2023-10-19 12:44:02 ET
Summary
- Moody's Corporation is a wonderful business trading at a fair price and remains a large Warren Buffett holding.
- MCO is currently trading at a relatively high valuation relative to the S&P 500 and its own history.
- China represents a unique and often underappreciated long-term opportunity for MCO via its 30% ownership stake in China's leading ratings agency CCXI.
- I am initiating MCO with a buy rating and would consider upgrading to a strong buy in the event that the stock declines significantly from current levels.
Warren Buffett, arguably the greatest investor of all-time, has famously said:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price
Moody's Corporation (MCO) is a wonderful company currently trading at a fair price. MCO's largest holder is Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B), which owns ~24.7 million shares representing ~13.4% of MCO shares outstanding. Berkshire's stake, which was initiated in 2000, is worth ~$8 billion based on current market prices and is Berkshire's 8th largest public equity holding.
Company Overview
MCO consists of two business: Moody's Analytics ("MA") and Moody's Investor Services ("MIS"). MA is a provider of financial intelligence and analytical tools which help support customers growth, efficiency and risk management objectives. MA accounts for ~ 52% of total revenue. MIS delivers independent credit ratings opinions and related information and accounts for ~48% of total revenue. While the revenue split is roughly equal, MCO derives ~62% of Adj. Operating Income from MIS as MIS has Adj. Operating Income margins of 51.3% compared to 28.8% for MA. That said, MA will likely make up a larger part of operating income in the future as the business is expected to grow revenues at a low-to-mid-teens CAGR over the next 5 years while MIS is expected in the mid-to-high single digits over the next few years.
Moody's Investor Presentation Moody's Investor Presentation Moody's Investor Presentation
Strong Competitive Moat
The credit ratings business is dominated by MCO and S&P Global ( SPGI ) while Fitch is a smaller player. These "big three" ratings agencies account for ~95% of the global ratings business with S&P and MCO are each estimated to account for 40% of the market. At first glance, one might be tempted to characterize this as a duopoly or oligopoly market industry structure. I would argue the market structure for MCO is even better and that the company actually has a degree of monopolistic pricing power.
To understand why this is my view let's take a look at other oligopoly industries. The telecom industry is dominated by Verizon ( VZ ), AT&T ( T ), and T-Mobile ( TMUS ) but each customer generally only chooses one carrier. The result is that VZ, T, and TMUS are all competing against each other for the same customer dollar. Similarly, FedEx ( FDX ) and UPS ( UPS ) enjoy a near duopoly in the shipping and logistics business but, in the event of each order, any customer generally has the option to use FDX or UPS but not both. While an oligopoly industry structure can be a good one (e.g. Visa ( V ), Mastercard ( MA ), and American Express ( AXP ) in the payment processing network business or Coca Cola ( KO ) and PepsiCo ( PEP ) in beverages) the intensity of competition of any duopoly is important in determining the outcome.
The credit ratings business has a relatively low degree of competition intensity as many issuers choose to be rated by both MCO and S&P (and sometimes Fitch.) While smaller issuers may choose to be rated by just one of the big ratings agencies, the majority of larger companies tend to have ratings from both MCO and S&P. For this reason, MCO enjoys some degree of monopolistic pricing power. MCO, in many cases, does not need to match a lower price from S&P in order to win business as many issuers feel a need to have ratings from both MCO and S&P. Issuers choose to be rated because the ratings fee tends to be small relative to the amount of savings in terms of the interest rate. Moreover, many institutional investors such as insurance companies have ratings restrictions that govern which securities can be held. For these reasons, the concept of issuer paid credit ratings is well entrenched in the financial system. To understand just how well entrenched MCO and S&P are in the financial system we can look to the lack of fallout from the ratings debacle surrounding highly rated subprime mortgage CDOs. In the end, the poor ratings judgement shown in the years leading up to 2008 did not significantly impair either MCO or S&P's global franchise.
MCO's MA business also enjoys some degree of monopolistic pricing as the collection of data that MCO owns and distributes to clients is proprietary. As shown below, MA's customer base is greater the 15,200 customers and includes 70% of the Fortune 100 and 52% of the Forbes 1,000.
Wide Moat Has Led to Strong Historical Financial Performance
As shown by the charts below, MCO has significantly outperformed the S&P 500 over both long periods as well as more recent periods. This relative outperformance is particularly impressive given the fact that MCO is a mature financial company and over the past few years the S&P 500 has been driven largely by the strength in large technology companies. The strong stock performance over both long and short time frames is evidence of the strength of the business. Moreover, MCO has also maintained very high margins which serves as additional quantitative evidence relating to the strong moat around the business.
Valuation
The market is clearly aware of the strength of MCO's business and, for this reason, the company trades at a high valuation. MCO receives a Seeking Alpha factor grade of F for valuation. Moreover, many of the hold recommendations on MCO by Seeking Alpha analysts are driven by concerns related to valuation. However, MCO shares have fallen by ~20% from all-time highs reached in late 2021. MCO's forward PE ratio has fallen from ~44 down to 32 suggesting the move lower has been driven by changes in valuation as opposed to changes in the growth outlook for the company.
