Moody's Corporation Q3 2008 Earnings Call Transcript

| About: Moody's Corporation (MCO)

Moody's Corporation (NYSE:MCO)

Q3 2008 Earnings Call

October 29, 2008 11:30 am ET

Executives

Lisa Westlake – Vice President, Investor Relations

Raymond W. McDaniel – Chairman and Chief Executive Officer, Moody’s Corporation

Linda S. Huber – Chief Financial Officer, Moody’s Corporation

Michael Madelain – Chief Operating Officer, Moody’s Investors Service

Analysts

Michael Meltz – JP Morgan

Craig Huber – Barclays Capital

Peter Appert – Goldman Sachs

Catriona Fallon – Citigroup Investment Research

John Neff – William Blair & Co.

Charles Murphy – Morgan Stanley

Edward Atorino – The Benchmark Company

Operator

Welcome ladies and gentlemen to the Moody's Corporation third quarter 2008 earnings conference call. (Operator Instructions) I will now turn the conference over to Lisa Westlake, Vice President of Investor Relations.

Lisa Westlake

Good morning everyone. Thanks for joining us on this teleconference to discuss Moody's results for the third quarter of 2008. I am Lisa Westlake, Vice President of Investor Relations. Moody's released its results for the third quarter of 2008 this morning. The earnings release and the presentation to accompany this teleconference are both available on our website at ir.moodys.com. Ray McDaniel, Chairman and Chief Executive Officer of Moody's Corporation will lead this morning's conference call. Also on the call this morning is Linda Huber, Chief Financial Officer of Moody's Corporation.

Before we get started, I call your attention to the cautionary language set out at the end of our earnings release. Certain statements my colleagues and I make today may be forwardlooking within the spirit of the Private Securities Litigation Reform Act of 1995. This act provides the safe harbor for such forwardlooking statements. I direct your attention to the management discussion and analysis section and the risk factors discussed in our annual report on Form 10K for the year ended December 31, 2007, and in other SEC filings made by the company from time to time.

I would also like to point out the safe harbor statement under the Private Securities Litigation Reform act of 1995 contained in our press release issued this morning. These set forth important factors that could cause actual results to differ materially from those contained in any such forwardlooking statements. I should point out that members of the media might be on the call this morning in a listenonly mode. I am now pleased to turn the call over to Ray McDaniel.

Ray McDaniel

I will begin our prepared remarks this morning with a brief summary of Moody's third quarter results. Linda will then take you through the quarter's operating highlights, provide some commentary on revenues and expenses and update you on our share repurchase program and our latest acquisition. I will then review recent developments in the regulatory area and finish with Moody's outlook for 2008. After that, we will be happy to respond to your questions

The disruptions and uncertainty in the financial markets worsened materially in September, undermining credit market activity across all asset classes and spreading into areas that have been relatively active earlier in the year. Moody's results in the third quarter were adversely impacted by the credit market freeze, which drove global nongovernment debt issuance for the month of September down more than 40% from already depressed levels a year ago.

Revenue for the quarter was $433 million, down 17% from a year ago. Strength in public and infrastructure finance and growth from Moody's Analytics was more than offset by extremely limited issuance of structured finance securities and speculative grade bonds and bank loans.

Operating income for the third quarter was $190 million, a decrease of 24% yearoveryear. Excluding the positive impact from foreign currency translation, revenue and operating income decreased 19% and 28%, respectively. Recurring revenue and our ongoing cost management efforts continue to reduce the impact of weak issuance conditions on overall performance.

Diluted earnings per share for the quarter were $0.46, down 10% compared to $0.51 a year ago. Excluding primarily legacy tax matters, diluted EPS for the quarter declined 12% to $0.45.

Turning now to yeartodate performance, revenue for the first nine months of 2008 was approximately $1.4 billion, a decrease of 23% from the first nine months of 2007. Operating income of $623 million was down 32% from the same period a year ago. Excluding the positive impact of foreign currency translation, revenue and operating income declined 25% and 35%, respectively.

Reported yeartodate earnings per share of $1.49 included a benefit relating to the resolution of certain legacy tax matters and adjustments made in 2008 related to the 2007 restructuring. Excluding these items, diluted earnings per share decreased 24% to $1.44 for the first nine months of 2008.

In recent weeks, the financial system has experienced significant additional turmoil as core problems in credit have been amplified by a much wider crisis in confidence and deceleration in macroeconomic activities. A range of global responses have been initiated to contain the damage. While we expect that these efforts will help stabilize markets, timing for recovery remains uncertain and has probably been extended.

