Description
Moody’s Corporation (MCO)
Looking for a way to “play” the credit crunch without a shaky balance sheet of toxic loans? Our thesis is that there is currently a lot of headline noise surrounding Moody’s, which is largely unfounded because of a fundamental misunderstanding of the credit rating industry; the headlines will pass and the business will return to trading on strong fundamentals.
Moody’s is one of two dominant players in the rating agency industry. Moody’s and S&P have roughly 40% market share each. Fitch trails with 16%. It is customary to have two ratings on debt issues, so more times than not, Moody’s and S&P are the rating agencies of choice. There are only seven NRSRO (Nationally Recognized Statistical Rating Organizations) in the U.S. While in part the NRSRO status creates barriers to entry, the real barrier is name recognition and the perceived “gold standard” that investors look to in Moody’s and S&P.
Roughly 80% of MCO’s revenue comes from providing credit ratings on debt securities. Moody’s breaks out revenue from credit ratings by the types issuers including: Corporate Finance, Financial Institutions & Sovereigns, Public Finance (U.S. municipal bonds) and Structured Finance (which we will spend a lot of time on). The other 20% of revenue comes from research and software product offerings such as Economy.com, Wall Street Analytics and Moody’s KMV, which largely focuses on credit and risk systems need by banks for Basil II.
Moody’s CEO, Raymond McDaniel, “grew up” with Moody’s and has been with the company in various capacities for over 20 years. He’s been an analyst and worked his way up through the ranks including COO, President and now CEO since early 2005. Ray understands the business; a business that is largely misunderstood by Main Street and even Wall Street (outside the fixed income department). While there is a lot of headline risk with “scape-goating” from various constituents, he has the patience to explain the business ad nauseam. Moody’s has a conservative corporate culture that is team-oriented; where people take pride in their work. It is the exact opposite of Wall Street’s reputation of mavericks looking for fortune and fame. This gives us confidence that a “smoking gun” is improbable, and even if there is one, management has the right temperament to navigate the situation effectively.
Berkshire Hathaway owns 17+% of Moody’s.
We think the best way to look at the company is to discuss and address the various issues that plague the stock right now. Investors, the market, regulators, politicians and the media fear that Moody’s will suffer declines in its revenues and earnings and worse, will have to address allegations of conflicts-of-interest, of being too slow to downgrade subprime structures, possibilities of future litigation and also additional regulation. These issues fall into three main categories: Business, Regulatory and Litigation.
Business Issues
• Conflict of Interest: Moody’s is paid by the issuers of fixed income securities. Critics argue that Moody’s has no incentive to give low ratings, because the issuers would simply take their business elsewhere. Moody’s would argue that reputation is its single most important asset and they have let business walk away because a short-term gain is not worth the long-term risk to the business.
So how can you avoid conflict of interest in the ratings industry? There are only two model alternatives and neither eliminates risk. If the investor pays, the investor still has a vested interest in the rating, plus there would be less information available in the market, unevenly distributed to the largest of institutions – surely this isn’t a better solution. If the government pays, then the market would be subject to the inefficiency that government involvement implies, plus the government historically is the biggest issuer of fixed income securities, so it too has a vested interest in the rating. So the best you can do is trust management to manage the conflict of interest and for regulators to oversee the business. We think this management team is quite trustworthy and takes its role as steward of a company with a long history of quality credit ratings seriously; the company is very transparent and is willing to discuss the issues.
A common criticism of MCO is that it is in bed with bond insurers because the guarantors are significant clients and have facilitated significant growth in the structured finance markets. The assertion is that if the guarantors fail, then structured finance as a whole will fail and Moody’s would suffer a blow to their structured finance revenues. We believe the business models of financial guarantors like Ambac and MBIA are extremely tenuous – in that they have repeatedly charged too little for taking on massive amounts of default risk. However, we think that Moody’s would continue to be in business even if the guarantors were to suffer immensely.