Seeking Alpha
MCO trades at 28.4x forward earnings compared to 18.1x for the S&P 500. The S&P 500 is expected to grow earnings by 12% next year while MCO is expected to grow by ~13%. Thus, MCO forward PEG ratio is 2.18 compared to 1.5 for the S&P 500. However, I believe this premium valuation is warranted given the competitive moat around MCO's business. Additionally, MCO benefits from 71% of revenue being recurring in nature which helps make MCO earnings more stable and less cyclical than most companies.
While DCF's tend to be highly subjective, I believe they can serve as a valuable part of the valuation toolkit. As you can see below, I made some assumptions and then backed into what the implied terminal cash flow growth rate would be to justify MCO's current valuation. To project free cash flow, I used MCO's own estimate for 2023 cash flow (MCO estimates FY 2023 FCF of $1.7 billion and has already generated $1.08 billion in Q1-Q2. Therefore, I have split the remaining free cash flow evenly for Q3 and Q4. Early projection years cash flow growth rates are based off of analyst earnings growth rates as I expect those to track reasonably closely. Cash flow growth rates in 2029 through 2033 step down to reach the terminal growth rate. Based on this analysis, MCO needs to terminally grow cash flows at ~6.3% in order to be fairly valued based on the current price.
The China Opportunity
The credit ratings business in China represents what I believe to be an underappreciated long-term growth opportunity for MCO. As Chinese domestic capital markets continue to mature, it is likely that credit ratings will play an increasingly important role in the financial ecosystem. While MCO does not operate inside China, it does have exposure via a 30% ownership stake in China Chengxin International Credit Rating Company Limited ("CCXI"). CCXI is the oldest Chinese credit rating agency and has the largest market share in China's domestic ratings market. MCO reported just $16mm in income from its CCXI investment for FY 2022. While China is not an important market for MCO today, I believe there is significant potential for China to drive a substantial earnings growth for MCO in the future. While there is certainty risk that MCO is forced to sell its investment in CCXI due to China / U.S. tensions, I believe that the Chinese understand the benefit that accrues to CCXI due to the association with MCO. Thus, I view the risk of forced divestment is relatively low and believe MCO remains well positioned to benefit from potential growth in the credit ratings business in China.
Q3 2023 Earnings Preview
MCO is scheduled to release Q3 2023 earnings on October 25, 2023. Consensus estimates call for the company to post quarterly EPS of $2.38 per share which represents a year-over-year change of 28.7%. Revenues are expected to increase 14.9% on a year-over-year basis to $1.46 billion. Recently, a report was released by Oppenheimer analysts which suggests MCO ratings revenue might come in slightly below consensus estimates based on weak debt capital markets results reported by banks such as J.P. Morgan ( JPM ). Given the long-term nature of the MCO growth opportunity, I believe market participants would be willing to look past any slight miss in terms of quarterly results. Moreover, MCO shares have fallen by 13.6% since the company reported Q2 results on July 25, 2023, significantly underperforming the broad market indexes. For this reason, I believe MCO could move sharply higher in the event of a positive earnings surprise while a negative surprise may also send the stock modestly lower.
Risks to Consider
Over the short-term, the biggest risk to MCO is a significant economic slowdown which leads to a drop in financing transactions. 29% of MCO revenue is transaction based and thus a significant freeze up in financial markets would have a negative short-term impact. Moreover, a significant economic downturn may lead to lower growth for the MA business as end users may look to reduce spending on data and information. While an economic downturn may impact short-term results, I believe any dip in the stock would represent a buying opportunity as the long-term strength of the business will remain intact. A longer-term risk to MCO is potential emergence of Fitch as a more serious competitive threat which will create more competitive pressures. However, I view this risk as somewhat limited given that MCO enjoys a stronger reputation in the market currently has vastly more scale than Fitch. Moreover, Fitch has been around for a long time and has thus far been unable to dislodge MCO's leading position in the market so it is difficult to see why this would change anytime soon.
Conclusion
MCO is a wonderful business due to a strong economic moat, high levels of recurring revenue, and continued organic growth opportunities. MCO has been a large holding for Warren Buffett's Berkshire Hathaway for many years and continues to be one of Berkshire's largest holding. Investors are well aware of the strength of MCO's business and thus MCO is not cheap given that it trades at ~28x forward earnings. In order to grow into this valuation, my analysis suggests that MCO will need to grow earnings and free cash flow by low double digit percentages for the next few years, and, after that grow by ~6.3% to justify the current valuation. I believe that MCO will be able to achieve this growth rate and thus I believe the stock is a buy at current levels. I would consider upgrading the stock to a strong buy in the event the share price moves significantly lower from here.
For further details see:
Moody's: A Wonderful Company At A Fair Price