Globally, a reduction of debt issuance has resulted from historically wide interest spreads that cause many issuers to delay transactions. Spreads for investment grade industrial debt are approaching levels not seen since the 1930s, while spreads over U.S. Treasuries for speculative grade debt reached a record 1600 basis points in midOctober.

In light of these recent developments, we have revised our guidance down for the full year 2008 earnings per share to a range of $1.71 to $1.77 excluding legacy tax matters, 2007 restructuring adjustments, and the Fermat acquisition. I will further discuss our revised outlook later in the call. At this point, I will turn the call over to Linda to provide more details on our financial results and other updates.

Linda Huber

I will begin with revenue for the third quarter. Moody's U.S. revenue declined 29% yearoveryear to $218 million. Revenue from outside the U.S. was $215 million, about flat with a year ago, and represented 50% of Moody's total revenue for the quarter. Recurring revenue of $268 million was up 8% from the third quarter of 2007 and represented 62% of total revenue for the quarter. For the first nine months of 2008, recurring revenue grew 12% to $807 million, representing 60% of total revenue.

Focusing on details by business segment, I will start will the ratings business. Moody's Investors Service revenue for the quarter was $297 million, a decline of 27% yearoveryear. Excluding the favorable impact of foreign currency translations, revenue was lower by 29%. U.S. ratings revenue was down 38% compared to a 10% decrease in nonU.S. ratings revenue. Revenue from outside the U.S. represented 48% of total ratings revenue.

Global structure finance revenue for the third quarter was $98 million, down 50% yearoveryear. U.S. structured finance revenue decreased 65% due to issuance declines led by residential mortgage-backed securities, commercial real estate finance and derivatives. NonU.S. structured finance revenue was down 25% from the prior year period. Declines in the European credit derivative and commercial real estate and financial sectors better partially offset by growth in assetbacked and residential mortgagebacked securities as banks took advantage of favorable arrangements with the European central bank by securitizing balance sheets.

Global corporate finance revenue of $75 million for the third quarter declined 19% from a year ago. U.S. corporate finance revenue decreased 22% yearoveryear led by a significant decline in bank loan ratings and a decrease in investment grade issuance to levels last seen in 2005. Outside the U.S., corporate finance revenue was down 14%, due primarily to declines in revenue from speculative grade bond and bank loan ratings.

Global financial institutions revenue of $64 million increased 2% from the same quarter of 2007. U.S. financial institutions revenue was down 10%, as revenue declines in the insurance and finance and securities sectors more than offset growth in the banking and managed investment sector. However, outside the U.S., financial institutions revenue grew 12%, primarily due to higher revenue from European bank ratings.

Global revenue for public project and infrastructure finance increased 11% to $60 million. U.S. revenue for these sectors increased 3% from the third quarter of 2007, with solid doubledigit growth in revenue from U.S. municipal ratings. NonU.S. revenue rose 30% driven by increased project and infrastructure finance activity, primarily by European utilities.

Turning now to Moody's Analytics, global revenue of $137 million increased 14% from the third quarter of 2007. Excluding the positive impact of foreign currency translation, revenue grew by 12%. U.S. revenue was up 7% to $65 million, while nonU.S. revenues grew 20% and represented 52% of total revenue.

Within Analytics, global revenue from subscriptions rose 10% to $119 million, while both software and consulting businesses saw strong doubledigit revenue growth driven primarily by software licensing fees and consulting projects for customers outside the U.S.

Turning now to expenses, Moody's third quarter operating expenses were $244 million, 11% lower than the prior year period. We continue to manage the business prudently and maintain rigorous control of nonessential costs. Lower incentive and stockbased compensation expense positively impacted these results.

Nonoperating expense for the quarter included a onetime benefit of approximately $5 million, or be $0.01 per share, relate to resolution of certain legacy tax matters.

Operating margin for the third quarter of 2008 was 43.8%, 390 basis points lower than the third quarter of 2007. Our effective tax rate for the quarter was 38.6%, compared with 43.3% for the prior year period. The decrease was due primarily to a larger portion of consolidated taxable income being generated from outside the U.S., which is taxed at a lower rate than the U.S. statutory rate, and the realization of credits and deductions available for U.S.based manufacturing and research activities.

I would like to turn now to an update on capital allocations and stock buybacks. Moody's remains committed to using its strong cash flow to create value for shareholders by investing in growing areas of our business, reinvesting in ratings quality initiatives, making selected acquisitions in related businesses, repurchasing our own stock, and paying a modest dividend.

Although transaction revenue has declined this year due to lower issuance, Moody's recurring revenue continues to generate significant and stable cash flow. We intend to continue returning capital to shareholders in a manner that is consistent with maintaining sufficient liquidity in this uncertain environment.

