Salli Schwartz - Global Head, Investor Relations
Ray McDaniel - President & CEO
Mark Zandi - Chief Economist, Moody‘s Economy.com
Michel Madelain - President and COO, Moody's Investors Service
Mike Rowan - Managing Director Global Commercial Group
John Goggins - EVP and General Counsel
Mark Almeida - President, Moody's Analytics
Geoff Fite - Executive Director and COO, Enterprise Risk Management
Rishi Khosla - Chairman & CEO of Copal Partners
Dan Russell - Executive Director, Research
Linda Huber - EVP and CFO, Moody‘s Corporation
Rob Fauber - SVP, Corporate Development
Lisa Westlake - SVP and Chief HR Officer
Moody's Corp. (MCO) Analyst Day Call September 12, 2012 8:00 AM ET
Good morning everyone. If everyone could take their seats, we're going to get started. Thank you very much for joining us at our Moody’s 2012 Investor Day today. I am Salli Schwartz, Global Head of Investor Relations for Moody’s Corporation. Before we start this morning’s program, I would like to spend just a minute thanking my team, the volunteers and event staff and of course Moody’s management team who have all helped plan and orchestrate today’s event.
Here we've listed our agenda for the day. I won’t go through the various presentations. I am sure you are all familiar with what we are going to do. But I'd like to note that in addition to what is listed here we've two scheduled breaks. The first after Mark Zandi's macroeconomic overview and a second after John Goggins' legal update.
Moody Analytics product demos will be available during the second break and again at the conclusion of the event and after Ray’s closing remarks we will serve a light lunch. We'll be in this room through Mark Zandi's presentation and then move next door just over here to room C and D. All refreshment breaks and product demos will take place right where we are now in rooms A and B. And we're going to ask that you hold questions until Q&A at the end of each session.
If you need help with anything, there are event staff that have on their name badges little red tags, so please ask them for what you need. There is also an information that is just outside this door into the left there. After today's event we'll be following up via email to ask you to complete a brief survey and we very much appreciate your feedback, so that we can fine tune future investor day events.
Now I've got some detail here, you’ll have a copy of the presentation when we move into the next room. Something more fun here. We've listed our recent financial performance and as you know we did very well last year. We had over 12% revenue growth, 39% operating margin, almost 16% earnings per share growth and an 18% total return which is dividends and share repurchases as a percentage of market cap from 2008 through last year.
Goldman Sachs was kind enough to conduct a screening analysis for us looking at companies in the S&P 500 and measuring how many performed at least as well as we did last year. As you can see here at the top in the green, we start with the S&P 500. We screen for our revenue growth of over 12%. Operating margin over 39%, EPS growth over 16% and total return over 18% and you could see how the numbers diminish. When we get down to the bottom, leaves us only with three companies including Moody’s. So the question is who are the other two, curious, if anyone has any guesses?
No, not last year. Any others?
Apple, good guess. Maybe next year depending on how they do with their new iPhone today, but no. Any last guesses? Well we are actually not going to tell you today, alright not yet tell you now. We will tell you later on today, we will get back to you with the answer and you can think on it over the next couple of hours.
At a higher level, I don’t think I have to tell you that Moody’s is a truly exceptional company, we endeavor to share with you today some of the many opportunities we see in the business and help you understand the ways in which we are pursuing our strategy.
To that end I would like to introduce Ray McDaniel Moody’s CEO who will provide opening remarks for the day. Thank you.
Okay, thank you very much Salli and welcome everyone who has been able to join in person and those who are participating remotely as well. Salli has got me on a fairly strict timeline here, so I going to have to move at some speed in order to get Mark Zandi up here for you, but I do want to prepare -- do want to offer some opening remarks for you.
I also have just returned from China, so a little bit of jet lag into the extent that my words come out randomly, just rearrange them in the right order. Okay, the session overview guidance and our ongoing growth opportunities first, then talking about some capital market considerations that influence our business. I do want to touch for a moment on our long-term strategy and then provide a bit of a spotlight on some key emerging markets which where it expands across both the Moody’s investor service and Moody's analytics businesses before offering some concluding thoughts.
Okay for those of you, who saw our press release this morning. We have updated our full-year 2012 guidance. Revenue and operating expenses are now both expected to grow at approximately 12% to 13%. This is from low double digit previously, just providing some more clarity on our growth expectations. Our operating margin is still expected to be about 39% and we will have forecast an adjusted operating margin which is a new metric that Linda Huber will talk about at approximately 43%.
Our earnings per share guidance is now $2.76 to $2.86 on a GAAP basis and $2.70 to $2.80 on a pro forma basis which eliminates $0.06 in a favorable legacy tax outcome that we have in the third quarter. Share repurchase we now expect to have about 300 million in share repurchase, up from 200 previously and the remaining metrics on this slide are unchanged from our previous guidance.
Looking beyond 2012 to the longer term. I would characterize these as the deep current drivers of Moody’s business. First of all debt issuance driven by global GDP growth and this is looking outside of cyclical leveraging and deleveraging and just taking the assumption that global debt and ratable debt will grow essentially in line with global GDP.
Secondly disintermediation of credit markets and we will talk a little bit more about this throughout the morning, particularly with the stress in the banking sector, disintermediation is alive and well. We have growth in our Moody’s Analytics for instance and that’s driven by further penetration of Moody’s Analytics client base. There are good opportunities there. It is a reasonably fragmented market and also driven by additional regulation that we’re able to provide products and services around.
And finally, pricing initiatives aligned with value and it leads as you can see two expectations that over time and on average, we would be able to achieve double-digit growth for the company as a whole. Looking at some considerations affecting the capital markets and that affect our customer base and necessarily so us.
Europe certainly is a top of mind issue and it is probably going to be for sometime. The uncertainty in Europe has an impact on business confidence on the negative side, but it also has some silver linings for the particular businesses that we operate in including low interest rates. So we have low interest rate environment both in the US and in Europe and the stress in the banking sector again is causing deleveraging and is causing corporations to move in to the [barn] markets that formally would have been exclusively in the banking markets.
And finally, risk models and regulation, there are changes in regulation going on globally and those are acting as a catalyst for ongoing needs for better risk models analytics and advisory services.
Now, all that obviously, the macro influences on our business are important, but we are also not simply a cork bobbing in the ocean. We can navigate these macro conditions, both challenges and opportunities for the benefit of the firm. Our proactive marketing and pricing to maximize the benefit from disintermediation, we also have products and strategies that are unrelated to issuance cycle and ongoing monitoring of our outstanding ratings for example generates fees.
As do our frequent issuer pricing agreements and the subscription base that we have for our research and data products. We also have continuing product development and upgrades and the ability to manage costs. We have flex in our incentive compensation programs, we have controlled over our largest expense line which is personnel and we have offshoring opportunities which again we'll talk a bit more about coming up.
Now, I've talked about that guidance, I've talked about growth and some of the macro conditions that we are dealing with and I want to step back and touch just briefly on Moody’s role in the financial markets and at a high level, the strategic priorities that we've identified to succeed in that role.
Most fundamentally Moody’s helps institutions manage financial risk, especially but not exclusively credit risk. In order do this, accomplish this we have to first measure the risk. We have to evaluate that and then we have to make sure that there is a strong nuanced understanding of what has been measured and evaluated.
The measurements include our core ratings product, EDFs through Moody’s Analytics, our market implied rating service. The valuation includes research from Moody’s investor service Moody’s analytics including our recently purchased Copal Partners acquisition and the software advisory services that go with that and then understanding customer understanding comes from for example our published methodologies, training and certification and analyst outreach.
The point here is that this is not Moody’s investor service on one side, Moody’s analytics on the other. Both operating companies do all of these things. It so happens that Moody’s ratings are hardwired into the global financial system and so that is considered appropriate for regulation, but otherwise what we do is complimentary and consistent across the organization.
Now, at a practical level, our strategic operating priorities in order to allow us to help institutions manage risk. Obviously we want to be the most respected authority serving risk-sensitive markets. To do that we have to defend and enhance our core ratings and research business, ratings accuracy and transparency, our timeliness, outreach and distribution to make sure that the ratings are received and understood.
We also have opportunities to invest in strategic growth areas. This is leveraging our brand, our skills and we want to broadly occupy the institutional credit and financial risk management and information vertical.
These are mutually reinforcing activities. Defending and enhancing our core ratings business provides us the opportunity to invest and grow outside of that business and growth in areas where we can lever our brand and where we can lever our skills and expertise fortifies the moat around the ratings business.
Looking at our use of capital, we do have twin commitments to supporting growth and returning cash to shareholders. We have strong free cash flow we enjoy that luxury. If we were able to invest in rating agencies around the world that would certainly be a very high priority for us.
But there are few acquisition targets of scale that are also actionable in that area, so we have organic investment in the rating agency and we have both organic and acquired investment in Moody’s Analytics. We have a methodical approach to acquisitions, we are careful about those and we will talk in more detail later in the morning about how we measure the acquisitions and how we think about both what are attractive targets and whether we are meeting shareholder expectations with the targets that we do pursue.
And then finally where we do not have other profit opportunities that we think are in shareholders best interest, we intend and do return cash to shareholders via a mix of stock buybacks and dividends. Turning to the emerging markets. Just a reminder, first of all of Moody’s global profile. We are present in 28 countries and we are active in all of the world's financial centers and frankly we are active in some places that really aren’t financial centers as well.
But you can see where we have presence and you can see our global staffing summary here on this slide. Now turning to our presence in key emerging markets. We are pursuing markets such as China and India and Latin America on really a portfolio basis. Moody’s investor service has presence in these markets and Moody’s analytics has presence in these markets.
And in China and India we are also represented through joint ventures, CCXI in China and ICRA in India. We participate in the global crossborder markets that is the key aspect of our ratings business, but also these domestic markets, in particular through the joint ventures we participate in the credit rating business in these domestic markets and then Moody’s Analytics is offering a range of products and services which again, Mark Almeida will talk about in more detail across these markets.
So it's really a portfolio approach, partly in response to what we think will succeed, partly in response to what we’re permitted to do in these markets and you can see the range of activities. You also see at the bottom of the slide, the revenue that we currently generate from these markets and I put this up not only because it's an attractive set of numbers but when you look at that compared to our total global revenue, it really is quite small and the opportunity here is quite large. So we're enthusiastic about the long-term opportunities that come from these key emerging markets.
And then finally, just in conclusion to this introductory set of comments, again Moody’s helps institutions manage risk. We're distinctively well suited for rapidly evolving financial world because we provide both finished products and services as well as platforms, software platforms and data that allow institutions to do it themselves if they wish to. So we are well suited for different attitudes and orientations of different institutions around the world to how they think about measuring, evaluating, understanding risk for sound risk management.
The diversification of products and services does allow profitable participation in economies at multiple stages of development. So we don’t have to wait for mature bond markets that demand our global scale ratings. We can participate profitably in markets that are on that long path to getting to well developed deep and liquid bond market, and this allows Moody’s not only to survive but to prosper. You are going to hear more about that in detail from my colleagues and I thank you very much for joining us today and I am going to turn this over to Mark Zandi now. Thank you.
Thank you Ray thanks for the introduction. I am going to expound for about an hour, not complicating a bit too much. I'll expound for about 10 minutes and then we'll take any questions or comments that you might have. The global economic recovery is just over three years old. It’s struggling, but I expect it to remain in tact. And while there would be a great deal of variability across the global, I do think it should gain traction by this time next year and by mid-part of the decade I think we should see solid growth throughout must of the global economics.
So let me sort of break that down a bit and take a little deeper look at different parts of the world. First Europe, obviously this is the weakest link in the global economy. The European economy is in recession, likely to remain in recession through the end of the year into next. And it’s going to be [slope] for the foreseeable future.
But I do think and it is my working assumption that the Eurozone will remain in tact, that it will continue to look like it does today for the foreseeable future and the reason for this view is that I believe European policymakers are fully committed to the Eurozone and this is most obvious by the recent actions in European Central Bank ECB.
You can see how aggressive they have been in this first graphic that shows the size of their balance sheet go back prior to the recession back in 2007 and 2008. There have been a Euro [1.5 trillion] on balance sheet; it’s now up to Euro 4.5 trillion and rising very quickly.
This amounts about a third of European GDP just for context. The Bank of Japan’s balance sheet is about 30% of Japan’s GDP. The Bank of England’s balance sheet is about 25% of UK GDP and the (inaudible) which of course has been very aggressive and remains aggressive. Its balance sheet is about 15% of US GDP.
So the ECB has been very aggressive. Over the past year cutting rates, cutting reserve requirements, providing very cheap funding to European banks through the LTROs and of course most recently last week, the announcement that they will engage in an open ended bond buying program to maintain very low interest rates.
I think this signals very strongly that the ECB will continue to do what’s necessary to keep the Eurozone together. There is a fair amount of criticism that all the Europeans have been doing is in the sense of kicking the can down the road, not addressing more fundamentally the economic issues that face in erecting the kind of institutions they need to have a more durable fiscal amount through a union. But I will disagree with that assessment I do think with each round of financial market, they are making progress and they are posing fiscal discipline on the troubled sovereigns, requiring the troubled sovereigns to engage in structural economic reform.
The ECB by its actions is beginning the process of debt mutualization de facto and the quid pro quo for the open ended bond buying will be that the troubled sovereigns will have to participate in a more rigorous fiscal process and I think that’s a key step towards developing the institutions Europe needs to have a more reverse fiscal process that will ultimately succeed.
Of course there is a lot of risk here, mostly political. I think the European leadership knows where they want to go and they have a rough road map in mind but to get the [electric] to follow along is obviously going to be tricky. The Germans are really not very about happy about having to [any] up all of this, and of course in Spain and in Greece the economies are close to depression like conditions and very close to bailing.
So I don’t want to be calling (inaudible) about this obviously the risks are very high but the politics will overwhelm the process, but I think there is a strong realization that the cause of not keeping Eurozone together are very, very high and at the end of the day we’ll figure out how to do that. And regardless it’s going to be [slot] for Europe but they will keep it together.
In the emerging world, growth has slowed I think the slowdown in the end is and its most pronounced literally right now, you can kind of get a sense of the slowdown here, this shows real GDP growth from 2011, 2012 and 2013 for four key emerging market economies. You can see the slowdown is occurring between 2011 and 2012.
The Brazilian slowdown occurred between 2010 and 2011. You can’t quite see that but if you go back to 2010 Brazilian growth is closer to [4% or 5%] and you can also see the slide that I do expect growth to stabilize soon and we will see a bit of the improvement as we move into 2013 and 2014.
The slowdown is in part related to the fallout from the European economy. China’s economy is much more depended on Europe than it is on the US and so that’s been a significant weight on growth. To some degree the slowdown in the end is by design. If you think back a year and year and a half ago, these economies were overheating, inflationary pressures were developing, food prices were rising very rapidly and so fiscal monitoring policy turning contractionary and that has succeeded in slowing growth.
And the slowdown is also in part due to policy errors. I think in some of these countries, they panicked a bit because of the slowdown it’s been a little bit more pronounced than they wanted and they’ve responded with polices that have been counterproductive. This is most obvious in countries like India and to a lesser degree Brazil.
But I do think the slowdown is at its worst end. We will see these economies start turning and the reason for this view is that these economies are now working really hard to stimulate growth, monetary policy, it's now much more expansionary, central banks across the [EN] are cutting interest rates.
And we're seeing some additional fiscal stimulus, the Chinese announced stimulus last week that it amounts to about 2% of their GDP. The Koreans last week also announced and these economies are very sensitive to monitoring fiscal stimulus.
I think they will succeed in turning these economies around by early next year and certainly by this time next year. One of the quick point about the [EN]. The [EN] is operating pretty close to capacity. So, even when growth accelerates, we're not going back to the kind of heady growth rates, we're getting back a couple of three years ago because this isn’t enough capacity to do that but we will see better growth.
In the case of United States, obviously the key risk is the fiscal issues. I think the US economy has come a long way since the recession and the financial crisis. We were writing a lot of wrongs in the private sector. Non-financial corporate balance sheets are in excellent shape. Businesses are very profitable, banking system is very strong, highly capitalized, very liquid. Even households have done a marvelous job of reducing debt, debt leverage are about as low as they have been in the data that we have, credit qualities are improving.
But none of that is going to shine through better private sector balance sheets and implications for growth are going to shine through unless we address our fiscal issues, and the fiscal policymakers obviously had some very significant work to do after the election.
They in fact have to solve three problems. One is the fiscal cliff that's the tax increases spending cuts that are coming in 2013. There is no change in legislation. Second is the Treasury debt ceiling that has to be increased again do a little bit of budget arithmetic, are we going to bump up against the budget ceiling early next year.
And finally, policymakers need to establish what might call fiscal sustainability that is the tax revenue increases spending cuts over the next 10years, 15 years there are sufficient to bring future deficits low enough under reasonable economic assumptions that the nation’s debt to GDP ratio stabilizes and actually begins to decline.
That's pretty difficult to do and you can see the implications if they don't do it here. This shows the affect of hit to GDP from discretionary fiscal policy. I am showing you a little bit of history back at 2008, decomposed a lot of different aspects of this discretionary fiscal policy to give you sense of the impact it has on GDP and the line represents to some of the different bars.
And you can see if you go back to 2009 that was the eight [pecks] of the fiscal stimulus to Recovery Act by my estimate, we added about 2.5% of GDP. 2010 stimulus was a small positive, 2011 was the small negative. By 2012 this year, it’s going to be a meaningful drag almost a percent to growth but take a look at 2013 and what happens if we don't get change in policy, the hit to GDP is quite significant in the (inaudible) for economic recession. So we need to address this. And I am here to say I think we will, I am not going to tell you exactly how unless you ask, but I do think the stars are aligned politically that we will get a reasonably graceful agreement by early next year and there is going to be a little bit of pain and suffering, a fair amount of political brink and its going to feel a little soft in the first part of 2013, but I think we are going to navigate through that and by this time next year and certainly as we make our way to 2014, 2015 the stronger private sector balance sheet is going to shine through, our economy is going to perform measurably better and we will have very strong growth.
So on that optimistic note, I am sure none of you brought into the optimism yet I will stop and pass it back to you and so if you have any questions or comments that you would like to make.
If you have a view I don’t know if you do, if you have a view could you share terms of…
I have a view on almost everything, the only I won’t give you view on is the Yankees and Orioles. I avoid that.
The prospect and the implications of increased self sufficiency in terms of energy in the United States natural gas, oil etcetera?
Yeah, that’s a very good question. It’s as you know, there has been significant technological breakthroughs both in terms of shale gas but also in terms of shale oil. In my economic forecast now look, if you look at the numbers, I am taking a very conservative view with regard to this. I am assuming that we get some benefit from shale oil and shale gas, but it’s relatively modest.
