- Updated outlook for ’23, and trading at high multiples was why I decided to look into the company’s financials and growth prospects.
- Moody’s Analytics segment is what has been offsetting some loss of revenue from MIS, but it is nowhere near enough to justify the multiple.
- The balance sheet isn’t bad, but it is also not helping the company’s bullish sentiment.
- With reasonable growth assumptions, the model suggests that the company is due for quite a correction as there are no indications of accelerated growth in the near term.
With Q1 results out, in which the management updated its EPS guidance for the full year ’23 to the upside, I wanted to take a look at Moody's Corporation's (NYSE:MCO) financials and growth potential, to see whether the high multiple MCO stock is currently trading at is justified. In short, the company is a solid pick as it is one of the biggest players in the sector; however, the potential growth outlook doesn’t justify the company’s high multiples, considering the looming recessionary period is upon us and I would suggest selling until the company improves its EPS dramatically through margin expansions or better revenue growth catalysts.
Q1 Results and Guidance
Q1 results beat estimates by quite a bit and the management went ahead and updated their '23 outlook to the upside. Adjusted the EPS figures by 50 cents on the previous range it gave during the last quarter, to the $9.50-$10 range. Investors loved that and the stock shot up around 3% at the open but dwindled during the day due to earnings of other companies bringing down all of the major indices down.
Revenues were up from the prior quarter, however, were down in the same quarter last year. Margins contracted and have trimmed their free cash flow for the year also because of rising expenses. Moody's Analytics segment has been performing much better in the last 2 quarters than Moody's Investor Services side, which is the credit rating side of things, and still, there isn't much growth projected to justify the company trading at one the highest P/E ratios we’ve seen in a while.
The management is still very positive overall on the ’23 outlook to deliver positive revenue growth, expecting revenues to rise in the mid-to-high single-digit percentages. I am honestly quite surprised by the update. A lot of sectors are seeing the demand for their services decline, some even in double-digit declines. If we are going into a recession, companies tend to issue less debt, which will keep bringing down the company's MIS revenue as has been the case in Q4 '22 and Q1 '23.
The company has been consistently above the 20 P/E ratio for almost 10 years, it has only gotten worse since the bottom of the pandemic panic. I wanted to see why it is trading so high. Is it their revenue outlook that's justifying such a multiple? Is it cost-cutting measures that improve margins dramatically in the next few years? Or is it that the company is one of the biggest players in the industry with a high moat and competitive advantage and is a trustworthy company to provide accurate rating information that helps investors decide where to put their money safely? The most plausible to me is the latter as with the growth that the management is guiding, the company is well overpriced and needs to come down quite a bit.
Moody’s Investor Services
This segment was the biggest contributor to total revenues for the longest time. It has seen a whopping 28% drop in revenues in ’22. I would expect this segment to recover slightly as the management does also, however, the economic headwinds that we are going to experience will prove to be very tough to overcome in the short run and I would expect this segment to be flat to maybe mid-single digits. Let’s be a bit more optimistic and say the recovery will be mid-single digits. With inflation still very elevated and the unemployment rate hasn’t ticked down considerably just yet, the management’s outlook is a bit optimistic in my opinion. The rates will be elevated for a bit longer than anyone anticipated just a couple of months back with the Fed chair taking a more aggressive/hawkish stance once again. His priority is taming inflation and 50bps hikes are back on the table.
The segment is very sensitive to these sorts of economic headwinds. Q4 was a tough time for MIS, going down 34% alone. I don’t think we’ve seen the worst yet economically speaking and we may see further declines in the upcoming quarters. Q1 ’23 saw a decline of 11% while margins also saw contractions. Management expects to return to normality by ’24. Normality here isn’t very great either. Past revenue growth has been in around the mid-teens, which in my opinion is not the growth I would expect to see from a company that has a TTM P/E ratio of 40.
So even if it does normalize in the future, the growth rate isn’t high enough to justify the multiple.
