In the below note, we’ll discuss the reasons why we view Moody’s Corporation (‘Moody’s’), as an exceptional investment opportunity.
Moody’s Corporation is a credit rating, research & risk analysis firm. The company was founded in 1909 by John Moody, the inventor of modern bond credit ratings. It was bought by Dun & Bradstreet in 1962, spun-out in September 2000 and subsequently listed on the NYSE.
Over the 25 years since listing, it has delivered an annualized return of 15% (16% including reinvested dividends). Over the same period, the company achieved a compound annual growth rate of 11% in sales and 14% in free cash flow per share.
Ratings & Analytics
Moody’s stated mission “is to be the leading source of relevant insights on exponential risk.”
Moody’s reports across two main segments:
- Moody’s Investors Service (‘MIS’); and
- Moody’s Analytics (‘MA’).
MIS is the credit rating agency arm of Moody’s Corporation. It generates revenue by charging issuers (borrowers) for assigning credit ratings to specific debt instruments (loans) or entities. The MA business segment then leverages this same information to cross-sell its analytics and risk monitoring products & services to institutional investors & other users.
External estimates suggest that half of the revenue generated within the Analytics segment is connected to the core MIS ratings business.
Revenue is split approximately 50:50 between the two segments. However, MIS delivers over two-thirds of the Group’s operating profit given it enjoys an operating margin almost 30% higher than MA at close to 60%.
Moody’s Investor Services (‘MIS’)
MIS is an independent provider of credit rating opinions & related information.
Credit ratings are an assessment of creditworthiness. They provide a measure of the likelihood that a debt issuer (borrower) will repay their debt obligations.
Credit ratings are crucial for investors as they provide a standardized measure of credit risk. Credit ratings influence borrowing costs & market access for issuers.
The global credit ratings market is highly concentrated with Moody’s, S&P Global (‘S&P’) and Fitch controlling close to 95% of the global market.
Market shares can vary by region, and it is common for bonds to be rated by more than one issuer. In the US, Moody’s and S&P often have over 90% of the market for new bond ratings.
Moody’s and S&P have maintained relatively consistent market shares over time, indicative of a durable competitive advantage. The level of industry disruption has historically been low.
Ratings revenue can be divided into two categories:
- Transaction revenue which relates mostly to initial ratings of a new debt issuance and refinancing.
- Non-transaction / recurring revenue which comes from annual fees for frequent debt issuers and debt monitoring fees.
Approximately 30-40% of MIS sales are recurring in nature, the remainder is transactional.
Strong pricing power in MIS is derived from a durable & dominant market position, alongside a service proposition that delivers significantly more value to the customer than it costs.
According to Morningstar, a rating costs an issuer c.8bps of the debt value but can lower the interest rate by c.30-50bps (annual savings). The value Moody’s provides to a credit issuer is significantly higher than the cost it extracts. This is a win-win for both customer and supplier.
The MIS segment is guided to grow sales at high single to low double digits over the medium-term.
Moody’s Analytics (‘MA’)
Moody’s Analytics generates revenue through subscriptions to its data, software, and research products. Clients include banks, investment firms, insurance companies, and corporations seeking risk management solutions.
MA was established in 2007 and split out as a separate operating segment in 2008. It has achieved a 12% revenue CAGR over the past 17 years, driven two thirds by organic growth and one-third though acquisitions.
MA provides a meaningful base of recurring, high retention, subscription revenue which mitigates against the more volatile cyclicality typically seen within the MIS business segment.
The MA segment is guided to grow high single to low double digits over the medium-term.
Quality
Moody’s benefits from significant network effects:
- The company has been providing credit data & analysis for over a century, iterating & improving its database and knowledge expertise over time.
- The ratings applied by Moody’s are internationally recognised and well-understood. Universal acceptance expands the market on a global scale.
- Credit ratings provide value to both issuers and investors. The more debt that is rated by Moody’s, the more valuable its ratings are to the end users.
“All else equal, the larger the ‘installed base’ of ratings from a given CRA, the greater the value to investors.” – OECD report on CRA competition in 2010.
Switching costs increase customer stickiness. An issuer rarely switches to another agency because of the sunk costs involved in starting a rating process with a new agency.
A multi-decade period of providing independent credit rating opinions raises Moody’s brand and reputational credibility.