Even though the guarantors’ business models are in deep trouble, we think it is highly unlikely they go out of business. Too much is at stake for several financial entities to allow guarantors to lose their triple-A ratings. This would cause serious damage to their ability to write default insurance. The guarantors would very likely raise additional capital from a large and stable financial entity that also owns sizable municipal (or other) bonds in their portfolios. The guarantors would also likely buy additional reinsurance or merge with other players before they allow a downgrade to their triple-A status.
MCO management is emphatic that it would rather lose market share than give higher ratings in order to win revenues. This was the case recently when Moody’s was not comfortable with rating certain bonds in the Canadian asset-backed commercial paper market and the issuer went with a competitor causing Moody’s to lose business. The buy-side firms that did not care earlier came around when the Canadian ABCP market suffered huge losses. MCO has since been asked to rate many of the new structures in that market.
• Will Moody’s survive a massive deleveraging of the credit markets?
According to Moody’s management, $40B in mezzanine subprime RMBS was issued in 2006 but the estimated exposure that banks and financial institutions have to this $40B is around $400B. This large gap is due to all the leverage, the credit default swaps, synthetic CDOs and the interest rate swaps that have been written in addition to the RMBS. Moody’s only generates revenues from the underlying $40B in RMBS and some synthetic CDOs but not from the other derivative sources of subprime exposure. We think it is more likely that a massive deleveraging will entail a substantial shrinkage in the derivative $400B market than in the underlying $40B RMBS market. MCO management does concur that around 10-12% of its market will disappear permanently. However, other growing areas of the business will eventually offset this loss of revenue.
• How can subprime debt turn into triple-A debt, the same as US Government debt? Why are there different sets of rating standards for municipal, corporate, and structured issues?
Moody’s uses different rating scales for munis, corporates and structured products. A single-A rating for a muni bond is not the same as it is for a corporate bond or a structured bond. Critics have alleged that a single-A rated municipal bond has a lower default risk than a similarly rated structured bond because MCO stood to earn far higher revenues from structured finance products (40% of its revenue base) and hence gave them higher ratings out of self-interest.
Management asserts that they had a different set of ratings’ scales for munis and corporate bonds for many years. When MCO tried to put the municipal bond scale on the same footing as the corporate bond rating scale, the municipal bond market was up in arms about it. Even though the muni bonds would have been upgraded as a result, the participants felt they needed more rating differentiation among municipal bonds. As a result, in a bid for transparency, MCO ended up making widely available a key to determine rating equivalents between municipal bonds and corporate bonds.
Corporate bonds and structured issues however use the same rating scale. Here too, critics allege that structured finance issues are given higher ratings than corporate bond issues. But since default rates on structured bond issues have been lower than those for similarly rated corporate bond issues for over two decades ending in 2006, management firmly asserts that rating structured issues higher out of self interest hasn’t proved to be the case.
The key is that the credit quality of a corporate issuer is based on the issuer’s size, industry dynamics, competitive advantages, debt levels and other factors largely outside its control, whereas structured bonds can be structured to become triple-A through over-collateralization. In other words, structured finance issuers have more say in how they want to be structured to get a triple-A. MCO has required varying degrees of over-collateralization of subprime RMBS structures over time. In 2003, for example, MCO required a triple-A RMBS structure to have 20% loss protection through over-collateralization and in 2006, it required 30% protection. Today it requires 40% protection. In other words, it took $120 to $140 less-than-worthy mortgages to create a $100 security. And remember even though several of them may get downgraded because the underlying collateral has deteriorated and there is less of a safety net, many of the A rated tranches may still pay all its obligations despite its downgraded status – it is just too early to tell.
• Too Slow to Downgrade: Credit rating agencies have been around over 100 years; it’s a boring business that most people don’t understand. They are largely ignored in good times and blamed in bad times; the credit crunch is nothing new. Credit ratings are expected to be stable over time, you don’t check the rating of a bond the way you check the price of a stock. Ratings upgrades and downgrades are supposed to mean a material change has occurred; it’s not a reaction to a blip in the data. As such, ratings lag the market, they’re not a leading indicator.
