|Shares Out. (in M):||236||P/E||16.4x||17.0x|
|Market Cap (in $M):||6,729||P/FCF||14.6x||15.0x|
|Net Debt (in $M):||1,000||EBIT||708||708|
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I respect Mr. David Einhorn very much, and I have a hard time writing this because I am going to disagree with him on Moody's.
Mr. Einhorn's basic thesis was that Moody's services is not needed.
I disagree with the following arguments by Einhorn and my explanations follow
1. MOODY'S WAS CREATED AS A GOVERNMENT OLIGOPOLY
The ratings industry is a scaleable industry that is not bound by geography. The industry structure will lead to a dominant player over time. You see this in the money management business (Fidelity), platform software business(Microsoft, Google), movie production (Pixar), acting or even arts (Picassos, etc). Ratings business is the same. If the government asks to dismantle Moody's right now, you will have a bunch of small companies offering research services. But over time, you will have another dominant player. A market crash can happen over the next 20 years and another firm will build a reputation and dominate. In fact this is what happened to Moody's.
Moody's date back to 1900 when John Moody first published his research service. He ran out of money during the 1907 crash and he was forced to sell his business. He returned in 1909 and built a reputation when the bonds he rated highly did not crash during the 1927 crash. This history suggests to me that Moody's (at least in the early history) is a result of free market economics at work and not government oligopoly.
2. EINHORN SUGGESTS AUSTRIAN ECONOMICS POLICY OF SOLVING THE ECONOMICS MAY BE THEORETICALLY GOOD, BUT POLITICALLY INFEASIBLE.
I love Austrian economics and I use it to analyze macroinvesting scenarios. But I won't recommend it as a policy of running an economy. Furthermore, even if it turns out to be theoretically the correct solution, it is politically impossible to carry out anyway. We are all Keynesians now. And we must give one credit to Keynes, because his monetary inflationary ideas actually led people back to education, which to me is eventually, the biggest driving factor of all progress. In fact, there are numerous studies that the progress that Asia went through over the last 50 years turns out to be due predominantly to old-fashioned massive improvement in education of the people, not the Keiretsu or kaizen or Confucian philposophy. In fact, it was this "keeping people in schools and bringing people back to schools" that ultimately made me realize that Keynes was more right than wrong.
My point is that no matter what, the governments have to massively inflate. It is just not politically feasible to do otherwise. Peter Schiff can say all he wants, but at the end of the day how can you convince majority of politicians to implement hard Austrian Economic policies? It is impossible from a human point of view. It is an exercise in futility. We must instead focus on things we can control - (David's quote borrowed from Michael Fox) - that is how do we get the Americans to work hard again and improve our massively weak educational system that has seriously deteriorated with its softness and preaching that "not memorizing" as the way to learn and be creative? Our educational system is a wreck and that is what we can control in terms of fixing it.
3. OUR GOVERNMENT IS TOO US-CENTRIC IN A WORLD THAT IS VERY GLOBAL (not Einhorn's thesis but I am adding this to support my case for Moody's growth outlook in point 7.)
Slightly off-topic, but I think our U.S. government should do more out of the box thinking other than just printing money. We have to learn from countries like Canada, Singapore or Hong Kong to solve our housing problems. We have roughly 2 to 2.5 million excess homes right now. There are 1 million households formed yearly in America (provided we don't have massive emmigration which is a risk in itself). The excess amount of housing can easily be sold if the U.S. government will do what Canada, Singapore or Hong Kong has done: They invite immigrants to buy a house with a minimum ranging from 500,000 dollars to 1 million dollars and they give permanent residence card. If the U.S. government did this, how many Europeans, Australian, Asians or Africans do you think will take up this offer? And people are dying to live in New York City( I verify this everytime I get in to Soho House and Cipriani's upstairs in W. Broadway or even Felix on Sunday Nights) and that will solve Bloomberg's problem. And this is a fantastic way to bring in bright people to the country as most of the kids of these people probably went to top U.S. schools to study.
Canada did this near 1997 to get people from Hong Kong to invest in their economy. The result: they got people like Li-Ka-Shing who now is probably the sole biggest contributor of Vancouver's economy. (He owns Husky Exploration and most of the real estate developments in Vancouver). Directly, Canada got the money but also indirectly, their economy got more closely tied to the faster-growing China and Hong Kong because of the ties these people had with Asia.
Or take even the case of stimulus checks. Our government handed out money to people and people kept it in their pockets. In China and Korea, they handed out vouchers and the citizens must buy capital goods (refrigerators, washing machines, cars) in their hometown to get their rebates. The result? Massive jump in car sales and sudden drop of inventories of cars, washing machines, etc. And now, chinese manufacturing index is back up.
It is time that we borrow the best ideas from the rest of the world, too. There is nothing wrong with that.
4. TRIPLE AAA CAUSED THE FAILURES OF AIG AND INFERS THAT TRIPLE AAA IS THE MAIN PROBLEM.
Einhorn said it was the triple AAA that caused this mess. But New Century's demise was not because it had a triple AAA. Neither was Countrywide, etc. AIG failed because it owned assets that ultimately were dependent on irresponsible companies like New Century, Countrywide and actually many "hedge funds" who lent as "croupiers" and "agents" and not as "principals". To say the triple AAA caused this financial crisis is oversimplifying the issue. The problem as I see it was lack of transparency. There were too many croupiers who were using "information or misinformation arbitrage" to make money with derivatives. They had wrong incentives and were trying to take advantage of what they think is "time and information arbitrage" to become profitable. Unfortunately, what they thought was "information arbitrage" was "misinformation arbitrage" and they eventually drank their own poison.