This is where the company can and has offset some of the revenue declines from MIS. Even in the last quarter of 22, the segment grew 7%. This segment is on the path to becoming the main revenue generator for the company. It represented almost the same percentage in FY22 as MIS, and if it keeps growing steadily as it has, it will surpass MIS. By the end of ’23, I would expect MA to be the largest revenue contributor. In my opinion analytics tools are much more resilient to such an economic downturn and I would expect this to keep performing well or even better. The management is expecting the MA segment to grow at a 10% Annualized Recurring Revenue [ARR].
Digitization is probably one of the best drivers of efficiency and profitability. The company would do well if it kept reinvesting into improving the systems, applications, and other tools associated with enhancing customer experience and streamlining it further. This will increase margins without the need for high revenue growth in the future. But is it enough? I don’t think so.
That is also not the kind of growth rate I expected a company with such a multiple to be guiding.
Typically, a company with a high P/E ratio is expected by investors to grow exceptionally in the future. The company has been around for over 100 years with a market cap of $55B. This doesn't seem to be a high-growth small-cap company. Let’s look at the company’s balance sheet for more clues.
The company had $1.8B in cash and $90m in short-term investments and $7.4B in debt at the end of ’22. Is this an issue? I don’t think so. Cash flow from operations was $1.5B while EBIT came in at $1.9B, which more than covers the company’s interest expense. The Interest coverage ratio is very solid.
The company also boasts a very healthy current ratio, which hovers around 1.7 as of FY22. This means that the company has no liquidity issues and can pay off its short-term obligations 1.7 times over.
In terms of efficiency and profitability, the company has been in a downtrend in ROA and ROE; however, these are still very acceptable. It is slightly worrying that it’s been losing its edge over time.
ROIC has also been on the decline since the last annual report, which suggests the company is losing its competitive advantage and its moat isn’t as strong as it was. Seems like the management couldn’t invest in high NPV projects in ’22 and if we’re going to see more economic headwinds in the near future, this figure could keep coming down. 13% isn’t bad but when it reached close to 20% in the previous years, it looks worse.
The balance sheet, though not the worst, certainly isn’t a big factor that could play in the company’s high valuation. The trends might continue for another year before stabilizing or coming back up.
Let’s take a look at what I think would be a reasonable growth trajectory for the company. In the past MIS segment has seen very volatile growth numbers ranging from 0% to 16% with an anomaly of -27% in Q4 of ’22. There’s no catalyst that would propel this segment to grow at much faster rates than it has seen in the past, so I will take a conservative average for the model, which will be around 9% growth over the next decade.
For the MA segment, I see slightly more potential here and I assigned a 10% average growth over the next decade. This segment has been performing much better than MIS, so it will take over as the main revenue generator in the future for sure.
In terms of margins, the company has seen some contractions recently; however, with time, further investment into digitization should bring much better margins in the future, so I improved the margins over time to the margins seen at the end of 2020 to reflect better efficiency.
I will also give a 25% margin of safety to the calculation just to be extra safe. 25% is the minimum I would like to give any company. It only goes up if I see some really bad balance sheets and, in this case, I don’t see major red flags in the books. With that said the intrinsic value of the company is $177.16 a share, which implies a 43% downside from current valuations.
Judging from the past, the company is never going to reach this valuation, which I think is still on the more optimistic assumptions. There is nothing that would justify the company trading at a 40x TTM multiple. The business is quite susceptive to a downturn in the global economy and if MCO didn’t have the MA analytics offsetting the revenue decreases in MIS, it would be worth much less.
The last time the company traded at this price was when everything collapsed in March 2020 and the P/E ratio was still above 20. Now, with $177.16 a share, the P/E ratio would be around 16x which seems reasonable to me, however, for this company I think 20x is as low as it can get realistically.
There are better investments out there right now that have really good growth prospects and are not getting the love they deserve. If you are going to invest in MCO, as you can see at the top of the article, the P/E ratio is well above its average.
It is a great company but if you invest now, don’t expect outstanding returns in the future. I’ll be setting a price alert at $200 and forget about it for a while, listening to a couple of more earnings calls and casually looking up the price from time to time as it is nowhere near where I would consider investing my money.
This article was written by
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