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Summary:

Moody's (NYSE:MCO) stock has risen from the high $30s to $68 (as of May 30th) in the past 12 months. And although Moody's is a great company with a good business model, the current valuation is too high, and a short/midterm correction should be expected. Arguments to support this statement are as follows:

  1. The end of the Fed's quantitative easing (QE) may have a negative impact on Moody's earnings.
  2. The rating industry has changed significantly after the financial crisis--there is more competition, more regulatory requirements, and fewer complex securities to be rated. These changes put pressure on Moody's profit margin.
  3. Moody's stock is overpriced compared to its main competitor McGraw-Hill Financial (NYSE:MHFI).
  4. There is an increasing legal risk that is not built into the current Moody's stock price.
  5. Some large investors (e.g. Buffett, Einhorn) have been actively selling/shorting Moody's stock.

Company Description:

Moody's Corporation is a leading provider of global credit ratings, research, and analysis, with operations in over twenty countries. It provides ratings on over 11,000 corporate issuers, 25,000 public finance issuers, and 100 sovereign nations. Additionally, Moody's rates and currently monitors approximately 94,000 structured finance obligations.

Moody's Corporation was founded by John Moody in 1909, to produce statistics manuals relating to stocks and bonds. In 1975, Moody's was identified by the U.S. Securities and Exchange Commission (SEC) as a Nationally Recognized Statistical Rating Organization (NRSRO). From the mid-1990s until early 2003, the "big three" rating agencies (Moody's, S&P, and Fitch) were the only NRSROs in the U.S.--today, there are ten agencies carrying this distinction. Following several decades of ownership by Dun & Bradstreet, Moody's was spun off as a separate publicly traded company in 2000.

Moody's is composed of two lines of business: Moody's Investors Service--with 68% of TTM revenue as of 1Q 2013--which includes the rating agency business; and Moody's Analytics--with 32% of TTM revenue--which comprises its non-rating activities.

Moody's competes mainly with the S&P and Fitch Ratings, as well as several diversified companies, including Bloomberg, Thomson Reuters, RiskMetrics, Dun & Bradstreet, Markit Group, Interactive Data Corporation, CME, Intex, and many smaller providers. Approximately 54% of Moody's 2012 revenue was derived from the U.S., with the remaining 46% derived from international markets.

As of March 31st, 2013, Moody's had $1.5 billion in outstanding debt, and $1 billion in additional undrawn credit facility. Its cash and cash equivalents were $1.758 billion at 1Q 2013, with 48% of that cash maintained inside the U.S. The following charts show Moody's revenue decomposition.

Figure 1. (click to enlarge)

Figure 2. (click to enlarge)

Financials:

Table 1 lists several financials among the "big three" rating agencies (Source: Bloomberg Terminal). Comparing Moody's and the S&P, Moody's has higher leverage, a higher growth rate, and a higher P/E ratio.

Table 1.

Name

Moody's

S&P (McGraw-Hill Financial)

Fitch (Fimalac)

Market Cap, ($mm)

14,370.77

15,477.42

1,486.61

Common Stock Price ($)

64.27

55.12

51.71

Revenue Growth (yoy) (%)

19.71

12.54

27.31

EPS Growth (yoy) (%)

22.62

19.70

48.99

P/E

19.55

14.96

19.31

ROE LF (%)

261.17

76.68

39.70

Dividend Yield (%)

1.06

2.01

NA

EV/EBITDAe

9.70

8.10

NA

Debt/Equity

356.41

76.12

NA

Debt/Cap

78.09

43.22

NA

Debt/EBITDA

1.37

NA

NA

Table 2 shows the earnings history for Moody's since 2003 (Source: Bloomberg Terminal). It appears that Moody's earnings ebbed in 2008 and 2009, but regained their pace after 2010. Thanks to an aggressive share buyback plan, the current EPS surpassed pre-crisis levels, and Moody's EPS guidance range for FY 2013 is $3.49-$3.59.

Table 2.

