Moody's Corporation's Logo
Moody's Corporation (MCO) Stock | NYSE: MCO

Covered by Stratosphere

The Bond Market's Gatekeeper

Moody's Corporation ("Moody's or "MCO") is a global leader in providing independent credit ratings and analytics solutions, consulting, training, and software services. Moody's plays an important role in global financial markets as a caretaker and gatekeeper of bond markets everywhere.

Moody's Analytics ("MA") is MCO's growth engine - although it does not contribute as much to MCO's bottom line today MA presents far more opportunities for growth than the credit rating business. While the credit rating business is important, MCO is seeking ways to use its data, research, and globally recognized brand name to build a foundational customer base and source of recurring revenues.

Stratosphere Score

9

Growth

3

Valuation

9

Quality

8

Margins

10

Dividend

7

Balance Sheet

3
Adrian Iwanicki

Author

Adrian Iwanicki

Equity Analyst

Investment Thesis

  1. MCO is the gatekeeper standing between public debt issuers and investors to the world's most valuable commodity - money. Without a Moody's credit rating, today's investor is more likely than not to reject a newly issued bond, potentially crushing a business' growth prospects or chance of survival.

  2. Moody's and S&P Global ("SPGI") approximately split their combined 80% global market share as credit rating agencies ("CRA[s]"). MCO's brand name, intellectual property, and growing recurring revenue base should uphold its position as a CRA and analytics leader.

  3. Moody's Analytics is the lesser-known growth engine that could be bigger than MCO's credit rating business one day. MCO is focusing its acquisition efforts and reinvestment opportunities on ways to grow its subscription-based analytics segment for high-quality, recurring revenue generation.

  4. Capital allocation is a top priority at MCO - shareholders have been rewarded with free cash flow ("FCF") per share outgrowing revenues to the tune of a few percentage points per year over the past decade. Going forward, management has committed to treating its shareholders well over the long haul.

Key Company Metrics

A set of metrics we constantly keep updated to monitor the investment thesis.

Competitive Advantages

The Gatekeeper

Every company in the world needs funding to make big things happen and stay ahead of its competition. There are very few companies - like Facebook and Lululemon - and countries out there that generate so much cash that they can avoid issuing debt. 

Moody's, therefore, plays a crucial role in the flow of cash around the world. It essentially has the power via its credit ratings to indirectly "decide" whether a country or organization will receive debt funding and at what price (i.e., riskier debt will have a higher interest rate; safer debt will have a lower interest rate). Missing a Moody's credit rating could also adversely affect a company or country seeking cash, potentially costing millions of dollars (or more!) over a relatively short period of time. 

Illustrative Impact of Moody's Credit RatingSource: Moody's Investor Relations

Moody's has so much power, it can singlehandedly send companies and countries into a downward spiral towards bankruptcy if it downgrades its debt or issues a junk rating, or even if MCO was not hired in the first place by the debt issuer.

Duopoly Position

MCO competes in a highly consolidated industry with only three major players - MCO itself, SPGI, and Fitch. SPGI, MCO, and Fitch control 95% of the global credit rating industry, although Fitch is a much smaller player than SPGI and MCO. Fitch controls about 15% of the market whereas SPGI and MCO roughly split the other 80%.

The credit rating industry is effectively a duopoly on a global scale. If one combines MCO's duopoly position with the fact that no company or country in existence would take on the risk of issuing unrated debt and potentially losing out on much-needed capital or paying astronomical interest rates, the result is magnificent pricing power on the part of MCO.

To add to MCO's moat is the fact that many bond issuances have credit ratings from at least two CRAs (mainly SPGI and MCO). Therefore, MCO and SPGI do not necessarily fight each other over who rates what – they peacefully operate alongside each other, and each get their piece of the global debt issuance pie.

Keeping Everyone Happy

An underappreciated competitive advantage that comes naturally to MCO is its position in society. MCO's credit ratings makes the job of investors and borrowers / underwriters (i.e., financial institutions) easier.

Investors are important stakeholders in debt issuance as they are the ones who provide capital to borrowers. Without adequate assurance that the debt they are buying is of satisfactory quality, investors would be left with deep uncertainty over their investments. Tapping into a pool of worried investors means little interest, higher interest rates, or potentially no funding at all.

On the other hand, borrowers and underwriters want to issue the debt to collect their funds (in the case of an underwriter, a commission calculated as a percentage of total debt issued). Borrowers and underwriters want to price debt correctly and satisfy the informational needs of investors to attain capital.

MCO makes the funding process easier for everyone - investors, borrowers, and underwriters - and its stamp of approval is recognized by the entire investment community. Without MCO, issuing debt would be akin to Russian roulette for all players involved.

Recurring Revenue Profile

MCO's higher-growth segment, MA, contains a lot of characteristics that can be found in today’s most popular software-as-a-service ("SaaS") companies – high retention, recurring revenues, and pricing power.

As mentioned earlier, MA retains over 90% of its customers from year to year and generates over 90% of its revenues from subscription-like, SaaS-based solutions.

Contractual terms that lock in customers for at least one year, providing great solutions for thousands of customers, and a recurring fee model all come together to enable solid pricing power at MCO. Recently, MA has been growing due to a mix of new sales and upgrades and price increases. We believe this exemplifies MA's ability to grow its existing customer base by expanding its software and product solutions, continuing to add value, and upselling current customers.

