI?

 

http://www.cornerofberkshireandfairfax.ca/forum/investment-ideas/mco-moody's/msg268716/#msg268716

 

The presentation posted is a nice overview of both.

 

I think SFP recovers long-term, which benefits MCO considerably more.

 

I don't see much value in the revenue diversification for S&P because ratings are such a large portion of total revenue. Basically reduces volatility and upside. Its so rare to own a piece of a business of such high quality like a CRA, I'd prefer a "pure play". If the ratings business fails for regulatory reasons, the other businesses don't raise the floor for S&P much.

 

In my mind, you pay an extra $10b (for S&P) for a worse CRA business (operations and analytics), worse software business (ops and analytics, again), and the DJIA/S&P indices royalty stream. Is it really worth buying the royalty stream (which faces secular headwinds) for $10b-$15b, just to get a worse CRA/software biz. I also like MCO management a lot more.

[valuefinder0525]

Amazing image of MCO's history

[Liberty]

Q3 is out, including a litigation update:

 

http://www.businesswire.com/news/home/20161021005227/en/Moodys-Corporation-Reports-Results-Quarter-2016

 

LITIGATION UPDATE

 

Following the global credit crisis of 2008, Moody’s has periodically received subpoenas and inquiries from various governmental authorities, including the US Department of Justice (DOJ) and states attorneys general. In a letter dated September 29, 2016, the DOJ stated that it is preparing a civil complaint to be filed against Moody’s and MIS in the US District Court for the District of New Jersey alleging certain violations of the Financial Institutions Reform, Recovery, and Enforcement Act in connection with the ratings MIS assigned to residential mortgage-backed securities and collateralized debt obligations in the period leading up to the 2008 financial crisis. The DOJ also stated that its investigation remains ongoing and may expand to include additional theories. A number of states attorneys general have indicated that they also expect to pursue similar claims under state law, which claims may include additional periods, theories, asset classes or activities. The Company is continuing to respond to the DOJ’s and states’ subpoenas and inquiries.

[Guest Schwab711]

No shock, I think MCO is cheap again. Especially relative to other high quality businesses.

 

I expect approximately 100% of any tax cut to flow through to shareholders given the lack of product price competition in the space. A lot of other industries may not realize benefits of tax cut. A corporate tax cut should also cause spreads between corps and munis and other tax-exempt securities to tighten (more money in rating corps). Demand for debt could increase if current tax proposals are realized (companies are incentivized to invest in US). I believe higher rates make securitized products more attractive, all things equal (especially MBS since borrowers no longer incentivized to refi). High WTI/Brent prices mean the HY space is stronger.

 

Basically, you get to own a great company at a fair price with the chance of it becoming a great price. The true "heads I win, tails I don't lose". Current guidance is based on Feb and May investor sentiment (including flight from O&G/HY). MCO could feasibly increase by >50% between now and when their 10k is released with crystallized tax reform and upbeat guidance.

[CorpRaider]

What is the secular headwind your foresee for S&P Dow Jones Indexes?

[Guest Schwab711]

What is the secular headwind your foresee for S&P Dow Jones Indexes?

 

Vanguard

[CorpRaider]

You mean the fact that they use some CRSP indexes?  Vanguard also uses a lot of S&P/DJ indexes as far as i know.  Mr. Buffett, famously, recommends VFINX. 

 

I am seeing what you are saying about valuation though.  Not too bad when you start digging into the pretax to EVs.

 

 

[Guest Schwab711]

I don't think people will continue to pay bps for the name attached to the sample of stocks tracked. I think Dow Jones/S&P have significantly more staying power than MSCI, but they all provide an exceedingly small amount of value. Either way, Vanguard lowering fees leads to less money for branding. Credit ratings will always have the opposite problem. All fiat currencies guide for inflation (of some amount). The fees for ratings will generally cost a few basis points. Thus, Moody's/S&P have some built in pricing power. It's a lot easier to be successful in a situation like that.