So just to give you context, we consume 19 million barrels a day of oil, of that we import 10 million barrels a day, 11 million barrels a day. The rest is imported, and I am assuming as we go forward that we see a little bit more domestic production it goes up to 12 million to 13 million barrels per day and so the import build narrows a bit. Still quite significant but narrows. I think there is a reasonable argument though that I am being too pessimistic that if we are able to get through some of the environmental issues that obviously is very important here and I think if we can, some really good energy [concept] claims someone, our staff, my staff think that if you look down five or 10 years from now, we will be still consuming 19 million barrels a day because we are getting better at using oil particularly in our transportation system, but our imports will be 2 million or 3 million barrels a day.
If that’s the case, that has very significant implications knowing for the economy but also in terms of our political relationships with the rest of the world in ways and could have significant implications to defense spending and everything else. So I think there is a lot of potential, if you are looking for a potential positive surprise I think it may very well come from the energy sector. But I am not, I am being conservative I am not including that yet into baseline forecasting but I think that’s something that we still can be surprised on the outside. Do I answer your question?
You said that you would share your view on what sort of path you thought would be successful in the US in resolving the fiscal cliff issues?
Okay. So my sense is that the election matters to some degree, but broadly speaking, regardless of who wins the election, under most scenarios, with regard to the election results, we're going to address the fiscal cliff and the treasury debt ceiling and fiscal sustainability issues in roughly the same way and we're going to address them largely because both parties, democrats, republicans have significant leverage in this debate.
Both parties have leverage with regards to sequestration, as you know sequestration or the automatic spending cuts that will kick in, we agreed to this as part of treasury debt ceiling we achieved last August, that’s truly over 10 years, $500 billion in defense, $500 billion in non-defense. So both Republicans and Democrats have a real strong incentive to negotiate to that.
The Democrats have a lot of leverage over taxes because by (inaudible) year tax cuts expire at sort of 2013 tax rates are going up on everybody. If there is not a piece of legislation and whichever party looses the presidency, that party will have leverage with regard to the treasury debt ceiling. So for example, last summer when we were debating the treasury debt ceiling, how Republicans use that as leverage and so whichever party is not in control with the presidency, they will be able to use and in no likelihood would use the treasury debt ceiling as leverage.
So in this context, when you have both sides with significant leverage, I think that’s the basis for an agreement and we actually came pretty close back last August when we recently introduced to debt ceiling the first time. Now I don’t think it is going to happen, it’s going to be very difficult for this to happen, well something happened before the elections could be very difficult for this to happen and wind up, but I do think when we get into early next year when an after tax rates rise and after some of the spending cuts begin to take effect this is going to have an impact on the economy and the economic pressure along with the political pressure will be the fodder for an agreement.
And I think the agreement you know sometimes solve our fiscal problems forever but solves them efficiently over the next decade that I think that will be sufficient in terms of investors and in terms of what it means for US economic growth. We have to come back and revisit and we have got a lot of other significant problems to address including our healthcare cost, but I think that's a problem for another day. I will say obviously there is a lot risk around that as well and again I don't want to be too probably bullish about it, but I think the odds are better than even that we’ll get a scenario that's close to what I am describing.
So capital raising activities been at a high level in the context of low rate environment, so what does your forecast say about debt issuance volumes over the next couple of years and can you tie that into rate expectations?
I think the working assumption that Ray used in his slide shows are very reasonable one that we'll get debt issuance growth as consistent with the rate nominal GDP and I'll say I think Ray’s assumption on nominal GDP growth is very conservative. If you look back at the slide it’s 3% to 4% but I think most long term economic projections for global growth are for growth closer to 5%, 4% or 5%.
So I think that’s a very conservative kind of assumption and I do think that I think it is though appropriate to forecast debt issuance consistent with nominal GDP growth because I think regulators globally are now focused on credit growth as a metric with respect to risk taking in the banking and financial system and they are going to calibrate capital ratios liquidity requirements to ensure their credit growth in its aggregate form is going to be consistent with overall GDP growth, and looking at the debt to GDP ratio that’s a key metric in their thinking and so you can kind of sense it when you listen to and talk about cyclically adjusted capital ratios, I mean that’s what they are talking about. So I think this is sort of a number that they are focused on and I think prudent forecasting would assume that that’s the kind of growth rate prudent yeah.
Now obviously in any given year we are going to be a little bit above that, a little bit below that, some of that will depend on economic growth, risk appetite and of course the interest rate environment, but I think it’s fair to say that interest rates don’t work very long time, I think I keep the feds words are exceptionally low for an exceptionally market like they say late 2014 very likely tomorrow they send that out into mid 2015, will they actually rate that longer raised rates, may be not, but only because growth is taking off at that point. But I think the spirit of what they are saying is we should buy into that and I think it’s real that the rate structure is going to remain low for a long time at least over the next couple of three, four years.
Just one final point, when the U.S. economy is operating at full potential, meaning we are growing our potential the unemployment rates at the natural rate 5.5% to 6% the equilibrium 10 year chart of where it should be in theory is somewhere around 4.5% to 5%, so we are going to go at some point, we are going to go from 1.7% where we are today to 4.5% but that’s a long road that we are going to go down, it’s going to take some time to stay on that path.
I’ve been curious to hear your thoughts on the US economy going through this time period when the politicians to deal with the fiscal cliffs and the debt ceiling and heat and certainly with the election do you think you’ll see any downward pressure on the economy in the latter part of this year going into yearly next year given the problems in Washington DC?
Yes, I think it is going to be tricky over the next six to nine months and I think it’s going to get very soft yearly next year, so Q1 is going to be a soft quarter and you know my sense is that policy makers aren’t really going to sign on the dotted line until we come right down in the wire and the wire is the treasury debt ceiling and if we do again as I said earlier if you do a little bit of budget arithmetic, it’s probably not until late February, may be early March when the treasury runs out of accounting techniques to avoid in actual default on a debt or more likely the social security payment or Medicare payment.
So that’s the drop that they; so my guess is policy makers will engage in a fair amount of brinkmanship and back and forth in January and in February, but of course in that period tax rates have gone up so our withholding schedules are going to change and we are going to less in our paycheck and the spending cuts are going to start to bite that takes more time, but they are going to start to hit and so that’s going to weigh on growth and of course confidence is going to start to erode just like it did back last July and August and will lead up to the agreement on treasury debt ceiling in that period.
So Q1 is going to be a tricky quarter, just to give you a number, in our outlook, we have 1% GDP growth in Q1. You would have to push me very hard to say it could be negative in Q1. You know, a small negative, but I do think that that’s well worth the cost, the economic cost if in fact on the other side of that, we get an agreement like I have describe and again I think that’s what we're going to get and it reduces a great deal of uncertainty, fiscal uncertainty and I think it lays the foundation for a much stronger economy as we move in to the latter part of 2013 and particularly into 2014, 2015 when we got a lot of other positive cyclical dynamics that are starting to kick-in.
So that’s a good question too, you know, whether the growth starts to, it's already weakened by the fiscal uncertainty, although, I can’t prove that, the circumstantial evidence and the anecdotal evidence would suggest that hiring rates are very low and investment spending weaker because of the uncertainty created by the fiscal cliff or the fiscal issues. This uncertainty will, I don’t think it will intensify into after the election, you know, in the lame duck, depending on how the election goes, the impact will be more or less significant.
So I don’t want to speculate, but I am speculating more now; suppose Governor Romney wins the election and this isn’t a forecast, I am just saying suppose, then I would think that would buy time for him, because he is not going to be President until the middle of January and so likely the people would and investors would give him more time to kind of figure it out.
If President Obama wins, then the dynamics will be a little bit different and so I think there will be more pressure to do something more quickly and the fiscal uncertainty will intensify more rapidly, so the impact on Q4 will more significant in that kind of area. But of course [I’ve got the iPhone 5], so you know I could bail us all out in Q4, yes I think we've time for one more question.
So in a classic analyst style, a two part question from last person; first you showed the slide that showed the tripling of the European balance sheet from 2007 till today. Is there are mark to market on that balance sheet and how do you and what happens to the European economy when and if that happens, first question. And the second is, if you could just comment on the US housing market, very low interest rates, driving very high refi, when does that is refi cycle slow, does the purchase cycle pick up, is there a smooth hand off or not?
Well, there is likely to be some more credit losses here and particularly on the new bond buying, the OMT is part of that arrangement. ECB is now, soon with other investors unlike their previous bond buying where ECB was kind at the top the hierarchy, they are now on a more level pain field with the rest of bond investors; so I think there is a fair amount of credit risk. But you know this is the Central Bank and I think they will be able to navigate around that reasonably gracefully. But you kind of make a very good point and that is that of course the ECB is Europe, Germans were 27% of the ECB capital base.
So when ECB is expanding its balance sheet and essentially buying debt, they are buying bonds, this is Germany and this is France and this is everyone else committing and buying in. So to a very real degree to dollars and cents, Germany is already committed to this, they have got a lot already invested and it’s rising by the debt and when this OMT kicks in it’s going to be rising very rapidly presumably. So that is in my view increases the odds that they figure out how to keep it all together because the cluster of allowing to come unraveled will be too high largely because they will come out of their high through the ECB’s balance sheet.
In terms of the housing market, U.S. housing market, the refi boom is quite significant obviously in part because of 3.5% fixed mortgage rates to prime borrowers, but the HARP program is doing good business, the administration made some big changes to the HARP plan late last year that have been implemented this summer, timing was pretty good. And so looking at both, HARP is the program for GSE loans, underwater GSE loans and that’s working quite well. There is about 1.4 million HARP refinancings when it’s all said and done, we could something that’s closer to 2.5 million HARP refinancing that will expire at end of next year.
So that significant and very positive development and the purchase market is starting to kick in slowly, but surely we are seeing demand, housing demand pick up, investor demand is very strong because rents have increased and so you are seeing strong demand in stressed markets. So bottomline, I think the housing market is off bottom, it’s going to improve, its not going to be a straight line, we may see a little bit of softness later this year or early next in the context of what’s going on with our fiscal situation and implications for the job market and what that does to confidence and uncertainty.
But my view by this time next year and certainly by 2014 and 2015, the housing market, the commercial real estate are going to be booming and that’s a key reason for my optimism in the mid-part of the decade. The construction cycle which is so key to every economic recovery has been muted in this one for obvious reasons, in fact it’s been a drag; it’s going to start kicking in and that’s when we are going to get the true cyclical boost and we start get GDP growth rates that are not 2% but 4% and that’s going to really create a lot of jobs and bring down an appointment. So I am going to end on a really optimistic note, I think when we are in this room in 2015 and 2016 we are going to all be feeling a lot better about how things are going.
And with that I am going to stop and we are going to reconvene in the other room and we’ll start up in there. Unfortunately, this is little yearly for cocktails, but there is coffee for you as well. Thank you very much.
Good morning everyone. This is much more frugal sitting in the next half, but I hope what we’ll be discussing this morning will be as attractive as the first glimpse we had. I am here this morning with really three messages. The first one is that Moody’s ratings are and will continue to be an important market tool. DMI’s franchise, our market positions, the businesses opportunities we have are solid and in some aspects have actually improved over the last several years and in a number of key markets.
My second message today is that our strategy continues to be focused first on the products and operational performance of MIS. Second, is on addressing and creating additional value for the uses of our ratings and third is to position MIS and the most attractive market, that Ray described this morning.
My third message also to all of you is that we’re managing MIS actively to mitigate both the uncertainties, the risk and the additional costs that are caused by the regulatory environment and a change in the competitive landscape we're facing.
Attending today this morning is Mike Rowan who is here who heads our commercial group and he would be talking about the gross drivers and the opportunities that MIS is facing today. But to keep this up, I would like to first address the question that I am sure is in top of your mind. And it is to what extent ratings that we see today being removed or displaced from regulation are losing relevance in the market place.
And my answer is that it remains, our Moody’s ratings and ratings in general will remain highly relevant to the market place and to fixed income markets. And they will remain relevant also we believe to policy makers and regulators. Now we'll have to recognize that we have to be ready for a world where there would be less use of ratings of regulation, but I want to reiterate today that we doing the regulation and we've said that for a long time as the underpinning our franchise and our future.
We have a standing view on the use of ratings and regulation. And our strategy is geared to really develop and grow this business without the uplift of regulation. Now let me say it again Moody’s is relevant. And I believe this relevance is by dividends, by the full factors that you will see on the slide. The first one is the growth rate we've seen in the rate and the mixed operating revenues we have. We had double digit growth in 2010 and 2011 and we have a high single digit guidance for 2012.
The second is the strong performance we've seen in the ratings related research and data revenues that Moody’s analytics is booking. The third is the strong and improving market position MIS is having and the fourth is really around the improving share and tone and coverage we see in media.
Let’s step back and go to the first slide on rating revenues. Step-by-step we are getting closer to getting back to the revenues we had at a peak in 2007, this was 1.8 billion you see on the left of this slide. And this is despite a significant contraction of issuance we have seen in a number of asset classes, you know you are familiar with those numbers. Issuance in structured finance, financial institutions, even on bank loans, the US have contracted significantly and this is really the result of both the global deleveraging we have seen as well as the dislocation in the structured finance markets.
Today we have a more balanced mix of revenues than we had across asset classes and we have higher yield and the last two years, our growth rate has exceeded the growth rate that our competitors have been seeing and we have posted the strongest operating margin. The second factor I would like to go to related to the revenues generated by Moody’s analytics from the distribution of Moody’s data and research contract.
This is a subset of figure you are showing on this slide and those revenues have been posting a high single-digit growth. Again this is driven by a strong focus of both organization on enhancing the content and our delivery platform as well as focusing on customer service and retention.
The third factor relates to a market position this is a topic that Mike will cover much more extensively in a few minutes, but what I would like to stress is that MIS as we are maintaining its lead in term of coverage in a number of markets and closing the gaps in markets where we are lagging against competition.
In the US and Europe as Mike will discuss later, we have retained very strong positions for fundamental ratings, you see the numbers here. In structured finance you see a drop in share, but the drop in share reflects the collapse of activity we are seeing in this market. The fact that we have a much more limited investor base and also some of the new competitive dynamics.
And Mike again will cover that later. The actual access of issuers and rated remains actually unchanged. It is actually declining in the number of markets, notably in the US and Europe and very often those issuance remain associated with either sovereign guarantee debt or some issues that benefit from a very strong reputation in our local domestic markets.
In Asia the phenomenon is somehow more prevalent and this is really due to the emergence and a very rapid growth in recent past on domestic markets and whereas in the cross border markets, we continue to enter a very strong share. We are taking steps to address these in a number of ways. One through marketing and direct marketing of something that our commercial group is doing very actively, but also we are leveraging our affiliates in the regions and as well as introducing new product and product innovation that are designed to address the coverage of these domestic markets.
I would like to cover a point that I am sure some of you have paid attention to is the fact that we're seeing request and a limited number of request to restore ratings in financial institutions and in some cases also as illustrated by the markets and then in structured finance, we see a rotation of our agencies taking place. Those are in most cases driven by what I would describe as rating shopping and as well as in many cases or many of those cases by the impact of the recent bank downgrades.
Our policy, let me be clear is that we maintain ratings. Whenever we’ve rated that outstanding and we have sufficient information to do so and we think that the value of this is to really continue to bring differentiating perspective to investors. We’ve voted or so in most asset classes. There is one exception we're facing today, which is to cover the markets in Europe where in some instance we have to, we saw the corporation of (inaudible) to actually withdraw our ratings.
Now the fourth factor I'd like to talk about is really the improvement we see in our position in terms of media coverage and share of [voice]. Both the tone and the frequency of the coverage has improved dramatically. We continue to have the leading share of voice as you can see on the left chart here and the drivers of coverage are essentially our opinions and ratings which is what we wanted to be and again those in terms of volume and quality of coverage, we have seen significant improvements.
To sum up, while I do not want to underestimate some of the challenges we're facing and some of the uncertainty that I will discuss later on the regulatory front, the MIS ratings continue as I said and are playing a very important role in market place and we see no reason for that to go away, the disintermediation continued to increase as Ray pointed out this morning. The economies of scale we are providing to the market place and to the participants are significant. And last the demand for a measure of risk that is both accurate but also widely available is easy to understand that is globally comparable remain very strong.
With that I would like to turn it now to my friend who will cover the next topic about the opportunities we have as an organization.
Thanks, Michel. In this section I'll start with the corporate segment. The corporate ratings business is the largest business segment in MIS. And while revenue growth slowed in the second quarter, this business has benefited for the last 3.5 years from historic levels of issuance driven by very low interest rates and ample liquidity as investor demand for corporate bond has been strong.
In fact this trend continued for the past several weeks and we've seen historical levels of issuance in August and the month to date in September. One would naturally question if corporate issuers have satisfied their funding needs and if refinancing has been pulled forward into the current periods. The good way to consider the answer to this question is to look at the US market which is the largest of the global fixed income markets.
Our studies are forward debt maturities which were published at the beginning of each year confirm that issuers have been prefunding their maturities and if you look at the maturities in 2014 and 2015 you can see that they step down in the ground.
But at the same time our annual studies you know show that the forward maturities in 2016 have been pushed out and these maturities reflect both the investment grade and speculative grade corporate bond markets and the leverage loan market and what you are seeing is the pushing out of that leverage loan market in 2016.
Another point to consider is that record levels of issuance in the past three years have been at historically low rates and they represent about one-third of the total stock of outstanding corporate debt in the US which was about 5.2 trillion at the end of 2011.
So there is still an ample amount of debt that needs to be refinanced and addressed in forward periods. It’s also noteworthy to consider that a significant portion of the capital that has been raised has been raised to increase liquidity reserves as corporate treasurers prepare for market disruption and raise excess capital in periods such as this.
We know from Moody’s research that corporates that we rate have accumulated substantial cash balances in excess of 1 trillion which has strengthened their balance sheets and positioned them well for the future. With interest rates likely to remain low next year, this trend will probably continue, interest rates will probably increase when the economy gains firmer footing and at this time it’s reasonable to expect that issuers will raise capital for investment and mergers and acquisitions.
We expect that many banks particularly in Europe will deleverage and shrink their balance sheets. This will reduce their debt funding needs and they will also use central bank funding to supplement some of those needs. As a result it’s likely to expect that issuance trends will continue to decline and overall funding needs will remain below pre crisis levels.
Nonetheless we note that our revenue from financial institutions is not correlated with debt issuance. Although banks are active users of our ratings for debt issuance, our ratings are also used in the interbank market for a number of reasons.
Our value based pricing programs recognize that these institutions are high frequency issuers with alternatives not related to debt and as a result we have greater recurring revenue streams in the segment. In some respects our revenue in the segment is better gauged by the number of institutions that we rate, rather than issuance volumes. We are expecting to see the number of financial institutions that use our ratings decline particularly in markets that are consolidating like Europe.