Moody's MA Retention RatesSource: Q4 2021 Moody's Investor Deck

Intellectual Property

MCO controls a significant amount of intellectual property, including trademarks, research, publications, software tools and applications, models and methodologies, databases, domain names, and other proprietary information.

New entrants to this space would have to build up superior processes and a brand name worthy of dethroning a credit rating giant that constantly built and refined these areas for the past 120 years.

Not only are new entrants unlikely to appear, but this significant amount of intellectual property also allows MCO to expand on its existing businesses and create new solutions. MIS and MA build on their respective processes, models, and solutions independently to improve their own businesses, and they also leverage each other's property and know-how to grow together.

As these businesses grow together and incorporate new solutions organically or via acquisitions, the more complex (and effective) its models, methodologies, and solutions become. MCO's natural moat widens while also appealing to new customers for exclusive access to its ever-expanding and trusted base of information and risk management analytics. MCO's intellectual property is a key source of its continued success.

Opportunities Ahead

  • COVID-19 gave way for a rise in global bond issuances, largely triggered by record-low interest rates worldwide and loose monetary policy flushing markets with cheap money. Although we hold no particular view on Modern Monetary Theory and its effect on markets, we believe it is no surprise that corporations and governments are raising debt when the cost of money is sitting at record lows. Yearly bond issuances hovered around $20 trillion between 2010 and 2018 but surpassed $25 trillion in 2020.

  • Global trends and growth provide a growing addressable market for Moody's for years to come. Also triggered by current monetary policies around the globe, disintermediation of financial systems is an emerging trend. Rather than raising capital through banks or other intermediaries, corporations are increasingly turning to public markets for larger and quicker access to funds than traditional sources. Additionally, growth in emerging markets ("EM") might be like adding fuel to the disintermediation fire. EM financial systems generally have lower capacity limits than more developed nations and may not be able to adjust quickly enough to accommodate rapid economic growth. The IMF expects EM gross domestic product ("GDP") to swell to $53 trillion in 2026, up from $34 trillion in 2020 - an 8% CAGR. Strong expected EM growth will translate to more public bond issuances that require MCO’s "stamp of approval". On a rather similar note, global GDP is set to grow to $122 trillion in 2026, up from $85 trillion in 2020 - a 6% CAGR. Growing global GDP supports the issuance of more debt as economies expand, invest in infrastructure and business operations, and then repeat the cycle all over again.

  • Don't forget about analytics - MCO's analytics solutions are crucial in mitigating the growing complexity and severity of climate change, extreme weather, pandemics, fraud, and cyberattacks, among many others. Risk preparedness is top of mind for many firms and governments, especially after the world entered a global pandemic. From a strategic standpoint, management is shifting from one-time projects to subscription-based products. This has driven the recurring revenue share in the MA segment from 78% in 2017 to 90% in 2020. That's not all – adjusted operating margins also expanded from 24.6% to 29.4% over the same period. Strong continued uptake of subscription-based solutions and disciplined cost management are fueling reinvestment in the business to deepen existing customer relationships, improve product offerings, and continue the shift away from project-based engagements.

Risks

Cyclical Revenues

Perhaps the most obvious risk is MIS's transactional nature of operations. Debt issuances ebb and flow with the broader economy and MIS's high gearing towards debt issuance volume could upend revenue to a significant extent when the economy falters or unforeseen events trigger corporate and government debt deleveraging.

Monetary and Fiscal Stimulus

An easy and cheap global monetary and fiscal environment is contributing greatly to debt issuances as companies seek to reinvest in their operations, raise money to cover cash flow concerns, and conduct M&A.

A drop-off or tapering of such stimulus efforts along with a corresponding rise in interest rates could tighten financial markets to an extent big enough that could impair MCO's ability to grow meaningfully.

Regulatory Oversight

Moody's is right in the crosshairs of regulatory scrutiny and has been for some time now. 

For one, MCO operates in an effective duopoly that will naturally attract regulatory reviews and lawsuits for monopolistic practices. 

Also, MCO was widely blamed for its part in the US subprime crisis of 2008, in which the US Department of Justice ("DOJ") claimed MCO failed to adhere to its own credit-rating standards and provide public investor transparency. MCO's 2016 income figures took a large $864 million hit because of the January 2017 settlement reached between the DOJ and Moody's related to its practices leading up to the 2008 crisis.

Going forward, MCO could take the blame and face gruesome lawsuits whenever credit ratings are perceived to be too optimistic in retrospect in the following months and years after a future financial crisis. We believe regulatory scrutiny will only increase from here.

Acquisition and Integration Risks

MCO already holds a substantial portion of the credit rating industry, rendering it unlikely that it will continue to grab meaningful market share from here. As a result, MCO's focus is shifting to opportunistic acquisitions.

One significant risk would be if MCO's main competitors, SPGI and Fitch, acquire attractive targets at offers greater than its bids. Also, MCO tends to purchase targets that are not immediately accretive to earnings, potentially destroying shareholder value if these acquisitions do not work out as planned. For example, RMS was one of the largest acquisitions conducted by MCO this past decade, but revenue synergies are not expected until 2025 and will not be accretive to earnings per share until 2024.

Join our stock investing newsletter

Investing articles and ideas in your inbox

We won't send you spam. Unsubscribe at any time.