Moody’s

It will take you a long time to find a company with such a strong and growing moat as Moody’s credit rating agency (and S&P Global, another of our companies). This strength flows to the bottom line and provides Moody’s with a return on invested capital amounting to an impressive 90 percent adjusted for goodwill.

Moody’s consists of two business units: Moody’s Investors Service and Moody’s Analytics. Moody’s Investors Service (Ratings) assesses the credit ratings when companies issue debt, while Analytics provides access to credit and risk assessment and risk management systems. Moody’s is expecting revenue to grow by high single digits. With subsequent increasing margins, earnings per share is expected to grow by more than ten percent annually.

Credit ratings have long been in demand from debt investors when they need to assess the risk of loans or bonds defaulting. Private individuals also go through a similar rating process when they want to obtain a bank loan. In such cases, the banks evaluate their customers in order to understand the underlying risk associated with the loan. A similar evaluation is needed when companies want to raise debt and get the best terms. This is where credit rating agencies like Moody’s enter when bonds are issued.

Combined, S&P Global and Moody’s Investors Services have a market share of around 80 percent of the market for credit ratings, and they are thus significantly larger than the remaining rating agencies. Even though Moody’s and S&P Global are competing for the same customers, the competition is not similar to many other industries. Many companies get ratings from both Moody’s and S&P Global, as this increases the chances of better terms when issuing debt as investors like to see a rating from both agencies.

We do not view the new “algorithm ratings” as a serious threat

On average, a credit rating from Moody’s Investors Services on a less complex debt issuance, provides the issuer with annual interest rate savings of 25 to 35 basis points. This may not sound like a lot, but when the issuance amounts to several billion dollars, the savings will be in the millions. On average, Moody’s charges 6.5 basis points of issuance to provide a credit rating of a less complex debt issuance, and each year it raises these prices by three to four percent. Thus, there are ample opportunities to raise prices on an ongoing basis while still ensuring significant interest savings for theissuing companies.

Besides fees from debt issuances, Moody’s receives payments on an ongoing basis for monitoring outstanding debt. This unique position allows the ratings division to have impressive operating margins of 58 percent, with 40 percent of revenue from subscription payments. We believe that the margins will increase in Ratings due to increased automation that allows the division to do more with the same number of employees. Ratings represents just under two thirds of revenue in Moody’s – but more than 80 percent of operating income.

The high level of earnings from providing credit ratings makes it natural for others to consider entering the market. However, Moody’s is protected by several factors. In theory, anyone can provide a credit rating – after all, it is mainly based on the company’s finances, future prospects, the industry and current debt. This, combined with technological advances, has made some observers concerned that the company will need to prepare itself for fighting off stronger competition from so-called “algorithm ratings” based on the increasing amount of publicly available data.

However, the interest rate savings that the issuers gain are mainly a result of the trust that investors have come to have in Moody’s (as well as in S&P Global’s) credit ratings over the years. In addition, the algorithms lack the supplementary information that Moody’s gains from engaging with the companies, and this information might be significant and not necessarily obtainable in published reports. Moody’s has a long and well-documented history of providing credit ratings, which demonstrates that the risk of losing money is lower once Moody’s has provided a rating.

Regulation is possible but unlikely

Moody’s has been around since 1909, and in addition to the trust it has accumulated, it has also gathered enormous amounts of valuable information and experiences. The company has been monitoring businesses and the economy in general through varying economic conditions for more than 100 years. However, during the global financial crisis, some trust was lost as several structured financial products with strong credit ratings defaulted, which ended up costing debt i
nvestors a lot of money. This also entailed a lawsuit from the United States Department of Justice, where a settlement was reached in 2016.

The rating agencies’ actions during the financial crisis also resulted in harsh criticism from several central banks and authorities, but those same institutions support the agencies’ business. The central banks use the agencies’ ratings to determine which bonds they buy during their monetary policy interventions. In addition, the authorities impose solvency requirements on financial institutions based on the same credit ratings.