However we are engaging with new customers in developing markets and these will provide growth in the future. So we anticipate deleveraging in this market will cost some disruption, but not a significant decline in our revenue from financial institutions. For the first half of this year, we have seen good growth in our public infrastructure and project finance segment. The key driver of this has been the resurgence of the US public finance market. The drop off in US public finance issuance in 2011 reflected the full forward of maturities in 2010 as the build America bond program expired and the uncertainty facing many municipalities given the general economic conditions.
This uncertainty caused many municipalities to defer capital spending for infrastructure which is a key driver of issuance in the US public finance market. We have seen activity return to more normalized levels in 2012 and we expect that to continue for the following reasons. Issuance for refunding will likely active as interest rates remain low. Many municipalities still need to invest in infrastructure spending that was deferred in 2010 and will ultimately need to be undertaken.
Given ongoing fiscal pressures at many municipalities we expect that this will occur in moderation and overtime, but the need for roads, schools and other public works is ongoing. Overall we see strong demand for ratings in the US public finance segment with increasing credit risk evidenced by recent municipal defaults. At Moody’s we expect to continue to distinguish ourselves in this area through insightful research and thought provoking analysis that helps investors navigate through these difficult periods.
Global structured finance business has been able to achieve moderate growth in recent periods with activity in the US offsetting weakness in Europe. The US business has positive trends in several segments. US asset based securitization has been very active, particularly in consumer segments such as [auto] receivables and credit card financing.
Investor demand for these asset classes has been strong and issuance is expected to continue. The commercial mortgage backed securities market has demonstrated good growth in issuance in the first half of this year.
We have good coverage of this market and in fact we lead all rating agencies in CMBS. Within the derivative structured credit market, the CLO segment which will collateralize loan obligations or pools of high yield loans has been very active. This is another segment where we have a solid market position.
One area in the US that is still largely dormant is residential mortgage backed securities. We expect this market to return at some point but probably not in the near-term.
In Europe, we're facing some headwinds as the ratings related to ECB funding represent a significant portion of the market. In addition, issuance and investor demand remain very sensitive to credit issues related to sovereigns and banks. Therefore, we expect greater uncertainty in Europe than the US and could see activity decline.
We also expect ongoing regulatory uncertainty and legislative changes continue to hamper growth in the structured finance market. This is occurring in many markets around the globe, most notably in the US and Europe.
We have adapted our processes to meet these new requirements and many issuers have also adapted their processes. Structured finance has always been a highly competitive market. We expect this to continue as new competitors focus on this market segment.
The competition was most evident in the US CNBS market where there are now six rating agencies providing services. We’ve continue to distinguish ourselves based on the quality of our work, analysis and service and we continue to lead in [coverage], we look endure to perpetuate that but don't discount the fact that many others are looking to build expertise in this area.
The other place where we have seen notable developments in the entry of emerging competitors has been in Europe where DBRS has established to position and is making progress in building coverage. Overall, we expect pressure on our current market position in Europe. In this morning’s news release, we revised our outlook for MIS noting that we now expect MIS revenue to increase in the high-single digit percentage range.
Nonetheless, we believe that MIS has the potential to be double digit growth company looking beyond 2012. Opportunities present themselves in a number of areas for example; our outlook incorporates to current market turmoil in Europe. Should the European market rebound, we believe that debt issuance will increase and our business is well positioned to provide the services in those markets.
This intermediation will also support growth as banks deleverage, shrinking their balance sheets and many companies return to the bond market for financing when increase in plus increasing demand for our rating services.
Our current outlook also reflects slow growth around the globe. And as Ray mentioned earlier in his comments Mark Zandi repeated in his outlook.
When global economics recover, demand for ratings will likely increase as debt issuance is used for capital investment and acquisitions. Emerging markets also present opportunities for ratings as their fixed income markets evolve and companies look to global bond markets for financing.
Our current footprint of 26 offices around the globe leaves us well positioned to service these issuers that wish to use the global fixed income market to raise capital. We also provide services directly in many domestic markets and through joint ventures in certain key markets as Ray had mentioned earlier in his comments on China and India.
Finally, the resurgence of the structured finance market particularly the mortgage backed securities market would present significant opportunity to drive double-digit growth at MIS.
The European non-financial corporate market is poised for growth. Many companies had historically used the bank market to a much greater extent than the bond market for funding, but this is changing. The shift from bank loans to bonds has occurred at a modest pace for the past several years.
With 9% compounded annual growth for bonds being greater than the 5% growth rate for loans, but loans still account for more than 80% of the funding for corporates in Europe versus only 50% for corporates in the US. We expect the shift to bond financing will accelerate.
According to (inaudible) European companies raise more money from bonds than loans in the first half of this year. As banks in Europe shrink their balance sheets and look to improve their returns on capital, it is reasonable for corporate treasurers to turn to the bond market to diversify funding sources and strengthened their liquidity.
This trend in disintermediation of the loan market will likely continue and while funding in Europe won’t shift overnight to 50% bonds as in the US, it will move in that direction overtime. Given the activity that we are seeing in Europe in the first half of this year, we have estimated that this intermediation has contributed about 10% to our corporate revenue base in Europe both from our existing customers refinancing loans with bonds and from new customers looking to access the bond market for the first time.
We expect that this will represent about 20% of our corporate business in Europe going forward. We expect that multiples of (inaudible) were exits from the Eurozone by peripheral countries would result in a prolonged period of market disruption. It’s likely that issuers from the effected countries would lose market access during this time.
To provide a perspective on how this might affect MIS’s revenues, we looked at the actual market disruption in 2008, following the collapse of Lehman Brothers and the AIG restructuring. While we have no assurance that the disruption in the Eurozone would have similar effect on our business, it is a reasonable benchmark for your consideration.
During this period, MIS transaction revenue declined for two consecutive quarters and then slowly recovered over an extended period as the economic recession eased and market conditions improved.
Through this period, recurring revenues provided stability and cushion that affected the decline in transaction revenue. We can give no assurance that a future event in Eurozone would have a similar impact on MIS but put this forward as an example of how market disruption has impacted our revenue in the past.
Now turning to the competitive landscape in little more detail as Michel Madelain had mentioned in his comments. The competitive dynamics in the global credit rating agency industry remain largely unchanged. In the global fundamental business which is an aggregation of corporate finance, financial institutions and project and infrastructure financing. You can see that MIS retains leading coverage in the Americas, Europe and Asia. While the dynamics of each of these markets are somewhat different, our focus is consistent.
We provide ratings that are globally comparable and to a rigorous standard. We deliver our service in local markets with a local presence in each region through our footprint of 26 offices around the globe.
In the structured finance market, conditions are different in each region. In the US market, coverage is the same across the major three rating agencies. Emerging competitors such as DBRS, Kroll and Morningstar are gaining a [total] in some market initiatives. DBRS has made the most notable progress in the commodity like ratings such as repackaged mortgage backed securities.
One area that all six rating agencies participate in is the commercial mortgage backed securities market for MIS is the leading agency but new entrants are also gaining opportunity to provide ratings.
In Europe and Asia, the structured finance markets from MIS continues to maintain leading position. With credit stress in Europe, many structured finance transactions are for ECB purposes and with sovereign and bank credit levels changing, it's likely that ECB related ratings remain a factor in the near future.
Since there is no end investor that’s specifically looking for Moody’s investors rating in those instances, new credit rating agencies regain entry in to this market through this type of rating service notwithstanding these developments for confident in our ability to compete, based on the quality of our work, the thoughtfulness of our research and the persuasiveness of the rationale for our ratings.
Now I'll turn back to Michel Madelain for discussing strategic themes.
Thank you, Mike. Let me return to my second theme today and it’s about our strategy which I am sure you’ve seen shaping out through the comments we made earlier but these management group has really format critical (inaudible). The first as I said before is to enhance the value of our product and services in all key markets where we operate.
We are working very closely with Moody’s Analytics to continue to introduce a number of new developments in term of content and in term delivery platform and in term of frequency and quality of analytics. This is aimed at strengthening the performance and the impact of our ratings and research product.
The second priorities to position our assets and resources in growth markets, to best address [policies] we described. We are doing so in a number of markets Asia is a big center of focus for us and we have working our best to do that.
Third priorities to improve our financial performance and this is but through a number of initiative from commercial marketing and pricing initiative or design to improve our financial performance. And finally, also a very important goal for us is to better resilient and compliant operating platform.
As I mentioned to you before the key measure of the success would be our performance metrics in term of credit and research, but also more importantly or as importantly our ability to sustain and develop the growth rate which you see in MIS and Moody’s Analytics ratings and research greater revenues.
And finally another important we mentioned would be our track record was in regulators that have ever sight on our operations. Now to execute this strategy, we continue to invest in MIS both in term of resource and infrastructure and I know this is a question that many of you have on your mind, how much and for how long, our investment are centered on technology and headcount and they are dedicated on a range of initiatives, some to servicing our new customers, creating the technology and infrastructure that we need to comply with the new environment that we will describe in a minute.
We also want to bid the capacity in some of the most rapidly growing regions and we also need to continue to make sure that we adapt our efforts and our sovereign’s effort on the credit changes that set and asset classes are facing in one example I will mention is US Public Finance for example. And last but not least, we also want to continue to dedicate resources to product innovation and new product development.
Now to support this investment, we are as I described before improving our revenue yield both through commercial and pricing initiatives and we are also focusing on a number of initiatives designed to improve our costs structure and bring greater improvements in our efficiency.
We now turn to my next and last theme which is really the increased impact on regulation and our research and rating operations. This pyramid illustrates the sort of the three dimension or the three levels of impact we are facing, the first is in the US and globally through the implementation of the Dodd- Frank Act.
As you know this act has required the commission to adopt a large number of new rules, they are wide ranging, they are centered on internal controls, specific procedures around design to manage the potential conflict of interest, a very important set of disclosure requirements that range from performance to methodologies, assumptions we are using, specific disclosure asset class so very sort of important set of disclosure we will have to put in a marketplace.
And last also we need to develop and introduce a specific program of [analyst] training and testing. As we know also the Act requires federal agencies to review existing regulation and identifies situations that refer to credit ratings and find substitutes to that. The ACC has published comments and proposals earlier this in 2011 and we expect the final rule making is based on the ACC website to really take place by the end of 2012.
Now we are working very actively as we imagine to implement these rules in the US and globally. This work involve the development and roll out of a large number of policies and procedures that are supported by significant amount of technology enabled solution and dedicated staff and as we have disclosed to you previously, we continue to expect that incremental and direct regulatory cost as well as compliance cost to give us $10 million to $50 million in 2012.
Now the second biggest building block in term of our regulatory infrastructure has led to the initiative taking place in Europe with what is called CRA-3. This is a third wave of regulation for rating agencies in Europe. This is a process that was launched in 2011 and is suspected to be close by the end of this year.
The discussions are currently taking place between the European Commission, European Parliament and Members of States and we expect again as I mentioned to you earlier to see a conclusion of this process by the end of the year.
In addition to some of the synergies we've seen through the Dodd-Frank Act and through previous regulations, there are really three topics, key things that are really left on table at the moment. The first relate to the liability regime that will apply to rating agencies. The second is about the limitations that could be imposed on CRI activities either through rotation or other tools such as shorter restrictions and finally there are discussions about specific course that may apply to several ratings outside of certain category of ratings.
Now, there is a large number of other features that are being discussed at the moment. It’s in the parameter of the commission, but those are the three most important for us. As you can imagine, we have significantly engaged directly, you know, at the senior management level, but also through our regulatory effort teams and through it’s process. We're seeing reasonably good process that have been made; when you look at the initial proposals and where we are today, but we have also steered very meaningful concern regarding the outstanding points that need to be resolved. And again as I said before, we expect a decision later this year.
In the interim, we're working very actively to work on various scenarios and that will be required to adjust our operations and depending on the outcome and in doing so, we really try to balance the risk and returns we see with the various options that are being now shaped and this may include exiting some of our activities, restructuring some of our work process, our operations and transferring some of the activities we’re currently ongoing outside of Europe.
So finally on this chart you see, we also have set a very distinct credit, basically regime and features that are really putting in place by various countries, effectively every country now where we operate and those that branch from Canada to Brazil, from Singapore to Japan and in most of these cases the features of this regimes are by again disclosure of governance reporting and while they are not really widely different from some of the themes that are initiated by the Dodd-Frank Act they do add basically effectively operation and administrative requirements on top of what we have to do as a result of both the Dodd-Frank and CRA3.
So in closing my remarks today what I like to reiterate is first that as I said before, our franchise of market operation positions and business opportunities are very solid and we have seen improvements and opportunities emerging in many aspects. Second, we are managing our business to address the changing regulatory environment we are facing and third and probably most importantly I think the state of play we have today it really reinforces the strategy we deploy now for several years which is really to focus on market position, the product performance and creating additional value for the users of our ratings and our research and data product.
And this is really based on one the resilience of our business drivers, but also the stronger current end and superior performance of MIS, so having said that, I can tell you that I am very, very confident in the success of MIS going forward.
That's really concluding. So thank you very much and now Mike and I will be in the position to --thank you very much. So Mike and I -- the next speaker is John Goggins on legal issues. That’s why we lost that. So I think I said that, now I think some of us are here and we will be happy to take your questions. Do you want to be the, but why don’t you were the first, so why don’t you go in.
Two questions; one on issuance and the second one on the liability standard in CRA3; how much impact on U.S. corporate issuance have you seen from European companies accessing the U.S. market; I guess it’s the so called Yankee bond phenomena, how bigger impact does that had and where do you see that going? And then on liability, obviously outcome is uncertain, do you expect that to be if it is adopted be a Pan-European adoption or will be a county-by-country standard and therefore you can kind of move operations around depending on where it’s more or less optimum to operate? Thanks.
May be Mike you want to take the first and I will take the second.
I’ll take the first question, in terms of European issuers accessing U.S. market, it’s a trend and phenomena that has started in the most recent weeks, and I would expect it to continue to the extent particularly that they are established issuers that are understood and risks are known. I think that credits at the margin and you will probably have more difficult access then credits that will be well recognized to established issuers.
At the same time, we have seen a resurgence across the business in European corporate, but again I think it will be fairly credit selective in that broad reaching down into lower ranges with respect to grade market.
Thank you. And the liability question, John do you want to start, do you want to -- okay.
Yes, it is Pan-EU proposal, so the objective is to have this part of rate of action at least the commission’s version apply across the EU so not being in any particular jurisdiction within the EU would be helpful.
And what are the range of outcome (inaudible)
Sure. On that, there has been lot of movement as Michel mentioned from the commissions original proposal and they are busy completing versions and the council of EU has a version that we can do with so and we are optimistic that’s the version also that’s quickly well in the dialogue and the discussion among the three EU bodies that’s now resuming this month and hopefully be resolved by the end of the fourth quarter. And do you want anything else?
Thanks. So I am wondering how confident you are in the 4% pricing benchmark that had been outlined earlier particularly in these asset categories where you are seeing more competition like in CMBS; what’s the level of push back you are getting on pricing both from issuers and what’s the level of competition on pricing you are seeing from some of these newer players in the market that was question one?
And then question two, I was hoping you might speak broadly about the scale of opportunity that you see in the structured finance market over the next couple of years in terms of newer product offerings, how big they potentially could be for you and may be translate that into how big the revenue opportunity and structured finance might be in the next couple of years for you guys? Thanks.
Maybe I'll take a short at the second, I think on the certain finance markets, I think Mike alluded to, there are a number of optionalities including what happens with RMBS and you know how we see things. The situation in Europe is also one which would very much depend on the unfolding of the current crisis and to what extent we see a return to more normalize basically source of funding financial institution and of course again to securitization.
So I think it's what we think today is we have certain asset classes where we have a fairly sort of good level of visibility in terms of what is a sustainable level of activities, but there is a lot of uncertainties as to how some of the other asset class may develop and as we link to macro condition as well as regulatory development that may take place. So we still have to navigate that environment with that in mind, on the pricing would you like to …..
Yeah, just to respond to your question on pricing, generally as you would anticipate, many customers want to talk about pricing; you used the term pushback and the way I think about it is, you know, there is a discussion around pricing and there is a movement of the customers towards the list price and our success rate around achieving our pricing strategy is quite high in fact. I have a very high degree of confidence in achieving the numbers that Ray had put up in his earlier discussion.
I think that if you look at our broad business around the globe, it's a blend and a position is different every market and in every segment. You had asked specifically about structured finance market and in the asset class that you asked the question about CMBS in particular where there are a large number of competitors and we deliver a premium service and a premium position even in that market based on the quality of our brand and execution and our position within CMBS as a thought leader really in analysis. So it’s based on that that we are able to negotiate and achieve less pricing in that particular asset class.
The Dodd-Frank suggestion that the borrowers have reduced their dependence on ratings; what they are going to do and just reduce your liability anyway if the guy that reduce the dependence on ratings so lose a lot of money on bonds?
I will to John on the liability question here.
Sure, on the liability question there was no change in our liability on the Dodd-Frank, is the short answer and we've always favored for over a decade and a half in reducing regulatory reliance on ratings it’s just the decision among the private sector.
No, the Dodd-Frank is – well, first of all we don't encourage investors in general especially retail investors to align our ratings but the emphasis on Dodd-Frank was to eliminate the regulatory reliance on ratings; we are moving references to ratings in the securities more than depending more so. But the bottomline is Dodd-Frank unlike the proposal in Europe I am see they do not change liability standard anyway.
First sort of a light question, does your French nationality help in terms of European political pressures?
I don’t think so.
With the DBRS increasing competitive pressure is that more a matter of adding if the issuer traditionally did see a Moody’s and S&P rating, is that more of a matter of adding DBRS rating or is it a matter using DBRS instead of Moody’s in the European context?
Let me try and please step in Mike, I think what’s happening in Europe is simply that we have a market today that is very commoditized; it’s essentially an ECB based to larger extent marketplace where there is no preference basically there is no investor preference or the real value of the ratings is simply eligibility criteria to the ECB. So basically in term of value proposition in that being recognized a rating agency give you access to that marketplace and that’s really what we see happening here. And I think that’s why the rapid round up we see into market share from DBRS in that market which I think has been largely taken out from other participants more than from Moody’s actually is driven by simply the fact that what would be in a normal functional market the key value proposition is simply not there and therefore you are just competing on effectively largely the ability or the eligibility criteria and the fact that you have a license to participate in that business.
Thanks. A couple of questions just on the nature of the increased competition; can you just establish between you talked about increase or heightened competition, are you talking about the establishment of new rating agencies versus in-roads; I was just wondering if you could comment there because obviously in the US we have 10 or 11 nationally recognized statistical rating organizations that hasn’t made much of a market impact. So just differentiate between the establishments of new competition versus actual in roads from competition? Second, are you talking about issuer repay models primarily or investor pay models in another words are these subscriber type businesses or are they actually getting ratings also on bonds and whose share are they taking?
