Moody's: Blowout Earnings, And Why It Shouldn't Buy FactSet

Summary

• Moody's reported a blowout Q1 which caused analysts to raise their EPS estimates further. Rising estimates help make the stock's valuation more palatable.
• The macro environment for Moody's won't be as good in the rest of the year. Issuances were pulled forward in Q1 and comps are very tough.
• The Analytics business is shining. This will be important in helping the firm manage weak issuances in 2H 2021.
• I don't want Moody's to buy FactSet. FactSet is growing slower than Moody's RD&A business. Moody's is doing so well without it.
• I'm still extremely bullish on Moody's even though it's my smallest position.

Photo by PeterPhoto/iStock Unreleased via Getty Images

Moody’s Reports Explosive Results

Moody’s (NYSE:MCO) reported blowout Q1 results which caused it to raise its 2021 guidance. Just when its forward PE ratio started looking a little high, it was lowered by estimate upgrades. The stock market sniffed out this great report, unlike analysts who were left in the dark. Moody’s stock was up 12.5% year to date heading into the report. This blowout was FAANG-like. Moody’s rode the macro wave in leveraged issuances, continued to benefit from being in the ratings oligopoly, and has executed well in growing the Analytics business.

I don’t expect Moody’s to make a big acquisition just because they have a new CEO. Why would they do that when their smallish acquisitions have delivered explosive sales growth and operating margin expansion in Analytics? I’m mentioning this because the company was rumored to be considering buying FactSet (FDS). I will review this rumor and the firm’s general statement on how it views acquisitions in this article.

Details On The Quarter

I am very pleased with these results as a shareholder. They support the stock’s rise in the past couple months. Even with conservative expectations, management had to raise 2021 guidance because the Q1 results were so good. Specifically, non-GAAP EPS was $4.06 which beat estimates by $1.26. This was driven by explosive margin expansion. Adjusted operating income margins were up 680 basis points to 57.1%.

The sales increase almost went straight to the bottom line because there was only a small increase in operating expenses. Sales were up 24% to $1.6 billion which beat estimates by $170 million. Operating expenses were only up about 7% to $747 million. 1.5% of that increase was due to strategic investments. The company is experiencing explosive margin growth while investing in the business to maintain its long term sales growth runway. This business is a well-oiled machine. There is no need to ruin the momentum with a major acquisition.

Amazing Macro Situation For Moody’s Investor Services

Moody’s has underestimated the macro improvement ever since the pandemic started. That’s ironic because its data and analytics are used to make macro projections. I will give the company a pass because most public firms like to be conservative. The company is focusing on what it can control. It is expanding the scope of its ratings such as through ESG scores and expanding its Analytics division. Those were key topics on the call, but ultimately being in an oligopoly that experienced extreme growth due to the macro environment drove results this quarter.

Source: Moody's Q1 Slide Deck

The slide above shows rated issuances in Q1 were up 23% in Q1 which made this by far the best Q1 in a decade. These are eye-popping numbers. Leverage loans, high yield bonds, and structured finance were up 94%, 85%, and 67% yearly. Generally, it’s preferable to have recurring sales over cyclical sales, but cyclical results can work beautifully when everything goes right. However, this high growth won't continue. Next quarter will have extremely tough comps because public companies raised a lot money in Q2 2020.

Financial conditions are very easy and rates are still low, but corporations have excess cash. Many firms, just like Moody’s, temporarily suspended their buybacks in 2020. Now they are seeing high profit growth which is giving them even more cash. It’s ironic that in the last expansion many called for the 'corporate debt bubble' to burst in the next recession. This prediction ended up being exactly wrong. The 2020 recession ended up being a uniquely great time to raise capital due to the Fed’s intervention. Now companies are overflowing with cash.

Source: S&P Global

As I mentioned, Moody’s an oligopoly in the ratings business. As of 2018, the Big 3 (Moody’s S&P Global, and Fitch) had 95.4% market share. Moody’s brand and long history in this business makes clients trust them. This is important because the entire point of a bond rating is making investors trust the business enough to lend to it at a competitive rate. Many issuances need ratings by multiple agencies, which further lessens the competition in the space.

