Moody's: Expecting Further Share Price Erosion

Singular Research is initiating coverage on Moody's Corporation (MCO) with a SELL rating, citing that continued dislocation in credit markets and material changes to the legacy business model are expected to hurt results, leading to further share price erosion. 

Key Points

• Ratings agencies, including MCO, have been identified as key culprits in the current credit crisis, which we expect will lead to significant changes in how these companies do business.  The ultimate resolution of this issue is still in doubt and thus will depress valuations until resolved.
• Results over the prior several years  were aided by growth in structured finance and other areas of securitization.  The current credit crisis has led to an evaporation of these activities, removing a key growth engine for MCO.
• Multiple parties including regulators and legislators have proposed a wide range of changes to the status quo, all of which are likely (if implemented) to have a negative effect on MCO’s core ratings business.
• A key casualty of the current environment is the concept of “Trust”.  With objectivity in doubt, trust has diminished, which further opens the door to competition. 

Risks

• Regulatory changes may ultimately result in minimal changes to the current business model.
• Strategic buyers may emerge for the company, resulting in support for MCO.
  

Company Overview

Beginning in January 2008, in response to the unfolding credit crisis, MCO reorganized its business into two segments: Moody’s Investor Service [MIS], which consists of the legacy ratings business and accounted for 79% of FY:07 revenue, and Moody’s Analytics [MA], which is focused on developing and marketing analytical tools used in credit portfolio management. 

MCO’s MIS business performs credit research on both commercial and government issuers in over 100 countries, with offices in major financial centers including New York, London, Hong Kong, Frankfurt, Madrid, Milan, Moscow, Singapore, Sydney, and Tokyo.  International revenues had remained steady at 36% – 37% of sales from 2003 through 2006, before rising to 40% of sales in 2007, and 46% in Q1:08. 

Further review shows that although international business represented an increased proportion of sales in recent periods, the change is due to the drop-off in US-based business, while international results have demonstrated less deterioration.  Within the MIS segment, ratings activities are focused on four main sectors of finance: Structured Finance, Corporate Finance, Financial Institutions, and Public/Project, Infrastructure Finance.      

The analytics business – MA – operates in roughly 85 countries, with over 1,800 clients, primarily in the form of subscriptions to Moody’s quantitative credit analysis tools as well as software and consulting services.  This business was reorganized as a separate reportable segment in order to segregate MCO’s “regulated” businesses from the non-regulated operations. 

With the impending threat of significant regulatory and legislative involvement in the ratings business, this allows the analytics business to operate more freely.  Additionally, in the near term, and likely the long term too, the analytics business offers much more opportunity  for growth thanks to the increased requirements of new standards of practice such as Basel  II.  The analytics business reported sequential growth throughout FY:07, while the ratings business, particularly in Structured Finance, fell significantly in both Qs 3 and 4.  Also of note is the fact that Structured Finance represents MCO’s largest sub-segment and is among the hardest hit areas in the current credit crunch.

Investment Thesis

The US credit crisis continues to unfold as it approaches the 12-month mark since major disruptions began to be felt last August.  In the latest chapter, “Fannie Mae” (FNM) and  “Freddie Mac” (FRE) teeter on the brink of full-scale government bailout.  We are certainly not the first to report this news or its root causes which trace to the collapse of the housing sector and defaulted mortgages.  What has also become readily apparent is the degree to which the “independent” ratings agencies were complicit in the assembly of the house of cards that has come down with devastating results.  Ratings provided by these agencies were often anything but objective and the product of shoddy work, as understaffed analysts sought to keep up with an ever-increasing stream of highly-complex securities. 

When the dust finally settles, we expect significant changes will be made in the ratings agency model as well as the competitive landscape in the industry.

With the housing bailout bill debate on Capitol Hill drawing to a close, the next target is likely to be an overhaul of the ratings agencies through increased regulation and/or changes in permissible business practices.  As is often the case, government intervention in business tends to the extreme, with an over-reaction  to negative occurrences in the form of heavy-handed legislation and regulation.  After the bursting of the internet bubble, including several high-profile cases of corporate malfeasance, Congress reacted with the Sarbanes-Oxley legislation, which has proven to be rather costly while not completely eradicating all the bad apples.  Accounting standards were also re-written post-Enron, but as we have seen, banks still had ample opportunity to park immense sums of off-balance-sheet assets in SIVs.  Particularly with 2008 being a Presidential election year, we are not optimistic that politicians will put their tee shot in the center of the fairway when it comes to proposed legislation.

One of the first casualties of the credit crisis was the evaporation of wide swaths of structured finance and securitization. As the aggregate issuance of debt falls, so does demand for credit ratings, as has been seen in MCO’s recent results. Trust has also been breached, which has the potential for distinct ramifications.  A likely fallout is increased reliance by institutional investors on their own analysis.  By doing so, they are able to insure the integrity of the analytical work, among other things.  The collapse of trust may also open the door for increased competition in the ratings business. The ratings market has long been dominated by MCO and Standard and Poor’s, which is a division of McGraw Hill (MHP).

Smaller players such as Fitch, A.M. Best, and a handful of foreign firms also provide competition but are often viewed as “second tier” opinions.  With trust now in question, the ability of these smaller players and/or new entrants to gain market share is a distinct threat.  While MCO shares have fallen nearly 50% since August 1, 2007, we feel additional downside pressure is likely, and thus rate the shares SELL. 

Comments

[Mr. Biggles...:]

Might have been a nice call before it dropped 50%. Closing the barn door after the horse has left. YTD MCO has outperformed the major indices and crushed the financial sector. ozaib.notlong.com

The company is extremely profitable with high returns on capital, and generates a ton of cash, and now it is on sale at a 14-15x PE, and 8x EV/EVITDA? You want to buy when others are fearful and sell when others are greedy. Selling MCO when all the bad news is baked in is just amateur hour momentum trading. No doubt these are the same “analysts” telling us to buy Pets.com at the IPO.

The ratings agencies are way out ahead of the regulators and legislators and have proposed changes which will mollify Washington while not denting their 50%+ operating margins. The company has traded at an average PE multiple of 26x over the last eight years. Even with lower volumes from less securitizations, the business model is extremely attractive and will get a higher multiple once the dust settles. Couple that with growing foreign and analytics business, and a compelling price and, if you have a time horizon longer than next week, this is a BUY, not a SELL.

2008 Jul 25 11:57 AM

[Lockstep In...:]

I have to agree with Mr. Bigglesworth. I got in on the short side February 2007 so my point of view your thesis is very old. The ratings model used for all of these structured products has already been disproven for a long time, so what quantitative impact going forward?

2008 Jul 27 05:54 PM