Field

FY 2012 A

FY 2011 A

FY 2010 A

FY 2009 A

FY 2008 A

FY 2007 A

FY 2006 A

FY 2005 A

FY 2004 A

FY 2003 A

Total Revenues

2,730

2,281

2,032

1,797

1,755

2,259

2,037

1,732

1,438

1,247

Operating Income

1,090

888

773

705

746

1,181

1,099

940

786

663

Net Income to Common

690

571

508

402

458

702

754

561

425

364

Basic EPS, GAAP

3.09

2.52

2.16

1.70

1.89

2.63

2.65

1.88

1.43

1.22

Diluted EPS, GAAP

3.05

2.49

2.15

1.69

1.87

2.58

2.58

1.84

1.40

1.20

Basic Weighted Avg Shares

223

226

235

236

242

266

284

298

297

298

Diluted Weighted Avg Shares

227

229

237

238

245

272

292

306

305

305

Investment Thesis:

Moody's stock price has increased over 90% in the last twelve months, and is now at $68, approximately 9% lower than the historical high of $74.8, which occurred in February 2007. The following statements support the previous price movements:

  1. The Fed's easy monetary policy has stimulated the overall stock market--both the S&P and DJX indexes are at historical highs.
  2. The Fed's low-interest monetary policy has encouraged more debt issuance, bringing more rating business, and supporting Moody's revenue growth.
  3. The structured finance market has recovered significantly over the past year.
  4. Moody's has been aggressively returning capital to shareholders during the past year.

I would like to argue, however, that although Moody's has a great business model and shows great earnings power, I feel that the current stock price of $68 is too high for the following reasons:

A. The rating agency industry has changed after the financial crisis

The rating industry has inarguably changed since the subprime financial crisis, due to:

  • Fewer complex structures in new issuance: Although the structured finance market has recovered from the financial crisis, its structure has become much simpler. People recognize that complex and highly-levered structured products are too risky and difficult to analyze. Therefore, the traditionally sophisticated structured products (e.g. subprime CDO, SIV) have disappeared and have been replaced by more "vanilla" products (e.g. CLO, ABS). This change puts pressure on rating agencies' profit margin because their fee structure is linked with the complexity of the product they rate. As cited in the Department of Justice (DOJ)'s report, rating agencies can charge up to $750k for each CDO that they rate. But for simpler structure such as regular mortgage pools, they can only charge up to $150k.
  • Ratings are not mandatory for institutional investors any more: In the past, traditional institutional investors (i.e. pension funds and insurance companies) required a public rating for any fixed income security that they could purchase, and banks needed at least two public ratings for each bond on their balance sheet in order to receive favored capital treatment (Basel I). These rating requirements slowly changed over time--especially after the financial crisis--and investors lost much of their confidence in rating agencies due to the poor performance of structured finance ratings. Many investors began to seek alternatives to rating agencies (e.g. in-house risk management teams or independent consultants) to analyze the credit risk of their fixed income portfolio. Furthermore, new regulations require investors to do their due diligence before investing. For example, the new Basel III capital rule does not require a public rating, but instead asks banks to do their due diligence and assign their internal rating without relying on public ratings.
  • More players are introduced into the rating industry: The "big three" rating agencies maintained a 98% market share in the rating industry before the financial crisis, but a lack of competition has caused poor performance ratings. After the financial crisis, regulators helped smaller players enter the industry in order to break apart the "big three's" monopoly, and gain market shares at their expense. And although it takes time to build a reputation and gain credibility in the rating industry, there is more competition now than ever.
  • High regulation requirement means higher costs and a lower margin: After the financial crisis, various regulations were introduced by regulators in the U.S. and around the world. The new regulations forced rating agencies to do more research, provide more reporting, maintain more internal audit and control, etc. These new requirements increase rating agencies' back office headcounts and drove up their capital and costs. And because of the increasing competition, these new costs are difficult to be passed on to the bond issuers.

The aforementioned changes all result in the same conclusion--going forward, the rating business will incur more cost and less margin. Figure 3 shows that the current operating margin (40%) is significantly lower than pre-crisis levels (55%), as well as the historical average (47%) (Source: Bloomberg Terminal).

Figure 3. (click to enlarge)

B. End of QE may impact Moody's earnings

As a rating agency, Moody's business strongly correlates with the fixed income market (Moody's revenue comes from rating the fixed income securities, and provides various analysis for these securities). The current fixed income market is inflated by the Fed's easy monetary policy, which can be viewed from two perspectives: on the one hand, the Fed's policy encourages companies to issue debt; on the other hand, it forces investors to buy high yield securities such as junk bonds and structured products. Once the Fed begins to reverse their QE and increases interest rates, the debt issuance will most likely take a hit, and will impact Moody's earnings in a meaningful way.

C. Moody's is overpriced compared to McGraw-Hill Financial

Moody's and McGraw-Hill Financial are almost always linked when it comes to representing the rating agency industry (The third company, Fitch, is much smaller and not publicly traded in the U.S.). Historically, McGraw-Hill Financial has had a similar P/E and larger market cap than Moody's. But this relationship has changed since the Department of Justice sued S&P for fraud in subprime ratings this past February (see Table 3).