This lack of competition was on full display with the massive margin expansion the firm experienced in Q1. Moody’s Investor Services (MIS) had a $245 million increase in revenue and only a $20 million increase in expenses. This cause margins to rise 720 basis points to 67.7%. On a year over year basis, incremental margins were up 93%. These high margins are not sustainable though. Guidance calls for 2021 MIS margins to be 61%.

Just because we are likely to see a cyclical fall off in issuances following this massive quarter, it doesn’t mean the company is in for long term issues. As you can see from the chart below, issuances correlate with nominal GDP growth. I believe governments are getting ready to spend more on infrastructure projects to drive economic growth. That’s evidenced by President Biden’s $2 trillion infrastructure plan.

Moody’s didn’t include this potential stimulative spending plan in its guidance. This means it could easily outperform its guidance for a 15% decline in issuances in Public, Project, and Infrastructure Finance in 2021.

Source: Moody's Q1 Slide Deck

I think Moody’s expectation for 2021 US GDP growth is too low because the economic reopening is accelerating growth. Moody’s has been underestimating this recovery for a few quarters which is partially why results keep beating guidance by such a large margin. We might see that continue.

Specifically, the firm expects 2021 US GDP growth to be from 6% to 7%. Oxford Economics is forecasting 7% GDP growth. It’s clearly a tough environment to predict because of the reopening. If I was Moody’s, I would be conservative as well. It hasn’t faced any ramifications for being too conservative in the past few quarters.

Amazing Moody’s Analytics Execution

At the onset of my discussion of the Moody’s Analytics division, I would like to point out that investors could easily be misdirected by the conference call. “ESG” was mentioned 23 times which is actually more than the company mentioned “economy/economics.” However, in 2021 the company only plans to generate $25 million from stand-alone ESG and $5 to $10 million through incorporating ESG risk analysis in its ratings and analytics products. It’s not as sexy to say the company is in an oligopoly, but that matters more than ESG.

I consider the Moody’s Analytics (MA) division to be where management's execution really shines. Most of the firm’s acquisitions are added to this business line. Plus, this business is newer than ratings. Part of the analytics division is simply double dipping on the data the company has from being a ratings agency. This is its credit research and data business. In Q1, it had 12% sales growth which brought it to $198 million in sales.

Source: Moody's Q1 Slide Deck

KYC (know your customer) and compliance had 24% sales growth. KYC is benefiting from the increase in demand for a wider range of risk metrics such as reputational and regulatory risks. Firms want this process automated and for it to be more precise. Within KYC, Orbis generates information on private companies. Companies are demanding more information on supply chain risks. That’s especially the case now due to the pandemic. The firm’s QuantCube service knows where every ship is all the time (also a leading indicator for the economy).

Insurance & asset management had sales growth of 18%. Moody's service helps insurance companies manage IFRS 17 which is the latest insurance regulatory standard.

Moody’s breaks down the MA business into 2 parts: research data & analytics (RD&A) and enterprise risk solutions (ERS). The overall MA division had 14% sales growth (10% organic growth). This growth is more sustainable than the boost in Investor Services because 92% of its revenue is recurring (up from 90% in Q1 2020).

The RD&A business had 17% sales growth bringing it to $419 million. It was boosted by KYC and compliance. Organic sales growth was 12%. It generated 5 points of sales growth from the Regulatory DataCorp, Acquire Media, and Catylist acquisitions. Regulatory DataCorp provides anti-money laundering and KYC services. Acquire Media helps firms measure media stories to interpret public sentiment via a simple score. Catylist provides property-level data in the commercial real estate market.

Not only is MA sales growth sustainable, this quarter was actually suppressed by a one-time event. The ERS business had only 5% sales growth ($145 million) because of a decline in one-time implementation services. Recurring sales were actually up in the mid-teens. This business only had one acquisition which is why organic sales growth (4%) was almost the same as overall sales growth. ZM Financial was the only purchase. This business helps banks with risk management.

MA translated its $68 million increase in sales into a $40 million increase in operating income. That’s not as good as Investor Services, but that shouldn’t be the threshold. Compared to its history, a 360 basis point increase in margins (to 32.9%) is phenomenal. The chart below shows the historical increase in operating margins since Q4 2018. Guidance calls for about 30% margins in 2021. I think that’s a little conservative. It depends on the size and the number of its future acquisitions.

