Where Are We Now
Updated on: 11/7/2021
We think the capital-light business model of Moody’s is extremely attractive especially when considered with the fact that it controls almost half of the world’s credit ratings. Besides credit ratings, Moody’s provides analytics software and tools to firms involved in the capital markets. Moody’s is one of the best businesses in the world and so we think the company is trading at a reasonable valuation.
Since credit ratings are more cyclical in nature, we think the growth in Analytics (10% or more each year) allows for diversified, recurring revenue growth while not spreading the company too thin.
Bond issuances are at record highs and we don’t expect that trend to stop anytime soon. Interest rates are low, meaning that corporations and governments will keep coming back to Moody’s for initial ratings and periodic reviews.
MCO is the gatekeeper standing between public debt issuers and investors to the world’s most valuable commodity - money. Without a Moody’s credit rating, today’s investor is more likely than not to reject a newly issued bond, potentially crushing a business’ growth prospects or chance of survival.
Moody’s and S&P Global (“SPGI”) approximately split their combined 80% global market share as credit rating agencies (“CRA[s]”). MCO’s brand name, intellectual property, and growing recurring revenue base should uphold its position as a CRA and analytics leader.
Moody’s Analytics is the lesser-known growth engine that could be bigger than MCO’s credit rating business one day. MCO is focusing its acquisition efforts and reinvestment opportunities on ways to grow its subscription-based analytics segment for high-quality, recurring revenue generation.
Capital allocation is a top priority at MCO – shareholders have been rewarded with free cash flow (“FCF”) per share outgrowing revenues to the tune of a few percentage points per year over the past decade. Going forward, management has committed to treating its shareholders well over the long haul.
MCO is a global company that provides independent credit rating opinions and analytics solutions, consulting, training, and software services. MCO operates through two business segments:
Moody’s Investors Service (“MIS”)
MCO is a true international player – MIS customers are located in over 140 countries worldwide and MA customers are scattered across 155+ countries.
Moody’s Investors Service (MIS)
MIS is the MCO credit rating arm that publishes initial and ongoing public credit ratings for debt structures or obligations. These services are provided mainly for corporate, financial institution, governmental, and structured finance obligations. A firm that operates in this space is known as a CRA.
MIS serves five main target markets:
Corporate Finance (“CF”)
Financial Institutions (“FI”)
Public, Project, & Infrastructure Finance (“PPIF”)
Structured Finance (“SF”)
MIS Other (“Other”)
MIS generates revenues primarily in the US while less than half of revenues comes from international organizations.
MIS Financial Profile (Q3 2021)
Source: Moody's Investor Relations
Overall, the MIS segment is mainly reliant on transaction volume. About two-thirds of revenues generated in this segment are from transactions while a third are sourced from recurring sources.
Using various forms of online media like internet pages or specialized finance technologies (e.g., Bloomberg terminal, Thomson Reuters Refinitiv Eikon, etc.) for distribution to the public, a company’s creditworthiness is analyzed to assess the risk of a newly issued or proposed debt security.
MCO’s credit rating system for long-term debt ranges from Aaa (best) to C (worst). Any credit with a rating above and including Baa3 would be considered “investment grade” while ratings below Baa3 would be considered speculative, non-investment grade, or junk. For short-term debt, the best credit would be rated “P-1” and the worst credit would be rated “Not Prime”.
These credit ratings serve some incredibly important uses to a company, organization, government, and society. They facilitate an organization’s:
access to funding;
investor transparency, credit comparison for quality, and overall market stability; and
planning and budgeting.
MIS makes money from the originators and issuers of debt transactions through initiation and ongoing rating fees. For an organization to raise debt capital, a credit rating must be attached to the sale to assure investors of the quality of the debt (i.e., the company’s ability to service the debt through its core business cash flows). In simple terms, MCO’s services are a tax on global bond issuances.
MIS has massive scale as a CRA – it has rated over $70 trillion of debt throughout over 35,000 organizations and structured finance deals and released almost 50,000 publications on issuer, sector, and other research using over 200+ methodologies. In the CRA business, size wins.
Moody’s Analytics (MA)
Moody’s Analytics is independent from MIS and offers a range of services that build on MCO’s core MIS business. MA is a subscription-based service that encapsulates research, data, and analytics in credit ratings and research, economics, business intelligence, company information, and commercial real estate. It also offers online and physical training and certification and credential services, and other software solutions and risk management services.