[CorpRaider]

Yeah, I don't know if they will take more share versus CRSP or MSCI in the commodity straight beta indexes but I think they can hold on to higher margins just due to their brand and the super long track record/first mover advantage.  I think they (and other index providers) will all take a TON of assets from active over the next several decades.  They have a lot of other "good" factor-based/smart beta products like dividend and buyback achievers, pure and enhanced value versions of their various cap weighted indexes, and low volatility (which is probably one of the biggest asset gatherers over the past several years).  I would maybe rather buy RAFI's IP but its not for sale.

[vinod1]

I like Moody's, S&P and MSCI in that order as far as moat and prospects for growth goes.

 

That said a lot of the value that MSCI gets from the indices is just not on fees charged for indexing or AUM based. That is on the order of 20% of total revenues.

 

In global equity indexing, MSCI is the unquestioned leader. It started tracking international stocks from its inception in 1969 and has a vast amount of historical global market and proprietary equity index data that is difficult to replicate. The brand is well established and recognized in the institutional investment community.

 

For example many pension funds usually benchmark to  MSCI global indices and uses MSCI provided data/analytics for performance and risk measurement. This is embedded in either the client or consultant's standard processes flows that they repeat each quarter or year. So there is a pretty significant switching costs at that end.

 

So even though there is not much value for an ETF or Index provider to base their product off MSCI and pay a high fees, the clients still would benchmark against MSCI data and use MSCI tools for portfolio performance measurement.

 

Vinod

[no_free_lunch]

There is talk of changes to the corporate income tax program that could impact Moody's.  Still speculative at this point.

 

President-elect Donald Trump and congressmen from his party have both suggested cutting corporate tax rates. To pay for those reductions, the House Republicans’ plan calls for eliminating a key tax benefit associated with companies’ borrowing, namely the right to deduct interest payments from income.

 

That tax deduction has helped the investment-grade corporate bond market grow to $4.87 trillion of debt outstanding. Ending that benefit could eventually slash that figure by around 30 percent, according to Bank of America Corp. analysts that considered data from the International Monetary Fund. When lawmakers eliminated deductions for consumers for most types of interest as part of sweeping tax reform in 1986, credit card borrowings plunged.

 

https://www.bloomberg.com/news/articles/2016-12-16/republican-tax-reform-seen-shrinking-u-s-corporate-bond-market

[RichardGibbons]

the House Republicans’ plan calls for eliminating a key tax benefit associated with companies’ borrowing, namely the right to deduct interest payments from income.

 

Does anyone think this is a good idea, saying that even if you're borrowing to buy manufacturing equipment or to pay workers, you can't deduct the interest on that borrowing?

 

It seems like a terrible idea to me, so I'm wondering if I'm missing something.

[DooDiligence]

the House Republicans’ plan calls for eliminating a key tax benefit associated with companies’ borrowing, namely the right to deduct interest payments from income.

 

Does anyone think this is a good idea, saying that even if you're borrowing to buy manufacturing equipment or to pay workers, you can't deduct the interest on that borrowing?

 

It seems like a terrible idea to me, so I'm wondering if I'm missing something.

 

Doesn't seem very pro business.

 

Could this also cause company's to start using more treasury shares for financing instead of debt?

[no_free_lunch]

the House Republicans’ plan calls for eliminating a key tax benefit associated with companies’ borrowing, namely the right to deduct interest payments from income.

 

Does anyone think this is a good idea, saying that even if you're borrowing to buy manufacturing equipment or to pay workers, you can't deduct the interest on that borrowing?

 

It seems like a terrible idea to me, so I'm wondering if I'm missing something.

 

Doesn't seem very pro business.

 

Could this also cause company's to start using more treasury shares for financing instead of debt?

 

It is pro business if they are lowering the tax rate at the same time.  It will create winners and losers but the winners are companies who use less leverage which might not be the worst thing to promote.

[DooDiligence]

the House Republicans’ plan calls for eliminating a key tax benefit associated with companies’ borrowing, namely the right to deduct interest payments from income.

