Stuff My Email Says
Man has created a technology of incomprehensible power, a technology at the center of a war between the forces of good and the forces of evil.
When used for good, it can transport thoughts and feelings instantaneously and bridge vast expanses of time and space. When used for evil, it can reduce multi-billion dollar companies to rubble and grown men to tears.
Of course, I am talking about email. Yes, email… so ubiquitous, so commonplace, and oh SO dangerous. Imagine if every word you've ever uttered could be replayed over loudspeakers for all the public to hear. Do you think in those thousands of hours of dialogue, you might regret at least one thing that you said? Do you think one or two of those things, if taken in isolation, might convey the COMPLETE opposite meaning of what was intended at the time?
There is no need to imagine anymore, my friends. This is reality! And it's all thanks to email.
Apparently, no one seems to have informed the analysts at Standard & Poor's (S&P) that their emails were being stored for everyone, including the U.S. Department of Justice (DOJ), to see. The DOJ, under pressure to find some, heck ANY, scapegoat for the financial crisis, has aimed their sights at the credit rating agency, claiming that S&P knowingly attached faulty ratings to structured finance products (also known as "fraud"). And the DOJ's case seems to rest solely on a treasure trove of sardonic emails shared among S&P analysts.
Upon news of the lawsuit, shares of McGraw-Hill Companies Inc. (MHP), the parent company of S&P, sold off dramatically, as did S&P's main competitor, Moody's Corporation (MCO), creating a potential buying opportunity in the space.
Moral of the story: A fool and his email can make you a richer person.
Don't Mess With Uncle Sam
On the fateful day of August 5, 2011, S&P downgraded the credit rating on U.S. Federal government debt from the highly touted AAA to the dreaded AA+. The AA+ rating is like the silver medal of credit ratings… and we all know second place is the first loser.
And, as it turns out, the U.S. government is a very sore loser. Now, some 18 months later, MHP finds itself staring flush down the barrel of a $5 billion lawsuit from the DOJ.
Moral of the story: Don't mess with Uncle Sam… even if he deserves it.
The lawsuit is potentially life threatening. MHP made $676 million in earnings from continuing operations in 2012. Unless the Federal government provides a 10-year monthly payment option, MHP will be providing the Feds with a bankruptcy filing.
As I mentioned, shares of both MHP and MCO sold off on the news.
Both were down more than 25%, reaching lows not seen for 6 months.
"Go for a business that any idiot can run -- because sooner or later, any idiot is probably going to run it" -- Peter Lynch
Well, Mr. Lynch, have I got a business for you. Imagine a business where your customers were forced to use your services and you had essentially only one competitor.
Technically, there are 9 Nationally Recognized Statistical Ratings Organizations (NRSROs). These are companies whose ability to determine probability of default so superior that only their opinions are worthy of being relied upon. But while there are 9 NRSROs, the market is dominated by just two: S&P and MCO.
The agencies rate corporate debt issues, government debt issues, and structured finance products (MBS and CDOs).
I'm not going to analyze the credit rating business in depth because it's just not that difficult to understand. The more issues you rate, the more fees you collect. The higher the notional value on the issues you rate, the more fees you collect. There's essentially no capex, no difficult-to-value assets, no threats from outside innovation… just employees at their desks working diligently (and obviously, writing too many non-work-related emails). As for competitive advantage… well, there's no competitive advantage quite like a government-sponsored oligopoly. Just ask the Canadian banks.
MHP requires some background. Up until 4Q2012, MHP was a conglomerate of McGraw-Hill Financial (MHF, which is essentially S&P), and McGraw-Hill Education (MHE), a world-class book publisher of entertainment and educational texts. Within MHF is the Credit Rating business, which accounts for ~60% of Revenue and ~65% of operating income, and the Index business (surely you've heard of the S&P500), which accounts for the remainder.
Now, MHF and MHE are very different businesses that, in the past decade, have taken very different paths. The financial business was a roller coaster ride of exhilaration, despair, and renaissance. Conversely, the education business was a terminally ill patient, slowly and painfully deteriorating. Wisely, in 4Q2012, MHP agreed to sell the publishing business to private equity, but not before it wreaked havoc on its operating performance over the last 10 years.
Revenues, earnings, and operating cash flow were all essentially flat. Despite the mediocre performance, MHP has still managed to outperform its own market index, the S&P500.
Going forward, MHP will consist solely of its financial business, and should have a much stronger growth profile. For full-year 2012, MHP announced revenue and EPS from continuing operations increased 13% and 32%, respectively. And the company has guided for 7-9% revenue growth and 15% EPS growth in 2013.
The strong growth has resulted in part from increased structured finance deals, which I'm sure are at least partly the result of the resurgent U.S. housing market, and the overall return of a semblance of confidence to the capital markets.
That brings me to Moody's Corp. MCO attached the same AAA ratings to the same crappy MBS and CDOs and profited all the same… and according to the DOJ filing was, in most cases, the market leader in loosening credit standards to secure business. Yet, somehow, MCO has not been named as a defendant in the S&P lawsuit!
Moody's was spun-out of Dun & Bradstreet in 2000, and focuses solely on credit ratings and associated data services. And despite the aforementioned roller coaster of the late 2000s, it has a remarkably strong, consistent operating history.
That kind of revenue and earnings growth over a 15-year period is enviable, and resulted in substantial outperformance versus the S&P.