During the third quarter of 2008, Moody's repurchased 4.2 million shares at a total cost of $145 million and issued 394,000 shares under employee stockbased compensation plans. For the quarter, we repurchased shares at an average price of $34.25. Share repurchases during the quarter were funded primarily from free cash flow. Outstanding shares as of September 30, 2008, totaled 239.8 million, representing 7% reduction from a year ago.

In the first nine months of the year, Moody's repurchased a total of 13.4 million shares at a total cost of $473 million and issued about 2.1 million shares under employee stockbased compensation plans. Yeartodate we repurchased shares at an average price of $35.22. For this period, share repurchases were funded using a combination of free cash flow and borrowing.

At quarterend, Moody's had $1.4 billion of outstanding debt with approximately $350 million of additional capacity available. Also as of September 30, 2008, Moody's had $1.6 billion of share repurchase authority remaining under its current program.

Before I turn the call back over to Ray, I would like to discuss our most recent acquisition. On October 9, we closed the acquisition of Fermat International, a leading provider of risk and performance management software to the global banking sector. The combination of Moody's credit portfolio management and economic capital tools with Fermat's expertise in risk management software positions Moody's to deliver comprehensive analytical solutions for financial institutions worldwide. We believe this is a particularly attractive opportunity given the current environment of heightened sensitivity to capital risk management and expect this business to generate annual revenues in excess of $70 million by 2010. With that, I will turn it back over to Ray.

Ray McDaniel

Thanks, Linda. I will provide a brief update on regulatory developments at this point. We continue to have active communications with regulatory authorities on both a global and regional level. At the global level, the G7 finance ministers recently stated that they would accelerate the implementation of the Financial Stability Forum recommendations which includes several points on credit rating agencies and the role and use of ratings.

Related to these recommendations, International Organization of Securities Commissions, or IOSCO, has published a revised code of conduct for credit rating agencies. We expect to publish a revised Moody's Code of Professional Conduct in the coming weeks that will address changes in the IOSCO code.

Turning to the U.S., as many of you are aware, last week I participated in a hearing held by the U.S. House of Representatives committee on oversight and government reform. This is one of a series of hearings that has been planned during the months of October and November by both the House and Senate. We anticipate that there will be additional hearings over the next year as U.S. policymakers and regulators seek to restore confidence in the stability and resiliency of the U.S. financial system.

Earlier in October, the President's working group released a progress update on its policy statements on financial market developments. The update summarized policy initiatives taken over the past several months, including the proposed rules for nationally recognized statistical rating organizations published by the Securities and Exchange Commission earlier this summer. It's expected that the SEC will publish its final set of rules by the end of this year.

Turning to Europe, this past summer, the European Commission published a proposal for the oversight of rating agencies in the EU, which drew comments from over 90 market participants, including Moody's. It is expected that the commission will publish a revised proposal by midNovember for review by the European parliament and the council of the European union. Moody's supports the ongoing efforts undertaken by global policymakers and regulators to restore confidence in the credit markets. We will continue to communicate our messages and address issues and concerns that various authorities may have in our mutual goal of greater market stability and the return of investor confidence.

I would like to conclude this morning's prepared remarks by discussing our outlook for the remainder of 2008. Moody's outlook for 2008 is based on assumptions about many macroeconomic and capital market factors, including interest rates, corporate profitability and business investment spending, merger and acquisition activity, consumer spending, residential mortgage borrowing and refinancing activity, securitization levels, capital market issuance, and the impact of governmentsponsored economic stabilization initiatives. There is an important degree of uncertainty surrounding these assumptions; and if actual conditions differ from these assumptions, Moody's results for the year may differ materially from our current outlook.

In light of difficult current conditions in the global debt markets and uncertainty regarding the pace of recovery, we've revised our outlook downward for the full year of 2008. At Moody's overall, we now expect full year 2008 revenue to decline in the low 20s percent range. This decline excludes any revenue relating to the acquisition of Fermat and assumes foreign currency translation in 2008 at current exchange rates.

We are maintaining rigorous focus on expense management and planning conservatively for the business in light of lower revenue expectations. Full year operating expenses are now expected to be about 11% lower on an asreported basis, compared to full year 2007. Excluding the impacts from restructuring in the Fermat acquisition, we now project full year expenses for 2008 to decline about 8% from 2007. And we expect full year 2008 operating margin to be in the low 40s percent range, down from our previous guidance of mid40s percent range due primarily to lower revenue.

Excluding the items previously mentioned, as well as legacy tax matters, earnings per share for 2008 are now projected in the range of $1.71 to $1.77 versus the previous range of $1.90 to $2.00.

