This American company has such a strong market position that it is more or less impossible for new players to challenge it. On top of that, Moody’s operates in a market in which there are ample opportunities for finding new pockets of growth and the competent management team has a keen eye for identifying them. At the same time, the level of earnings is simply staggering.
Most people find that debt is an unavoidable part of life – whether it be private individuals needing a mortgage, car loan etc. or companies that need to finance their daily operations or make a major investment to expand their business. Private individuals go to the banks to find out what they can borrow, but companies go to the credit rating agencies such as Moody’s and S&P Global, which is also one of our companies.
Both Moody’s and S&P Global hold dominant market positions in the credit rating industry, and combined, they have almost 80 percent market share more or less evenly distributed between them.
For debt investors and banks it is essential to understand the underlying risks of a company or debt issuance as any erroneous interpretation can result in huge losses. A credit rating from Moody’s or S&P Global is a stamp of approval of the company’s creditworthiness and sends a clear signal to potential debt investors, as these credit ratings are very credible and based on numerous decades of experience.
Moody’s was founded in 1909 by John Moody, as he began preparing and selling analyses of American rail companies’ shares and bonds. These analyses were in very high demand, and during the next 15 years, Moody’s grew its business and began covering more shares and bonds. In fact, Moody’s grew so much that in 1924, the company was close to covering 100 percent of the American bond market – a rate that they are still close to.
Strong pricing power
The credit ratings are made by Moody’s Investor Services, which today accounts for approximately 60 percent of Moody’s total revenue of over 4.5 billion US dollars and almost 80 percent of its earnings. Moody’s Investor Services operates with an impressive level of earnings from operations of almost 60 dollars per 100 dollars in sales, and it is thus an extremely profitable and very value-creating business division – both for the company and for us as long-term co-owners.
One of the reasons for the high level of profitability and dominant market position is that the interest rates are lower if a company issues debt that has been given a credit rating by Moody’s or S&P Global. A typical issue of debt will be 0.3 percentage points lower a year, for example. This may not sound like a lot, but if we take an issue of debt of one billion dollars and add the savings above, this amounts to annual savings of approximately three million dollars – savings which can only be achieved via a credit rating.
Moody’s charges approximately 0.07 percent of the total issue of debt per year to make an evaluation and it is increasing its prices by 3 to 4 percent per year. The ability to increase prices is very valuable for the company and its investors, and it still leaves the companies issuing debt with significant savings on interest rates.
A difficult market to enter
Moody’s is able to charge this fraction and at the same time increase prices on an annual basis because of the trust that the debt investors place in Moody’s credit ratings and also the regulatory advantages that come with having a credit rating. The company has over 100 years of experience in this sector and throughout this period it has demonstrated a clear positive correlation between their credit ratings and the actual risk of a bond – despite periods of higher unpredictability such as, for example, the financial crisis. One of the reasons for this great track record is found in the information advantage that Moody’s has from being in direct contact with management teams and companies.
Generally speaking, anyone can create a credit rating since much of the relevant information on a company’s finances, current debt and future prospects is in the public domain. However, the interest rate savings that the issuers of debts gain are, as mentioned, mainly a result of the trust that investors have come to have in Moody’s ratings.
This trust and a long track record of results create incredibly high barriers of entry for outsiders, and it makes Moody’s the industry standard. The barriers to entry only become greater and greater the more years pass, and they are also getting harder to breach due to growing requirements for documentation from the authorities, making it even harder to compete in a market where 80 percent of it is dominated by only two actors and the third-largest competitor, Fitch, has a 15 percent market share. The threat of increased competition from new players is therefore very small.
Some trust was lost
Even the existing competitive landscape is not what is seen in most other industries. This is because companies typically approach more than one credit rating agency for a rating. This is so that the debt investors can get as complete a picture as possible of the company’s financial position and take into account any potential preferred methodologies.
The trust in the credit rating agencies did, however, suffer a blow during the financial crisis, as several financial products with good credit ratings ended up defaulting on their payment obligations and thereby costing the investors money. It also resulted in a lawsuit from the United States Department of Justice against Moody’s, though this was settled at the end of 2016.
It is regrettable that financial products with good credit ratings led to losses. This does not, however, change our view that Moody’s and S&P Global remain market standards when it comes to credit ratings. If you are a company that wants to get the best terms for borrowing when issuing debt, there is no getting around Moody’s and S&P. The financial crisis also resulted in increased regulation, and while this increased the cost base of the credit rating agencies, it also reinforced the already towering barriers to entry for new potential competitors.
The credit rating agencies’ actions during the financial crisis were also criticised by the central banks. However, this is somewhat paradoxical, as these exact same central banks use the credit ratings to determine which bonds they are allowed to purchase with their monetary policy programmes.
Refinancing will happen sooner or later
Generally, issued debt is the result of refinancing of existing debt – and the demand for such will steadily increase in the years ahead. Corporate debt falling due, and thus, presumably scheduled for refinancing, is expected to grow by just over 5 percent per year up until 2025. The amount of debt issued can vary greatly from quarter to quarter – for example due to the companies’ expectations for interest rates or credit spread – but the refinancing cannot be postponed indefinitely and must be done before or when the debt matures.
Refinancing is therefore a supporting factor for Moody’s credit rating business, and the refinancing cycle creates a stability and predictability that we appreciate as co-owners. The stability in the business is further supported by many of Moody’s customers paying for ongoing monitoring of their outstanding debt.