Note: both MHP and MCO have repurchased so much stock that they have no tangible equity, which renders any discussion of their balance sheets meaningless. This is a strange phenomenon that will absolutely fry your brain when considered in the extreme. It's like trying to divide by infinity or picture 13 dimensions.
Anyway, we clearly have two strong operating companies here with an enviable market position, so could the recent sell-off have created a buying opportunity?
Scaling The Limbs Of The Probability Tree
As I see it, the potential impacts of the DOJ lawsuit are two-fold.
1) An outright loss or settlement leads to a major write-down against earnings, and potentially causes bankruptcy.
2) A loss or settlement leads to regulatory changes that could negatively impact the future growth prospects of the rating agencies going forward.
With respect to the former, we must consider the likelihood that S&P will lose the fraud case outright. Again, I will link to Matt Levine's article on Dealbreaker, which was probably the best article I read detailing the DOJ's (thin) case. Ultimately, it's going to be very difficult for the DOJ to prove that S&P was anything other than just plain stupid. So, some sort of settlement is the most likely outcome.
In either event, there is likely to be some sort of regulatory changes as a result of the litigation. Can we predict how damaging (to MHP and MCO) those changes might be?
First, the U.S. government is generally loathe to enact major regulatory changes that materially change the makeup of an industry. Dodd-Frank may have added more paperwork to the U.S. financial system, but it did not change the industry landscape. The players that existed before the regulation are the same players that exist after the regulation.
And credit ratings, for better or worse, are a bedrock foundation on which the financial system is built. Credit ratings are used by financial institutions to allocate capital, by pension funds to allocate investments, and even by butchers to determine the quality of steak (just kidding). If the Federal government were to waive a magic wand and instantly remove credit ratings from the system, it would be the economic equivalent of pulling the pilots out of an airplane while it was in mid-flight. This is just a bad idea, even if the pilots have questionable judgment.
So the credit rating industry itself is likely here to stay. What about the agencies within the industry, MCO and S&P specifically? Let's discuss some industries where sweeping regulatory changes have occurred in the past.
Again, not a single large U.S. bank was put out of business by Dodd-Frank, or Basel III, or any other regulations.
Accounting went through significant changes with Sarbanes-Oxley (SOX) in 2002. SOX was brought about by a plethora of accounting scandals in the late 1990s and early 2000s. Most notably, Arthur Andersen (AA) was convicted of obstruction of justice in 2002 for shredding evidence related to the Enron incident. This conviction forced AA out of the audit business.
BUT did you know that in 2005, the Supreme Court actually overturned the conviction! At the time, AA was the auditor in ALL THREE of the largest accounting scandals in history (Waste Management, Enron, and Worldcom, causing some $260 billion in investor losses). And it was caught red-handed with a warehouse FULL of shredded evidence. And it still wasn't guilty of anything!
And while it was the worst perpetrator, AA certainly wasn't the only accounting firm greasing the books. Yes, AA was forced out of the audit business… but the audit business remained. It became more rigorous, perhaps a bit more onerous, but the last I checked, the remaining major accounting firms were doing just fine.
There is some precedent for the U.S. government increasing competition in oligopolistic industries. It did so when it broke up the AT&T monopoly in 1984. It did so again in the telecom industry with the Telecommunications Act of 1996, which forced incumbent carriers to share their networks with competitors. But while smaller competitors entered the market, it is the major telcos that thrived.
Moral of the story: The U.S. government's bark is much worse than its bite... we shouldn't expect anything to radical to come from the proceedings.
Look Inside My Crystal Ball
With all that in mind, I believe the potential outcomes of the DOJ/S&P lawsuit are as follows:
1) A small settlement and some regulatory changes, but mostly window dressing, and the industry continues on as though nothing happened.
2) A larger settlement and some stricter regulations, which hamstrings growth, but ultimately does not change the favorable nature of the industry for the agencies.
3) A still-larger settlement, which the DOJ then uses as ammunition against MCO in a future lawsuit, and significant regulations are introduced that dramatically increase competition and/or reduce reliance on rating agencies altogether.
4) MCO and S&P are shut down.
For What It's Worth
Now, down to my favorite part: the valuation. I assumed various growth rates and write-downs against earnings based on the 4 scenarios outlined above, and I assigned probability weightings to each one of those scenarios.
I've assumed MHP has higher growth in all stages in all scenarios because of MHP's index business, which will not be impacted by the lawsuit in all but the most extreme circumstances. Note Stage 1 is 5 years, and Stage 2 is 10 years.
As you can see, both businesses appear to be substantially undervalued.
I think these are very conservative valuations given the following:
1) Even at 2.5% and 5%, the likelihood that these companies are terminated is probably greatly exaggerated.
2) There is no scenario considered in which S&P incurs no loss from the lawsuit
3) The 5- and 10-year projected growth rates are conservative given historical performance and earnings guidance for 2013.
There have been plenty of theories as to why S&P was singled out by the DOJ: perhaps MCO didn't have the same thick stack of self-implicating emails, perhaps it is simply more cost effective to pick off one agency and use that win to bring the others in-line, and perhaps it is simply revenge. The truth is probably some mix of all three.
Whatever the reason, MCO is not being sued, and there is no indication at this stage that it will be, making MCO an inherently less risky proposition. And that is a big reason why it has a cheaper valuation in my model.
With that said, MHP (even post-sale of MHE) is a more diversified business than MCO. If the ratings agency was gone tomorrow, MHP would still own a world-class franchise in the S&P500 and its relatives utilized everyday all over the globe.
Moral of the story: Buy the ratings agencies.