Do you want to take that?
Yeah sure; yeah, I think if you look at the emerging competitors that are coming in, most of them are following an issuer pace model right, so they are looking to replicate the business model that we have and the places where new entrants look to come into the ratings business are areas where it’s established already that a third or fourth rating agency might be acceptable; instances where there isn’t a differentiation based on the quality of rating.
As Michel made the point before, the DBRS example in Europe is a perfect one, as I said in my comments there is no investor on the other side that’s looking specifically from Moody’s ratings so that’s not a circumstance where our brand and premium position and our historic basis for differentiation plays at; that’s an area where there is a regulatory use of rating and as Michel said a licensed rating agency that can provide that service.
That’s also a commodity driven business and so it’s not a high price point business. The other areas are circumstances where there is a trading used for ratings and there isn’t an actual issue of customer on the other side there is actually a trader looking for an arbitrage transaction. Most instances where emerging competitors are coming in, given that circumstance is structured finance where it has historically been acceptable for multiple rating agencies and there isn’t a customer relationship on the other side that would become sticky the way you would expect to see a relationship with a corporate or a financial institution where the management company makes a considerable investment in the rating relationship overtime and the relationship becomes sticky for that reason and you don’t see the new entrants in that area.
The other place where new entrants are looking to find a way in is public finance and again you know, that’s a three rating agency market with a very large segment of unrated small municipalities where there is an opportunity for other rating agencies to play in, but it's not a circumstance to your point earlier of making inroads in the corporate business or the financial institutions business. It's really those other elements of the business that I just referred to.
In an earlier presentation shown to us, your revenues this year are tracking very similar to what 2007 revenues were, probably as you know better than us here in the room, that your cost were up significantly since 2006-2007 levels as a company partly for regulation, legal but also some small acquisitions, much by your own choice.
As you think for here once all the regulation cost in your numbers, you annualize that ones, CRA has put in for example. That’s the top line gross say 7%-10% for a few years. As you cost haven't necessarily grown that high each of those years as you think about how you budget your business here?
Unidentified Company Representative
We are here in a rapid phase in terms of the cost of regulation and I would expect that once we reach basically or funded effectively the development of the technology and the infrastructure of that, I have been discussing I think that we should have a stabilization of those costs clearly. I think that if you look at where we have invested in terms of accounts and technology. Technology is clearly related to a large extent to regulation but also to solution that are enabling our business to perform better and so you will see here on that part we will continue to see an ongoing investment in the business.
I think we expect also to continue as I mentioned to continue to invest in a new geographies and product development, but those should be supported you know in sync with a revenue projection that you would expect. So to summarize we are in a ramp up phase at the moment, both in term of adjusting our basically infrastructure to this new environment and responding to the need we feel we need to meet in order to support our strategy, but I think at some point we'll we would expect to see a stabilization of that growth basically.
Unidentified Company Representative
I think Linda will talk about the margin later on and I leave that to her, but the message I would give to you is that we are in an investment phase at the moment to respond to the some of the demands on the business that I've discussed and as this demand you know phased out we should go back to just a level of spend in term of IT and the kind of growth basically.
And just two follow up questions, just on the issue of competition in areas where you mentioned that you don’t have a relationship with an issuer and you can have multiple ratings, what percentage of your revenue does that represent and what is your response to that and ultimately what do you think will happen there?
The second question is on the Dodd-Frank reducing the reliance of government agencies on ratings, you mentioned that you expect something at the end of the year to this year understanding that we have no fore signs of what will happen there, what is your most likely outcome and is it possible that you will see government agencies reducing their reliance on ratings and if so what is your response to that?
Unidentified Company Representative
I will take the second may be ask (inaudible) to address the first. On the second point I think in terms of the rule making from the SEC it’s we-- expect it to be very much in line with the proposal that we initially issued and so it’s really for us really a question of implementation of procedures and policy as I described to you. So we don’t expect and John may want to comment on that, but at this stage we don’t expect surprise from these process basically.
In term of the reduction of reliance which is the other aspect of Dodd-Frank I think that’s – it's going to be a long process, but again I think for us it’s very important that we stress the fact that we don’t see that regulatory usage as really the driver of our future and growth and really what we want to do is make sure that we bring in value to market participants and out growth and sustainable position in the marketplace is really driven by that value. Do you want to?
Yeah I will try and take a shot at that. Transaction related revenues that don’t have an issuer or customer on the other side and are a subset of our structured finance business and to some degree some portion of our project finance business. The structured business has a number of different dimensions associated with it and the non relationship piece is a subset and I don’t have a specific number for you.
But there are also relationship type credit arrangements that have that same ECB purpose that don’t have the end investor on the other side and that is actually the more important piece in terms of differentiating the European market from the US market where US market is largely an investor driven market and therefore it has got a different dynamic.
How do I think that it plays out? I think it plays out based on the quality of service and execution and rating level and as a result there are opportunities for other rating agencies to provide services and as I said in my comments I think that, that means that in that business segment we will face increasing pressure from competition.
How does the MIS goal of 1% to 2% growth from disintermediation compare it to the experience of the first half and can you comment just in general on what you see in the ratings pipeline right now?
In my comments on disintermediation I had taken a very narrow slice of our business and communicated that in the context of our corporate business in Europe and raise earlier comments for MCO overall. He was speaking about the MCO business broadly and even within the MIS business, disintermediation is relevant even in the US context and US market where we do see issuers using the bond market to reduce their reliance on bank funding, even for liquidity purposes and I mentioned that $1 trillion dollar cash reserve earlier.
I would put that in the same category of disintermediation. In Europe, it's a little more pronounced in that you know, the banks are more actively or more apparently shrinking their balance sheets in deleveraging and the 80% 20% corporate financing dynamic in Europe that I put up on the slide was purposely just to draw that out, but Ray's comment about 1% to 2% was much broader in terms of MCO and the piece that I was talking to was a slice within that.
You mentioned that your corporates in Europe had 10% growth I believe from disintermediation. So what does that relate to the total for Moody’s. So did that add 2% or 3% to growth for disintermediation because I am not sure how big corporates are in Europe as a proportion to the whole?
We don’t break down and disclose corporates in Europe versus corporates in the US, but it's a much smaller business in Europe than it is in the US and it would be a fraction of the broader number that Ray was talking about for MCO and be very small.
So, just to be clear, so is the one to two, is that kind of where you’re [trailing] at now from disintermediation?
At the MCO level?
I can’t really speak to the MCO level. Do you want to speak to the MCO level, Ray?
The one to two is in terms of current conditions is probably on the low side and what I was doing was looking at the overall long-term opportunity from disintermediation and the one to two also includes the fact that as the rest of our business grow the corporate disintermediation component will be a smaller piece of the overall business in the longer run. So that's why I put in a number that under present circumstances will look conservative.
I had the same question, but the whole corporate disintermediation in Europe, there is a big delta between where Europe is and where US is. Can you talk a little bit about can the gap be closed, what needs to happen. Do you think let's say three to five years where each closer to 50% or what you see are the drivers going forward?
I think some of the – I may give a try and then you may want to elaborate on that. I think you know clearly on of the drivers is really what is happening in the banking market today was banks basically deconstructing in term of the ability to land and corporations looking at the bond market as substitute to banks which historically and traditionally has been the most active. If you look at the largest corporates in Europe you probably and look at the level of usage of bonds versus loans, you probably are much closer to the picture you seen in US. So I think the question is really around as moving down basically in term of scale and deepening the penetration of the bond market into smaller companies and different geographies.
So I think that's really what needs to happen and the pressure as I described to you that currently existing on the banking system are you know if you are going to be very helpful in accelerating that transformation.
Well thank you very much for your time and we would be around for the rest of the morning. Thank you.
Unidentified Company Representative
Good morning. So I want to cover two topics, the first just a very quick update on our MCO litigation matters and then spend a little more time on our MIS ratings related litigation matters. On MCO not much new to report on our shareholder class action. The big news of course in this case was last year when the plaintiffs failed to have their class certified. So as a result of that what they were hoping would be a billion dollar class action is now only allowed to proceed with the three individual plaintiffs. Those plaintiffs are very small and what they haven’t actually told us what their early damages are based on the amount of shares they own we believe less than a 100,000 in aggregate basically. So now this is a very small case, but it continues to slog on and we've been engaging in discovery since last year and motions for summary judgment are due in October next month.
On our [sell] to derivative suits, we recently settled all of those. We agreed to a settlement implementing structural and governance changes. That settlement was approved by the court just last week, no money was paid to the plaintiffs, but the court did award plaintiff's council approximately $4 million in fees and also reimbursement of approximately a million dollars for their expenses.
For those who are interested, the full terms of the settlement we filed an 8-K disclosing that on July 24, if you are interested.
Okay a large number of the cases that have been filed, ratings related cases that have been filed?
Since the financial crisis what we refer to as 33 odd cases, these are cases where the plaintiff lawyers allege that Moody’s and other rating agencies were acting as underwriters with the hope that we then have liability under this Securities Act of 1933. There was a novel theory and every judge that heard it rejected, it is 6 different judges and then in May of last year I got a favorable decision from the second circuit upholding the dismissal of one case and making it very clear that rating agencies can't be sued as underwriters under the 33 Act and importantly the court also affirmed that ratings speak merely to the agency's opinion of the credit worthiness of any particular security.
Okay, just a summary of where we are against since 2007, we have switched the slide. We made good progress of the more than, a little more than four [dozen] cases that had been filed in the US. Nearly three [dozen] of those have now been dismissed or voluntarily withdrawn, outside the US there had been approximately 19 cases have been filed to-date and of those eight have been dismissed or withdrawn.
In addition to 33 of our cases, we’ve been making good progress on other ratings related matters. Cases have been dismissed on several grounds. I will give a couple of examples here. Half a dozen cases have been dismissed because the court found that ratings are opinions, they’re not actionable as misrepresentations of fact unless the plaintiff is able to prove that our analyst actually didn’t believe the opinion they made at the time of issuance.
We also had a number of cases dismissed on the absence of a duty to the plaintiffs. Importantly, one of those cases are just last month. The second (inaudible) had held that opinion and very favorable precedent on what you need to prove keep a negligent misrepresentation claim against the rating agency and we also had success in one case on personal jurisdiction, our first community case. That was in Tennessee. We had a number of other cases where that defense is also pending.
Turning to some specific cases, in the Abu Dhabi case, there's been a lot of activity this year. Nine of the 11 of regional claims have been dismissed. So the only two claims remaining are [fraud] count and negligible misrepresentation claim. As you see here in June of 2010 class was also denied in this case.
Most recently in August, the court ruled our summary judgment motion on the fraud claim, the court held dismiss the fraud count as the three plaintiffs in its entirety and significant count of another plaintiff’s claim, the effect of those dismissals substantially reduced the amount of the alleged damages claim by the plaintiffs.
With respect to the remaining claims, our motion was denied. So for those four accounts we would go to trial on that. The court just yesterday at a conference scheduled the trial for February 11 of next year so relatively soon for trial.
On the remaining negligent misrepresentation claim the reason second circuit decision we believe is a controlling precedent in the court in light of that decision is or the plaintiffs to show court why they shouldn't have their negligent misrepresentation claim that dismissed. Plaintiff’s filed a brief at the end of August and we're in the process of following our response we expecting a ruling by the judge on the negligent misrepresentation claim in light of this favorable interest decision like perhaps as earlier as October.
At the same time, plaintiff took the opportunity to ask the judge to reconsider the dismissal of three of the four fraud claims and we're also obviously responding to that. And then in the (inaudible) case, in another case we got a lot of questions about very little progress to report there at the end of last year. We've finally finished litigating what's called an anti-SLAPP motion which is another protection that California has types of opinion, had a favorable ruling from the judge on the first (inaudible) of that holding that their ratings are protected speech under the anti-SLAPP statute but didn’t have a favorable ruling on the second (inaudible) so we appeal that and we are not expecting the decision on the (inaudible) appeal until sometime in 2013. So that’s our update, happy to take any questions that you might have.
With regard to Abu Dhabi, it’s fairly unprecedented to move one of these cases to trial with the incumbent risks of the jury potentially what is your position on settlement in the seal settlement which would not establish any sort of precedent going forward?
Unidentified Company Speaker
Sure, well our strategy has been not to sell our ratings related to matters and with respect to the Abu Dhabi case that we are very confident that we are going to prevail ultimately. So we are not expecting all to settle this case. The rating opinions that Moody’s put forward in the Abu Dhabi case in the (inaudible) the analyst always believe them at the time and there is no forward and that’s a factual matter we expect to be able to demonstrate better at the trial.
If there was unfavorable outcome in the jury trial, are there enough unique aspects to the Abu Dhabi situation that precedent risk sort of awakening other sleeping dogs is limited in your view or unclear?
Unidentified Company Speaker
Well two things, first if we aren’t successful at trial we do have the right to appeal and we are very confident that given the lack of any evidence really much (inaudible) convincing evidence which is the standard put forward in the second circuit that we will prevail in the second circuit but given that in any fraud case you have to prove fraud with respect to that particular rating, we don’t feel that it’s necessarily precedent that could, you certainly couldn’t argue that because there was a finding of fraud in Abu Dhabi and then there was fraud in the other ratings related case.
Obviously we were not to prevail in the second circuit that might encourage all the litigation but it is certainly won’t be [evidence] for.
Do you have a sense of what that number is and you know if it went against you is that something else also tax deductible?
Unidentified Company Representative
I don’t know the tax answer but the exact dollar amount it is been reducing significantly. The three of the plaintiffs roughly $200 million but one of the plaintiff’s damage award is still confidential and as I mentioned the plaintiffs have now asked the judge to be reconsider three of those four dismissed claims. So we have a better sense and hopefully by October but the significant reduction from the original $800 million that was alleged.
But even I should mention even with respect to the $800 million we think that is a very inflated number they are asking for and incredible amount of interest and so although they are worth noting there of course is that they are co-defendants in case. So there is no realistic scenario we think we would be the only defendant that could be held liable.
Do you have any visibility on when legal expenses might start declining? Give us any benchmark in terms of the level of expenses currently that’s question one and question two, which you might have addressed this earlier but I might have missed it, the changes that are being talked about in Europe in terms of legal liability, just more color on what that might mean to you guys. Thanks.
Sure. With respect to the proposal on CRI3, as Michel mentioned, I mentioned briefly. They’re basically three competing versions but the original proposal from the European Commission would in effect create a private right of action where investors or issuers would be able to bring a case if they believe there was a breach of the European regulation. The primary objection that we have to that and which is corrected in the counsel’s version that is reversal weren’t approved so we are optimistic that the counsel’s version would prevail but that’s something that’s still yet to be resolved and hopefully would be resolved by the end of this year.
Do you expense an increase in the number of suits, just as this is resolved? Are suits pending, waiting to see how this goes?
The private right of action hasn’t been created yet. So it will be a new.
So in other words, in the US for example, only the SEC has authority to bring in action if there is an alleged breach in any of the SEC rules. So with respect to the rules for rating agencies in Europe, the idea would be that in addition to ESMA and other securities regulators that individuals would be able to enforce the securities regulations.
What about the (inaudible) proved this year though?
(inaudible) approved this was basically, we think that’s important because if the burden is on the rating agencies, it could be difficult to demonstrate that there was no wrong doing even in the fact when there wasn't wrong doing, or no breach of the regulations. So it’s an important point for us and as I said that that’s reflecting in the counsel’s version. So we are working to make sure that we use our, as this process continues.
We don't disclose our legal cost but unfortunately on these rating related cases they are going to continue for the foreseeable future at least the next two or three years so there probably could be any like there would any drop of for those expenses.
John, do you have any, whether that (inaudible) case is going to be appeal to the US Supreme Court and also any other circuits ruled on this negligent misrepresentation?
I don't know if they are sending file and appear with the Supreme Court but as you probably know the Supreme Court only takes relative handful of cases. So seems unlikely this would be a case that would interest the Supreme if they were to file a notice. But I don't know what their plans around that. And so I second part?
Any other circuits?
No this is the first. The good news prior to the financial crisis there was very little case go out there on what the [liabilities] extended should be for rating agencies this particularly for claims brought by investors. So, we now have two favorable second circuit decisions, one in the 33 claims and that one on negligent misrepresentation but so far that’s it and but of course no negative circuit court rulings either.
You and I've talk about this in the past but the benefit will you just explain about the statute of limitations across these different court cases, but in case if you lose some cases along and some cases would work against you or past that time here?
Sure, and we have discussed in the past the statute of limitations question which is basically the issue of how long you can wait before you file a claim. With respect to claims arising of the financial crisis is a complicated question. It varies depending on the claims or a fraud claim you might have six years at one jurisdiction and two years in another, breach of contract or negligence claim would have a different statute of limitation so.
But broadly speaking, the outermost range for most claims is six years so as we get close to the six year anniversary of the start of the financial crisis, it could be more difficult to bring those type of claims but they are also very fact specific. It’s a question of often times when did the plaintiff become aware of something so.
Just coming back to CRA-3 for a second, the proposal for mandatory three year rotation on ratings or rating agencies has lost a lot of momentum what do you think is the most compelling reason why it lost momentum and what do you think the odds are that some form of it will surface when the final recognitions were made?
Sure, we have a good sense of why we lost momentum, if it was just a rating agencies objecting to rotation, I think we probably have rotation but many issuers and investors fortunately were outspoken that they thought this was not a good idea.
The commission’s original approach, basically have operated under the assumption that their 10 license rating agencies or 15 license rating agencies in Europe and that they are all basically fundable. So with Moody’s rotated off of an issuer that they could just a rating from a Bulgarian or Greek rating agency, but issuers were very quick to point out that in the real world that’s not how it works. So there was a lot of push back and again the counsel’s version we think the most sense and they limit rotation do they see a subset of securitization, so subset of structure finance rather resecuritizations and that is perhaps the more likely outcome but again just like the liability issuance here right through that still needs to be worked out and but they refer to as a trial [log] process that’s just started up again so.
Okay no other questions. Well thank you, that’s great.
I think we are going to get started; definitely going to get started. Still pressing the AV model here, so bear with us, but we're going to get started. We’re going to turn the program to a discussion of Moody’s Analytics. We're going to do that principally through a panel discussion with number of my colleagues, but in preparing for this I actually had an idea, I was thinking about bring in empty chair up next to the podium and having a conversation with an imaginary shareholder, but Salli rejected that idea. She said, no; go with the panel, so we're going to go with the panel. However, before we dive into the panel there are few key themes, short listed things that I think everybody should know about Moody’s Analytics. So I am just going to touch on those very quickly.