Moody’s investor presentation has a graph of 1999-2006 vintages showing the cumulative loss rate against months of seasoning. Even at 18 months it is difficult to see a discernable pattern in a vintage’s performance, meaning 1999-2005 all clustered around 0.2% to 0.5% loss rates at 18 months. So using this data to analyze 2006, it was reasonable to assume the losses would perform in this range. And until a vintage starts to under perform, a rating agency really cannot change a rating.
Moody’s relies on representations from lenders that loans in the pool meet certain criteria. If underwriting standards change and its not disclosed, it is not reasonable to think anyone outside the organization would know. The fact that half the downgrades stem from four California lenders is telling that lending standards probably did change.
• Will Moody’s suffer a blow to its reputation?
Many (even smart) people think that the failure of many Moody’s rated CDOs and RMBS was the chief reason for the demise of several hedge funds. We find this thinking erroneous. The earlier, highly publicized failures of hedge funds was more due to excessive leverage, margin calls that forced liquidation or sharply lower mark-to-market, and use of non-rated equity tranches of subprime RMBS than due to defaults of triple-A or other higher rated structured bonds. We think that reputation risk is a big one for Moody’s but that would ultimately play out only if a lot of their triple-A and other A-rated structures defaulted and didn’t pay off at maturity. Roughly 91% of their rated 2006 vintage subprime RMBS structures were rated Aa or higher. For 2006, most of these Aa or higher rated subprime RMBS structures had over-collateralization of anywhere from 20% to 30%. Recently released data (from the government) indicates that subprime comprised of 13.1% of all loans outstanding. And of all the outstanding loans to date, 1.69% are in foreclosure and 5.59% are delinquent. Of all the loans in foreclosure, 55% are subprime loans. This means of a total of 1000 loans outstanding, 131 are subprime. And of these 1000 loans, 55.9 are delinquent and 16.9 are in foreclosure. Of the ones in foreclosure, 9.3 (55%) are subprime. So out of a total of 131 subprime loans, 9.3 or 7.1% are currently in foreclosure. Even assuming a 75% loan-loss rate, net of recoveries, on foreclosures (historically 50%), it would take a 27% foreclosure rate (close to 4x the current rate among subprime) for payments on A-rated tranches to begin to get affected. Of course you should get a lot of downgrades between now until maturity as foreclosure rates increase – but a majority of these structures should pay off.
The post-Enron collapse is another case in point. After that, many questioned the role and relevance of the credit rating agencies. Instead, Moody’s research revenue showed a substantial growth from 2001 to 2007. Now that could also largely be credited to easy-credit bubble helped by Greenspan. This time around we think that the markets will rely more, not less, on quality ratings once they realize there was no malice or wrong intention on the part of Moody’s.
• Ratings will become irrelevant: Ratings have existed for 100 years and are necessary for issuers to access the capital markets. Many industries such as banking and pension funds have regulations requiring certain level of ratings in their holdings. Massive changes to existing regulation would be needed if credit ratings didn’t exist.
Moody’s roughly $2.3B business can be divided into:
Credit Derivatives and Commercial Mortgage 23%
Asset Finance (includes RMBS, ABS, ABCP and Other) 21%
Corporate Finance 19%
Fin’l Institutions and Sovereigns 13%
Public Finance 4%
Research 13%
MKMV 7%
Total 100%
Despite the unfounded concerns that have been raised, the reality is that subprime and the credit crunch are real problems that will put pressure on Moody’s in the near term.
U.S. derivatives and U.S. RMBS generate 19% of the Moody’s total business, of which approximately one-third is from rating securities of sub-prime mortgages, or about 6.75% of the total revenues. Of course, a deep credit crunch in the U.S. will engulf segments far beyond the subprime, but to imply that subprime is the bread and butter of Moody’s is incorrect. In addition, Moody’s generates close to 40% of its revenues from international markets, which are still growing (and have been less affected than U.S. markets in the current turmoil) at 18% in 3Q07. Besides, strong franchises in the developed countries, Moody’s owns sizable stakes in the leading rating agencies in India (ICRA), China (CCXI) and other smaller agencies in the Czech Republic, South Africa and Indonesia.
