Moody's Current Headwinds Present a Buying Opportunity

In my May 3, 2022 Chevron Plans to Accelerate Share Repurchases post I conclude that 'my focus is on acquiring shares in great companies which are experiencing headwinds and have fallen out of favour with investors.' I consider Moody's (MCO) current headwinds to present a buying opportunity.

In my October 26, 2018 post I disclose a new position in Moody's Corporation (MCO) in one of the FFJ Portfolio's 'Side Accounts'.

In early January 2022, I completed an Investment Holdings Review at which time MCO was my 24th largest holding; it was my 26th largest holding in mid-April 2021 and my 25th largest holding in mid-August 2020.

The rankings of my holdings have undoubtedly changed since early January 2022. Unless I undertake another Investment Holdings Review, however, I can not readily determine MCO's ranking because I hold investments in 19 investment accounts. Nevertheless, I have reason to believe MCO is still within my top 30 holdings.

I most recently reviewed MCO in this February 11, 2022 post at which time I disclosed the purchase of 300 shares in one of the 'Core' accounts within the FFJ Portfolio.

At its March 10, 2022 Investor Day, MCO communicated Q1 diluted EPS guidance of $2.28 - $2.78 and adjusted diluted EPS guidance of $2.50 - $3.00.

Actual Q1 2022 results released on May 2, 2022 are:

  • diluted EPS of $2.68, down 31% from 1Q 2021; and
  • adjusted diluted EPS1 of $2.89, down 29% from Q1 2021.

These results are within the guidance ranges provided almost 2 months ago.

Following the release of MCO's Q1 2022 results and revised FY2022 guidance on May 2, 2022, MCO's share price declined by ~$15. What has likely triggered this pullback is that FY2022 diluted EPS and adjusted diluted EPS guidance ranges are now $9.85 - $10.35 and $10.75 - $11.25, respectively. Previous guidance provided on February 10, 2022 called for FY2022 diluted EPS of $11.50 - $12.00 and adjusted diluted EPS of $12.40 - $12.90

This is now an opportune time to revisit MCO given these significant revisions.

Business Overview

Since its founding in 1900, MCO has evolved to become a leading global integrated risk assessment firm that provides organizations and investors with the tools and information to make better decisions.

Item 1 in MCO's FY2021 Form 10-K provides a comprehensive overview of the company and its 2 operating segments (Moody's Investors Services (MIS) and Moody's Analytics (MA)).

Financials

Against the backdrop of geopolitical turbulence and volatile markets, MCO's Q1 2022 Earnings Release reflects revenue of ~$1.5B, a 5% decline from Q1 2021.

The MA segment continued to be a strong source of consistent growth while market disruptions negatively impacted the MIS segment.

MA's Q1 2022 revenue grew 23% - the 5th consecutive quarter of double-digit growth.

Over the past few years, MCO has successfully transitioned the MA business to a predominantly subscription-based model, with strong recurring revenue, which now accounts for 94% of total MA revenue.

In this regard, MCO has introduced an annualized recurring revenue (ARR) metric; this is the annualized run rate of recurring revenue for active contracts at a point in time. Renewable contracts include subscriptions, term licenses, and software maintenance.

Management expects this new metric to provide greater transparency into the growth trajectory of MA’s recurring revenue with visibility specifically into the growth of the subscription business from both the acquisition of new customers and business expansion from existing customers.

As of March 31, 2020, MA’s ARR of $2.6B reflected 25% growth from the prior-year period or 9% on an organic basis.

MCO - MA Segment Has Strong Recurring Revenue Growth - May 2, 2022

Source: MCO - Q1 2022 Earnings Presentation - May 2, 2022

MCO's MIS segment is experiencing headwinds. The issuance factors were highlighted in the Q4 2021 earnings call and should come as no surprise.

In Q1 2022, MIS revenue declined 20% from last year’s record level as geopolitical concerns, rising yields and elevated economic uncertainty contributed to a 25% decrease in rated issuance. Corporate finance, financial institutions and public project infrastructure revenue declined 31%, 19% and 14%, respectively, with many issuers remaining on the sidelines due to unfavourable market conditions and existing levels of balance sheet liquidity. Structured finance revenue increased 24%, supported by a 10% growth in issuance, primarily from commercial and residential mortgage-backed securities, offset by a decline in collateralized loan obligations (CLO) refinancing activity.

This period of market disruption, however, is to be put into historical context.

The following chart illustrates MCO's rated issuance over the last decade with the grey bars representing periods of market volatility. Activity typically rebounds after periods of market disruption and has grown steadily over time.