In a concentrated market, where two companies such as Moody’s and S&P Global are so dominant, there are clear regulatory risks. A rotation principle, like the one which has been discussed for auditors that involved financial companies potentially being forced to switch one audit firm for another after a given number of years, would not be positive for Moody’s and S&P Global. However, we find the risk of increased regulation limited and assess the current regulatory environment to be calm and currently not a focus area for politicians.

The issuance of bonds is mainly associated with the refinancing of existing debt where there is an increasing need for refinancing within the next few years. The need for refinancing is not expected to change significantly
– independent of interest rates going up or down.

The interest rate level only has a modest impact on debt issuance in the long run. When interest rates decrease, the incentive for companies to restructure or issue debt at a lower interest rate increase. However, when interest rates increase – as long as they are rising due to increased economic growth – this will encourage businesses to seek expansion either through increased organic investments or through acquisitions. Many companies do not have sufficient funds to finance these expansions themselves, thus requiring them to issue debt in order to take advantage of the market conditions.

Debt issuance by corporate bonds are becoming more common in Europe and Asia, but the levels are still significantly lower than in the United States. European and Asian debt investors will thus have more need for reliable credit ratings and analyses of debt. Moody’s is in a strong position, as it is generally recognised as an industry standard, but also through its ownership in the credit rating agencies CCXI in China, Equilibrium in Latin America and Korea Investor Services in South Korea. China is currently a smaller market for international debt, but it is expected to become the second largest in the future – only surpassed by the US market.

Acquisition of a supremely sound Dutch company

The need for information to decision-making also supports Moody’s other business unit, Moody’s Analytics. Analytics provides customers with access to credit and risk evaluations and risk management systems. Analytics has been growing revenue at an average rate of 10 percent annually over the past decade, and it is expected to continue to do so with an increased customer demand for easily accessible information and analysis.

The growth has been positively impacted by minor acquisitions and a single major one in 2017, when Moody’s acquired the Dutch company, Bureau van Dijk, for 3.3 billion dollars. The acquisition has increased the debt levels to an amount equal to almost two times operating income before amortisation and depreciation. With low capital expenditure at around two percent of revenue and a high cash conversion that provides free cash flows up to almost six percent of the market value, we are, however, confident that the balance sheet can soon be delevered again. Moody’s pays dividends amounting to around 1.5 percent of the market value and will repurchase shares for one billion dollars in the fiscal year 2019, amounting to four percent of market value.

In general, we are sceptical when it comes to acquisitions, and we prefer that our companies grow organically. However, because Bureau van Dijk is so complementary and has such good opportunities for organic growth (alongside Moody’s own requirements for the investment), we have a positive view on this one. Moody’s has been successful in accelerating sales after the acquisition, and these have been driven by cross-selling data and analyses from Bureau van Dijk to Analytics’ existing customer base.

Bureau van Dijk has high margins of around 50 percent, and it thus contributes to Moody’s objective of increasing the margin in Analytics from the current level of 26 percent. Analytics is a stable business in which more than 80 percent of the sales are from subscription payments with retention rates of 95 percent. This adds a lot of predictability.

We strongly believe that the strategic and value-focused management will remain so under CEO Raymond McDaniel, who has been at the helm since 2005 and helped steer Moody’s safely through the financial crisis. In 2018, Mark Kaye took over as CFO when Linda Huber decided to step down after 13 years in the position. We have appreciated Linda Huber’s commitment and the passion she has put into her work over the years, and we are very confident that Mark Kay can assume this role with the same passionate leadership style. Mark Kaye is joining Moody’s with 15 years of experience in the financial sector.

Moody’s Investors Service and Moody’s Analytics are still headed by the skilful Robert Fauber and Mark Almeida, who have been with Moody’s since 2005 and 1988, respectively.

With a market-dominant position in a structurally growing industry with high barriers to entry, high returns on the invested capital, the ability to raise prices each year, and strong free cash flows, we have a positive view of Moody’s ability to create value for us as shareholders.