First, our businesses is doing very well and it has been for sometime. If you look at us relative to our peers, you’ll find that we're performing at a very high level. Second, in a short period of time we've build out a very solid position in the market. The rich product portfolio that we've created has allowed us to greatly expand our footprint with our customers and obtain a larger share of their spend on risk management tools and services. And third, there is a lot of opportunities ahead of us at Moody’s Analytics and we think we are exceptionally well positioned to build on our reputation and realize good growth in this business over the next several years.
So I am going to quickly run through a few slides to reinforce these points. Its well know that at Moody’s Analytics we serve financial institutions almost exclusively and we get a lot of questions about how business conditions at banks particularly in the form of the headcount reductions are impacting the Moody’s Analytics business.
And as you can see from this chart sales of our research and data product have been very strong despite weakness in financial services employment. And the short story here is that except in periods of extreme stress where you have failures of major customers, our business is not vulnerable to headcount reductions on Wall Street and there are two principle reasons for this.
First, in periods of stress there tends to be very strong demand for risk management tools like those sold by Moody’s Analytics. And secondly, our pricing model limits the downside to our fees with customers reduce headcount. So combined with our unusually strong retention rates and our pricing power, these factors allow us to realize meaningful growth even from large and mature customers and even in periods where they are under intense cost management pressure. This is one of the reasons why we have delivered seven consecutive quarters of double-digit growth.
I also get questions about how the components of our increasingly broad product portfolio fit together. And this chart attempts to show which functions within financial institutions are served by our various product sets. You can see that there is considerable overlap in the customer base which gives us much opportunity for cross-selling and otherwise leveraging our long standing relationships with these accounts. This allows us to embed our information, tools and services ever deeper with these customers. So we are serving a more extensive set of needs and winning a larger share of wallet with our customers as we extend our penetration across the account base.
And while our current penetration is good, our opportunities for growth are far from exhausted. In this chart you can see that we have achieved solid penetration across our primary customer segments. At worst, we have an established presence with about one-fifth of the target market. And importantly, within the top tier of each segment you can see that our penetration is near or well in excess of half the potential customers. This speaks to our credibility and our relevance; lots of institutions are customers of Moody’s Analytics and they are customers in a substantial way. The average price point is a six figure fee and is well over $0.5 million in the very important banking segment. This is why we feel good about what we build and why we are confident about our prospects. We have a substantial presence for a lot of customers, but there is still plenty of opportunities to expand our penetration and deepen our relationships.
To put some numbers around the size of our opportunity, our market research tells us that across all of our business lines the total market is worth about $12 billion dollars. In some markets, we have a better position than in others, but we are not active in any market where we aren’t a leader or a very strong competitor. Again, given the progress we’ve made to-date, we feel very good about our prospects for achieving further growth in these segments. In short, we believe we can continue to win more and more of that $12 billion market.
One way to illustrate our relevance in growth trajectory is to look at our recent experience with some of our largest customers. This chart shows trailing 12 months sales for six of our largest accounts. Over the past three years, sales to this half a dozen accounts has grown by more than 22% annually, 12% on a purely organic basis. That 12% organic growth represents nearly $20 million across just six customers.
Given the size of these accounts and the difficult environment that they have been operating in over this period, 12% organic growth is extraordinarily good. Again, this reflects the relevance of our product offering to deeply essential activities within these firms. It tells you there were selling need to have products because nice to have products can’t generate this kind of growth in this kind of an environment.
Now when you drill down on the individual institutions, you start to see some interesting things going on. For two of them, we realized significant growth in the RD&A segment. One grew RD&A at 10% annual rate, rising to more than $10 million. The others average growth of 15% a year, after declining in 2009 as the company went through a major restructuring. Also you can see that in the first case, Copal adds significantly to scale of our relationship and the work that Copal with this customer connects very directly with their use of our RD&A products. So it's a perfect example of why we feel very strongly about the industrial logic of including Copal in our product portfolio.
In the case of another customer which happens to be MA’s single largest account with more than $25 million dollars in trailing 12-months sales, RD&A has been flat over three years, but we still generated nearly $14 million in organic growth, largely driven by the bank’s adoption of our enterprise risk solutions to assist in their compliance with the Basel Capital Rules. This is a great example of how relevant our software business is to an institution like this. Because we sell mostly licenses and services in ERS, the business tends to be rather lumpy as you can see. You see this variability in the ERS salaries volumes in both examples on this slide.
However, with Copal in the product line up, we expect more recurring revenue to offset the lumpiness of ERS and this is nicely illustrated in the second case on this slide. So these case studies demonstrate how different segments of our product offering are relevant to different customers at different times. Over the long run, we would expect that our customers will tend to adopt our products to a substantially similar extent. This gives us confidence that we can continue to grow these large accounts by deploying our products and services as they align with the most critical priorities of each customer.
Now in addition to financial results and numbers like these there is other evidence of our growing relevance and creditability. I think of this slide as our trophy case; it’s listed awards and other acknowledgements that Moody’s Analytics has picked up recently from a wide range of trade media and industry bodies. As we build out this business we're getting more and more recognition in third party surveys of customers and a variety of industry publications. With growing awareness of MA’s capabilities the market is increasingly recognizing us as a category leader. With this higher profile we are better able to sell into our various opportunities while contributing to the overall value of the Moody’s brand.
Of course its good to be acknowledged and well respected by the customers, but it really helps when what you are selling is essential to those customers. Delivering tools and services that are needs to have rather than nice to have is a core part of the Moody’s Analytics product strategy. By doing this, we're able to take advantage of several dynamics that make are offerings essentially.
The first and most powerful is regulation. Much of what we sell is directly relevant to enabling our customers to meet their regulatory requirement whether we're talking about banks that need to comply with Basel rules and undertake stress testing projects or insurance companies that are working to meet the Solvency II regulations. We also offer products and capabilities to take advantage of network effects. The best example here is our distribution of research and data that are produced by analysts and the rating agency. The widespread use of Moody’s ratings in the fixed income market creates enormous demand for supplementary information about those ratings.
So our position as the exclusive distributor of that information is very, very powerful. And in many of our businesses we're able to sell into demand for capabilities that help customers compete better in their industries, examples here include our training services and Copal’s outsourced research services. These offerings enable our customers to ensure that their staff stay current in their professional disciplines and that they manage the expense of their analytic staff as efficiently as possible. So again, while naturally we want to have good products and ensure that our customers are satisfied, we also want to focus very specifically on those opportunities where we can enjoy the most demand by taking advantage of regulatory developments, network effects and competitive conditions that stimulate demands for our products.
Finally, I am going to close with a very brief discussion of our profitability, Linda will talk about this more later, but this chart shows our revenue and adjusted operating income over the past two and a half years. The key takeaway here is that the business is growing in scale and we are generating good returns even while we have been establishing ourselves and focusing on topline growth. At mid 20s kind of margin we fall squarely in the middle of our peer group. We feel good about where we are and about sustaining the margin at this level over the near-term.
So I realize this was a very quick tour of Moody’s Analytics, but I just wanted to cover a couple of major themes before we drill down in the panel discussion and to summarize those themes are that the business is performing well, we have established ourselves as a major player in risk management products and services and we believe we are very well positioned to continue to generate good growth.
So with it, let’s move on into the panel discussion and then we will take your questions. And let me start the panel by introducing my colleagues. We have got Geoff Fite here; Geoff runs our Enterprise Risk Solutions business and that of course is a very high growth business for Moody’s Analytics and the business in which we have made the most investment over the last several years and frankly have made the most progress.
Next to Geoff is Dan Russell; Dan is responsible for the Research business within Moody’s Analytics and he is here to talk about what’s going on in the Research Data and Analytics segment. The research business in Moody’s Analytics is our single largest business. It’s our most mature business, but still growing at a very respectable high single digit rate.
And finally, at the end of the table we have our newest colleague Rishi Khosla; Rishi is the CEO and Founder of Copal Partners and he has joined our team since the end of last year. And Salli you are going to moderate this correct?
Yes. Thanks Mark. My intention is to serve as the voice of the investor and ask some of the questions that we most often hear from you and or that you have submitted when you registered for the event, so I’ll try to get some information out there that can be helpful to you here. I will go ahead and jump right in with Geoff. Mark showed us a little while ago that on the trophy page as he said, that Moody’s Analytics was a named a firm of the future as a leading provider of risk management technology and Moody’s Analytics has built up a pretty good position in the risk management software space; how did Moody’s get involved in the space and why did you think it would be successful?
Sure. Well, we started with a leading position in quantitative risk models through the Moody’s KMV business as well as deep domain expertise in banking. As we looked forward we saw a regulatory change in the implementation of enterprise wide solutions being the vehicle for future improvements in risk management and in analytics generally, and so we decided to embark on building software base and services based solutions so that we would not be disintermediated by software companies that would eventually develop the ability to build risk models. That's how we got it.
Sounds very good. How would you say you're doing today?
Unidentified Company Representative
Yeah, I think we're doing very, very well. We embarked on an audacious plan to build out a pretty broad suite of solutions. We've executed on the product pipeline, the product plans that we have. We signed many customers, both large and small all over the world. We have an unbroken track record of successful implementations and consulting projects and we’ve been recognized in the industry, both in industry publications as well in referenceable clients as a leader in the space.
Understood. Rishi what about you, Mark mentioned that you are the most recent member of the team and Moody’s acquired Copal last year, what are the benefits that you saw, that you were expecting when you joined Moody’s?
So some of the benefits that we are expecting and some of the benefits which have actually come to fruition to date are actually going to market together to jointly sell products. So for example on the risk analyst tool, actually being able to provide and actually spreading services, packaged a long way to risk analysts.
As another example, helping Moody’s actually launch new offerings in to the market, for example research on Asian private companies and content analysis and I think over a longer term as well, as more buy side clients actually look at conducting more and more in-house credit research, the ability for Moody’s to actually supplement the ratings research was provided by the customized credit research services which Copal offers it clients I think would be a strong value proposition.
And say those are the external sort of client facing opportunities as well as the ability just to add cost efficiencies across the existing Moody’s businesses i.e. MIS shared services and [M&A].
Just to make sure I understand is Copal's business different from traditional outsourcing business.
Unidentified Company Representative
So I think the traditional outsourcing business is known I mean again as people look at outsourcing they think of things like pay roll outsourcing HR, IT services call centers et cetera. And that is typically what people have pressure of outsourcing is which are very standardized typically non core functions, function which have been outsourced for tens of years typically to onsite player than over the last decade more to offshore players.
Copal is pretty significantly different. I think the Copal really works on the front and middle office functions which are much more core to what a client does and much more non-standardized. As examples, within investment banking divisions, we'll help clients on client coverage, on origination of deals, on execution of deals with the sell side, we'll help clients with macro credit, equity, research as well as risk management support and for the buy side clients we will help them on investment, screening, diligence as well as monitoring.
So it’s pretty different to what traditional outsourcing is know for and they also say very nascent business as an overall industry. So we see pretty substantial growth opportunities.
Nascent, okay. So do you have a sense of the size of the market opportunity for you?
Unidentified Company Representative
So we estimate the current market to be close to a billion dollars today and estimated to grow at about a 30% rate over the next five years on a collective basis. And that's the subset of what we define as a much larger category of what we define as research outsourcing consulting, research and analytics and market data services which is close to a $150 billion market today.
I think as we look at sort of the current environment and growth drivers for the business as a value proposition for our clients we tend to save around 75% of that fully loaded internal cost. And given the current environment if you keep look at the areas which we play in for example, with investment banking divisions the fact that on average they need to pitch five or six times more to win the same dollar revenue.
If you look within sell side research, the fact that over the last decade research budgets have been cut by 60 to 80% on those (inaudible) bracket firms and then asset management firms they need to actually conduct deeper diligence as well as sort of continually reevaluate the investment hypothesis, of that just drives for more demand for our services which we feel will help accelerate the growth of the industry.
I am going to ask one more while I am on here, is this only reason clients come to Copal just to save costs?
I think again clients, the type of clients we service are clearly a number of the major financial institutions. I think a number of them will be represented in this room and may be not on the same divisions, but for sure the same clients.
The main drivers and costs -- that main driver why they look at the model, but the reasons why they choose to buy and actually execute on this model is they build and try to get process improvement. As a firm with about 1,700 people today, the functions which we actually address, we typically have more scale in any single function than anyone of our clients. Therefore the ability to bring best practice and drive consistency in quality and then second to that the fact that we are operationally taking control of these functions which means that all the recruiting, training, retention problems which management typically spend a reasonable amount of their time on actually get dealt with by a third party to bring them up to actually focus on more revenue generating activity, so it’s a substantially more than costs.
Could you just repeat that anecdote you told me about the unnamed bank, investment bank and their experience with the class they had recently recruited?
Unidentified Company Representative
Sure. So as an example, we have a number of clients who clearly are focused on cost reductions across the middle and back office and then in the front office there has been continuous sort of headcount reductions, but clearly an example I gave of needing to sort of pitch 5 or 6 times more to win the same dollar of revenue with an investment banking divisions drives the need to actually have a certain amount of resources.
And there are a number of factors which were outplayed. First of all recruiting into the banking industry is becoming harder for a number of our clients because the overall pay opportunities in terms -- in the investment of five or ten years to hopefully make money at the end of the line is known as thoroughly as bright as it was.
So what is typically happening is that a lot of the analysts which have recruited into again investment banking divisions are lost within the first two years. So it is 80% or 90% in some of the banks actually turn over to either outside the industry or into private equity and to again previously hedged funds and less so today. And I think a lot of that is driven, use of Copal and also the drive to reduce class size is going forward. So actually reduce gradual intake because of the use of Copal as a replacement.
And that do seem to be in cost saving mode, it is a challenging -- clearly challenging time for them. But they are still spending on some things and I know we mentioned that our credit view offering in our last earnings call, Dan what is credit view and why is it selling so well even in this environment?
Sure let me take what credit view is and then I will take a stab at why it is selling so well. At it's core, what credit view is, is a repackaging, a reprising and a representation of our core content back out to the market, you can almost think of it as a relaunch of our content. It's based on the content, the rating agency creates but we also add components that are manufactured in some of our other business units to provide a comprehensive view of the credit.
And really what has changed is historically we had taken the position that as we added new content to our product offering, each component was treated as a separate product with a separate price and overtime with that drove was an overly complex cumbersome product offering that became overly difficult for our customers to digest and think about it and just too many decisions.
So what credit view does, it dramatically simplifies the offering and at the same time dramatically upgrades the content that’s available in our packaging and I think that leads to wide selling so well.
You know, one thing we believe and that we've learned in an information overload market that we live in, the content producers that are going to win are those that can deliver high value content to their customers the way they want it, when they want it and how they want it and credit view takes a big step in doing that for us and I think in the end that’s why people are paying us for.
So you had 9% revenue growth in RDNA over the last year-to-date but you've got a fairly mature business, how long do you think you can keep doing that?
Unidentified Company Representative
Well, that’s a great question. We clearly agonize over that on a regular basis, but the risk of over simplifying, let me give you a little bit of how we think about that question you know and we think about the demand side and the supply side. On the demand side what we look at is overall activity in the credit markets and that's activities like issuance, secondary trading, overall risk appetite of firms not just quantity but also variety of risk they are willing to take.
And then finally and very important is what I will call innovation, the new capital markets products being brought to the market that folks will need assistance in researching and analyzing. From where we sit right now, we see the current environment extending for the next couple of years.
So not the most robust credit market activity over the next couple of years, but enough activity to give us opportunities for growth. On the supply side, we remain very confident in our ability to deliver value added content into the market and I think what that means I will put another way as when we look at our new product pipeline, it is very strong, a very robust and we are quite confident where we can deliver high value added content and sustained growth over the near term.
There is only one question about Moody’s research if that's what you are looking for. On the other hand Geoff, you are competing against IBM, SunGard, Oracle how you been able to penetrate the market and what do you think Moody’s competitive advantages to compete against those names?
Unidentified Company Representative
Sure, I mean they are somewhat ominous in that list of competitors to be sure. Well we are different first most, we combined domain expertise in banking and more and more insurance with quantitative analytical capabilities and we've developed enterprise class software capabilities.
We're just a serious builder of software and engineering products as SunGard and Oracle are and when we compete with them, we compete on the basis that we understand the business of banking or the business of insurance depending on our customer and who we are selling too and how they are using our products.
In ways that Oracle and SunGard cannot. We also have enough breadth to be able to understand each regional difference that we have in our customers globally, we are able to implement locally where ever our customers maybe and so we are on par with them and in some cases even surpass some of these firms in our ability to be where our customers need us to be when they need us to be there.
Can you talk a little bit about internal competition, internal development?
Unidentified Company Representative
Sure, so there is always in any institution when they are looking at implementing infrastructure that helps them manage risk and that infrastructure involves technology. There are always elements or people within those institutions that would like to consider building it themselves. And we always face that, we provide a fairly compelling case, we help our customers with total cost of ownership and return on investment analysis of how they are doing it.
And in some cases our customers do decide to build their own. But when they do, we find that we often have something to offer them while they are doing that, they may purchase some consulting services and advisory services from us, some models from us et cetera. And then in that case, in the event that these internal projects don’t go as planned which is generally 50% of the time or better we are there and ready to come in and help them fix it.
That’s great. Well Rishi I only hear up against IBM, but who are your competitors. I don’t’ know your market as well I think for this audience, who are you positioned against?
So I think somewhat like Geoff, I mean we had two categories of competitors. One is actually the bank’s internal divisions within places like India and then the other third party competitors. So the third party competitors are people like S&P, CRISIL e-value service are probably the two largest competitors that we have in this space.
But the largest single competitors for us are actually inhouse divisions of our clients. So firms like Goldman and JPMorgan et cetera all have sort of Indian outsourcing or internal outsourcing centers based in India which typically focus on back and middle office functions and then IT and typically they will try actually putting a lot of the research and analytics work into those centers sometimes prior to using third parties, so often we have the same struggle. We sort of help the consultative through the prices of them trying to do themselves and then typically where they had to pick up the pieces on the other round.
And you got cases where some of -- may be even your largest customer has a substantial captive in India, right?
Unidentified Company Representative
Without a doubt in every, again we service most of the major global (inaudible) banks, nearly all of them and well pretty much all the top ten have large presences in India. Our largest client has about 20,000 people in the shared services center in India. So they definitely have scale, but yet they still have a significant team with us of 150 people
I am going to go back around this again just to make sure I understand. So outsourcing is not a low margin business here?
Unidentified Company Representative
Outsourcing as Copal places, not in the low margin business. I mean the work we do is non-standardized. I mean again the way to think about it is that look at something like payroll from one organization to another, there is pretty little difference in terms of how one organization from the other actually executes payroll and then you look at some like investment research, I think that at least lot of friends would argue there is a substantive amount of difference between the sort of the global research you receive from one house and the other.
