Moody’s Current Valuation Is Not Justified

I last reviewed Moody's Corporation (MCO) in this July 26, 2022 post at which time MCO had just released Q2 and YTD2022 results. Based on this analysis of MCO's Q4 and FY2022 results and FY2023 outlook released on January 31, 2023, I am not adding to my exposure because the current valuation is not justified.

Financials

Q4 and FY2022 Results

I reference MCO's FYE2022 Form 8-K and Earnings Presentation.

MCO Q4 and FY2022 results reflect the impact of challenging market conditions in the Investors Service Segment and the resilience of the Analytics segment; the Analytics segment contributed ~50% of total revenue for the first time in MCO's history.

In FY2022, MCO accrued $0.114B in total restructuring charges. This is up from the $85 million guidance provided in October. Of this total, ~$49 million was for MA and ~$65 million for MIS. Looking forward, MCO expects to incur up to $15 million in incremental pre-tax personnel-related charges and $20 - $40 million in real estate charges in 2023.

Moody’s Investors Service (MIS) Segment

In my previous post, I indicated that MCO expected debt issuance to remain significantly constrained in the coming quarters. This is confirmed by the FQ4 and FY2022 actual results.

MIS generated $2.699B of FY2022 revenue versus $3.812B in the prior fiscal year. All areas (Corporate Finance, Structured Finance, Financial Institutions, and Public, Project and Infrastructure Finance) experienced weaker results.

Given the anticipated weak results in this segment, MCO executed its expanded expense management program that it announced in October. MCO expects to deliver over $0.2B of annualized savings in 2023.

In 2022, MCO made several important investments to enhance its ratings presence in emerging markets of which one was the acquisition of a majority stake in the largest domestic rating agency in Africa. MCO also announced in early December of its agreement to acquire SCRiesgo, a leading group of local credit rating agencies serving domestic financial markets in Central America and the Dominican Republic. The acquisition significantly expands MCO's presence in Latin America.

Moody’s Analytics (MA) Segment

Fortunately, MCO had successfully transitioned the MA business to a predominantly subscription-based model, with strong recurring revenue. Strong results in this segment have helped offset the weak results reported in the MIS segment.

Operating Cash Flow (OCF) and Free Cash Flow (FCF)

In FY2012 - FY2022, MCO generated annual OCF (in millions of $) of $0.823, $0.927, $1.019, $1.198, $1.259, $0.755, $1.461, $1.675, $2.146, $2.005, and $1.474.

In FY2012 - FY2022, 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, $1.866, and $1.191.

FY2023 Outlook

In FY2023, MCO expects expenses to increase by $10 - $20 million.

From a restructuring perspective, MCO still expects to incur up to $0.17B in aggregate charges in FY2023. This will be split into ~$70 - $90 million for MIS and ~$65 - ~$80 million. These charges relate to the real estate rationalization and the reduction of personnel as MCO selectively downsizes and utilizes alternative lower-cost locations.

The inflationary environment, the pace of interest rate increases are still causing volatility in equity and debt markets, and the trajectory of economic growth in major economies remains uncertain. MCO expects these factors that impacted debt issuance in 2022 to persist at least through the first half of 2023. However, management is optimistic conditions will improve in the second half.

By having taken decisive expense management actions in Q4, MCO expects MIS's adjusted operating margin to return to the mid-50% range in 2023.

Significant investments made in the MA segment by way of product development and acquisitions have helped MCO deliver $1B in additional recurring revenue. Recurring revenue growth was 9.2% in 2020, 9.7% in 2021, and 11.1% in 2022.

FY2022 CAPEX was ~$0.283B and plans are for ~$0.3B in FY2023.

MCO's FY2023 outlook includes the repurchase of ~$0.25B of outstanding shares subject to available cash, market conditions, M&A opportunities and other ongoing capital allocation decisions. While this amount is below recent prior-year levels, MCO's capital planning and allocation are unchanged. It remains committed to anchoring its financial leverage around a BBB+ rating, which it deems to be an appropriate balance between ensuring ongoing financial flexibility and lowering the cost of capital.

However, MCO's gross leverage at FYE2022 was above 2.5x because of the current cyclical market conditions. Therefore, as MCO heads into FY2023, it wants to retain the financial flexibility to marginally improve its gross outstanding debt position if needed.

The plan is to return ~$0.8B of FY2023 FCF but this is subject o available cash, market conditions, M&A opportunities, etc..

In addition to ~$0.25B in proposed share repurchases, MCO expects to disburse ~$0.56B in dividends.

Credit Ratings

There is no change to MCO's senior unsecured domestic long-term debt ratings and outlook.

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

Both are at the top 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.

MCO's Form 10-Q and Form 10-K include a schedule of its total indebtedness. The FY2022 Form 10-K is currently unavailable. Therefore, I include a schedule of MCO's total indebtedness from its Q3 2022 Form 10-Q.

