As I have written previously, all of the ratings agencies have made serious mistakes. No one would debate that. My purpose in this article is not to defend shoddy assumptions that ratings agencies made about the housing market, but to discuss the underlying economics of the industry, which remain largely unchanged.
In addition, I have immense respect for David Einhorn, and I say with no embarrassment that I am even a member of his Facebook fan group. (Note to group creator, please don't kick me out for this article.) I simply think that, on balance, there are compelling reasons to believe that Moody's (MCO) will continue to be a wonderful business franchise.
At the most basic level, ratings agencies have some of the best economics of any business. They exchange opinions for money. While this may initially appear to be a rather facile observation, it leads to a variety of wonderful economic effects.
Ratings agencies have some of the highest profit margins of any business on earth.
Their returns on capital are immense, since they require very little capital.
They are in the best positions of any firm in the debt markets since they are paid a fee for their analysis before any bond holder receives one cent of interest payments.
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The pricing structure of the industry makes it extremely difficult for new entrants.
Margins.
At a very basic level, Moody's has some of the highest profit margins of any business on earth. We can clearly illustrate this by taking cash flow from operations as a proxy for real economic earnings with some simple back of the envelope calculations.
2008; 2007; 2006
Cash Flow from Operations: 534,700; 984,000; 752,500
Total Revenue: 1,755,400; 2,259,000 ; 2,037,100
Cash Flow Margin: 30.46%; 43.56%; 36.94%
“But wait,” you may say. You have read the annual reports, and you recognize that deferred revenue from some of Moody's business in the ongoing monitoring of credit ratings reduces the size of the denominator (revenue), and its inclusion in cash flow increases the size of the numerator (cash flow), making the margins look artificially high in the above calculation.
Granted, the revenue number should be adjusted for deferred revenue, which would reduce the margin numbers a bit. Deferred revenue amounted to approximately $430 million per year. You could still drive a truck through Moody's profit margins. The point stands.
However, unlike many companies which receive cash in advance and in turn have a liability to perform future services, do you really think that Moody's incurs large marginal costs to monitor credit ratings? I would imagine that, at most, salaried analysts stay late at the office. Therefore, cash flow is a very real proxy for what a private owner could take out of the business, and hence, reflect real economic earnings. The capex is very minor. This is one of the most free cash flow generative companies in the world. It does not get much better than exchanging opinions for money.
If you're unconvinced by my arguments for cash flow, the straight GAAP profit margins were:
2005; 2006; 2007; 2008
32.4%; 37.0%; 31.1%; 26.1%
ROA.
Moody's needed very little capital to generate its cash flow.
2008; 2007; 2006
Cash Flow From Operations: 534,700; 984,000; 752,500
Total Assets 1,773,400; 1,714,600; 1,497,700
Cash Flow ROA: 30.15%; 57.39%; 50.24%
Again, the provision for deferred revenue decreases the reported assets a bit, but the point still stands. Immense returns on assets.
Straight GAAP ROAs were:
2005; 2006; 2007; 2008
41.3%; 46.5%; 46%; 27.6%
Going to David Einhorn's comment at the Ira W. Sohn Investment Research Conference, “Ironically, for a firm that evaluates credit, its balance sheet is upside down, with a negative net worth of $900 million.” I think the comment is a bit facile.
Most companies in the financial industry are driven by balance sheets and changes in net worth. Assets are amassed, a spread is made over liabilities, and earnings are a reflection of increases (or decreases) in net worth.
Moody's in a totally different animal. Its business is cash flow driven, not balance sheet driven. Remember, opinions for money. The only thing it shares in common with most financial institutions is that it rates them. It makes no wagers on bonds, it makes no investments in the complex instruments it rates, and it does not risk capital. In reality, the company has a negative net worth because cash flow is so immense. This conclusion would initially seem backward, but it is very easy to prove. In essence, the company decided to use its immense cash flow to buy back stock. Then, it went further, realizing that it could even borrow a bit to buy back stock, since cash flow was so strong. Why couldn't it replace equity with debt? Why does it need a positive net worth to issue opinions? The answer is that Moody's does not need capital to analyze bonds and credit derivatives. Replacing equity with debt was a discretionary decision.
Exactly how strong is Moody's balance sheet? Total liabilities for the latest quarter reported were $2,521.7 million. Of course, there is $427.5 million in deferred revenue in there, along with a grab bag of tax items, etc. Even so, let's leave everything in, just to make the test harder. Even though I think Moody's will do at least $600 million in cash flow from operations in 2009, let's use 2008's $534.7 million to be more conservative. At 2008 cash flow numbers, it would take Moody's 2521.7 / 534.7 or 4.71 years to pay down all of its liabilities.
That is extremely conservative, and it illustrates that the true measure of a debt load is the ability to pay it down with cash flow. A more fine-tuned calculation with reasonable adjustments might show that all debt could be paid down in less than 3-4 years. That would put a Puritan to sleep.
Positioning.
Pretty self-explanatory. Moody's, as a credit rating agency, has the best position of any participant in the debt markets. What would you rather do--buy debt, risk capital, and hope you get paid interest, or get a fee upfront for doing analysis and expressing an opinion? Who would invest in a bond when they could invest in a dominant credit rating agency? It is almost like owning an oil well which never runs out. The disintermediation of the credit markets will only increase and bond issuance will increase over time with the growth of GDP.
The pricing structure inhibits new competitors.
Moody's and S&P charge a tiny fraction of a percent to rate bonds (the fee varies depending on a variety of factors, including the type of security, etc). That means that to achieve any meaningful economic return, a new entrant would have to rate billions and billions dollars worth of debt instruments. Without a large, capable, and experienced staff, a firm will never get the opportunity to do so, which means any new entrant is virtually assured of sustaining large initial losses in an effort to establish a beachhead in the market.