For the global Moody's Investors Service business, we now expect revenue for full year 2008 to decline in the low 30s percent range in anticipation of poor market conditions for remainder of the year. For the full year 2008, we now project Moody's Investors Service revenue in the U.S. to decrease in the low 40s percent range and revenue outside the U.S. to decrease in the midteens percent range.

We expect structured finance revenue in the U.S. to decline in the mid60s percent range, reflecting significant percent declines across all asset classes. However, we expect the percent decline outside the U.S. to be about half the U.S. rate.

Corporate finance revenue for the U.S. is expected to decrease in the low 30s percent range, with weakness across all asset classes led by declines in speculative grade bond and bank loan ratings. International corporate finance revenue is also projected to decline, but at a much slower rate.

We now project a low singledigit decline in global financial institutions revenue, with U.S. revenue expected to decrease in the lowto midteens percent range, partially offset by international growth.

We anticipate slight growth within the global public project and infrastructure finance sectors, with U.S. revenue expected to be about flat and low doubledigit percent growth expected outside the U.S.

For Moody's Analytics, we now expect revenue growth in the low doubledigit percent range, as market weakness among financial institutions is leading to longer sales cycles and somewhat higher customer attrition. U.S. revenue is expected to grow in the high singledigit percent range, while nonU.S. growth is still projected in the midteens percent range.

Growth in the subscription business is anticipated at a low doubledigit percent rate. In the software business, we now expect revenue to be about flat with 2007; and in the smaller consulting business, we continue to anticipate strong growth reflecting sustained demand for professional services and credit training projects.

While sales cycles are lengthening due to financial market uncertainty, robust demand continues for Moody's expertise and credit education risk modeling and scorecard development. Of

That concludes our prepared remarks; and joining Linda and me for the questionandanswer session are Michael Madelain, the Chief Operating Officer of Moody's Investors Service, and Mark Almeida, President of Moody's Analytics. We would be pleased to take any questions you may have.

QuestionandAnswer Session

Operator

(Operator Instructions) Your first question is from Michael Meltz with JP Morgan.

Michael Meltz JP Morgan

I just have two questions. Linda, can you give us, you gave a breakdown for recurring revenues, can you give that for each segment? But kind of separate from that, because I kind of backed into the number, Ray, can you talk about what you're seeing in the fourth quarter here. Is there, obviously, there's some issuance, but what are you seeing and how does it differ from what you saw in Q3?

Ray McDaniel

I will start. What we're seeing so far in Q4 reflects what we were seeing in the latter part of Q3. The earlier part of the third quarter issuance activity was certainly, I couldn't characterize it as strong, but there were areas that had been active through the year and remained active for the first couple of months of the third quarter, including investment grade bond issuance in the U.S. and in Europe. That has slowed and the areas that have been slow continue to be slow.

We are at a very low point in terms of bond issuance both in the U.S. and we've seen a slowdown in issuance activity in Europe as well. October looks a lot more like the latter half of September than it does like the earlier part of the third quarter.

Linda Huber

On your question on transactions revenues and then relationship revenues, for the corporation as a whole, we are at 38% transaction revenues for the third quarter and 62% relationship revenues. Let me break down the rating agency for you and then I will add analytics to it. For structured finance transactions, revenues are 54% of structured finance revenues and relationship revenues are 46%. For corporate finance, it's 53% transactions, 47% relationship. For [FIG], it's 37% transaction and 63% relationship. [BPIF] is 61% and 39%. For the rating agency as a whole, right now we're running 51% transaction and 49% relationship.

Moody's Analytics of course is much more relationshipbased. It's 9% transaction revenue for the quarter and 91% relationship revenues. As I said, that all averages out to 38% transaction revenue and 62% relationship revenue.

Michael Meltz JP Morgan

That's basically what I had backed into. Ray, can you talk about how you're guiding here for the end of the year? It's a wide range for Q4, obviously, given the couple hundred basis points for the full year, turns into a wide range for Q4. But you're still expecting $100 million plus of transaction revenues, right? Is my assumption based on your guidance?

Ray McDaniel

There continues to be some activity in the market. Utilities, some investment grade issuance, the slowdown internationally has not been as significant as the slowdown in the U.S. So we are trying to forecast a very weak issuance environment, but not a nonexistent issuance environment. You are right, we do have a wide range for the point in the year that we're at. The reason for that is the potential downside would have to do with a greater freeze occurring outside the U.S. than we have seen so far. The upside would be if credit spreads come in somewhat, there is a significant amount of potential volume that could enter the market quickly.

Michael Meltz JP Morgan

My final question, I promise, Linda, can you talk a little bit about what you're doing on the cost side? I know the hurdle gets harder in the fourth quarter because you did pull back last year. But guidance implies expense is up yearoveryear in the fourth quarter. Can you talk about that please?