Table 3.

FQ1 2013

FY 2012

FY 2011

FY 2010

FY 2009

MCO Market Cap ($mm)

14,377

11,234

7,490

6,088

6,348

MHFI Market Cap ($mm)

15,612

15,253

12,412

11,214

10,567

MCO P/E

19.55

16.31

13.53

12.34

15.42

MHFI P/E

14.96

19.88

21.52

13.59

14.14

Since the DOJ's lawsuit, Moody's stock price has recovered 43%, while the S&P's stock price has recovered only 24%. The 20% price change difference between the two stocks cannot be justified by the DOJ lawsuit because:

• It is not clear if the DOJ will sue only the S&P and not Moody's. Because the two rating agencies are very similar in their rating business (they even use similar rating methodologies), and because Moody's and the S&P have assigned same rating grades to many of the troubled bonds mentioned in the DOJ's lawsuit, it is easy to wonder if the DOJ will sue S&P alone, without going after the others. And if the DOJ sues only the S&P, they might find it difficult to prove any wrongdoing to the judges.

• If we check the market cap changes from before and after the DOJ lawsuit, the difference between Moody's and the S&P is over $3 billion. This suggests that markets are discounting the S&P's stock price, assuming it will lose $3 billion for the DOJ lawsuit. In their lawsuit, the DOJ is seeking a maximum penalty of $5 billion from the S&P; however, many experts believe that the DOJ has presented a weak case, and that the S&P will win the case or settle for a much smaller amount.

D. There is a legal risk premium that isn't built into Moody's current stock price

As previously mentioned, although Moody's has not yet been sued, it is most likely the DOJ's next target, as well as other states' attorneys general. The legal risk has increased significantly after the financial crisis, and there are already judges stating that they will not dismiss lawsuits against rating agencies on First Amendment grounds. Thus rating agencies have successfully avoided legal action. I expect, however, that rating agencies will continue to face legal risk from central government, states, and investors.

E. My fair value model shows Moody's stock price at $55-$60

Table 4 shows Moody's historical P/E ratio between 2006 and 2012. Based on the previous analysis, Moody's and the entire rating business will face more competition, more regulation, less margin, and more legal risk in the years ahead. I use a $3.5 EPS (the lower end of a company's EPS guidance range), and a P/E of 16.5, to reach a target price of $57.8 for Moody's stock.

Table 4.

Field

Average

FY 2012

FY 2011

FY 2010

FY 2009

FY 2008

FY 2007

FY 2006

Year End P/E

16.23

16.31

13.53

12.34

15.42

11.04

14.28

30.69

Highest P/E

23.54

20.70

19.42

17.57

17.16

18.31

33.26

38.33

Lowest P/E

13.26

13.69

12.39

10.79

8.81

6.25

14.28

26.61

Historically, Moody's P/E averages at 16.2, but peaked at 20+ levels before the financial crisis (see Table 4). However, as previously mentioned, the entire rating industry changed significantly after the financial crisis, and those high P/E levels were not sustainable considering the decreasing margin. On the other hand, the pre-crisis high P/E ratio was partially supported by the inflated structured finance market (at that time structured finance generated over 40% in revenue for Moody's), which has dropped significantly. Although the market has recovered since the last year, it isn't anywhere close to the pre-crisis levels. Figure 4 shows the historical structured finance issuance volume.

Figure 4. (click to enlarge)

F. Several large investors are actively selling Moody's stock recently

The most significant move to date is that Warren Buffett sold about 1.7 million shares in early May, 2013. Since 2009, Buffett has constantly tried to unload his large amount of Moody's shares, decreasing his holdings from 48 to 26.6 million in shares. This only adds support to my argument that Moody's stocks are currently overpriced.

Another prominent investor who has a negative opinion on Moody's is Greenlight Capital's David Einhorn. Einhorn's short position in Moody's is by no means new information, but a recent report said that although Einhorn closed more than a dozen of his short positions due to rising stock market made it more difficult to short companies, he still stuck to his bet against Moody's. This report further strengthens my arguments that Moody's stock is overpriced and has more downside risk than its competitors.

Conclusions:

Moody's Corporation is facing more competition, more regulation, a lower future margin, and uncertainty on future revenue. The current stock price of $68 is too high, and may be subject to a correction of over 20% in the near future. For investors who want to maintain exposure to the rating industry, McGraw-Hill Financial is more reasonably priced and should be viewed as a better investment candidate than Moody's.

Source: Moody's Is A Great Company But Not Worth $68