Key Risks
The business cyclicality derives predominantly from the fact that there are periods of low volume issuance. A tougher economic environment in the form of higher interest rates & wider credit spreads can lead to a decline in companies issuing debt which can weigh the on the ratings business, as seen in 2008/09 and more recently in 2022.
Although debt issuance is volatile during the short-term, over the longer-term and through a cycle, it correlates well with economic activity and global nominal GDP growth.
The threat of increased regulation represents a key risk factor which could lead to pricing pressure from increased competition and/or alternative risk assessment products entering the market.
Competition stems predominantly from S&P Global and Fitch, the other two major rating agencies. There are other smaller players but together they make up for approximately 5% of global rated debt issuance. Critically, the industry dynamics have remained relatively stable for decades and, as noted previously, in many cases issuers acquire ratings from more than just the one agency.
Brand or reputational damage could inhibit the long-term earnings power of the business model. A failure to appropriately assess credit risk, especially in the event of widespread defaults could permanently damage the brand and the lead issuer and user to place less reliance on Moody’s products and services in the future.
The Great Financial Crisis of 2008/09 was the ultimate test for Moody’s. Moody’s reputation took a blow due to the widespread perception that it failed to accurately assess risk. Lehman Brothers was rated ‘A’ by all three major rating agencies prior to its bankruptcy.
Despite the damage, the Moody’s brand and business model proved resilient. It retained its dominant market position (alongside S&P and Fitch) due to the lack of viable alternatives and the entrenched role of ratings in global finance. By 2010, Moody’s financial performance had largely recovered, with revenues rebounding as markets stabilized.
Fundamentals
Over the past seven-years, Moody’s has achieved a compound annual growth rate of 18% in Group Sales and 27% in Diluted EPS.
Group operating margins will fluctuate depending on the level of bond issuance given that MIS has a higher operating margin. Prior to the 2022 rate hiking cycle, the company achieved 50% operating margins, versus 41% in 2010.
Moody’s management guides to high single to low double digit revenue growth in the medium term and targets an adjusted operating margin in the low 50%.
The subscription nature of Moody’s, particularly in MA, combined with its asset-light business model helps drive strong FCF conversion, enabling the company to return capital to shareholders, invest through the cycle, and execute M&A.
Moody’s targets a dividend payout ratio of 25-30%, and it has delivered a 27% CAGR on dividends over the past 7 years, in line with EPS growth. Moody’s share repurchases have meaningfully benefited earnings per share. In 2023, Moody’s had average diluted shares of 183m, down 23% from 237m in 2010.
Ownership & Management
This is not an owner-operator business, however, senior management have been working within the business for a long period of time. Internal hires are preferred over external hires.
Robert Fauber was appointed as CEO in January 2021. He previously served as COO and President of MIS and has been with the company since September 2005.
Senior management’s compensation is predominantly performance related with the CEO’s base salary representing only 7% of total compensation. 93% of remuneration is geared toward company & equity performance. The interests of shareholders and senior management are closely aligned. Moody’s equity is backed by a number of highly reputable & successful fund managers all of whom focus on finding the highest quality businesses with sustainable competitive advantages. Warren Buffett’s Berkshire Hathaway, Chris Hohn’s TCI Fund.
Moody’s equity is backed by a number of highly reputable & successful fund managers all of whom focus on finding the highest quality businesses with sustainable competitive advantages. Warren Buffett’s Berkshire Hathaway, Chris Hohn’s TCI Fund,
Akre Capital and AKO Capital all hold positions in Moody’s[1].
Conclusion
Positioned as a toll collector on the flow of global debt, Moody’s is a high-quality business with a strong & durable competitive position, significant pricing power and a high level of capital efficiency.
In the near-to-medium-term management has relatively good line of sight on the upcoming level of debt maturities given the concentrated nature of the market. The presence of significant debt maturity walls in the coming years points to continued demand for refinancing. Long-term growth is underpinned by the global expansion of debt capital.
Despite cyclical business risks tied to market sentiment and bond issuance volumes, the long-term drivers for Moody’s are strong. As with many high-quality businesses, the opportunity to invest in the equity at a reasonable price is rare. The most attractive opportunities will most often appear when sentiment is at its lowest and expected performance is temporarily weakened.
[1]Based on 13F Filings at the time of writing.
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Written by Archie Tulloch, Senior Investment Analyst, Middleton Enterprises
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