Description

Moody’s Corporation is one of the two global giants in the credit ratings business. Standard & Poor’s, a subsidiary of McGraw-Hill, is the other. Fitch IBCA, a subsidiary of Fimalac, is the only other substantial global credit rating company, but it is considerably smaller than Moody’s or S&P. Moody’s was spun off from Dun & Bradstreet on September 30, 2000.


What’s to like about the credit rating business and Moody’s?

 Business opportunities in the U.S.: Virtually any company seeking financing through the capital markets needs to have their debt offering rated. If they don’t do this, they limit the number of investors willing to accept their debt, which usually results in higher financing costs.

 Business opportunities in other countries: This will be the great growth engine of the industry’s future. In the last two years at Moody’s, international revenue as a percent of the total has risen from 20% to 30%. Financing in most countries outside of the U.S. has traditionally been done through banks; however, more are turning to public capital markets due to improved efficiency and lower costs. In addition, asset securitizations, which lead to improved regulatory capital management for financial institutions, are also on the rise in other countries (up 33% in Europe last year). Moody’s will greatly benefit as the rest of the world adopts the public financing and market strategies of the U.S.

 Immense barriers to competion: Moody’s is a 100-year old company that has built a stellar reputation delivering third party credit opinions. In my judgment, it would be nearly impossible for a global credit rating company to start up from scratch, given the difficulty of establishing this kind of reputation. A pre-existing financial institution would also experience difficulty starting a credit rating subsidiary because their opinions would not be unbiased (i.e., Most financial institutions have investment portfolios and are subject to being rated themselves.); in addition, it is unlikely that other financial institutions would be willing to open their books to a competitor.

 Friendly competition: Most large debt offerings are rated by BOTH Moody’s and S&P. Because of this, neither company is likely to enter into a senseless price war.

 Very little regulation: Since the credit rating business doesn’t directly impact the public, it is unlikely that it will ever be heavily regulated. Imagine the public outcry if AT&T complained that it was being charged too much to have its debt rated (sarcasm intended). In fact, increased regulation of financial institutions tends to benefit Moody’s, because they are the ones generally called in to do the regulating.

 Not as cyclical as it used to be: In 1989, Moody’s generated 93% of their revenue through transactions (i.e., They got paid a fee for each credit rating.). During economic slumps, this revenue was reduced. Currently, they generate roughly half of their revenue through non-transaction based sources that should be more stable during difficult times.

 Cash flow extraordinaire: Over the past three years Moody’s has averaged $169 million of free cash flow per year. To put this into perspective, their capital expenditures have averaged approximately 7% of cash flow from operations; it doesn’t cost much to maintain several small offices or expand into new geographical regions. The other 93% can be used for dividends (not much), share buy backs (very much), and paying for old D&B’s past mistakes – an income tax liability and a lawsuit brought against a former separate subsidiary of D&B (too much, but not likely to be threatening long term). Over the same period, sales have averaged $554 million for a cash flow to sales ratio of 30.5%; 10% is considered exceptional. Please note that $113.75 million was added to 2000 cash flow from operations; this represented 65% (income tax-adjusted) of the $175 million Moody’s had to pay during 2000 for a tax settlement owed to the IRS because of problems at old D&B over a decade ago.

 Strong co-ownership: The largest shareholder of Moody’s is Warren Buffett (via Berkshire Hathaway), an investor who “occasionally” gets one right (more sarcasm). Berkshire owns approximately 15% of the company, the most permissible without triggering anti-takeover provisions. The Oakmark funds also own a substantial stake.

 Reasonable price?: The current price to free cash flow is 31.25, a 33.6% discount to the S&P 500’s 47.09 (S&P 500 ratio according to Market Guide); this is not dirt cheap, but reasonable considering the quality of the company. Calculating future free cash flow discounted to the present using a 12% risk-free discount rate, Moody’s would have to grow free cash flow at approximately 8.9% per year to justify it’s current price. Considering that operating income has grown at almost double that rate (17%) during the last 20 years, this should be an attainable goal.

Catalyst

Catalyst: Now that Moody’s is no longer part of the woefully managed D&B conglomerate, it should in time capture the attention of investors seeking stable companies with exceptional growth potential.