Investors should consider Moody's Corporation (MCO) if interested in a high quality growth stock in which to invest for the long-term.
- Moody’s (MCO) occupies an enviable position with S&P Global at the heart of global financial markets.
- MCO lowered its guidance in Q3 2018 for the remainder of FY2018 and yet did not meet that lowered guidance when FY2018 results were released February 15, 2019.
- MCO typically generates gross margins in excess of 70% and operating margins in the 40s.
- Despite a weak bond issuance outlook MCO is projecting revenue growth and margin stability in 2019.
- MCO has just announced a ~13.6% increase in its quarterly dividend and a $0.5B accelerated share repurchase program that is expected to be completed during Q2 2019.
- I intend to increase my MCO exposure but will patiently wait for the valuation to retrace to a comparable level to that at which I initiated a position in late October 2018.
In this recent article I indicated that 98.39% of the dollar value my overall holdings are held in 30 companies. Moody’s Corporation (NYSE: MCO) and S&P Global Inc. (NYSE: SPGI) are not within this group but I certainly intend to increase my exposure in these two companies when valuation is to my liking.
MCO has just released its Q4 and FY2018 results and since I analyzed SPGI in this recent article I view this as an opportune time to revisit MCO.
At the time of this March 4th SPGI article I viewed MCO and SPGI as somewhat expensive and indicated I would wait for a better valuation before initiating a position in them.
At the time of my October 26th MCO article, MCO had just released less than stellar Q3 results and the investment community hammered MCO’s stock price. Based on my review, however, I came to the conclusion that MCO’s valuation had reached a level where I was prepared to initiate a position for the ‘side accounts’ within the FFJ Portfolio. I acquired 250 MCO shares on October 26th at $143.61/share and subsequently MCO’s share price has risen over $25.50/share.
I also wrote a SPGI article on October 26th and indicated that I had also acquired 200 SPGI shares on October 25th at $175.8799; those shares have increased in value by ~$22.50/share.
Fast forward to February 15, 2019 and MCO has just released Q4 and FY2018 results that fall short of Wall Street estimates. MCO’s $169.26 share price, however, is $5.53/share, or 3.38%, higher than the close of the previous business day. Why?
Perhaps this has to do with MCO’s guidance for FY2019, the 13.6% increase in its quarterly dividend from $0.44/share to $0.50/share payable March 18th to shareholders of record on February 25th, a $0.5B accelerated share repurchase program that is expected to be completed during Q2 2019, and guidance for FY2019.
With all this recently provided information I now take this opportunity to look at MCO to determine whether this is an opportune time to acquire additional shares or whether I should patiently wait on the sidelines. Before doing so I provide the following Industry Overview.
What has attracted me to this industry, and in particular, MCO and SPGI is that in 1936 the Office of the Comptroller of the Currency banned banks from holding bonds that were below investment grade (so…someone had to assess the credit quality of the bond issuers!). Then, in 1975, the SEC began using ratings in its rules (think that increased the importance of MCO and SPGI?).
As capital markets expanded globally and the variety and complexity of financial instruments grew, the importance in the role played by ratings agencies was reinforced by new regulations that designated "Nationally Recognized Statistical Ratings Organizations" (NRSROs) as the sole issuers of credit ratings for several purposes. In fact, the SEC specified that the only companies whose grades could be used were S&P, Moody’s, and Fitch.
This has ultimately led to what I view as a virtually insurmountable barrier for would-be competitors. In fact, in my March 3, 2018 MCO article to subscribers I provided an industry overview and indicated that MCO and SPGI are the two largest ratings agencies of the 10 NRSROs.
Even though the major ratings agencies failed miserably in properly identifying risk prior to the Financial Crisis, they have always been the clear market leaders since the inception of this industry.
In fact, years after faulty ratings helped trigger the worst financial crisis since the Great Depression and despite efforts by lawmakers to increase competition, MCO and SPGI are as dominant as ever; MCO and SPGI are in an enviable position because issuers are highly unlikely to find buyers for their bonds unless there are two ratings on those bonds.
Subsequent to the Financial Crisis, Morningstar entered the ratings business. It has, however, gained little market share as bond investors and regulators continue to use S&P, Moody’s and Fitch to measure risk.
Together, these 3 companies provide in excess of 90% of all credit ratings. Look at page 7 of 11 in this document. I recognize this study was published by the European Securities and Market Authority and focuses on the European market but nevertheless it is interesting to note that S&P, Moody’s and Fitch command a market share in excess of 93%.
If you are wondering why I like MCO and SPGI so much have a look at how dominant S&P, Moody’s and Fitch are in the US. There are several statistics starting on page 10 of 34 but in a nutshell, this is an oligopoly which is great for investors.
Roughly 4 decades ago, credit ratings agencies started charging for ratings services. The rationale they used was that objective ratings provided considerable value as ratings from these agencies tend to reduced information costs, increase an issuer's value in the market place, and increase the pool of possible borrowers. In a nutshell, the benefits provided by credit ratings agencies drill down to 1) improving access to capital and 2) reducing the costs of obtaining capital.
The reason why I like this oligopoly is that these firms do not compete on the basis of price. They look to compete based on the quality of their ratings and the value of their ratings.
These agencies know there are limited alternatives. In fact, if a rating is not provided by a highly respected ratings agency, the market notices this and the debt issuer’s cost of capital will rise. As is often the case, the cost of capital will rise to a far greater extent than the cost of obtaining the credit rating.
With MCO and SPGI being a ‘natural duopoly’, Berkshire Hathaway Inc., MCO’s largest shareholder, acquired a stake many years ago because of MCO’s pricing power.
Buffett has even gone on record to say ‘There are very few businesses that have the competitive position that MCO and SPGI have’. Pricing has no bearing on whether somebody is going to issue debt or not because the extra interest a borrower would have to pay on an unrated bond is significantly greater than the cost of a rating.
Credit ratings are not the only services provided by MCO and SPGI. If you are remotely interested in learning more about their respective lines of business, I highly encourage you to go directly to the first section of the most recent 10-K (MCO) and (SPGI); as I compose this article the most current version for MCO is the 2017 report while that for SPGI is the 2018 report.
Q4 and FY2018 Financial Results
In its July 27th Q2 Earnings Release, MCO reaffirmed its full year 2018 diluted EPS guidance of $7.20 - $7.40 and adjusted diluted EPS guidance of $7.65 - $7.85.
When Q3 results were released on October 26th, full year guidance was lowered to FY2018 diluted EPS of $6.95 - $7.10 and adjusted diluted EPS $7.50 - $7.65. (cont’d.)
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Disclosure: I am long MCO and SPGI.
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