Most of MA’s revenues are generated by research, data, and analytics (“RDA”) solutions with the balance coming from enterprise risk solutions (“ERS”). Contrary to MIS, MA is diversified globally to a larger extent, generating less than half of revenues within the US and the rest abroad.
MA’s customers are primarily insurers, corporates, asset managers, public sector organizations, and banks. In 2020 alone, over 31,000 customer users and 337,000 individuals accessed the Moody’s research website.
MA issues invoices to customers before the contract period, upon delivery, and as services are provided for subscription contracts, software licenses, and professional services, respectively. Most of these contracts last about one year but can also range between 3-5 years.
RDA boasts extremely high customer retention rates (94%) and recurring revenues as a proportion of total revenues. ERS is slightly more “transactional”, but still delivers high retention rates (~92%) and most of its revenues are recurring. Overall, MA provides MCO with a cushion given the cyclical nature of MIS operations – as a whole, MA generates about 90% of its revenues via recurring subscription-based solutions and the remainder from one-time projects.
MA Financial Profile (Q3 2021)
Source: Moody's Investor Relations
MCO has been firing on all cylinders over the past decade – MCO consolidated revenues grew at a low double-digit compounded annual growth rate (“CAGR”). MIS revenue growth over this period was slightly less in the high single-digit zone. MA revenue growth, on the other hand, upheld MCO’s double-digit growth rates by growing almost twice as fast (based on a percentage rate) over this time.
Moody's Historical Revenues ($M) (Q3 2021)
Source: Moody's Investor Relations
Although MA has contributed greatly to the top line, its margin contribution is rather muted when compared to MIS. On a non-adjusted basis, MIS's operating margins are close to 60%. MA’s lower 20% operating margin dilutes MIS’s margin profile – on a consolidated level, MCO's margins are almost 50%. As MA continues to grow, MCO's total margins are likely to decrease gradually.
Moody's Historical Profit Figures ($M) (Q3 2021)
MIS is larger and contributes more to the bottom line than MA does. When the lower-margin business (MA) is growing at a faster rate than the higher-margin segment (MIS), investors may be concerned about how profits, business reinvestment, return on invested capital, mergers and acquisitions (“M&A”), and the share price will be impacted over the long run. These would all certainly be fair concerns, but we believe Moody’s is on track for further growth if this performance continues for the following reasons:
Top-line growth is arguably the most important facet of long-term share price growth.
MA’s margins are still high and could expand as the business grows.
MA does a great job retaining customers and earns recurring revenues to a far greater extent than MIS.
MCO’s history dates to the early 1900s when John Moody, the creator of Moody’s, published Moody’s Manual of Industrial and Miscellaneous Securities (“Moody’s Manual”). John Moody is credited with inventing modern bond credit ratings, an area that is crucial to the proper functioning of global financial markets.
Moody had a vision to simplify access to information and create an easy-to-understand, recognizable, and consistent global language of credit. Moody’s Manual was meant to facilitate this access, containing detailed statistics about stocks and bonds related to financial institutions, government agencies, manufacturing, mining, utilities, and food companies.
By 1903, Moody’s Manual became a well-established publication in his native country, the United States, and many investors considered the book a library staple. The success of Moody’s Manual prompted a few more finance-related texts under the newly established Moody Publishing Company.
After the stock market crash of 1907, Moody wrote Moody’s Analyses of Railroad Investments in 1909 just as the railroad industry began to flourish and grow. This book was yet another hit by Moody, in which he used credit ratings to complete his detailed analyses of railroads that existed at the time.
By 1914, Moody created Moody’s Investors Service (MIS) as we know it today in response to high demand from investors for his stock and bond ratings. Within 10 years, MIS covered the entire US bond market.
John Moody passed away in 1958 and Moody’s was later bought out by Dun & Bradstreet Corporation, a credit and information rating company. Moody’s legacy lived on, however – Moody’s was spun off from Dun & Bradstreet in 2000 and became a public company, the one we know and appreciate today.
It was not until 2007 when Moody’s began to venture into the analytics space as part of an aim to use its existing research, ratings, and content to expand its operations outside of solely credit ratings. By 2008, Moody’s Analytics commenced operations as an independent entity from MIS providing financial risk solutions to its customers.
The 2010-2020 decade is one marked by acquisitions, investments, and global expansion to grow MCO’s portfolio outside of its core business competencies. MCO’s focus on real estate, cyber security, and ESG (i.e., environmental, social, and governance) has stretched its goals and appears to be working as planned. Today, MCO is a credit rating and analytics monster with its eyes set on one thing – growth.