Linda Huber

You are right. Guidance does imply that. We took a heavy ax to cost in the fourth quarter of last year when we were somewhat out of line at the end of the third quarter. So frankly, we took out things that were easier to take out at the end of the fourth quarter last year. So this year, you're right, is going to be a little bit more challenging. We have been very conservative on how we've handled incentive compensation. That's down for the third quarter. We would expect, if conditions continue to be bad in the fourth quarter, it would look similar obviously to the third quarter. We are working on all the other lines of noncomp across the P&L. I think we're doing quite well with that, as you see, perhaps an 11% expense reduction. So we've done quite a good job on expenses. We plan to continue that. On the other hand, ratings quality is paramount. We want to make sure that we continue to be able to get the ratings right. We have got to get this balance right. It's an important topic for us.

Operator

Your next question comes from Craig Huber Barclays Capital.

Craig Huber Barclays Capital

First question on cost. How much yearoveryear did you say for lower incentive and stockbased compensation?

Linda Huber

From last year, I will do a quarter over quarter. First of all, I will do absolute percentages and then we will look at the comparison yearoveryear for the third quarter. Incentive comp is 7% of total compensation for the third quarter. Stock compensation is 11%. Salaries and benefits are the remaining 82%. That brings total comp to 66% of expenses. Last year at this time, the numbers were running incentive comp at 7%, stock comp at 9%, and salaries and benefits at 83%. Comp was at 67% of total expenses. That basically gives you the breakout.

Craig Huber Barclays Capital

In terms of dollars, how much did you save if you have that yearoveryear?

Linda Huber

Year over year.

Craig Huber Barclays Capital

Incentive and stockbased combined please.

Linda Huber

Our incentive comp this year, we're down about 33% yearoveryear in incentive compensation. The numbers go from 17.7 last year to 11.8 this year. Then stock compensation goes from 23.4 to 16.9, which is a 28% savings. Salaries and benefits down 141 to 131, which is a 70% savings.

Craig Huber Barclays Capital

Do you mind updating us on your fulltime equivalent employees at the end of this quarter versus the end of, say, three months ago.

Linda Huber

Sure. We are at 3,582 at the end of the third quarter. That's actually up 10 heads from the end of last year. Let me see, from the end of, that's what I have as the most recent comparison. We do expect to add to that, though, Craig, the addition of Fermat, which is going to be another 275 heads.

Craig Huber Barclays Capital

Speaking of that acquisition, can you just give investors a little more detail on that? The revenues that you are talking about for 2010, but what are the trailing 12month revenues there in EBITDA margins to start with.

Ray McDaniel

We're not at this point disclosing the trailing revenue and margins for that business. We're looking at this on the goingforward basis. And the reason we're pointing out to 2010 is because while we will have good revenue and cash from that business in 2009, we have to work through the accounting of having purchased software business and having that business on a GAAP basis.

Craig Huber Barclays Capital

What should we assume for the D&A for the fourth quarter? Dilution of what, $0.05 to $0.07 in the fourth quarter?

Ray McDaniel

Yes, $0.05 to $0.07 dilution.

Craig Huber Barclays Capital

What is the D&A impact here? Is there anything into the fourth quarter or is it all just lack of profits?

Linda Huber

I don't think we have disclosed that. We're taking a conservative view of converting an IFRSbased business over to a GAAP business. We will have more to say on this in the fourth quarter when we're ready to talk about the final financials for Fermat.

Craig Huber Barclays Capital

My last nitpick, on the interest expense line, can you just talk about the moving pieces there.

Linda Huber

Basically, interest expense is up a little bit. If you want to look at the components of nonoperating expense, the main cost there would be the interest expense on the borrowing. We don't break out the details on that. That's offset, though, by some upside on legacy tax and some gains on foreign exchange. Basically those are the main components of what's going on.

Craig Huber Barclays Capital

That foreign currency exchange, how much of that impact this quarter versus a year ago.

Linda Huber

It's about $2 million to positive and last year we were about less than a million dollars positive.

Operator

Your next question comes from Peter Appert Goldman Sachs.

Peter Appert Goldman Sachs

Ray, based on the tone of the hearings with Mr. Waxman, it feels like the folks in Washington are getting even more riled up about the rating agencies which might imply some more serious legislative action. How do you read that, number one, and number two, how do you place probability on investor pays model becoming the standard in the industry and how would that affect the economic [inaudible] guidance.