So we really focus on the-non standard work as well Copal has really positioned itself as a premium provider in this market. So what typically pricing at a 10% to 20% premium to our other competitors and we are able to do that because you are already savings circa 75% of the fully loaded cost for a client.
So when they are making a buy decision, that we will need to buy sort of the confidence of the brand and oversee further reinforced by the Moody’s relationship, but also the reputation which we build up of delivering high quality on a consistent basis, it is worth then paying that 10% or 20% premium.
And it tends to be very sticky right?
Unidentified Company Representative
I mean once you win a client there has to be a very good reason for them to actually switch because they typically desize that particular function internally therefore its highly disruptive to change. So I would go as far as saying we [never] had a major client switch to another competitor for (inaudible) five years, seven years and given we have been around for nine years that’s a pretty good metric. So once we (inaudible) clients very, very sticky.
Make sense. What about you Geoff, can you talk about the expectations for your profitability of your business?
Yeah, well we are a profitable business today. If you look at just our operating expense so the dollars that we spent to build product and serve customers, we are operating in the low 20s. I expect that we will increase that margin somewhat over the next few years, not dramatically. One thing about providing software solutions and risk management is something about [arms] race and that you have to keep current on regulatory change, you constantly have to be innovating in building new product and so you have to be careful about sitting back and hoping that a single product you have already launched is going to extract revenue for a very, very long time. You have to continually reinvest in the business. The way you get scale in this business though is by building recurring revenue streams. I mean it’s not an easy thing to do. So we are working hard to build products that can warrant subscription based pricing and subscription type services, some of our customers are adopting those. We provide subscription and one-time license pricing for all of our products today. And so some of our customers are adopting subscription basis somewhat depending on how they spend the capital. And so that’s the key. So as you start to gain scale in this business, in addition to increasing our current revenue rates then you start to increase your margin.
The finances of your businesses are bit different may be at a higher level how does your [invested] into Moody’s overall and Moody’s Analytics specifically, what's the industrial logic to use on (inaudible).
Sure, well I mean so far as Moody’s provides ratings and research, credit research and risk management solutions, it’s in a business of managing risk and especially with regulatory change in the implementation of risk management practices into the operational aspects of running a bank or an insurance company, using risk management less is our retrospective view on how we have been doing business but more as a real time input into decision making on originating a loan or writing a policy etcetera. Software and infrastructure becomes the vehicle for risk management. And so in that way to the extend that Moody’s is working hard as it is to improve the risk management generally and make the financial market safer and more reliable; this business is right in that.
And Dan I want to go back to you for a second because I haven't asked you anything in a while. Content wise, I know that we saw MIS research has been mentioned a couple of times today. But I know we saw some more than through our DNA, what other products are in your portfolio?
Sure, it’s a great question because the portfolio has got and might be some very outstanding product. I mentioned just a three of them. First is our quantitative credit metrics and there we look at market prices, equity market, credit-default swaps, bond prices can extract a credit assessment out of those prices that serves customers very well because one it gives us the ability to [try] credit assessment on names that the rating agency may not rate so we can expand coverage. But also it’s a great compliment to the fundamental research done in the rating agency for our customers to look at our market view of credit as well so that’s one.
Second, our structured product even though that segment is struggling a bit, our product array is quite successful many, many significant customers rely on that and we help them manage and value their portfolios there.
And last but not least, I would mention our economics in consumer credit business, perhaps more broadly known as where Mark Zandi works but nonetheless he is backed up by a team of outstanding economists, analysts and data professionals that provide outstanding economic forecasting and research to a large number of customers around the world. So it’s a very, very robust product portfolio in our DNA.
Well I am getting the queue that we have just a few minutes left. So I’ll one of these broad questions and I am curious to hear from each of you what you are most about? What keeps up most of the night, may be I will go back to Dan first.
Well, I think one probably we will all talk about is a big negative downsize price out of Europe that seems to be where we are looking at the most risk. If something like that were to occur would probably put a lot of pressure on European institutions and they are very, very big piece of our customer base. So when you pressure on them to reduce cost or reduce purchasing would be a negative event for us.
And secondly, I would go back to one of the comments I was making just a lack of vigor and creativity in innovation in the credit markets broadly. If the credit markets persist the way they are and it perhaps even diminish a little bit that would be a limiting factor on our ability to grow the business.
Yeah, in addition to Europe, I am little bit concerned about China and fast growing economies. The fast growing economies have been the big piece of our growth for us and I am always concerned about disruption and slowdown in Asia particularly but on a day-to-day basis, I am concerned and worried about how we continue to drive our current revenue growth in this business and that’s first and foremost for us as we think about how we build products and serve our customers.
May be I will go to Rishi next.
I think for us, our biggest challenge is as we mentioned the business tends to be very sticky, clients have actually focused a lot on taking the cost out of the middle and back office there, they are looking for other ways to take cost out so, taking cost out of front office is clearly a logical place and for us, it is actually keeping up with demand and we are potentially experiencing with the number of clients sort of potentially step increases in our relationship size because again once we are in and proved ourselves within the client division, the (inaudible) is actually propagated across the organization is much greater. So it’s really keeping up with that demand and again on the buy side which you see continued drive to actually conducting higher levels diligence actually before making investments and as I mentioned some of the more robust investment monitoring processes. So again leading to high demand for our services and I think the case in point is during 2008 and 2009 which is probably the financial crisis we saw continue to robust growth across our client base. So even if there is large negative event in Europe we still feel that it continue growing.
And in fact as Mark mentioned earlier, Moody’s Analytics as a whole whether the financial crisis is relatively well, I think we are out of time in terms of our prepared questions but wanted to go ahead and open it up to the audience for questions and before I do that just thank the panelist for their time and input thus far. I will start with John.
And with all up there I thought I would ask, could you just give us a sense may be take us into the meeting room, give us a sense of how, to what extend and if but really how go about discussing competing for capital to sort of feed your businesses and sort of support your individual domains that you will [proceed]?
Unidentified Company Representative
Why don’t I take a crack at that and may be you guys want to fill in. John, we focus on what do we need to add to the product portfolio in order to realize our strategy and grow the business, that sort of what we start. And frankly, one of the benefits we have being part of this corporation is that we got a fair amount of capital and when we identified opportunities for us to do things to accelerate our growth, to expand our product offering. We are I think very rigorous and very disciplined about evaluating those opportunities and making the case for them.
But I don’t think we have ever been prevented from doing anything because we don’t have the money, that’s never been an obstacle to our building out the Moody’s Analytics business. So and I think its fair to say that if you push that down to the individual operating businesses with MA that continues to be the case. And I look to Geoff to tell us to make recommendations about what he needs to do to build out his product offering, whether it’s through M&A or through organic investment.
In order to take advantage of the opportunities that we got from and that would be true of the other businesses as well. Is that fair?
Yeah, within enterprise risk solutions, we look at use of capital in two ways M&A and then on going operating expense and product development.
On the M&A side, the acquisitions have to stand on their own, it means that the business case that we use for valuation of the acquisition, we had executed against that business case and this to fold into our existing operation. We haven't run anything as a standalone within the area as we incorporate the products and services and people as quickly as possible and thus far with the two major acquisitions that we've done from (inaudible) and Barrie & Hibbert, we've been executing against the plans that we used as the basis for the valuation. So that's on the M&A side.
On the product development side, we go through a fairly rigorous S-curve analysis in other words we have expectations for every dollar that we spend today in new product development with respect to how its going to return, when the products will become profitable on their own what are return on capital invested on the product-to-product level is. So we go through that rigorous analysis and we have expectations for that and that's used as the basis for how we spend our operating dollars in building new products.
So Ray talked earlier about 2% to 3% incremental revenue growth contribution from Moody’s Analytics which I think would imply sort of 6% to 9% top line growth rate for the businesses. So the question is that Mark how you think about it in terms of realistic organic growth and is that an organic growth rate number? Then two, you talked about the adjusted margin in the low 20s and maybe could go a little higher, what are the constraints to higher margins, why shouldn't it be higher I think looking back this was a mid 20% margin business and just throw another part in here. This might be more for Linda later, but you are talking about adjusted margins, the market really looks at GAAP results for you. So is that a fair way to think about the business?
Let me address your first question first or you are going to have remind me what it was. Your math is right. Ray talking about us contributing 2% to 3% to the overall top line that would imply mid-to-high single digits on an organic basis and I think that’s very much what we organized the business to do, that’s what our strategy would suggest we should do and if anything, our aspirations and our expectations would be a bit higher than that.
With respect to margin why isn’t it higher? I think it’s the short version of your question. The reality is Peter that we see a lot of opportunity particularly in Geoff’s business right now to win a lot of business from a lot of customers. There is a tremendous amount of regulatory driven demand from banks and insurance companies for us to help them meet the [basal] requirements to help them meet the solvency II requirements.
But and there is a great opportunity, I think we are very well positioned. But its I think that opportunity is going to be relatively short lived, its only over the next couple of years and we are bound and determined that we are not going to miss that opportunity. We want to make sure we take full advantage of that wave and as Geoff said, his is business in which we got to continually be investing in order to be able to continue to grow. And then the other thing is if you look at the margin of this business overtime one of the things that you are observing Peter is just, it’s the reality of the math, I mean back in the day when Moody’s Analytics was really just a rating agency research that is as you might guess a phenomenally high margin business.
As we do other things as we build out other aspects of the Moody’s Analytics business and if Geoff’s growth rate is that of Dan’s by definition our margins are going to go down, and so as we continue to build out the top line, I think that’s just the nature of building our larger business that serves more customers in more ways.
Question from Steve.
Just a follow-up to Mark and Geoff. So can you just help us understand to me, you talked about the opportunities on the [KMB] side with regulatory capital but where are we exactly on the S-curve, I mean is it that, banks or insurance companies have been grappling with this for the last several years and so you have been selling a lot of subscriptions and a lot in this area and so just a continuation of the run rate or as the regulatory requirements get finalized, you really been investing in building your capabilities. We are likely to see more of an explosion in terms of the new business opportunities?
Yes, so the products that we started with when we embarked on our mission are the most profitable products that we have today. The risk out, single-obligor risk models and spreading the scorecard solutions or risk analyst product. They are very mature and they are very profitable. We take the revenue and the profit from those products and we poured it into through acquisition and internal development, regulatory capital products. Those are becoming profitable on their own meaning that the maintenance streams that we make on those products is paying for the ongoing development, we have to do to sustain them and every additional sale and implementation we do provides more revenue over time. As we look at that though, we say okay now we want to grow more into loan originations for banking and so we are very early on the S-curve there. It will be a number of years may be five years, six years before the investments that we are making in that product today have paid for themselves and we start to improve long-term profitability on that product and as we get into insurance we have early S curve products in insurance and other areas. So every product is on it's own cycle. Some products are very mature and paying for the development of the other products and overtime, you know, the firm have moved up that S curve when we take less and less new profit dollars and put them back in product development.
Steve, to you question about regulation. You are quite right. Banks have been complying with Basel IV, many years really. What we're seeing right now is sort of a next generation Basel. Right, Basel III sort of changes everything for all the banks. So all the banks that have already adopted a Basel II solution, they’re now going back and saying, well we now need a new and different solution. So we’re really well positioned to be able to sell into that new wave of opportunity.
Question up front.
This might be for Mark. To what degree does the intellectual capital that you developed and deployed to clients also feedback to Moody’s Investor Services in terms of improving the quality of what they produce?
I think it does to a degree. I mean certainly some of the content and some of the analysis that is indigenous to Moody’s Analytics like marks Andy’s work and the work of his people. You know, MIS is a consumer of that information. They are consumers of that analysis. MIS is a consumer of the market applied ratings work that we create. They are consumers of some of Geoff’s tools. So, the Moody’s Analytics product is used within MIS; I really I guess preferred to show to the extent of that usage, but I mean I wouldn't characterizes MIS as a big customer of Moody’s Analytics, the one exception to that maybe frankly in (inaudible) where we're talking about doing a fair amount of work.
Any other questions? And so the interest that we have had from the fair group and again with the panel, I appreciate your comments we're going to go ahead to move to the next session, so I'll introduce Linda Huber who is Executive Vice President and Chief Financial Officer of Moody’s Corporation.
Good morning everyone and we are hoping we can get through this before the introduction of the iPhone 5, so we'll try to stay on schedule. I have with me today Rob Fauber, Senior Vice President of Corporation who runs Corporate Development and we get million of questions about what we are doing in Corporate Development so we thought we let Rob present for himself today, so he is going to do that. And then following Rob will be Lisa Westlake SVP of Human Resources and we get question as well about our Executive Compensation and so Lisa will take you through that quickly so you can understand what we're trying to do.
What I would like to talk about today is our financial overview in terms of how we've done for the first half of the year. I would like to emphasize a very strong first half growth across Moody’s businesses; I want to explain why a diversification strategy makes sense and why we should do that as Moody’s rather than having the investors do that. I want to talk a little bit about cost saving strategies and then also we are very proud of our double-digit EPS growth and we want to explain that.
For Peter’s benefit we want to talk about our new non-GAAP measures, this is very exciting for Moody’s. We don’t come out with new financial measures very often in fact this is the first time in eight years we are moving into different businesses and we think it provides better comparability, so we will explain that. And then lastly capital allocation, always a very popular topic; we are going to explain the balance for that and how we think about it and we are going to talk a little bit about cash flow which remains a very strong feature of this business.
Now for the first half of the year against extremely difficult comparables the rating agency which is the top set of graphs did quite well, corporate finance grew 3% even against historically high first half growth last year, structured finance a business which we were told was left for dead, actually is growing at 5% for the first half of the year. Financial institutions remains flat in revenue despite the fact that issuance has come down, so that’s pretty interesting. And public project and infrastructure is up 17% over this period of time, so the rating agency up 5% for the first half, a very nice growth by the rating agency against tough comparables.
Now MA, the main purpose of this event today is to make all of you appreciate what’s going on in the Moody’s Analytics business. And one of the things we are concerned about is that the analysts frankly focus obsessively on the rating agency and it’s time for that to change; it’s time for people to appreciate what’s going with Moody’s Analytics.
So just take a look at these numbers; RD&A which is a business which resells research from the rating agency, revenues up 9% for the first half of this year, when investment banking budgets are shrinking, so pretty phenomenal achievement. Enterprise software revenues up 17% this is a $100 million revenue business, now there are other companies that are buying these businesses at a fantastic rate.
If we were to look at that the value of this business by 14 times EBITDA standard which is what other big companies have been snatching up these businesses at would equate about $600 million valuation on enterprise with software, so we have build a very nice business, created real value for share holders and we love the growth opportunities in this business, so 17% this year half, organic half acquired.
And then lastly professional services which now include Copal, it is not a body shop business; it is a high end business. It’s replacing the work of investment banking analysts at a much more efficient cost, but the professionals at Copal are CFAs, they are CPAs and they are very highly qualified people who work specifically for those investment banks. So it’s very sticky and very high conversion cost, the people who are working out in those businesses would have to change out [SEZ 70] requirements if you know what those are, so that relationship is very strong.
So Moody’s Analytics businesses have done a tremendous job, driven growth of 19% for the first half of the year and we are very proud of what is going on with the Moody’s Analytics and we would help that the sell side analyst would share our enthusiasm and write about this a little bit more.
Now going back to the ever popular obsession with the issuance outlook for the MIS business. Last year as I said, first half very strong issuance; second half of the year rather weaker issuance and this was a difficult period to manage through. First quarter of this year again, very strong, second quarter pretty good and the third quarter looks and this is an estimate that it will be somewhat better than the second quarter, so third quarter as you know historically strong issuance earlier this week, $20 billion high grade issuance day on Tuesday, so the markets are running very strong right now. It’s too early to tell what will happen in the fourth quarter, I heard yesterday that the October high grade pipeline maybe $100 billion, but again unclear and we have a lot of factors which could cause this to break the wrong way. So fourth quarter, we’re not quite sure about that. We’ve seen views that are as strong as the third quarter. We’ve seen views that are quite a bit weaker. So you can make your own call there. What is important is we have historically low issuance cost and that is going to continue to bring treasures to the market.
Now for those of you who really like the MIS business, it has a lot of great attributes. It is a high margin business, but the revenue view is a bit variable. This is a high amplitude around the revenue line for MIS. Back to the financial crisis, we saw shrinking revenue lines coming out of MIS. As we came through that, we saw very strong growth on the MIS line, but again, we at Moody’s are sort of takers on what issuance rates look like and for this year, because we had such strong growth last year, the growth has kind of dampened and moderated for MIS, so you see broad swings in revenue, from down 35% to up 30% on the revenue line.
Now, if you superimpose MA, what does it look like? Much more stable, nice ballast for the business, good growth, but steady growth and growth that we can drive through the sales efforts with products; we can do that to some degree on MIS, but again issuance are something that we don’t control. So the combined business is dampened and it's amplitude, it’s a little bit more predictable and it's easier for us to manage through. That’s one of the reasons why we have two businesses.
Now if you look at the corporation as a whole, for the past 18 quarters, we have been successful in exceeding 40% margin in half of those quarters and we’ve not been successful in the other half of the quarters and we do try to manage the business to match revenues and expenses. We don’t always get it right. We plan over a year’s period of time and we don’t always know what we’re going to get. So much to Craig Huber’s disappointment, we do not hit 39% margin every single quarter. We would like to, but it's a little tough to manage the business with issuance bouncing around as much as it does. But we want to assure you that we pay very good attention both to cost management and also to revenues.
Now, we would love to have near term margin expansion, but I don't think that's particularly realistic; we are managing some cost pressures of becoming a heavily regulated business and that's expensive, we need to run this business now to be bullet proof in the face of some pretty heavy regulatory scrutiny and that costs money. So what we are doing is investing in IT, we're investing for Dodd-Frank, we're investing for CRA3 and we can't give you any numbers on CRA3, because we don't know what we are up against yet.
But on the other side we're trying to manage this; we are looking to right source. We are using Copal ourselves as a way to reduce our own expenses. We are standardizing processes across the organization and we're pushing very hard on our vendors. So we just don't take these cost increases lying down; we're looking to offset them as much as we can.
Now if we do have a slowing in the cost of the regulatory expenses overtime in the mid-term that's three years out, we may see some expansion of the margin, but that's not a goal of ours immediately. The goal is to make the business bullet proof in the regulatory situation and to support the growth in Moody’s Analytics.