Of course, no new rating agency has yet succeeded in putting a significant dent in market share for Moody's, S&P, and Fitch. It's a chicken and egg problem. If you buy into the thesis that the ratings agencies are irreparably harmed from the subprime meltdown, try hanging a shingle as a rating agency and drumming up business. It is not going to happen. Not only will you not succeed, but the evidence shows that the agencies are just as relevant as ever. Global bond markets shudder at the prospect of S&P or Moody's downgrading sovereign debt. The credit rating agencies are hugely relevant.
But, you may argue, a firm such as BlackRock (BLK), with strong cash flow from asset management, could start a credit rating agency, even if it had to deal with daunting initial losses. Well, Chinese Wall or not, I am not sure that most market participants seeking conflict free analysis will embrace ratings from a firm owned by one of the world's biggest bond investors. That is like playing in a baseball game and simultaneously umpiring it. We have all seen how well that has worked in equity research at investment banks. However, I admire BlackRock. It will be interesting to see what happens. I think it will be very tough for them.
Conflicts of interest? Which kind would we prefer?
The recent debate over whether issuers or investors should pay ratings agencies totally misses the point. Both models create incentives for potential distortions of ratings behavior.
As many have pointed out, when issuers pay, there is a clear incentive to make the initial rating higher than it otherwise might be. No one would debate that.
However, the investor pays model creates incentives for distortions of ratings behavior which could be just as damaging. For instance, in an investor pays model, the initial ratings may be lower. However, the ratings agencies would be incentivized not to downgrade debt. Doing so would create losses for bond investors. These same investors could steer business to ratings agencies which are more amenable to not downgrading debt.
Perhaps even more disturbing, as large institutions such as PIMCO, BlackRock, or Legg Mason would probably be paying among the highest fees in an investor pays model, there could be distortions in debt markets tied to their holdings, which may become statistically less likely to be downgraded. In such a scenario, the strategy of smaller bond investors might be to imitate their portfolios, not because they are evil or dumb, but out of a rational urge to safeguard capital. The dangerous herd instinct of our capital markets would be further intensified and the very bubbles regulators are trying to stop could develop.
Bottom line, each business model incentivizes distortions in behavior. I do not see any serious risk of a government-mandated investor pays model.
In the final analysis, the government will not want increased competition.
Some have pointed to the salutary effect of competition. I would counter that it is precisely the urge to increase market share that has the effect of incentivizing raters to scrape the bottom of the barrel when rating debt. If an issuer has the choice of choosing from dozens of judges of credit worthiness, the issuer will choose the most lenient rating agency, in order to minimize interest payments. Indeed, executives at debt issuers have a fiduciary duty to minimize borrowing costs. It would be akin to choosing your regulator. When given the opportunity, firms choose the most lenient regulator. The government will realize that in regulation (and credit rating is essentially private regulation), more competition does not mean stricter standards—quite the opposite.
To be clear, I believe in free people and free markets. I am not advocating government sponsored monopoly, ever. However, when investing in a regulated industry, we need to coolly evaluate policy responses to social conundrums. In the final analysis, the rational policy response to raise rating standards will not be to increase competition, which would only incentivize lax regulation, as market share would flow to the rating agency with the lowest standards.
Legal risk have recently decreased.
I am not a legal expert, but suffice to say that District Judge Lewis Kaplan's latest ruling hurts the bear case against Moody's.
But hasn't Warren Buffett been selling his Moody's stock?
I am the first to point out that billions of dollars says that he is right and I am wrong. However, I would argue that Moody's downgrade of Berkshire from a triple-A rating must be a massive insult to Buffett. Can you imagine being one of Moody's largest investors, taking a hit on your stock when Moody's rates subprime debt triple-A, then having the same firms which granted subprime debt a triple-A strip away the prized rating which you earned over half a century of noble stewardship and prudence?
Ironically, to prove how conservative they have become, Moody's has gone from being lax on subprime to being (in my opinion) too harsh on Berkshire! In my humble opinion, it is almost as if Moody's used Berkshire as an example (however unwarranted), to prove their bona-fides as tough judges of credit worthiness. At the end of the day, Moody's has probably gone overboard and is overcompensating for past sins. If my view is correct, that would mean that in a very real sense, Berkshire is also a victim. But I'm just a simple boy from Houston. What do I know about these things?
Combine that with wanting a bit more capital around to make acquisitions, the perception of headline risks, a fat profit from an early purchase after the spin-off from Dun & Bradstreet, and concerns about franchise value, and I could see that all of these factors could lead to Buffett's sale.
What's the bottom line?
Moody's is still in business.
They are more conservative than ever. After the searing experience of their mistakes with sub-prime mortgages, they are threatening to downgrade the sovereign debt of profligate nations to prove how tough they've become on issuers.
While the public thinks they are incurring the wrath of regulators for past sins, what would really upset the government is if the United States lost its triple-A rating. In an effort to prove how conservative they have become, the rating agencies have essentially said, “OK, you want us to raise our standards? We will prove how conservative we have become by downgrading sovereign debt, even if you politically threaten us for doing so. Not only have we learned our lessons, but we have gone to the other extreme and we have become Puritanical. To preserve our franchise as the standard of excellence for another 100 years we will make sure that no one will be able to accuse us of being lax ever again.”
It has one serious competitor, McGraw-Hill's (MHP) S&P.
If they have $600 million in cash flow this year, an investor is essentially paying 12.8X cash flow for a duopoly.
Disclosure: Author holds a long position in MCO