In 3Q07, US Structured Finance declined 15% y/y (driven by Residential, but Commercial Mortgage Backed Securities still grew). International Structured Finance was still growing at 10% y/y. So overall Structured Finance was down 6%, with some continued strength in certain sub-sectors.
Additionally in 3Q07 (we’re focusing on the last quarter since the fixed income market has substantially changed and we think it’s the best proxy for forward looking assumptions), all other reportable segment’s revenue grew y/y:
Corporate Finance 17%
Financial Institutions & Sovereign 7%
Public Finance (U.S. Muni’s) 12%
Research 29%
Moody’s KMV 3%
Overall (incl Structured Finance) 6%
Considering a strong 1H07, full year 2007 guidance is for high single/double digit revenue growth, which obviously implies a down 4Q07.
Moody’s has generated Net Margins ranging from 26-32% the last 10 years. Free Cash Flow (FCF) Margins have been 30-38% since the spin-out (from Dun & Bradstreet in 2000). Moody’s has grown the top and bottom line at 21% and 25% 5-year CAGR respectively. While Moody’s faces tough comparisons for 4Q07 and 2H08, it has lot of margin of error to weather the storm. And while the U.S. is working through the subprime and credit crunch mess, international markets are still booming (3Q07 grew 18% y/y). Outside of the U.K., the international fixed income markets are not as developed, therefore there are excellent growth prospects. Since 2001, Moody’s international revenue has grown from 30% of the total to 42%, or 22% CAGR. Global rated debt market-wide, excluding structured finance, has grown 21% annually (23% included structured finance) the last five years.
If you believe that securitization was a bad idea and it will never come back, then you probably didn’t read this far. If you believe that securitization will come back, maybe not entirely, but in some form at some future unknown date, then Moody’s is a pure play investment on the ratings industry that has historic strong growth and no foreseeable reason it will not return to strong growth once the current situation works itself out. Moody’s trades at historic lows and you still have reasonable growth in other segments and internationally that lend support to the current price.
We made conservative assumptions in our DCF that includes negative revenue growth in 2008 and a return to 7% revenue growth off the lower base in 2009 (vs. 21% 5-year CAGR); we took 300 bp off operating margins in 2008; we used a 10% discount rate. We calculate an intrinsic value of $68, representing 76% upside from today’s levels. Furthermore, since 2000 Moody’s average annual P/E has ranged from 22 to 28x. Today’s 2007 P/E is 12.5x and 2008 is 16.5x, which supports our DCF valuation.
Moody’s Corp Selected Financials:
($ in millions, except per share data)
04A 05A 06A 07E 08E 09E 10E
Revenue 1,438 1,732 2,037 2,259 2,168 2,327 2,505
y-o-y growth 15% 20% 18% 11% -4% 7% 8%
Operating Income 786 949 1,099 1,180 1,067 1,168 1,258
Operating Margin 55% 55% 54% 52% 49% 50% 50%
Net Income 455 558 655 652 612 671 724
Net Margin 32% 32% 32% 29% 28% 29% 29%
Diluted EPS 1.49 1.82 2.24 2.39 2.37 2.76 3.18
Cash Flow Margin 33% 33% 38% 34% 30% 31% 31%
A credit rating measures the likelihood of default. It does not measure the volatility of the security’s price between issuance and the final payment. It does not measure the liquidity, or ability to trade a security that is still in re-payment. (Although Moody’s has the data and could provide separate measures for these, representing additional revenue if the market requires new measurements.) Downgraded structures may still end up fulfilling all its obligations. So a downgrade and a default are two different animals and most of the downgrades have been on lower-rated paper not triple-A or A rated structures. We think most politicians, media and participants in the market don’t understand what a credit rating is and what it is not. Its mostly uninformed grand-standing that we see in the headlines. We think most of the market is confusing headline risk with business risk. We believe once the subprime mess is off the front pages of newspapers, Moody’s will go back to being valued on its strong business prospects.