Now on the EPS line, we have been able to grow EPS at double digit rates since 2008 and if you look at this, we have had 54% of that come from what the business has driven with its double digit revenue growth. But we provided the other 46% of that below the line so the financing tax teams have been very, very busy; 28% comes from share repurchase; we reduced the share count by 40 million or 16% over this period of time and really good tax planning which is an incredibly important thing for Moody’s we've reduced the tax rate as well as. So 46% of the EPS growth comes from what we have been able to do below the line. So what you need to take away is that we work every single line hard at Moody’s; we appreciate the opportunities we have above and below the line and we work on all with them.
Now the new non-GAAP financial measures, the controllers teams has submitted this contribution as to why we are doing this and I would like to have the group study this at its leisure, but what we are trying to do is provide better comparability across periods and in comparison to other companies. And so what we would like to explain on adjusted operating margin, all we are doing here is taking the normal EBIT margin and adding back D&A so 39% margin on an adjusted basis if you add back $80 million the D&A becomes 43%.
Now why are we doing this? It’s because this is the way the competition in the Moody’s Analytics space shows its margins and we need to be able to compare more directly. Looking at this on an EBIT margin view really frankly discriminates against MA and how well it’s doing against other companies, so we decided to make the change. If you want to study the detail of what we are doing page 117 has a lot of tables on reconciliation and what we are up to.
Now cash flow, normal measure of cash flow here in orange which is operating cash flow, subtract out the blue CapEx line and you get the yellow free cash flow line. And over this period of four years, our free cash flow has grown 17% and the mean for the most of the companies in the S&P 500 is 10% but the median is only 4%. So again cash flow is a very important feature of this company and we continue to do really well on that front.
Now capital allocation; again a lot of questions about this; we thought we would give a big shot out to everybody who owns our stock here, so we hope to see you prominently featured on the list. Our top 10 investors own 54% of the stock led by Berkshire Hathaway which owns 28.4 million shares; Berkshire Hathaway has not sold any shares since October 21, 2010 when they sold the stock at $26.10. Our stock just went through $43 this morning, so that’s interesting.
ValueAct capital is well represented here; we welcome everyone from ValueAct all 12 of you and that owns now 17 million shares of our stock; Capital World has lost its second place position we had encourage them to battle that out, 16.8 million shares; Vanguard is fourth, T. Rowe, Manning & Napier, BlackRock and State Street are index investors; IFP is here; (inaudible) is here from London, we have Global Investors which is great and then MFS.
So we work very hard at our relationship with the shareholders. We had more than 200 calls and meetings with the 120 institutions this year, so we view this as a competitive differentiator; we know that some of our competitors are little bit more shy, little bit more reticent; we are very happy to meet with everyone and anyone who wants to come talk with us and we hit the road, we have been in 11 cities this year we do non deal road shows on other continents and we also participate at investor conferences. A hint would be if we have sell side analyst coverage, we feel better about going to conferences, so for those who are contemplating please keep that in mind.
Now who owns our shares; it is very interesting, if you go back to 2008, 36% of our holders were value investors, times were dark, stock was cheap and value investors owned about a third of our stock and things have gotten better. Majority of holders in Moody’s now are GARP investors and growth investors only 12% are value folks. So what we see here is we are a GARP stock; we don’t view ourselves as a value stock and our multiple has moved accordingly.
Now, if we don’t get enough out of meeting with investors constantly, we survey them as well. We survey investors twice a year and the sell side analysts and we ask them what would you like us to do, what is your preferred capital deployment strategy.
So we hear from investors that the very important thing that they want us to do is either repurchase shares, invest in product development or increase the dividend and we understand that each of those things are important to different shareholders. Bolt-on acquisitions are also something that is considered somewhat important.
Reducing our debt is not considered important and making a major transformational acquisition is considered not as important. So we have no intention of making a transformational acquisition. Rob will speak a little bit more about our criteria in a minute. Now, within the repurchase shares and increase the dividend view, we have hawks on the other side of the question.
We have people who call us up and tell us do we purchase many more shares and we have people who meet with us and tell us to greatly increase the dividend. We're not going to make everyone happy. We're trying to find the right balance. So what we have here is a chart of our capital allocation since 2008 over four years. This is 2.5 billion of capital we have had to work with.
Of that, you see that 1.6 billion has been returned to shareholders. Two-thirds has been returned to shareholders and over this period, it's tended toward share repo dividends at 17%. Rob’s going to talk about the acquisition slice of the pie, which is 0.6 billion and in fact it's a smaller piece of the pie, but two-thirds of the capital going back to the shareholders.
Now our goal here is to keep our leverage about as it is. We’re rated BBB+ by Standard & Poor's. Like every other company, we think our rating is too low, but we're comfortable with our leverage levels and we’re looking to maintain that strong investment grade rating, being in the business that we’re in that’s important and we want to maintain the balanced approach of returning cash to shareholders.
So our balance sheet has had some activity this year, we did a $500 million bond deal in August, a 4.5% coupon. It was five times over subscribed, it traded 20 bips through our existing deals, we're very proud of that. We have a billion dollars of the bank line which is completely undrawn at this point and no major maturities until 2015.
The bond deal will be used partially to pay-off the term loan that you see on the bottom left. And our debt to EBITDA is reasonable and well within our rating. Now our cash has moved from very heavily offshore with the bond deal to about 50:50 back onshore.
Now we have about $550 million of cash offshore, the cost to bring that back to bring back $550 million would be about a $100 million. I don't think it's prudent to spend a $100 million to bring back $550 million. So we did a bond deal, we issued at a very reasonable price, we have some more flexibility and we will see what happens with the elections and where US tax policy goes.
Now on share repurchases on the left hand side you see we've come to sort of moderated view where we do $200 million to $300 million a year of share repurchase. If you missed it in our guidance this morning we've upped our share repurchase view for this year from 200 million to 300 million.
And our dividends have been increasing at a nice clip. We took it up 20% last year, we are increasing dividend in line with earnings and we'll talk more about what we are doing with dividends in December.
We are aware that some of you would like us to increase the dividend, we've heard that, got it. Recent tax planning has been very helpful to us. In 2004 this company paid a 41% effective tax rate, we are located in New York. It’s a high tax jurisdiction, but as a 50% international company there was a lot of room to do more. So what we've done as we've planned very effectively, we've planned very conservatively and we have gotten our tax rate down in 2010, we were at 28% this year we are guiding to 32. If you look at some of our competitors our tax rate for companies that are in like businesses in like jurisdictions, we are doing pretty well and we feel pretty proud of that.
On the other hand Moody’s will never undertake any sort of aggressive tax planning, we are very conservative and we are only moving on strategies which are very well tested and really above reproach that we will continue that, but savings of $350 million since 2004 by reducing the tax rate.
Now back to the funnel. I hope you have all had a good long time to think about the funnel and no going ahead, so I see Brad is going ahead. So you start with 500 companies in the S&P 500, four of them were kicked out because their market cap is less than 2 billion. Of those, look at this only 40% have revenue growth that’s equal to or in excess of ours, only 40% have the growth on the top line that Moody’s has, take that group and you cut it again only 12% of them have the operating margin that we have, puts you down to 25 companies.
EPS growth of greater than 15.8%, you get about half of those, 13 companies and total return greater than 18.2% over this period only three companies. Okay so who are they and if you guess this you get extra points. Okay, it’s Philip Morris International which is not domiciled in the US and Visa and compared to these guys I would submit that we are still a bargain at 15.2 times forward PE, Philip Morris International at 16 times and Visa at a very healthy 19 times.
So again we are very proud of our performance and we think we do represent a growth at a reasonable price opportunity. And with that I will give you the guidance again, you see as Ray had said revenue and OpEx at 12% to 13%, tax rate down to 32, EPS guidance rate went through, share repurchase please note the extra hundred million dollars and other things remained the same. The longer term targets, low double digit revenue growth and the adjusted operating margin which is the EBIT margin plus the D&A in the low 40s and with that I will turn it over to Rob to answer all questions on corporate development.
Thanks Linda. When I first joined from Citi about 7 or 8 years ago, my boss reminded me that I was going to a company for credit rating analysts and I think he thought that didn’t bode well for M&A. We've gotten some M&A down, but I can assure you that the approach here at Moody’s is analytical, it is rigorous and as you would expect from Moody’s conservative and I am going to talk to you a little bit today about how we spend, how we evaluate, execute and track on that 20% to 25% of free cash flow that Linda talked about.
So corporate development team really three primary functions, one is to facilitate corporate portfolio decisions. John you asked the question about how do we allocate capital, one of the things that we do annually we have a market analysis framework where we look at both the markets in which we operate today as well adjacent markets within the business information services.
We look at forward growth rates, profitability, size and market structure and we make decisions about where we want to invest further and where we may actually want to consider divesting and we will review that framework with our board annually. Second we lead geographic expansion in high growth markets. This really is in Asia, to a lesser extent Latin America. We have a good bit of experience in both diligence and structuring in some of these jurisdictions and finally we assist our lines of business in executing their strategies. All of the deals that we do at Moody’s are led by the business. These are not corporate led deals, but we do want to make sure we ensure some corporate consistency. We also want to ease the execution burden on the businesses and you’ll see, I mentioned here target screening and proactive outreach. We want to make sure that we’re not sitting around competing in auctions. So we do everything we can to find opportunities that are directly in line with the strategies of our businesses.
So I get asked all the time how do we source deals, how selective are we? Do we compete in auctions and so on and so and in keeping with Linda's funnel theme, since January 2005, we've analyzed roughly 475, just under 500 companies. That has resulted in, as you can see 14 majority transactions and just taking a look at the difference in the transactions between the ratings and analytics.
As Ray mentioned, when we started, if we can invest in sizeable ratings opportunities around the globe, we would do that all day long. Unfortunately, there are very few opportunities of scale that are also actionable. So you can see that we've done a handful of minority investments. Often times, are really always dictated by the foreign ownership restrictions in the countries in which we’re investing.
And we’ve made several small majority acquisitions, but you can see the purchase price on the ratings deals, very small on average. The Moody’s Analytics deals would be more you expect in terms of the typical control transaction, still very much in the bolt-on. We've done transactions ranging from $2 to $200 million but since 2005, we’ve only done four transactions with a purchase price of greater than $40 million.
So, how much have we spent, we spent about $680 million since 2005. That's about $85 million a year on M&A. There is no quota, there is no objective in terms of the number of deals that we will do at -- in any given year. Some years we've done no deals, some years we have done as many as five.
For that $680 million we have acquired about $225 million in first year revenues, that's an average multiple on a revenue basis of about three times and we think that compares quite favorably to the multiples that are paid in the business information space. I just took just literally did a data dump from our database, we are showing about 3.4 times, a little longer than 3.5 times revenues paid in the space. And as you know transactions in this space tend to be quite expensive.
So how do we choose what and when to invest. So we and as Linda mentioned we get this question frequently. So we decided to answer it today. We have some financial parameters and we have what I'd call kind of operating in strategic parameters. So around the financial parameters, no real magic here. We have several different things that we look at in every transaction, we obviously are seeking an internal rate of return in excess of the cost of capital of the target which we are acquiring and that ranges depending on the size of the business, the location of the business and the type of the business.
Very importantly we look at cash on cash return and we seek to have a greater than 10% cash on cash return within three to five years. Why not one year because we are acquiring growth companies, they are growing into these returns and why 10% because that roughly approximates our cost of capital. We also look at, but I wouldn't say a primary metrics payback periods as well as GAAP EPS accretion. We like for this deals to at least be GAAP accretive within three years.
In terms of what kinds of companies do we like to buy. Again we seek ratings or standards businesses that would be the highest priority for us. Those are relatively few and far between, so we then we have this market analysis framework. This is just kind of a sanitized snapshot of that, where we seek to invest in high growth markets.
Obviously we are seeking to invest towards the top and towards the right. We are also looking to make investments in companies that have a financial services client base that leverages our distribution, our brand and our credit expertise and analytical rigor.
We also look for demonstrable synergies in every transaction, that's both top and bottom line and we see that as really a proxy for the degree of fit with our organization. Every time we are acquiring a company, we are asking ourselves are we the best owner. If we can’t drive significant synergies, it’s telling us that we are probably not the best owner for the asset.
We are looking for a repeat or recurring revenue streams, I think you heard from Rishi today about the nature of that business and how we think of that as really a recurring revenue business. Just like you saw on Linda’s slide with the low capital expenditures we are looking for businesses that have low capital intensity and you should not be expecting transformative acquisitions from us.
So how do we know how we are doing? Once we acquire business of greater than purchase price of $10 million we have some periodic tracking that goes on. And really that’s twofold, but first you have to understand that we typically integrate except for Copal really which were I would say have kind of a collaborative approach on it. We typically integrate every business that we acquire.
We do that because we think that, that creates a more coherent products and services offering for our customers. The downside to that is that it makes it difficult to track earnings, we can obviously still track revenues, we can still track other key performance indicators. It gets more difficult to track earnings of the acquired business once it is fully integrated.
So we have a quarterly dash board, we have a set of key performance indicators that are both financial and operational in every deal as you would expect as we do our revenue builds, we look at we make assumptions around client retention, employee retention and the like and then we track that on a post closing basis.
And we do that quarterly and we share that with both the management and with the board. We also do annual acquisition reviews, so I get the pleasure of going in front of the board every year and talking about the performance of our acquisitions, how they are tracking against the acquisition model, what worked, what didn’t work like we expected, why and how are we going to incorporate those lessons learned into the acquisition process going forward and also a discussion about is there still a strategic fit.
Is the strategic rationale still valid. Finally we also get to do with our accountants, our annual impairment testing process where we compare our assumptions around fair market value of the asset to the purchase price.
So that’s how we track it, how are we doing. In terms of the key performance indicators which are really again financial and some of the operational metrics when we first touch on Copal and [BNH] and these are really our three largest transactions since the Fairmont deal back in 2008.
So I wanted to focus on these. Copal and BNH we consider those to be on track with our acquisition models and our assumptions. CSI slightly behind, the training market has softened even though CSI exceeded its first year KPIs in the second year as we've seen a slowdown in Europe which is actually impacted the training business and even the training business in Canada. We have seen some slow downs, so what have done about it. We have made some management changes, we have accelerated the integration of the CSI business with our legacy training so that we can drive more top and bottom line synergies in order to get back to hopefully achieving that cash-on-cash return of 10% within a five year window.
So I think as you get more understanding of the businesses that we have acquired, you can start to see how they fit in terms of what we are looking for. We think of CSI as really a standards business that anchored our training business, a must have, a need to product in training and we both the Copal and B&H acquisitions as primarily investing in growth.
So I will close with in addition to the $225 million of revenue that we have added to the company, what else is our $680 million and our corporate development effort gotten us why should you care, we even expanded the addressable market I think Mark alluded to an addressable market of about $12 billion versus what we think of the core addressable market for the ratings business of closer to $4 billion. And we have expanded our addressable market into high growth markets as well.
We supported double-digit top line growth for Moody’s. We are leveraging some of the competitive advantages that we have in regards to brand and global distribution. We are building scale in a high multiple, high growth analytics business primarily the enterprise risk solutions business. We believe that we have created a top five global player in that business.
We are adding capabilities as Mark talked about and Mark and the team to further penetrate our existing financial services client base and we also added back office platform which will be able to leverage in terms of cost management and finally we developed a local presence in sort of key emerging markets, we feel very good about our position with our joint venture in China. So with that I will turn it over to Lisa and happy to answer your questions.
Thank you, Rob. So this morning you have heard a lot about our business strategy. You just heard about our financial strategy and so what I would like to do in the next minutes is tell you how we pay our people and how we incent them to deliver on that strategy.
What I am going to be discussing is targeted at our named executive officers so those that appear in our proxy but broadly for the top 50 senior managers at the company what I am describing exists for them as well.
So we get started, what's our compensation philosophy? Well, we are really trying to do three things. First, we are trying to link realized compensation with business success and also each person’s individual contribution to that success.
We're also looking to align executives’ words with the shareholders interest because the shareholders own the company and we are working for you at the end of the day. And then thirdly, we are very cognizant of offering a competitive package to our executives in terms of motivating them to deliver superior performance but also to retain them. We've got smart people I hope you can see that, they do have other opportunities and we want to make sure that they are incented to not only work well here but stay here.
In terms of corporate governance, we've got I would say very, very strong oversight of our executive compensation. The governance in compensation committee of the board is responsible for the comp structure at end of the day, also for evaluating executives’ performance and setting their goals that committee is comprised in entirely of independent directors.
They also work with a comp consultant Meridian Compensation Partners, the comp consultant attends each and every governance in comp committee meeting, and he really provides a wealth of the information in terms of emerging trends in the executive comp arena gives us the sense of what best practices are and most importantly helps us and the committee to benchmark our compensation versus our peer group and also versus the broader financial services industry.
So how do we pay people, what are the components. We really have two components although you see three boxes up here, we have got a base salary and we have incentive compensation. Base salary is just what it appears, on the incentive side, we have short-term incentives in the form of annual cash bonuses and then we have medium and long-term incentives denominated in equity.
Our equity on the medium-term, we have three year performance shares and I will take you through those momentarily and on the longer term we have got 40 stock options.
We tend to what we focus on benchmarking the total comp package first but we do pay attention to mix as well in terms of our mix of comp as oppose to our peer group.
So in terms of that mix, our CEO comp is structured this way and these numbers again are reflecting what’s in our latest 2011 proxy. Base salary is about 18% of total target compensation and then the amount that means the amount of compensation that’s out risk for our CEO is 82%. 32% of that is in the annual bonus and then the other 50% is equity based.
The number shift slightly for the other named executive officers, you can see there is a range here base salary goes from a low of 18% to a high of 30%, the annual bonus target around 30% overall and then the equity based incentives between 40% and 50%. Those named executive officers who have operational roles like the heads of our businesses have more compensation at risk than those who have more corporate roles.
In terms of how do we fund these various incentives, we have a variety of targets. So you can see here on this chart for our CEO CFO and General Counsel we have two main targets for the annual bonuses. We are looking at company wide operating income performance and we are looking at company earnings per share performance.
In terms of the heads of our businesses, you can see they share those metrics at a lower percentage and they each have 50% of their targets based on the operating income performance of the area that they are managing directly.
So they are tied both to making sure the company overall does well but also focusing on the areas of their responsibility. An important component to this so you could say we have got a real financial focus here, we do, it’s true but we do have a customer focus as well. We have a modifier, every year we do a blind survey of institutional investors those who are focused on investing in the debt market and we ask them how are we doing compared to our competitors and depending on overall how we are doing but also how we are differentiating ourselves among the competitors that we have, we adjust funding for bonuses up or down up to 10%.
In terms of long-term equity, I guess the first thing I would want to emphasize here is when we are thinking about how much equity to award. We look certainly at competitive values. So what are our peers awarding but apparently even more importantly, we look consistently at share utilization.