Ray McDaniel

I am sure for those listeners who heard the hearing, they would note that there were pointed questions, pointed statements about the ratings industry and the performance credit rating agencies. We expected that there would be, frankly. I expect in hearings that we participate in in 2009, think our participation is probably inevitable. I expect that there will be pointed questions there as well. I think the tenor is going to be for the financial services industry as a whole, is probably going to be skepticism and criticism about how we got to the position we are in. That rhetoric is going to be harsh.

I think what we have to do, though, is separate harsh rhetoric from an effort to find solutions which leads to the second part of your question, which is how likely is an investor pays model. In my opinion, it is unlikely for a number of reasons. First of all, I think there is a growing appreciation, as I have talked about before, that the avoidance of conflicts of interest in this business by moving to an investor pays model is a fiction. The question really is how do we demonstrate that we are managing potential conflicts properly and transparently so the people have confidence in the independence of our work.

The investor pays model has a number of other issues with it, including the willingness and interest of investors to pay, because their interest is in the general existence of ratings as opposed to rating on any particular bond. There's some practical questions as well. I think the real issue around investor pay is philosophically is it somehow better and, as I testified in the House committee hearing, I think one of the bigger mistakes that can come out of a review of this industry is a belief or an assumption that moving to an investor pays model somehow cures the potential for conflict of interest and for people, either at the rating agencies or among oversight authorities, to then take their eye off the ball of properly managing those potential conflicts.

Peter Appert Goldman Sachs

One other unrelated item. You gave us some catalytic advice, potentially your recovery in issuance volume and the investment grade category. What do you think needs to happen to bring life back to the structured finance market?

Ray McDaniel

I think that right now the structured finance market, to the extent that there are securitizations being issued, a significant portion of that are securitizations that allow collateral to be pledged to central authorities for liquidity purposes. I consider that not a real continuation of prior structured finance or resumption of activity. I think it's more a temporary category of issuance.

I think what we need to see are simpler and more similar structures. Simpler is going to help more people understand what the mechanics of a securitization are and more similar is going to allow investors to learn about a category of asset rather than learning about an individual security, which allows them more confidence in buying and more confidence there will be a secondary mortgage trade in because of greater familiarity about the mechanics of those securities.

The absolute critical element, though, and I said this repeatedly, is to have enough information in the hands of investing public about the security structures and the underlying assets so that there is not a blind investment or investment that relies only on the opinion of a rating agency where, in fact, we are not in a position to put confidential information in the market either. I would very much favor a regulatory regime that requires asset information and securities structure information to be clearly transparently communicated to the investing public.

Linda Huber

Just to follow up a little bit. You had also talked about the investment grade and in terms of what we would need to see to see some of these markets move. Our credit trends group has done some work on this. Our view, and others may have different views of course, for the investment grade market, we think that 100 basis point drop in spreads could lead to approximately $40 billion to $45 billion in monthly original origination of investment grade. That would compare to a monthly average of $61 billion during the period of 2005, 2006.

For high yield, we're thinking that a 250 basis point drop in spreads could lead to about $12 million in monthly originations, which is about equal to the 2005 and 2006 average. But wouldn't be sustainable unless spreads came in further. We are thinking that it may take a while to get back to those levels, but that can give you some sort of view as to where the upside might be if and when spreads do come in.

Operator

Your next question comes from Catriona Fallon Citigroup Investment Research.

Catriona Fallon Citigroup Investment Research

Most of my questions have been asked and answered. Could you give us a quick update on any of the lawsuits and if anything has moved forward there?

Ray McDaniel

There's really no new news to report on the litigation front. We are continuing to handle the items that we have already talked about; and if we had any new information, we of course would be communicating that.

Catriona Fallon Citigroup Investment Research

Then I guess I do have two questions. I am surprised the head count is up yearoveryear in that there were discussions that maybe 275 head count reductions over the course of the year. Those have definitely been slow. We've been slow to see those. It seems like that's not actually happening. Yet you still have been able to bring op ex down. I am wondering what are the plans there as far as head count and how have you been able to achieve cost cuts without reducing head count?

Ray McDaniel

First of all, we did make the head count reductions that we said we were going to make. That was part of the restructuring charge that we took and we completed that. There are other areas, though, where we feel it is appropriate to be adding head count. We continue to do so because we are planning for the future of this business outside of the storm that the credit markets are currently in.

We have added people to our Moody's Analytics business. We have added people in the compliance and regulatory area for the rating agency because we do have additional obligations there. We have been adding head count in monitoring and surveillance because of the very active market that we have had in terms of demanding rating actions. Finally, we have made several acquisitions over the last 12 months, including Credit Quotes and Mergent.  Those added to the head count total.

Linda Huber

Just to follow up, we have also added head count internationally. Basically we're moving the heads to support the revenue growth. That's caused up to come out about flat to this point.

