Moody's: Still Dramatically Undervalued

Includes: MCO, SPGI
by: Harry Long

On January 28th, I wrote (here) that David Einhorn's short thesis on Moody's (NYSE:MCO) was wrong. I still believe that Moody's is dramatically undervalued.

Moody's is essentially a duopoly in credit rating along with S&P (Fitch is a distant third) and at less than 10X Price / Cash Flow, the valuation already prices in headline and regulatory risks, in my view.

Since I first wrote about MCO on the 28th, the stock has dropped almost 7.4%. However, fundamentally, I believe the company has a unique value proposition. Unlike most companies in the financial space, it does not risk capital, instead, Moody's essentially trades opinions for money.

On the regulatory front, my analysis was a bit more prescient. I wrote:

Some have pointed to the salutary effect of competition. I would counter that it is precisely the urge to increase market share that has the effect of incentivizing raters to scrape the bottom of the barrel when rating debt. If an issuer has the choice of choosing from dozens of judges of credit worthiness, the issuer will choose the most lenient rating agency, in order to minimize interest payments. Indeed, executives at debt issuers have a fiduciary duty to minimize borrowing costs. It would be akin to choosing your regulator. When given the opportunity, firms choose the most lenient regulator. The government will realize that in regulation (and credit rating is essentially private regulation), more competition does not mean stricter standards—quite the opposite.

Since then, multiple news reports have pointed to the distorting incentives of competition among the credit ratings agencies (see here). Indeed, it appears that the debate has shifted to how much competition among the credit ratings agencies for market share drove ratings decisions (see here). Good public policy does not depend upon the virtue of individuals. It depends upon creating robust systems which harness incentives towards positive end effects.

The best thing the government could do to end competition among credit ratings agencies to inflate their ratings (see here) is to allow S&P, Moody's, and Fitch to merge. That way, market participants will not be able to shop around for a regulator using the only criterion they value-laxity (see here). With one major credit rating agency, market participants would not be able to pit one credit rating agency against another.

Disclosure: Author holds a long position in MCO