Every company in the world needs funding to make big things happen and stay ahead of its competition. There are very few companies – like Facebook and Lululemon – and countries out there that generate so much cash that they can avoid issuing debt.
Moody’s, therefore, plays a crucial role in the flow of cash around the world. It essentially has the power via its credit ratings to indirectly “decide” whether a country or organization will receive debt funding and at what price (i.e., riskier debt will have a higher interest rate; safer debt will have a lower interest rate). Missing a Moody’s credit rating could also adversely affect a company or country seeking cash, potentially costing millions of dollars (or more!) over a relatively short period of time.
Moody’s has so much power, it can singlehandedly send companies and countries into a downward spiral towards bankruptcy if it downgrades its debt or issues a junk rating, or even if MCO was not hired in the first place by the debt issuer.
MCO competes in a highly consolidated industry with only three major players – MCO itself, SPGI, and Fitch. SPGI, MCO, and Fitch control 95% of the global credit rating industry, although Fitch is a much smaller player than SPGI and MCO. Fitch controls about 15% of the market whereas SPGI and MCO roughly split the other 80%.
The credit rating industry is effectively a duopoly on a global scale. If one combines MCO’s duopoly position with the fact that no company or country in existence would take on the risk of issuing unrated debt and potentially losing out on much-needed capital or paying astronomical interest rates, the result is magnificent pricing power on the part of MCO.
To add to MCO’s moat is the fact that many bond issuances have credit ratings from at least two CRAs (mainly SPGI and MCO). Therefore, MCO and SPGI do not necessarily fight each other over who rates what – they peacefully operate alongside each other, and each get their piece of the global debt issuance pie.
Keeping Everyone Happy
An underappreciated competitive advantage that comes naturally to MCO is its position in society. MCO’s credit ratings makes the job of investors and borrowers / underwriters (i.e., financial institutions) easier.
Investors are important stakeholders in debt issuance as they are the ones who provide capital to borrowers. Without adequate assurance that the debt they are buying is of satisfactory quality, investors would be left with deep uncertainty over their investments. Tapping into a pool of worried investors means little interest, higher interest rates, or potentially no funding at all.
On the other hand, borrowers and underwriters want to issue the debt to collect their funds (in the case of an underwriter, a commission calculated as a percentage of total debt issued). Borrowers and underwriters want to price debt correctly and satisfy the informational needs of investors to attain capital.
MCO makes the funding process easier for everyone – investors, borrowers, and underwriters – and its stamp of approval is recognized by the entire investment community. Without MCO, issuing debt would be akin to Russian roulette for all players involved.
Recurring Revenue Profile
MCO’s higher-growth segment, MA, contains a lot of characteristics that can be found in today’s most popular software-as-a-service (“SaaS”) companies – high retention, recurring revenues, and pricing power.
As mentioned earlier, MA retains over 90% of its customers from year to year and generates over 90% of its revenues from subscription-like, SaaS-based solutions.
Contractual terms that lock in customers for at least one year, providing great solutions for thousands of customers, and a recurring fee model all come together to enable solid pricing power at MCO. Recently, MA has been growing due to a mix of new sales and upgrades and price increases. We believe this exemplifies MA’s ability to grow its existing customer base by expanding its software and product solutions, continuing to add value, and upselling current customers.
MCO controls a significant amount of intellectual property, including trademarks, research, publications, software tools and applications, models and methodologies, databases, domain names, and other proprietary information.
New entrants to this space would have to build up superior processes and a brand name worthy of dethroning a credit rating giant that constantly built and refined these areas for the past 120 years.
Not only are new entrants unlikely to appear, but this significant amount of intellectual property also allows MCO to expand on its existing businesses and create new solutions. MIS and MA build on their respective processes, models, and solutions independently to improve their own businesses, and they also leverage each other’s property and know-how to grow together.
As these businesses grow together and incorporate new solutions organically or via acquisitions, the more complex (and effective) its models, methodologies, and solutions become. MCO’s natural moat widens while also appealing to new customers for exclusive access to its ever-expanding and trusted base of information and risk management analytics. MCO’s intellectual property is a key source of its continued success.
Global Credit Boom
COVID-19 gave way for a rise in global bond issuances, largely triggered by record-low interest rates worldwide and loose monetary policy flushing markets with cheap money.