 

Does anyone think this is a good idea, saying that even if you're borrowing to buy manufacturing equipment or to pay workers, you can't deduct the interest on that borrowing?

 

It seems like a terrible idea to me, so I'm wondering if I'm missing something.

 

Doesn't seem very pro business.

 

Could this also cause company's to start using more treasury shares for financing instead of debt?

 

It is pro business if they are lowering the tax rate at the same time.  It will create winners and losers but the winners are companies who use less leverage which might not be the worst thing to promote.

 

Aha! Kinda jibes with something I just learned today about how to decompose ROE...

[cmlber]

There is talk of changes to the corporate income tax program that could impact Moody's.  Still speculative at this point.

 

President-elect Donald Trump and congressmen from his party have both suggested cutting corporate tax rates. To pay for those reductions, the House Republicans’ plan calls for eliminating a key tax benefit associated with companies’ borrowing, namely the right to deduct interest payments from income.

 

That tax deduction has helped the investment-grade corporate bond market grow to $4.87 trillion of debt outstanding. Ending that benefit could eventually slash that figure by around 30 percent, according to Bank of America Corp. analysts that considered data from the International Monetary Fund. When lawmakers eliminated deductions for consumers for most types of interest as part of sweeping tax reform in 1986, credit card borrowings plunged.

 

https://www.bloomberg.com/news/articles/2016-12-16/republican-tax-reform-seen-shrinking-u-s-corporate-bond-market

 

I think the House plan calls for eliminating deductibility of interest expense and replacing it with allowing immediate deduction of 100% of all capital expenditures.  Trumps plan is to allow companies to elect either deductibility of interest, or immediate deductibility of capital expenditures.  I have no idea where we end up, but I think it's largely irrelevant for anybody with a long term view.

 

Earnings will go up 20% with corporate tax reform, so if demand for debt goes down by a lot it'll probably be a wash.  I think there are a lot of other factors that make the analysis much more dynamic then an initial gut reaction though.  In a static world, higher after-tax cost of debt should mean a mix shift from debt financing to equity financing.  In a dynamic world, higher after-tax unlevered ROIs on investment projects due to immediate deductibility of capital investments, higher GDP growth from pro-growth policies and tax reform, more policy certainty, etc. should mean there are more projects to finance, so even with a mix shift to more equity financing, total debt financing could still rise.  Also, if individual tax rates go down, demand for corporate bonds at a static pre-tax yield should go up, so that pre-tax cost of debt probably goes down, mitigating some of the effects of reduced or eliminated deductibility of interest.  All in it's hard to figure out where it ends up, but my guess is it's all a net positive.

 

[DooDiligence]

There is talk of changes to the corporate income tax program that could impact Moody's.  Still speculative at this point.

 

President-elect Donald Trump and congressmen from his party have both suggested cutting corporate tax rates. To pay for those reductions, the House Republicans’ plan calls for eliminating a key tax benefit associated with companies’ borrowing, namely the right to deduct interest payments from income.

 

That tax deduction has helped the investment-grade corporate bond market grow to $4.87 trillion of debt outstanding. Ending that benefit could eventually slash that figure by around 30 percent, according to Bank of America Corp. analysts that considered data from the International Monetary Fund. When lawmakers eliminated deductions for consumers for most types of interest as part of sweeping tax reform in 1986, credit card borrowings plunged.

 

https://www.bloomberg.com/news/articles/2016-12-16/republican-tax-reform-seen-shrinking-u-s-corporate-bond-market

 

I think the House plan calls for eliminating deductibility of interest expense and replacing it with allowing immediate deduction of 100% of all capital expenditures.  Trumps plan is to allow companies to elect either deductibility of interest, or immediate deductibility of capital expenditures.  I have no idea where we end up, but I think it's largely irrelevant for anybody with a long term view.