Catriona Fallon Citigroup Investment Research

My last question is just on outstanding issuance backlog. I hear numbers of $85 billion in backlog. Is that number growing? It seems that things continue to get pushed out. Does the amount of backlog continue to grow or are some of those ideas just going away?

Ray McDaniel

We hear numbers similar to the kinds of numbers you're quoting. $65 billion to $80 billion have been quoted to us from various market sources. Broadly speaking, I don't think we would expect to see a decline in that pipeline because I think this is largely companies that are either interested or going to need to tap the debt markets and they're waiting for the opportunity to do so. I don't think these are nonessential capital raising opportunities that would constitute the majority of the pipeline right now. Nor do I think it's importantly comprised of structured securities at this point. I think that would be a longerterm rebuilding of pipeline and structured finance.

Operator

Your next question comes from John Neff William Blair & Co.

John Neff William Blair & Co.

I have a few for you. Linda, if I heard you correctly, 49% of MIS revenue is relationshipbased in the third quarter?

Linda Huber

That's right, 49% of MIS revenue in the third quarter is relationshipbased.

John Neff William Blair & Co.

How long is the average runoff of those revenues? And the approximate rate of that runoff.

Linda Huber

Considerably long life on those deals. It's 8 to 10 years, primarily. The rate of runoff for this point, is very modest. We're still dealing with the big revenue years that came on of 2006 and 2007. We're not seeing, it's basically flat what we're looking at for the fourth quarter and going forward into next year.

John Neff William Blair & Co.

That's very helpful. Then, I am not sure what you are assuming in the way of debt issuance in terms of putting that into your fourth quarter guidance. Would it be, I realize it's early, would it be fair to say that fourth quarter earnings and the run rate off of that level, are you thinking that's the potential trough? In other words, can issuance get much lower that what you're anticipating in your fourth quarter guidance?

Ray McDaniel

I guess the answer to that is yes, I would consider it a potential trough; but if you would ask me that in any of the other recent quarters, I might have said the same thing. But consistent with what I did say earlier in the year, a lot is going wrong, but not everything is going wrong. There is still the potential, if everything goes wrong, for us to have another leg down. We are increasing the number of areas of the capital markets that are not functioning very effectively. So there are fewer things left that could dysfunction.  That increases the likelihood that we are at a trough.

John Neff William Blair & Co.

Any change to the longerterm view on operating margins? I think if they include the $0.05 to $0.07 dilution from the Fermat acquisition, I am getting an operating margin in the fourth quarter of sort of the upper 20s? Any change to the longterm view?

Linda Huber

I think you might have hit that a little bit hard for the fourth quarter. We will go down potentially, potentially into the 30s if the weaker side of this forecast prevails for the fourth quarter. I am not sure that we will get all the way into the 20s.

Ray McDaniel

In terms of the longerterm view, if the issuance activity remains as constrained as it is, we will see more growth coming out of the Moody's Analytics side of the business than we will out of the rating agency side of the business. That will have some effect on margin. We will also probably have some additional margin erosion on the rating agency side of the business, again, if this is an extended seizing up of the markets.

On the other hand, if issuance activity begins, we could see a rapid stepup in margin because a lot of the queue of potential debt issuance is associated with companies or municipalities that we already follow as rating analysts and as a firm. This would be incremental issuance activity associated with companies that we already are dedicating significant analytical resources toward.

Linda Huber

Some interesting changes here in the margin view for the third quarters, so you can think about this a little bit. Looking first with last year, the rating agency part of the business was running at 53% margin last year for the third quarter. This year it's running at 47%. But the good news part of the story conversely the Analytics margin for third quarter of 2007 was 24% and that's increased to 30%, which is a pretty healthy increase in the margin for the Analytics business. That's how you get to the blended rate, but we're working hard to improve the margin in the Analytics business. In the ratings business, some additional revenue here would be helpful. But our longerterm goal would be to get back to the close to 50% level. Again, we can't do that until we have some market recovery and some revenue recovery.

John Neff William Blair & Co.

That's helpful. And a quick question for Michael. International revenue so far has held up relatively better than the U.S. Do you expect that to continue?

Michael Madelain

I think Ray addressed that. I think international [inaudible] much stronger support due to better conditions, the benefit of some of the government programs for structured finance, and there's no reason really to see that moving away at this stage. I think Ray alluded to the fact that obviously there’s a risk of seeing that support softening in the last quarter [inaudible].

John Neff William Blair & Co.

The last question here, probably for Linda. I realize that the Fermat acquisition from a revenue contribution standpoint is unclear at this point. Do you have any preliminary sense of the contribution in terms of incremental amortization expense and incremental operating expense in terms of operating G&A?