Although we hold no particular view on Modern Monetary Theory and its effect on markets, we believe it is no surprise that corporations and governments are raising debt when the cost of money is sitting at record lows. Yearly bond issuances hovered around $20 trillion between 2010 and 2018 but surpassed $25 trillion in 2020.
Global Bond Issuances ($B)
As MCO’s credit ratings are highly sought after by bond issuers, MCO directly benefits from the strong fundamental base in bond issuances that is now experiencing growth due to macroeconomic factors and increased M&A activity. More new debt originations mean MCO makes more money on first-time ratings and a growing base of outstanding bonds globally means MCO makes more money from annual monitoring fees. In other words, its MIS business is growing both on volume and its recurring revenue stream.
Also triggered by current monetary policies around the globe, disintermediation of financial systems is an emerging trend. Rather than raising capital through banks or other intermediaries, corporations are increasingly turning to public markets for larger and quicker access to funds than traditional sources.
Additionally, growth in emerging markets (“EM”) might be like adding fuel to the disintermediation fire. EM financial systems generally have lower capacity limits than more developed nations and may not be able to adjust quickly enough to accommodate rapid economic growth. The IMF expects EM gross domestic product (“GDP”) to swell to $53 trillion in 2026, up from $34 trillion in 2020 – an 8% CAGR. Strong expected EM growth will translate to more public bond issuances that require MCO’s “stamp of approval”.
On a rather similar note, global GDP is set to grow to $122 trillion in 2026, up from $85 trillion in 2020 – a 6% CAGR. Growing global GDP supports the issuance of more debt as economies expand, invest in infrastructure and business operations, and then repeat the cycle all over again.
Global GDP ($B)
We believe MCO has a strong and reputable brand name and immense pricing power that could allow it to grow at rates above the total value of bond issuances or global GDP for years on end.
Don’t Forget About Analytics
MCO is widely known for its credit rating prowess and the global credit boom has investors’ eyes locked in on the future growth of MIS. However, MA should not be forgotten as it has many growth levers it can pull organically and through acquisitions.
MA already has a myriad of use cases addressable by its solutions. To name a few, MCO’s analytics solutions facilitate commercial real estate analysis, effective Know Your Customer (“KYC”) and financial crime monitoring, and insurance and actuarial analysis. The common denominator between its use cases is that each one is plagued with critical risks that operators and governments would like to stay on top of and avoid.
MCO’s analytics solutions are crucial in mitigating the growing complexity and severity of climate change, extreme weather, pandemics, fraud, and cyberattacks, among many others. Risk preparedness is top of mind for many firms and governments, especially after the world entered a global pandemic.
From a strategic standpoint, management is shifting from one-time projects to subscription-based products. This has driven the recurring revenue share in the MA segment from 78% in 2017 to 90% in 2020. That’s not all – adjusted operating margins also expanded from 24.6% to 29.4% over the same period. Strong continued uptake of subscription-based solutions and disciplined cost management are fueling reinvestment in the business to deepen existing customer relationships, improve product offerings, and continue the shift away from project-based engagements.
Further supporting MCO’s shift towards subscription-based products is M&A activity in the MA segment. In 2020 alone, MCO purchased 100% stakes in five analytics businesses and obtained a minority stake in one KYC and ESG data and insights provider.
MCO is extremely active on the M&A front, seeking complementary businesses that build its analytics moat that targets several niche industries that face substantial risks.
Most notably, MCO recently entered a definitive agreement with RMS, a leading global provider of climate and natural disaster risk modelling and analytics, at a purchase price of $2 billion. RMS serves the global property and casualty (“P&C”) insurance and reinsurance industries, which would expand MCO’s portfolio of integrated risk assessment assets. With RMS under its belt, MCO will immediately see its insurance data and analytics business rise to nearly $500 million in revenue.
The growing complexity and severity of climate change, extreme weather, pandemics, and cyberattacks raise the need for risk preparedness. In unison with MCO’s analytical capabilities, RMS is poised to serve these customers with preventative solutions to bulletproof their operations and take calculated risks, rather than getting hit with them unexpectedly.
Risks are not going anywhere anytime soon. MCO knows this and it has built a strategy around providing the best risk assessment tools in the world as an aspiring global integrated risk assessment firm. A strategic focus on recurring revenues, disciplined cost management and reinvestment in its software and licensing solutions, and intelligent acquisitions of complementary businesses should boost MCO’s position in the risk assessment and management space across many niche industries.