Regulatory Issues
• Could Moody’s lose its “special” NRSRO status? The SEC and other politicians/regulators took five years to formulate The Credit Rating Agency Reform Act of 2006. While Moody’s has had NRSRO status since 1975, the 2006 Act established a transparent process for NRSRO designations, prohibited anti-competitive behavior, and gave the SEC enhanced oversight over the rating agencies in terms of inspection, examination and enforcement. The SEC has been continuously monitoring and assessing the rating agencies in their practices and methodologies, yet the SEC has not come out with any comments on alleged misbehavior or wrongful acts. Many regulators have also recently indicated that new legislation is unlikely since the SEC just did this last year and any sweeping changes in such regulation probably gets revisited once a decade.
While we think the U.S. in unlikely to introduce any additional regulation in this industry, we do believe that there will be greater industry regulation in Europe. We don’t think such regulation would be any more stringent than the current SEC regulations though.
Litigation Issues
We think the market is nervous about the possibility of legal action against Moody’s and other credit rating agencies. Moody’s will probably get named in some class-action lawsuits from lawyers representing hordes of retail investors, institutional investors and Attorney-Generals. Yes, lawsuits could be aplenty but will they be able to prove malice on the part of Moody’s or that management and analysts recklessly promoted known falsehoods? Would they be able to find some smoking gun to nail Moody’s on? We think that the A/Gs will likely sift through a lot of rating agency files and documents and find something that may imply Moody’s could have rated the bonds better or that they had certain information that they could have used to make better judgements. But we don’t think the regulators will find any smoking gun or find malice or wrong intention on part of Moody’s. We are not lawyers by training but have spoken to a number of leading lawyers and read through some key prior case law.
The key defense rating agencies have in a many such lawsuits is their status as a financial publisher with 1st Amendment Protection of Speech. None of the three largest rating agencies (MCO, S&P and Fitch) have ever lost a major legal challenge involving liability for their credit ratings – worldwide. The courts have generally ruled in favor of the rating agencies and their expert opinions and that they are financial publishers not advisors. This 1st Amendment protection is quite strong unless it can be proven that the agencies showed reckless disregard for truth or printed known falsehoods. And the burden of proof is quite high with rating agencies. In general, it is much easier to claim negligence or intentional wrongdoing than actually prove it. We have also gathered opinions from several legal experts (1st Amendment litigators) who continue to believe that rating agencies should have strong protection for their credit opinions. Now if the regulators and/or litigators do find a smoking gun (an email, a taped conversation etc. such as the ones Eliot Spitzer found at some investment banks and their analysts) that proves MCO purposely and intentionally rated a bond or structured product much higher than it should have, Moody’s could be held liable. We think it is highly unlikely that a smoking gun would be found. We don’t think the Moody’s culture is such that their analysts/managers would be incentivised by mega bonuses if they lied to get deals done. Such a culture clearly existed at investment banks and motivated bankers/analysts to knowingly turn s%@# into gold during the internet-bubble years. A rating-agency’s culture (especially Moody’s) is a staid culture where division heads/analysts don’t get multi-million dollar payouts to goad them into ratings bordering on illegal behavior.
Even outside the U.S., in dozens of jurisdictions where Moody’s operates and that lack 1st Amendment protection, the rating agencies have never lost a significant challenge involving liability for their credit ratings. Management has also commented that burden of proof is higher outside the U.S. and that plaintiff-friendly outcomes of class-actions and contingencies are largely a U.S. phenomenon.
We point the reader to numerous cases that have been brought against Moody’s or other rating agencies over the last decade that have been, for one or another reason, been ruled in favor of the rating agencies:
• American Savings Bank v. UBS Painewebber (2004) in which no rating agencies were sued regarding rating actions but were asked to provide more information.
• Commercial Financial Services (CFS) v. Arthur Anderson (2004) in which CFS had sued Arthur Anderson which subsequently sued the rating agencies claiming they were negligent in rating CFS debt as investment grade. Both the trial court (and later the Appeals court) ruled that rating agencies were protected by the 1st Amendment and bore no liability.