When the corona virus hit the world at the start of 2020, it forced many companies to halt or slow down daily operations and it also led to a hunt for liquidity to cover various fixed costs. At the same time, the US Federal Reserve pushed interest rates down and these two factors increased the demand for credit ratings due to both better opportunities for refinancing at lower interest rates and the issuing of new bonds. Therefore, Moody’s and S&P Global are among the companies who experienced tailwinds throughout the pandemic and the significant increase in newly issued bonds will, all other things being equal, also increase the demand for refinancing in the future. The pandemic has thus not weakened these two companies’ strong business models.
Growing market for products within ESG
One of Moody’s strategic objectives is to expand the coverage of outstanding debt. This expansion is both in terms of geography and new products. The United States is the largest credit market and also the market where bonds are most used compared to conventional bank loans. As a result, Moody’s is focusing on providing its credit rating services to the rest of the world, and China in particular may turn out to be a significant market. It is estimated that China’s market for total outstanding debt will be larger than the European market in the near future.
Moody’s has a presence on the Chinese market via their CCXI joint venture and they have a market share of approximately 40 percent of domestic credit ratings in China. Currently, debt with an international credit rating is only a very small proportion of this market. The growth trajectory of this business area is thus strong, with a development and a potential that can benefit us as long-term co-owners as the international debt investors only account for two percent of the Chinese credit market. Across the developing world, Moody’s Investor Services has increased its revenue by 14 percent per year since 2009, and this emphasises the large potential that is to be found here.
For new products and services there is an increasing focus on sustainability, cyber risks and KYC (know your customer), both in Investor Services and Analytics. Here exists ample business opportunities with a growing societal interest and, among others, Moody’s subsidiary, Vigeo Eiris – which has 40 years of experience with ESG (Environmental, Social and Governance) assessments – is one of the wholly owned subsidiaries helping to create transparency and an overview of corporate social footprints.
The largest bankruptcy in history
Moody’s and S&P Global’s dominant market position and high levels of earnings entail the risk of stricter regulation from authorities. In the United States, there are periodic political discussions about changing the payment model so that it is the debt investors who pay for access to credit ratings and not, as it currently is, the companies issuing the debt. This is not, however, something we see as being imminent.
This model has, however, been applied in a similar form in the past. The model was changed in the 1970s in the wake of the bankruptcy of Penn Central Station Transportation Company, which was the largest bankruptcy in history. Critics felt that the investor-paid model meant that only wealthy or large institutional investors had access to credit ratings and thus created an information advantage that benefitted those and harmed the “small” investors. This underscores how there is no obvious choice for a model to replace the current one.
The evaluation of risk in the companies issuing debt is also offered to Moody’s customers via its Analytics division, which is the second pillar of Moody’s business. Analytics offers credit and risk assessments for many different kinds of segments and also offers risk management solutions to its customers. Analytics is a very stable business, and over 90 percent of the revenue stems from subscription fees – where the renewal rate is at over 90 percent.
This provides a high and desirable level of predictability. Analytics, which generates almost 40 percent of Moody’s total revenue, has been growing at impressive rates in the past decade, with average annual growth rates of 13 percent. The majority of this growth has been organic and in the existing business, where price increases and upgrades to existing contracts have been strong contributors. Roughly speaking, two thirds of the growth in Analytics have come from the above, while the remainder has come from newly signed contracts with both new and existing customers.
This growth from higher prices and upgrades of existing contracts flows almost directly through to the bottom line and thus contributes to the high level of earnings at Analytics, which are just over 28 dollars per 100 dollars in revenue. With the acquisition of the Belgian company, Bureau van Dijk, in 2016, Moody’s strengthened its position on the European risk analysis market. With earnings of an entire 50 dollars per 100 dollars in revenue in Bureau van Dijk, this acquisition has also improved the level of earnings in Analytics from 23 dollars to 28 dollars per 100 dollars in revenue from 2016 to 2019.
With capital investments being low at around 2 dollars per 100 dollars in revenue and high cash conversion, Moody’s generates free cash flows amounting to almost 3.5 percent of its market value. Moody’s primary focus on investing in the existing business seems sensible to us. Not least due to a return on invested capital of almost 90 percent if adjusted for goodwill mainly stemming from the acquisition of Bureau van Dijk. The surplus cash is returned to shareholders through dividends and share buybacks amounting to, respectively, one and two to three percent of the market value.
A successful CEO will pass the torch
Since 2005, Moody’s has been successfully headed by CEO Raymond McDaniel, who was joined by CFO Mark Kaye in 2018. The results have been admirable, and in January 2021 the previous COO, Robert Fauber, succeeded McDaniel as CEO. After 34 years of faithful service in Moody’s, McDaniel will continue as chairman of the board, and we have every reason to believe that the strategic and value-oriented management focus will continue and keep its objective of delivering annual earnings and free cash flow growth of over 10 percent per share.
Moody’s has been through an eventful year in 2020 helping its customers getting access to much-needed liquidity during a difficult time, and the company itself has achieved revenue growth and improved its level of earnings. With a dominant market position, a high return on invested capital and the ability to raise prices each year deriving strong and increasing levels of free cash flows per share, there are ample opportunities for future value creation.
As long-term co-owners, we appreciate such value creation.