Source: Author's Calculations

Moody’s highlighted its QUIQspread service on the call. This is its automated financial spreading tool used by banks globally. The ERS SaaS business is a platform for risk management for banks. I wish an analyst on the call would have asked about the massive spike in bank & thrift M&A activity in 2021 that you can see below.

Source: Driehaus Capital

The overall company definitely benefited from M&A-driven issuances. The corporate financial group (CFG) within Moody’s Investor Services had 34% sales growth. This is the firm’s biggest category ($605 million). Some of the deals that may have been shelved during the recession last year are coming back. As I mentioned, corporations have a lot of cash. That money is being used to do deals.

Please Don’t Buy FactSet

I’m not entirely sure what to make of the veracity of the rumor that Moody’s could buy FactSet. Dealreporter stated last week that a major industry player was considering buying FactSet. Of course, Moody’s was lumped in with the group of firms that could buy FactSet since it is in the data and analytics business. S&P Global (SPGI) won’t buy it because it is in the process of buying Markit (INFO).

I don’t want Moody’s to buy FactSet because right now Moody’s is the best pure-play ratings agency. If that is going to be ruined, let it be by small deals and organic growth in MA over time. The MA business is expanding margins which is slowly making it more attractive. FactSet only had 4.9% organic sales growth in 2020, while Moody’s RD&A business had 12% organic sales growth. I’m usually not a fan of major acquisitions. Moody’s historically hasn’t been either. There is no reason to ruin a good thing.

Analysts obviously want to know if Moody’s is going to do a deal because of this rumor and because it has a new CEO. The firm sort of squashed this rumor, but not completely. Management stated,

“I wouldn't say itching to do a large acquisition. I think I just kind of come back to we're running our own race here, and we feel very good about the outlook across our entire business. We have got some - we are serving some very high-growth end markets, and we are very well positioned in those end markets.”

By saying they are running their own race and that they are in high growth end markets, it suggests to me that they won’t buy FactSet. If you are running your own race, you aren’t running a race with a competitor coming into the fold. By highlighting MA's high sales growth, it suggests to me that the company wants to do deals with fast growing business. FactSet is growing sales slower than MA. That’s my interpretation of the comment. Clearly, Moody’s will never say what it is actually going to do. We must wait to see what will happen.

Guidance Raised

Moody’s raised its 2021 guidance because Q1’s results were so good. Adjusted EPS went from a range of $10.30-$10.70 to $11-$11.30. The company is still being conservative because it knows it faces very tough comps and that Q1 may have pulled forward some issuances. The firm stated it still expects 2021 investment grade supply to fall 30%.

Source: Moody's Q1 Slide Deck

It’s great that Moody’s is ahead of the game on predicting a low single-digit decline in issuances in 2021 because it prevents the stock from getting too overheated. The chart above shows its issuance guidance broken down by category. Low borrowing costs and M&A activity will help issuances in Q2, but the firm expects 2H to be weak. At that point, the firm will really lean on its recurring sales in MA.

Valuation

Analysts raised their estimates following this blowout earnings report which makes the stock a little cheaper. This is important because its multiple had been getting stretched before the report. From January 30^th to April 29^th, 2021 EPS estimates have risen from $10.25 to $11.41.

I’m valuing the stock based on 2022 earnings. The stock currently trades at a 2022 PE ratio of 27.49. Valuations are tricky. I don’t want to sell this until I know it’s really expensive. I will consider selling if it gets to a 35 PE multiple on 2022 EPS estimates by the end of this year. Keep in mind, estimates might increase. Q1 2022 will have an extremely tough comp. Even still, 6.07% EPS growth in 2022 is a beatable estimate.

My Position

Moody’s is only 3.36% of my taxable account. It is my smallest position out of 17 individual stocks. Moody’s is my 3^rd favorite business. My small position sizing is mainly based on other opportunities being better due to their valuations. My position also has been limited by my lack of cash at times when the stock has dipped. The stock was cheap in January when I had little cash.

I will not sell Moody’s if it buys FactSet, but I will be less bullish. I certainly don’t hate FactSet. I just think buying FactSet will create an unnecessary integration headache for a business that is doing so well without it.

Analyst’s Disclosure: I am/we are long MCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.