• Compuware v. Moody’s (2005) - Compuware brought a case against Moody’s claiming that its debt had been unfairly downgraded to junk status and that Moody’s had favored Compuware’s competitor IBM. A federal district court dismissed the case as Compuware was unable to prove malice or negligence.
• Newby v. Enron, CRRA v. Lay (2005) – Moody’s, S&P and Fitch were all sued by CRRA to recover $200M that it had pre-paid to Enron under a previous agreement claiming that the rating agencies had colluded with some investment banks to misstate or conceal material information about Enron’s financial condition. The rating agencies all maintained investment grade ratings on Enron until shortly before the company filed for bankruptcy. CT’s Attorney General alleged that the rating agencies should have asked tougher questions to probe Enron’s financial condition further. The rating agencies claimed that Enron had provided false and inaccurate information that negatively affected the ratings. The US district Court ruled in favor of the rating agencies and stated that CRRA could not prove malice and CRRA’s claim was dismissed because the rating agencies could not be held liable for not disclosing something that they did not know. Even though the court indicated that the rating agencies’ protection was qualified and that the rating agencies owed a duty of care to their clients, a counterparty still had to prove malice or recklessness on the agencies’ parts. It was after this case that regulators significantly stepped up scrutiny of the rating agencies – the industry was reviewed by the House, the senate, the SEC and others – and effectively caused the Credit Rating Agency Reform Act to pass in 2006.
The company (and the entire industry) has gone through some intense years of scrutiny by regulators and has made its processes and its internal conflicts of interest quite transparent. We believe Moody’s stock will face a lot of headline risk from regulators’ and politicians wanting to pin blame for this subprime crisis in an election year. We think, upon not finding or being able to build a good case against the rating agencies, the regulators will shift their focus more to the mortgage originators and their role in causing this crisis.
Recommendation and Opinion
Moody’s has been the whipping boy of many unrelated parties. Regulators, short-sellers, attorney-generals, media and the like have been constantly beating the company (and the industry) up and blaming them for a big hand in the current subprime crisis. The stock has gone from its high of $76 earlier this year to its current level of around $35-$38 – a whopping loss of 50% or more than $11 billion. While its business levels will certainly suffer over the next year (see business issues above) and we may never again see the super-high growth rates for structured issues, we still think the basic business of credit rating will survive and ultimately (in a few years) continue to thrive again. The potential legal issues, the grand-standing by politicians, consistent headline risk, finger-pointing, we believe, will ultimately subside and die down. There will likely be no legal liability that will arise from all this grand-standing. And responsiveness and transparency on the part of the management will go a long way in resolving any legal issues expeditiously. While many other financial companies may not survive hits to their flimsy capital structures and overpriced assets, this one likely will. Even if Moody’s was slapped with an unlikely fine of several hundred million dollars, the share price would likely go up on resolution of this legal uncertainty (they have already lost more than $11 billion in market cap). And strong trends of increased international debt issuance, disintermediation of capital markets in many developed and developing countries will also more than offset a decline in U.S. structured finance revenues. The stock price already more than reflects any anticipated decline in structured finance revenues. We don’t think securitizations or CDO structures will vanish but we do think some of them will likely not return. Moody’s will likely keep its reputation intact once all this hoopla dies down. There will continue to be debt issuance, securitizations and the issuers will still be the ones to pay (because that is the only model that works and promotes transparency) and the issuers will still turn to Moody’s and S&P. Moody’s has an excellent management team that is very responsive to investors, regulators and journalists. This is exactly what you need a management during a crisis to be like. They are aggressively buying back shares at these levels. With excellent profitability (margins likely to be maintained long-termbecause of minimal existing competition and high barriers to entry), strong competitive position, no real exposure to the balance sheet, the stock is currently trading at a compelling valuation never seen since it spinout. If you have a 2-year investment horizon, you could buy this here at 12x earnings (on 2 years out). And wait to see credit conditions improve, news headlines to focus on something else, not much in the way of legal consequences to transpire and see stronger international growth.
Catalyst
Headlines shift to next big thing; future demonstrated performance; lack of material negative developments