Linda Huber

We are going to have to table that one until we do fourth quarter, because we are literally going through bringing this thing on now and we have to do to conversion as we discussed. We would rather we have everything nailed down, and we will talk about it next quarter if that's okay.

Operator

Your next question comes from Charles Murphy Morgan Stanley.

Charles Murphy Morgan Stanley

Thanks. I was wondering if you could discuss the outlook or your outlook for the regulatory environment in Europe over the next couple months?

Ray McDaniel

Sure. We will see the European commission proposals I mentioned in our prepared remarks. We expect to see that I think in midNovember. That will begin a period of debate at the European parliament level about what is the appropriate form of registration and oversight of this industry. I would expect to see a registration requirement and European oversight of the industry on a goingforward basis, which would bring Europe more in line with what we now have in the U.S. in terms of oversight to the SEC. What is less predictable is how that oversight mechanism might work in terms of a coordinated European approach or more of a countrybycountry approach.

As you might imagine, we would prefer to see a coordinated approach because it gives us, in effect, one source of oversight and one source that we would have to respond in communicate with. So, to the extent that we are going to be moving into an oversight environment in Europe, it's different than what we have had in the past. We would hope that it would be on coordinated European basis. As far as the details of that oversight, I think we're just going to have to wait until midNovember and see what comes out in the European commission proposal and what the reactions on the continent are to that.

Charles Murphy Morgan Stanley

As a quick follow up, I wanted to ask about relationshipbased revenues in MIS. If we were to take an average deal this year versus last year and consider the relationshipbased revenues, would you say those revenues are higher per deal this year versus last year? And any extent would be helpful.

Ray McDaniel

That's a little bit of a tough question to answer, but I will give you my instinctive answer based on my understanding of the relationship revenues.

I think that we would see an increase in the absolute dollar of relationship revenues from 2007 to 2008. But as a percentage, it's going to be importantly related to the character of who is issuing. Are they large investment grade issuers, which tend to have a greater proportion of recurring revenue associated with them? Or is it more of the speculative grade market which tends to be more transactionbased and the revenues more heavily weighted to that stock? Because we have seen more investment grade activity this year, I would expect that we have a greater proportion of recurring revenue associated with the mix of issuance that we've seen. So both absolute dollars and percentages would be my estimation just without having reviewed that in detail.

Operator

Your next question comes from Edward Atorino The Benchmark Company.

Edward Atorino The Benchmark Company

First of all, Ray, I want to congratulate you on surviving the inquisition. As a taxpayer, I was thoroughly embarrassed by the activity on the commission. Anyway, if I look at the fourth quarter, at the third quarter expense and projected for the fourth quarter, is that the run rate to go into early part of next year?

Ray McDaniel

We're working on putting together our operating budget for 2009. I think the risk of giving you misleading information, if I try to talk about the run rate for 2009, is probably a little too high for me to comment on that. I probably should not comment on your original comments about ...

Edward Atorino The Benchmark Company

Please don't, they might be listening. I got to worry about myself now as I leave the office. I could get kidnapped by the gestapo.

Ray McDaniel

Any other questions?

Edward Atorino The Benchmark Company

No, thank you.

Operator

I will go back to Craig Huber Barclays Capital.

Craig Huber Barclays Capital

I do have a follow-up question. Ray, as you think out in the future here, what asset classes would you expect to come back first when you get a thawing? Or is it too hard to tell?

Ray McDaniel

In the securitization area?

Craig Huber Barclays Capital

Just overall. I ask this question going back to the spring of this year. As you know, investment grade picked up some substantially in April and May of this year, a lot of people thought that was leading to a thawing of the credit market. It turned out to be a head fake, and it's been significantly worse since then.

Ray McDaniel

I would expect to see the return of activity at the investment grade, in the higher end of investment grade first then working down to the lower investment grade and into speculative grade from there. Similarly from more well known names for vanilla bond issues into more complex issues over time. I think just as the seizing up of the credit markets there was a flight to quality to the upper end of the credit spectrum. I think that was the last part of the market to go into the freeze and I think it will be the first part of the market to come out of the freeze.

Craig Huber Barclays Capital

One last thing. In your fourth quarter guidance, the midpoint of your guidance, are you basically assuming the lack of transactions you saw in the month of October that continues in November and December?

Ray McDaniel

We are not expecting a significant pickup in activity, that's accurate.

Operator

That does conclude today's questionandanswer session. Mr. McDaniel, I will turn the conference back over to you for any closing remarks.

Ray McDaniel

Just want to thank everyone for joining us and we look forward to speaking with you after the close of the fourth quarter. Thank you again.

Operator

That does conclude today's conference. Again, thank you for your participation.

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