Again, how are we positioned versus our peers and how are we using the shares overall. So starting with stock options, these are fairly typical, probably something that you have yourself or you are aware of. These are options that are priced on the [ground]. For us, they invest ratably over four years and then they expire after 10.
So if there is no stock price appreciation between the (inaudible) and 10 years later, these have no value. Our performance shares, this is something that we introduced about three years ago in 2010 and what those are, they’re basically a promise to paying executive a certain number of shares in three years depending on our performance against various targets and it's cumulative three year performance.
And those performance targets that we have is a measure of Moody’s profitability overall, the rating agencies accuracy in its ratings so that’s something that we do track. It's actually something we publish as well and Moody’s Analytics sales.
Now depending on what you do at the company, your ways are different and that’s what you see on this slide here. So again, for the folks that have broader, more corporate roles, each individual has each of those three targets and you can see the weightings.
It's primarily weighted toward profitability but given that the top three individuals listed here also have impact into investment funding etcetera for the rating agency, there is the ratings accuracy fees is part of their goals and in addition the Moody’s sales.
For the heads of the businesses slightly different mix, it doesn't make a lot of sense for the Head of Moody’s Analytics to have ratings accuracy goal so he doesn't and likewise we've got for the head of the rating agency profitability and the ratings accuracy goal.
One other things that I want to mention here is since this is the three-year program that we started in 2010, we haven't made any payments yet. We will be making our payment at the end of based on the performance at the end of 2012 that would be the first full three year piece of this program.
We also have stock ownership guidelines; these have been in effect for quite sometime. So executive officers are expected to own a certain multiple of their base salary at all times. Our CEO is expected to hold six times his salary that was increased from five times in July. This is an emerging trend that we're in seeing in executive comp, more companies are shifting toward six times and some are even greater than that but very few. Right now between depending on what survey you look at, between 20% and 30% of companies have six times or higher.
So we feel that we are more on the forefront there. The rest of the named executive officers are required to hold three times of their salary in terms of stock ownership and then our non-management board directors are expected to hold five times their annual cash retainer. So they have got skin in the game too in terms of ownership in the company.
We also have a hold until met requirement. So what does that mean? For us, this means that if you are an executive officer and you haven’t yet achieved your stock holdings, you must hold all of your shares; he must hold 75% of all of the shares you are awarded until you reach that requirement. So we are helping people along getting to where they need to be in terms of stock ownership.
Also stock options and any unearned performance shares do not count. So you really must hold the shares yourself. And because 2013 is the first time we are going to be paying out on these performance shares, we expect based on performance over the last two years and the latest guidance we just provided that once we pay that we will pay our performance shares and after that you should see a significant increase in share ownership by named executive officers of the company.
So in summary, four key points we would like you to walk away with, first, that our comp plans are directly aligned with shareholders’ interest. We feel that’s important. We have robust and independent governance around executive compensation.
We routinely benchmark and we are inline with our peers in the broader financial services industry and I guess most importantly we are very pleased that shareholders last year approved our executive comp program by 98%. So with that I am going to invite Linda back up and we are open to questions.
Okay. We will be happy to take questions unless there are about a very complicating compensation plans which I am going to turn back over to Lisa. We will start with Peter.
Linda, I don’t think I fully understood your comments on margin. Are you suggesting that you are guiding to or anticipating flat margins on a go-forward basis versus previously I think you talked about on the old metric low 40% margins achievable in the business?
I think we haven’t moved from what we said before but let me look at the last slide that we had. Okay so for 2012, EBIT margins as we have traditionally reported 39% and that is our guidance for 2012. As everyone knows, we haven’t given guidance yet for 2013 that will come in our February earnings call that covers the fourth quarter of this year.
For the longer term, we would expect both revenue to be double digit Peter and the longer term adjusted operating margin in the 43%. So we are saying that would be 39ish. Now, again if things break correctly and we are able to do better, we would hope for margin expansion. In the near-term, I think we are going to be facing some headwinds in order to achieve that. In the longer term, it would be our goal to have margin expansion but we are not going to specifically speak to 2013.
So yes, I think we are looking to get there but we are now thinking about this and the new way of looking at EBITDA margin and so we are saying the low 40s percent there.
Can you talk about, we know about the regulatory cost, the incremental cost there, where do the other cost pressures come in that would prevent you from seeing a little bit more margin leverage in the context of your double digit revenue target?
Sure, there are couples of things, for this year most immediately when we are moving up guidance we are doing better than we had expected at the beginning of the year that results in greater incentive compensation. Looking at this increased guidance view; we are probably looking at about $20 million of additional incentive compensation of all forms which will probably share the employee group sitting over there, but we have done better than we expected. So that will be one item.
We are facing as Michel has spoken about, increased IT costs in order to handle the regulatory side and we have added headcount to drive the very strong topline growth that we’ve seen. So the main components would be the additional headcount, very much below that would be the IT costs and then if we’re doing better than expected, we do have additional incentive compensation which will come into effect for the rest of this year.
I don't know if this is as much of the question as it is a comment, but what are the things that you referred to Moody’s Analytics business and you want people to look at it in different way and you cited higher multiples for that business and where acquisitions are being made, but on the other hand, I think Ray this morning, in his prepared comments said, look, these are not separate businesses. They’re integrated. There is big cost synergies between the businesses; you know, presumably, unless you’re going to sell that business, what's the use of placing that high multiple on it. So how do you look at the value of the business overall, because it seems a decent conflict from what I have heard this morning?
I don't think there’s any conflict and I am sorry if we left you with that impression. The businesses are mutually reinforcing and we only have two business lines and we think that they do help each other out quite a bit. Look, I was trying to explain is that the Moody’s Analytics business perhaps may not be fully appreciated in terms of when, for example someone might to some of the parts valuation, which might be one way to look at how you would aggregate or value to get to our stock price.
So I think what we are trying to explain is that our job in redeploying capital to Moody’s Analytics is to make sure that we are providing appropriate returns to shareholders and that we are being appropriate stewards of that capital. And what I was trying to explain is that if we did take a market view, we have done a very good job particularly in enterprise with software of developing a business which has perhaps under appreciated value; I was just using it as a point of illustration, so sorry if we caused any confusion. Is that Bill yes, hi?
Linda, do you have a sense at this stage what the incremental regulatory costs could be in 2013 and clearly your cost of doing business has gone up and so I just wonder if there is going to be any kind of change of thinking on pricing as we get into 2013? Thank you.
Sure. This is the question that Michel and I get several times of day in terms of what we will be the regulatory costs for 2013. We have a pretty good idea as Michel and John explained earlier, what's going on with Dodd-Frank; that is a roll forward of rules that have been written. The SEC has got to comply with what was approved by the Congress and signed by the President, so we know where that’s going. So that’s something we can easily determine and bake in.
CRA3 is a bit of an open question, though its very difficult for us to know where that's going and what is going to cost. So I think the first time we may be able to deal with that question would probably be on the end of year earnings call in February, because it would probably be less than helpful for us to put out any type of number when we don't know where that's going. And Michel I don't know if you want to comment any further. So we are not even going to take a slag of that at this point.
On pricing, we believe in pricing perfectly appropriately for the value we are providing; you saw that Ray had said approximately 4% price increases; you heard Mike Rowan speak about how that varies across geographies and products and we are very effective at getting the yield on those price increases. We are aware that we would like to cover increased costs, but we think more about providing value for the issuer than anything else. Yes John?
I must ask you, a transformative acquisition is not currently a high priority for your investors, but my question is if you came across an opportunity and you have very high conviction, would you do it?
I will probably ask Ray to comment on that when he gives his closing remarks. I think amongst management teams we’re probably uniquely humble and realistic. We are probably not the best suited for taking on a transformative acquisition. I think we are running a business right now which is in a period of intensive change as we move from an unregulated environment to a heavily regulated environment and we are doing a pretty good job of growing Moody’s Analytics. So I think Mark and Michel and I would say we have pretty much got our plates full with what we are trying to do right now.
I think Rob would probably echo that, but never say never, but we don’t have huge expertise at handling those transformative acquisitions and I think the risk go up as you are betting the ranch on a transformative acquisition. All the literature in history on big acquisitions would be that they are very seldom of value creating, so I think that would cause us to be even more cautious and I think it’s just the nature of the beast that we are pretty conservative here. If you see something we should look at John let us know, but I wouldn’t hold your breath. Craig’s going to ask me a hard question.
Actually it’s pretty easy I think. The $700 million or so in your balance sheet is tied up overseas and still the federal government does not give you and other companies a tax holiday; what is your plans going forward, could you do small bolt-on analytics acquisitions outside the US to get to that cash?
Well, the numbers are I think the end of the second quarter we have $770 million outside the US and a good chunk of that is what’s called permanently reinvested. We can dividend some of that money back to a limited extent within the arrangements that we have offshore. I think our view would be to use that yes for bolt-on acquisitions; the majority of the ones we have done recently have been outside the US, so in some sense those acquisitions are paid for in lower tax dollar which makes it a more efficient way to do those acquisitions. If we do have a tax holiday, we would obviously be prepared to change our plans; we have done that analysis and we will have to see what the future brings, but for right now we think the situation we have is probably the most tax effective and best for the shareholders.
Is there a scenario where you would list your shares on the London Exchange or another exchange to take advantage of the cash held overseas?
It is a good question Andrew; we’ve looked at that; you have to look far to find analysis we haven’t done on these questions. It cost quite a bit to list in London and the real question is to whether that would be effective? There is also question of whether that would subject us to yet more additional regulatory overview and oversight which at this moment is not something we have a huge appetite to engage in. So I think our view was that it would probably be relatively expensive and unwieldy to do and we don’t have a huge outstanding float. So I think at this point, we will probably stay where we are. We have looked at that and we thought it doesn’t make particular sense. Situations change. We look at it, every so often, but it's a good question. Doug Arthur has a question back there.
Doug Arthur - Evercore Partners
Yeah this maybe more purview for Michel or Michael, but you talked about the outlook for the financial institutions risk area. That ratings area has been really essentially flat for you for four straight quarters and it sounds like based on the comments that’s not going to change much near-term, right? What will eventually get that area really?
Sure, I would invite Mike Rowan to add to this. I think the first issue there Doug has been that spreads have been very wide for financial institutions of late, which has caused them to delay coming to market for as long as they possibly can to see if those spreads would come back in. I think some banks recently have come to market. The FTA decided that Santander for example was able to come to market last week, but spreads are quite high and that’s what's really dampening issuance. Mike may have something more to add to that.
Yeah Linda, the only thing I would add is that the growth in our customer base in developing markets overtime, you know, starts often with the financial institutions themselves and as that customer base builds, then I would expect to see some growth overtime in that particular franchise.
You know, sometimes I’ve gotten these (inaudible) stock prices because of headline sort of risk; do you envision a scenario where the multiple is so low and the pretax yield so high that it would be considerate to take the tax hit on a share buyback in a more opportunistic way; is one question. The second question is, as a long term shareholder, really happy to see the continuity of people here tonight and today and have you noticed because of the downsize in the industry in the financial services in general less a day of a competitive fair in terms of people being lured away or maybe easier to call the people? Thank you.
Sure. For the first question we haven't discussed that analysis since yesterday, literally yesterday, we discussed that analysis and yes we know exactly at what point the stock price would become attractive to do that trade. One of the things we would notice we could borrow more money; we have a revolver which is untapped. There are others way to go about it; I would view again that $550 million permanently reinvested offshore as an expensive way to do something like that which is why we did a bond deal in August when we were able to finance very cheaply. So yes we know exactly the answer to that question and it’s we are not in the zone.
In terms are we able to hire and are we able to keep people? Absolutely; and we don't have deferred compensation; our pay checks clear; our bonuses are paid in cash; its great, which is a real competitive advantage at this point. What we are finding is that we're able to talk to you know lots of different people who might have perhaps felt that they had a higher calling a few years ago, but now are very interested in working for Moody’s. So we are not having a great deal of difficulty hiring people right now in fact certain jobs we are looking at we have literally hundreds of resumes, hundreds. I’ll let Lisa comment on that further if you would like to.
Linda’s got it right; the job markets certainly all around the world are not as robust as they have been in the past. Even Asia has slowed down in line with the GDP numbers that you say. So our retention is higher and that’s probably true for financial services in general and although they are jettisoning people in the banks and we are not and Linda reminds people of our employees about whole time quite honestly, but it still takes us the same amount of time to find the right people with the right skills and fit for Moody’s.
We are happy to accept any resumes if you have any thoughts. Anything else we can answer for anyone before I turn it back over to Ray to do the concluding remarks. Okay, well thank you very much and back over to Ray.
Okay. I will be brief, first of all want to see if there are any other questions that you have that haven’t been answered in each of the segments that we have addressed today. So I would be happy to take. Yeah Peter.
How do you think about M&A as a driver of growth, should we be thinking of this as another 1% or 2% of the topline beyond the 10% organic? And then secondly, maybe just more commentary, I personally thought that the 10% cash on cash return metric didn’t seem that challenging; it seems to low, can you think about that or talk about that please?
Sure, I can invite Rob to comment on that, but this is a threshold that we are looking to clear and it’s over a period of time, so obviously the returns would be expected to increase overtime, but the 10% is a rate at a point in time that we are using as a metric. Actually got that from Berkshire Hathaway as one of the metrics that they had historically used. I am sorry you had part of the – yeah M&A.
Yeah, I did not include M&A in that build although that certainly would act as a catalyst for the topline to the extent we continue to do bolt-on acquisitions. Those are -- the opportunities are not certain there; we look at an awful lot of potential acquisitions for relatively low hit rate, and so I feel that rather than identify that as a deep current driver for the business, I would put that more in the category almost the way we might describe the mortgage backed securities market at this point is there is upside or optionality that comes from that if we do pull the trigger on additional acquisitions.
With respect to just complete the loop on the transformative acquisitions, I would very much echo the comments that the management team made, I think it’s unlikely that we are going to pursue a transformative acquisition; if we find a high growth opportunity that’s very cheap with no auction of size and highly certain return, okay; but we are not holding our breath on that so.
So 20 years from now, when you look back on the period between now and then, how will you judge your success?
Unidentified Company Representative
20 years, in terms of Moody's financial performance or?
Your tenure as CEO?
Unidentified Company Representative
Well, I am not going to have to wait 20 years to look back on my tenure as CEO, I guarantee you that. But, I mean, first and foremost, just given the point in time, that I’ve been in this position, it's going to have to include a heavy dose of managing through the financial crisis.
Will Moody's position be as relevant as important in the financial market place when I retire as it was when I came to the job? I think certainly we want to have a larger, more diversified business that still aligns with our brand value expertise and skills. We're going to have a greater global presence in the future.
These are, I mean this goes to some of the comments I was just going to sum up with. I don’t do hype real well and many of you who know me know that, but I feel better about this business today than I have not only since the financial crisis, but since before the financial crisis because we have weathered a very, very tough storm.
Our relevance is probably at a high watermark. In some respects, we maybe too important. If we’re too important to speak, we’re too important. The expansion of the business in to long-term growth geographies, Asia, Latin America, the Middle East is very promising for the long-term future of this business.
The diversification not only into new products and services, both at Moody’s investor service and Moody’s analytics but also into more recurring revenue, subscription based revenue, recurring ratings revenue is going to bode very well for the long-term future of this company.
So I will judge our ultimate success or at least the success as of my departure. Not only financially, clearly financially but also by how relevant we are to the financial market place that we operate in. And as I said right now, that's probably at a high order margin.
Can you talk a little bit more about financially?
Unidentified Company Representative
While you seen the growth rates that we put forward, so all you have to do from that is extrapolate the growth over my remaining tenure and we don't know what that is yet.
Over the next few months, you are going to get a much more focus competitor in S&P, how is Moody’s preparing for the new environment going forward?
Unidentified Company Representative
Sure, I do expect we will have a more focused competitor and ironically I think that's probably good. I think that in the credit ratings industry, certainly that side of the business, it is somewhat difficult to differentiate ourselves from them over time. So I think the better we both operate the more accurate and timely and in sight for our analysis that that creates a halo effect for the industry. And it’s certainly I have to pay attention to them as a competitor, but and I have talked to a number of you about this before. When I think about competitions especially in ratings, it’s first and foremost the unrated marketplace that I think about.
I am happy for other rating agencies to provide their services as broadly as they can, as long as I am providing comprehensive comparative coverage through that side of the business. So I think it’s you know, they are going to be a good competitor, they are going to be a tough competitor but that’s probably good for the industry as a whole.
Ray, just going back to the pie chart on capital allocation, where its gone over the last few years, and leaving aside the very low probability of a big transformative transaction and could we have you talk just a little about the portion of capital that gets used for those smaller transactions and whether you think about the outcome of the last few years as purely a bottom of (inaudible) the result of what’s been available and the alternative with buying back stock or some kind of a normal that we should think of as a benchmark when we look at many years in the future that may be somewhere between a quarter and a fifth of the capital gets used for these kinds of acquisitions?
Yeah, it’s probably, I will answer in two ways. It’s probably not a bad benchmark to use. I would frankly be somewhat surprised if we found more opportunities or at a more rapid rate find the opportunities going forward then we have going back. If anything and I will invite Linda, Rob and the team to weigh in on this or Mark Almeida, certainly with respect to some areas of the Moody’s Analytics business that we felt were really more need to have the nice to have, we move forward on those and I think there are fewer need to haves going forward.
We feel we got that business built out well, there may be a couple of areas that there would be some nice tuck ins and I certainly wouldn’t ignore those but we have moved largely down the path from need to have to what might be nice to have and if anything that probably has a dampening effect on the pace at which we would be acquiring.
And that’s probably even more true on the ratings side of the business. We have made investments in rating agencies and in number of jurisdictions around the world, we have not been able to make 100% acquisitions in every case and that’s why we have joint ventures and minority investments in some cases.
So we would like to build those up to where we have majority or 100% control but the opportunities to acquire or invest in additional rating agencies in domestic markets around the world I think has clearly gone past its high watermark and Michel, I don’t know if you have anything to add to that. So you’ll see few of those as well. And even from the management team any one want to contradict me that would be fun. Anything else?
Okay, let me just first of all thank everyone who has participated this morning. We really appreciate you taking serious amount of time out of your day to listen to us talk to you. You get to hear from Linda and I and you get to hear from Linda and me and then Salli on a regular basis, but this is an opportunity here from the rest of the management team. We did put a lot of thought and effort into trying to address the kinds of questions we hear from you when we meet with you one-on-one.
I hope we have done that to a satisfactory level and we appreciate that you have a lot of things you can invest in. It's a great business. It's got challenges; it's always going to have challenges. Everybody does, but the opportunities are sizeable.
Salli and the IR team, I want to thank you very much for putting this together, a tremendous effort and to everyone on the management team, thank you for your very thoughtful commentary. Thanks a lot everybody.
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