 

Earnings will go up 20% with corporate tax reform, so if demand for debt goes down by a lot it'll probably be a wash.  I think there are a lot of other factors that make the analysis much more dynamic then an initial gut reaction though.  In a static world, higher after-tax cost of debt should mean a mix shift from debt financing to equity financing.  In a dynamic world, higher after-tax unlevered ROIs on investment projects due to immediate deductibility of capital investments, higher GDP growth from pro-growth policies and tax reform, more policy certainty, etc. should mean there are more projects to finance, so even with a mix shift to more equity financing, total debt financing could still rise.  Also, if individual tax rates go down, demand for corporate bonds at a static pre-tax yield should go up, so that pre-tax cost of debt probably goes down, mitigating some of the effects of reduced or eliminated deductibility of interest.  All in it's hard to figure out where it ends up, but my guess is it's all a net positive.

 

Makes sense...

[no_free_lunch]

Thanks cmlber.  It makes sense that there is a counter-balancing force.  I wasn't aware of the capex deduction.

[SlowAppreciation]

I haven't followed Moody's for too long, but it seems like a wonderful business at a pretty fair (to slightly undervalued) price. So what's the bear case? I struggle to see one.

 

- 13x EV/EBITDA

- 7.5% operating earnings yield

- DCF gets you to around $140

- good growth prospects

- durable moat

[Jurgis]

Not sure there's a bear case, but here are some devil's advocate arguments (I don't necessarily subscribe to them, so please don't expect me to argue for them):

 

- Coming decline of bond issuance == decline in business

- Losses from lawsuits, government actions, etc. - I believe they just settled, but settlement was somewhat large.

- Crappy capital allocation - their main business has huge moat and tons of CF, but they may not allocate it well, may diworsify, may waste it, etc.

- Crappy balance sheet - negative shareholders equity, etc. If there's another bond-like-instrument collapse, this could bite them.

- Crappy past ratings - this is possibly negative from two sides: are they ethically challenged company and not investable, could they do crappy ratings again and suffer from it.

 

None of these are strong negatives IMO, but perhaps they are weak negatives.

[giofranchi]

- good growth prospects

 

I like MCO, but its growth prospects are not very clear to me.

The industry it competes in has always been an oligopoly of very few players: is MCO going to steal business from its competitors (not easy imo), or does the industry as a whole enjoys good growth prospects?

Can someone help me better understand this?

 

Cheers,

 

Gio

[SlowAppreciation]

Not sure there's a bear case, but here are some devil's advocate arguments (I don't necessarily subscribe to them, so please don't expect me to argue for them):

 

- Coming decline of bond issuance == decline in business

- Losses from lawsuits, government actions, etc. - I believe they just settled, but settlement was somewhat large.

- Crappy capital allocation - their main business has huge moat and tons of CF, but they may not allocate it well, may diworsify, may waste it, etc.

- Crappy balance sheet - negative shareholders equity, etc. If there's another bond-like-instrument collapse, this could bite them.

- Crappy past ratings - this is possibly negative from two sides: are they ethically challenged company and not investable, could they do crappy ratings again and suffer from it.

 

None of these are strong negatives IMO, but perhaps they are weak negatives.

 

Thanks for the input, much appreciated. Agreed that these aren't the strongest negatives. Also, despite the negative shareholder's equity/balance sheet, I'm not sure this even is all that bad. $1.3b net debt, and annual FCF is just shy of the remainder so their debt levels aren't reasonable.

[marazul]

there are many growth avenues:

 

-Global credit should grow over time with global GDP (maybe 3%)

-Bonds are taking share from bank lending (this should add to bond issuance volume over gdp growth)

-Pricing (this is an underpriced product with significant pricing power)

-Moody´s Analytics is growing from a relatively low base

[Guest Schwab711]

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.619.650&rep=rep1&type=pdf

 

And relative pricing power:

When Moody's has the superior (higher) ratings, bond yields are approximately 8 basis points lower than when S&P has the superior ratings. Thus investors appear to hold Moody’s reputation in higher regard than S&P’s.