MCO - MIS Segment - Issuance Increases Over Time - May 2, 2022

Source: MCO - Q1 2022 Earnings Presentation - May 2, 2022

While there is uncertainty as to how long the current disruptions will last, MCO believes issuance activity will eventually reset amidst higher interest rates. Secondly, expectations are that issuance growth will eventually resume. The medium-term drivers of debt issuance, however, remain strong and issuance is a function of several macroeconomic factors with economic expansions being the most significant.

In addition, more than $4T of debt needs to be refinanced over the next 4 years. Management expects the continued buildup in first-time mandates will drive recurring revenue growth.

Free Cash Flow (FCF)

In FY2012 - FY2021, MCO generated annual FCF (in millions of $) of $0.778, $0.885, $0.944, $1.109, $1.144, $0.664, $1.370, $1.606, $2.043, and $2.619.

Cash flow from operations in Q1 2022 was $0.47B and FCF was $0.411B. The FCF forecast has been reduced from $2.3B - $2.5B to $1.8B - $2.0B.

FY2022 Guidance

When MCO released its FY2021 results on February 10, 2022 it provided FY2022 guidance that included a plan to return ~$2B to shareholders in the form of dividends and share repurchases; the $0.5B accelerated share repurchase plan was completed in April 2022.

MCO - FY2022 Corporate Level Guidance

Source: MCO - Q4 and FY2021 Earnings Presentation - February 10, 2022

MCO's new corporate guidance is as follows.

MCO - Updated FY2022 Corporate Guidance - May 2, 2022

Source: MCO - Q1 2022 Earnings Presentation - May 2, 2022

 

MCO - Updated FY2022 Issuance Guidance - May 2, 2022

Source: MCO - Q1 2022 Earnings Presentation - May 2, 2022

 

MCO - Updated FY2022 Segment-Level Guidance - May 2, 2022

Source: MCO - Q1 2022 Earnings Presentation - May 2, 2022

Despite the temporary impact of market uncertainty on MCO's Q1 2022 financial performance, there is no change to management's expectations for the medium-term. Management strongly believes the market volatility in the first half of FY2022 is cyclical and that the business fundamentals of both MIS and MA remain firmly intact. Therefore, MCO is prudently managing expenses and MCO will continue to invest through the cycle to realize its medium-term growth prospects.

At its March 10, 2022, 2022 Investor Day, the following medium-term growth targets set earlier in the year, were reaffirmed.

MCO - Reaffirm Medium-Term Growth Targets - Investor Day 2022 - March 10, 2022

Source: MCO - 2022 Investor Day Presentation - March 10, 2022

Credit Ratings

MCO's senior unsecured domestic long-term debt ratings and outlook are unchanged from my last review.

  • S&P Global - BBB+ with a stable outlook; and
  • Fitch - BBB+ with a stable outlook;

Both ratings are the top tier of the lower medium-grade investment-grade tier. These ratings define MCO as having an ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to MCO having a weakened capacity to meet its financial commitments.

The Summary of Outstanding Debt and Debt Maturity Profile as of March 31, 2022 reflects a well-balanced maturity schedule.

MCO - Total Debt at March 31, 2022

MCO's credit risk is acceptable from my perspective.

Dividends and Share Repurchases

Dividend and Dividend Yield

MCO's dividend history reflects annual dividend increases starting in 2011 following a dividend freeze that was precipitated by challenging business conditions during The Financial Crisis.

On April 26, 2022, MCO's Board declared a regular quarterly dividend of $0.70/share payable on June 10, 2022 to stockholders of record at the close of business on May 20, 2022.

On May 2, 2022, I acquired another 50 shares ~$300.88/share in a 'Core' account within the FFJ Portfolio; the $0.70 dividend yields ~0.93%. In contrast, the dividend yields at the time of prior reviews are:

  • September 9, 2021 -  shares were trading at ~$382 and the $0.62 quarterly dividend yielded ~0.65%;
  • October 30, 2021 post - shares were trading at ~$404 and the $0.62 quarterly dividend yielded ~0.61%; and
  • February 12, 2022 - shares were trading at ~$332.50 and the $0.70 quarterly dividend yielded ~0.84%

Share Repurchases

MCO's Diluted Weighted-Average Shares of Common Stock Outstanding during FY2011 - FY2021 (in millions of shares) are 229, 227, 224, 215, 203, 195, 194, 194, 192, 189, and 188. Outstanding shares as of March 31, 2022 total 184.5 million, down 1% from March 31, 2021. As of March 31, 2022, MCO had ~$1.2B of share repurchase authority remaining.