But there is reason to be "incurably optimistic" (again, Michael J Fox's book) - history tells us all financial improvements will get improved with new technologies. For example, banking was formed in the late 1700s in the USA and who will not agree that over time, despite the 1907 crisis, 1927 panic, that banking was beneficial to the society?
Twenty years from now, the information arbitrage business will become less and less existent and the true producers of society's benefits - the scientists, artists, movie producers, music composers will get a bigger piece of the pie than the so-called agents(e.g. Youtube, internet based network of VC capital and Angel Investors, etcetera).
In fact, I am very bullish that because of Google and Facebook, information arbitrage gap, which used to provide all the profits for what Munger calls the croupiers or "agents", is getting closer and closer to zero. There is no doubt in my mind that if everyone has "truth" in his hand, he will make a better informed decision. That is what Google and Facebook do. Same with sumzero or valueinvestorsclub which means most of us must try to look for a backup skill :)
5. THERE IS NO NEED FOR A RATINGS BUSINESS
I disagree. The history of John Moody explains it all. If you dismantle the ratings business, free markets would suggest that sooner or later people will form clubs to evaluate "fixed income securities" because it saves resources and time. The clubs become coops. And then soon, some entrepreneur will provide a business model for this. Over time, there will be a ratings business again. The more things change, the more they stay the same. It might not be John Moody or it may be John Chung or John Shah or John Price but there will be a ratings business.
6. WHERE THE GROWTH OF MOODY'S WILL COME FROM
I think we U.S. based investors are really underrating the importance of China and the emerging markets in the coming years. Up till now, I see books written by very smart people that China and India are both a big bubble. Well, I think one has to really live in China for a few years to get a reality check. I really believe the U.S.' relative dominance will be much smaller 15 years from now. And during the next 15 years, there will be a lot of credit products that will be issued from foreign countries, emerging markets, companies in distress. It will take me another 15 pages to write why China is not a bubble. I will keep this short for this write-up.
People in China,India,Philippines,Malaysia,Indonesia,etc do not have credit cards. Banks in China don't even do factorization of receivables. People buy houses with cash. Think of how much demand for fixed income products will come when these countries start leveraging a little bit. Another ratio to look at: U.S. represents 5% of the world's population and uses 25% of the world's resources. Just imagine the demand for financial products as the rest of the world try to be more like us. And let us not forget, all the companies that have become bankrupt need to issue securities to reorganize themselves. GM needs to have their debt evaluated by firms too. A ratings firm can get a piece of the action in so many ways. In basketball parlance, a ratings firm is like Michael Jordan or Lebron James who get to touch the ball in most of the offensive plays.
7. THE ONLY THING I AGREE WITH DAVID EINHORN ON MOODY'S: THE INTRINSIC VALUE OF THE BRAND HAS DEFINITELY BEEN DIMINISHED.
I agree with Einhorn on this. In fact, Moody's had the opportunity to come out of this crisis with their business even better had their products protected the investors from financial ruin (circa 1927 when John Moody entrenched his reputation).
8. IT STILL COMES DOWN TO VALUATION
So I have laid the case that Moody's business is not zero, and that there is a need for Moody's service. Now, it still boils down to valuation of the business.
Moody's EBIT has grown from 270 million in 1999 to 1.2 Billion in 2007 and its trailing EBIT is 707 million. The company does not need much capital to generate this EBIT and uses most of its EBIT to buy back shares and that mostly explains its negative net worth. The company has roughly 1 Billion of Net Debt in the balance sheet. So much how much would you pay for a business like this?
I will argue that 2009 or 2010 will be a trough year for Moody's. When demand from Chinese countries, emerging market countries, Middle East countries etc come back, in a world that is massively depreciating its paper currency, 1.2 Billion dollars (albeit depreciated) of EBIT (back to its 2007 highs) is not a stretch. So applying 10 times EBIT (The metric Buffett uses to purchase his private companies) You get enterprise value of about 11 billion and a stock price at least 50 percent higher from here. But do you think Moody's will sell themselves for only 10 times EBIT? 10 times EBIT applied to manufacturing companies like maybe like Mitel Precision, or Clayton Homes.
Now, the caveat is my time horizon is longer than David's. And frankly, David is so smart and right so often that a lot of media journalists write about his positions. I am sure that the press write-ups and blogs will affect the stock price over the next year or so. I advise the readers to wait another 2 years before they take on the position. I also warn I do not care much for earnings estimates especialy in this economic environment so the estimates filled in the table are meaningless.
I intend to do the same with an initial position here. Revisit this no earlier than 1 year from now. And then decide to pile on 2 years from now. It takes about 2 to 3 years for the financial media to lose its "effects" on stock prices. Finally, I write this to encourage debate. I want to see where I am wrong and frankly, I never really cared much for large cap stocks but I am also curious about conversations regarding the macroeconomic ideas/Chinese stimulus/my fix for our housing problems/ that I shared in this write-up.
No catalyst but good opportunity. I wait 2 years at least before you seriously enter your position with an initial position here.
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