Risk-Managed Capital Allocation
MCO knows all about risks in its core business and applies risk management to its capital allocation strategy as well. Management has set out a clear set of policies for capital allocation that will allow shareholders to sleep soundly at night.
Reinvesting in its core business and conducting bolt-on M&A to complement its portfolio enable MCO to exercise optionality within the risk management realm.
MCO is also dedicated to returning capital to shareholders in the form of share repurchases and dividends, appealing to those seeking some form of cash flow as well as those who want to see a reducing share count over time.
Moody's Allocated Capital ($M) (Q3 2021)
MCO seeks out acquisitions of all shapes and sizes to build its risk assessment and management portfolio. The largest one in the last 10 years was the $3.3 billion acquisition of Bureau van Dijk (“BvD”), a global provider of business intelligence and company information, in 2017.
BvD added a great deal to the RDA segment, helping boost MCO’s customer base by thousands and accelerate revenue growth. MCO made several other acquisitions in commercial real estate, pensions, data and analytics, and KYC solutions to keep the growth train running.
MCO’s capital allocation policies appear to be working effectively. On a net basis, MCO allocates capital in an accretive manner, having grown FCF per diluted share at a mid double-digit CAGR since 2011. Impressively, this is greater than MCO’s low double-digit revenue CAGR over the same period.
FCF per Diluted Share ($) (Q3 2021)
We believe MCO has a strong track record of effective capital allocation practices. Going forward, management is committed to continue allocating shareholder capital prudently and opportunistically, which should bode well for MCO shareholders.
Perhaps the most obvious risk is MIS’s transactional nature of operations. Debt issuances ebb and flow with the broader economy and MIS’s high gearing towards debt issuance volume could upend revenue to a significant extent when the economy falters or unforeseen events trigger corporate and government debt deleveraging.
Monetary and Fiscal Stimulus
An easy and cheap global monetary and fiscal environment is contributing greatly to debt issuances as companies seek to reinvest in their operations, raise money to cover cash flow concerns, and conduct M&A.
A drop-off or tapering of such stimulus efforts along with a corresponding rise in interest rates could tighten financial markets to an extent big enough that could impair MCO’s ability to grow meaningfully.
Moody’s is right in the crosshairs of regulatory scrutiny and has been for some time now.
For one, MCO operates in an effective duopoly that will naturally attract regulatory reviews and lawsuits for monopolistic practices.
Also, MCO was widely blamed for its part in the US subprime crisis of 2008, in which the US Department of Justice (“DOJ”) claimed MCO failed to adhere to its own credit-rating standards and provide public investor transparency. MCO’s 2016 income figures took a large $864 million hit because of the January 2017 settlement reached between the DOJ and Moody’s related to its practices leading up to the 2008 crisis.
Going forward, MCO could take the blame and face gruesome lawsuits whenever credit ratings are perceived to be too optimistic in retrospect in the following months and years after a future financial crisis. We believe regulatory scrutiny will only increase from here.
Acquisition and Integration Risks
MCO already holds a substantial portion of the credit rating industry, rendering it unlikely that it will continue to grab meaningful market share from here. As a result, MCO’s focus is shifting to opportunistic acquisitions.
One significant risk would be if MCO’s main competitors, SPGI and Fitch, acquire attractive targets at offers greater than its bids. Also, MCO tends to purchase targets that are not immediately accretive to earnings, potentially destroying shareholder value if these acquisitions do not work out as planned. For example, RMS was one of the largest acquisitions conducted by MCO this past decade, but revenue synergies are not expected until 2025 and will not be accretive to earnings per share until 2024.
MCO is a monster with a big appetite for growth and a wide moat that will shield it from competition, allowing it to grow in peace. It is effectively a gatekeeper to the global public bond markets, which firms, organizations, and governments are increasingly turning to so they can meet their funding and investment plans.
MA is another beast that most investors do not think of when they hear about Moody’s – its high-retention, recurring revenue business model has been outgrowing the MIS segment for which MCO is better known. MA is essentially MCO’s vehicle for growth – it conducts M&A, reinvests, and tries new things within the risk assessment and management realm to keep customers happy, upsell and raise prices, and introduce new solutions in our ever-changing and complex sphere.
We believe MCO exemplifies the very definition of quality. As such, management rewards long-term shareholders with meaningful value creation and return of capital. Those investors who stick around will likely not regret their investment in MCO.