In Q1 2022, MCO repurchased ~0.5 million shares at a total cost of $0.158B and an average cost of $350.60/share. It also issued net 0.5 million shares as part of its employee stock-based compensation programs. The net amount includes shares withheld for employee payroll taxes.

As noted earlier, MCO commenced a 1.5 million share/$0.5B accelerated share repurchase program in Q1 that was completed in April 2022.

Valuation

When I reviewed MCO on September 9, 2021, management's adjusted diluted EPS guidance was $11.55 - $11.85. Using a ~$382 share price and the $11.70 mid-point of guidance the forward adjusted diluted PE was ~32.7. In addition, the following were the FY2021 - FY2023 adjusted diluted EPS analyst estimates:

  • FY2021 - 16 brokers - mean of $11.87 and low/high of $11.69 - $12.52. Using the mean estimate, the forward adjusted diluted PE is ~32.2.
  • FY2022 - 17 brokers - mean of $12.40 and low/high of $11.54 - $13.50. Using the mean estimate, the forward adjusted diluted PE is ~30.8.
  • FY2023 - 12 brokers - mean of $14.01 and low/high of $13.05 - $15.25. Using the mean estimate, the forward adjusted diluted PE is ~27.3.

At the time of my October 30th review, MCO was trading at ~$404 and management had raised FY2021 adjusted diluted EPS guidance to $12.15 - $12.35. Using the broker guidance available at the time, I arrived at the following:

  • FY2021 - 17 brokers - mean of $12.04 and low/high of $11.70 - $12.67. Using the mean estimate, the forward adjusted diluted PE is ~33.6.
  • FY2022 - 17 brokers - mean of $12.46 and low/high of $11.62 - $13.61. Using the mean estimate, the forward adjusted diluted PE is ~32.4.
  • FY2023 - 14 brokers - mean of $14.03 and low/high of $13.04 - $15.72. Using the mean estimate, the forward adjusted diluted PE is ~29.

Shares were trading at ~$332.50 when I wrote my February 12, 2022 review. The forward adjusted diluted PE levels using current broker guidance were:

  • FY2022 - 16 brokers - mean of $12.66 and low/high of $11.87 - $13.60. Using the mean estimate, the forward adjusted diluted PE is ~26.3.
  • FY2023 - 14 brokers - mean of $14.11 and low/high of $13.42 - $15.45. Using the mean estimate, the forward adjusted diluted PE is ~23.6.
  • FY2024 - 4 brokers - mean of $16.23 and low/high of $14.90 - $17.55. Using the mean estimate, the forward adjusted diluted PE is ~20.5.

As noted earlier, my recent purchase was at $300.88/share. Management's FY2022 diluted EPS and adjusted diluted EPS guidance ranges of $9.85 - $10.35 and $10.75 - $11.25, respectively. Using a $10.10 diluted EPS mid-point, the forward diluted PE is ~30 and the forward adjusted diluted PE is ~27.4 based on $11 in adjusted diluted EPS.

The forward adjusted diluted PE levels using current broker guidance are:

  • FY2022 - 18 brokers - mean of $11.28 and low/high of $10.85 - $12.90. Using the mean estimate, the forward adjusted diluted PE is ~26.7.
  • FY2023 - 18 brokers - mean of $12.99 and low/high of $12.31 - $14.20. Using the mean estimate, the forward adjusted diluted PE is ~23.2.
  • FY2024 - 9 brokers - mean of $15.04 and low/high of $13.81 - $17.45. Using the mean estimate, the forward adjusted diluted PE is ~20.

Final Thoughts

The investment environment over the past few years, other than for a brief period in early 2020 when COVID shutdowns started in North America, has made it exceedingly difficult to identify fairly valued/attractively valued high-quality companies. Investors should welcome some of the investment opportunities that are being presented of late.

The aphorism 'a rising tide lifts all boats' is associated with the idea that improvements in the general economy will benefit all participants in that economy. It can also be used to describe the impact Central Banks have had on the broad market. Central Banks have flooded the market with liquidity to the point where so many investments appreciated even though the investments might have been highly questionable.

Now that interest rates are rising and Central Banks are beginning to reduce liquidity, valuation levels will hopefully retrace to more rational levels and companies which should not be in existence will fail.

What I see in MCO is a high-quality company that is currently experiencing challenging business conditions. The headwinds are likely to continue to negatively impact MCO's results for at least the remainder of FY2022. Eventually, however, these headwinds will end. This is why I think now is the time to acquire shares in this great company.

I wish you much success on your journey to financial freedom!

Note: Thanks for reading this article. Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long MCO.

Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decisions without conducting your research and due diligence. You should also consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.