The LTD at FYE2022 (December 31, 2022) amounts to ~$7.389B. The minor variance from the September 30, 2022 carrying value of ~$7.476B is adjusted for the fair value of interest rate swaps used to hedge the fair value of the notes.

The schedule of MCO's long-term debt that is accessible here is currently as of June 30, 2022. Updates are likely to be posted at the same location on MCO's website.

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 January 30, MCO's Board declared a regular quarterly dividend of $0.77/share, a 10% increase from the prior $0.70/share. The dividend will be payable on March 17 to stockholders of record at the close of business on February 24.

While MCO does return capital to shareholders in the form of a dividend, dividends are the 3rd priority in its capital allocation priorities.

With shares currently trading at ~$323, the $0.77 quarterly dividend yields ~0.95%. These are the dividend yields when I made my last 3 MCO share purchases:

• May 2, 2022 - shares were acquired at ~$300.88 and the $0.70 quarterly dividend yielded ~0.93%.
• June 1, 2022 - shares were acquired at $287.83 and the $0.70 quarterly dividend yielded ~0.97%.
• July 26, 2022 - shares were acquired at $286.14 and the $0.70 quarterly dividend yielded ~0.98%.

MCO is positioned as a 'growth' stock so the unappealing dividend metrics may dissuade some investors from investing in MCO. Investors, however, should focus on an investment's total potential return.

Share Repurchases

MCO's diluted weighted average number of shares outstanding during FY2011 - FY2022 (in millions of shares) are approximately 229, 227, 224, 215, 203, 195, 194, 194, 192, 189, 188, and 185. The diluted weighted average number of shares outstanding for Q4 2022, however, has been reduced to 183.9 million.

In Q4, MCO repurchased no shares and it issued net 38,000 shares as part of its employee stock-based compensation programs; the net amount includes shares withheld for employee
payroll taxes.

MCO repurchased 3.1 million shares at an average cost of $312.49/share in FY2022. It, however, issued net 0.6 million shares as part of its employee stock-based compensation programs; the net amount includes shares withheld for employee payroll taxes.

As of FYE2022, MCO had 183.2 million shares outstanding. This is a 1% decline from December 31, 2021. At FYE2022, MCO also had ~$0.848B of share repurchase authorization remaining.

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.

When I wrote my May 4 post, I had recently added to my exposure at $300.88/share. Management's FY2022 diluted EPS and adjusted diluted EPS guidance ranges were $9.85 - $10.35 and $10.75 - $11.25, respectively. Using a $10.10 diluted EPS mid-point, the forward diluted PE was ~30 and the forward adjusted diluted PE was ~27.4 based on $11 in adjusted diluted EPS.

The forward adjusted diluted PE levels using broker guidance at the time were:

• 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.

Management's FY2022 revised diluted EPS outlook at the time of my July 26, 2022 review was $8.10 - $8.60; its revised adjusted diluted EPS outlook was $9.20 - $9.70. Using my $286.14 purchase price and an $8.35 diluted EPS mid-point, the forward diluted PE was ~34.3 and the forward adjusted diluted PE was ~30.3 based on $9.45 in adjusted diluted EPS.

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

• FY2022 - 19 brokers - mean of $10.13 and low/high of $9.53 - $11.15. Using the mean estimate, the forward adjusted diluted PE is ~28.2.
• FY2023 - 19 brokers - mean of $11.91 and low/high of $11.17 - $13.60. Using the mean estimate, the forward adjusted diluted PE is ~24.
• FY2024 - 10 brokers - mean of $13.99 and low/high of $12.58 - $16.70. Using the mean estimate, the forward adjusted diluted PE is ~20.5.

I expected these broker estimates to be revised lower over the coming days thereby resulting in valuation levels somewhat similar to those derived using management's FY2022 guidance.

MCO has now reported $7.44 and $8.57 in FY2022 diluted EPS and adjusted diluted EPS. With shares currently trading at ~$323, the diluted PE and adjusted diluted PE levels are ~43.4 and ~37.7.

Management's FY2023 diluted EPS and adjusted diluted EPS outlook are $8.05 - $8.55 and $9.00 - $9.50. Based on the current share price, the forward diluted PE range is ~37.8 - ~40. The forward adjusted diluted PE range is ~34 - ~36.

Current broker-adjusted diluted EPS estimates are likely to be adjusted over the coming days. However, the forward valuations using the currently available estimates are:

• FY2023 - 19 brokers - mean of $9.32 and low/high of $7.68 - $10.00. Using the mean estimate, the forward adjusted diluted PE is ~34.7.
• FY2024 - 17 brokers - mean of $11.27 and low/high of $8.82 - $12.20. Using the mean estimate, the forward adjusted diluted PE is ~28.7.
• FY2025 - 5 brokers - mean of $13.49 and low/high of $12.90 - $14.80. Using the mean estimate, the forward adjusted diluted PE is ~24.

Analysts have been gradually lowering their FY2023 earnings estimates. Following the recent release of MCO's FY2023 outlook, I anticipate some brokers will lower their FY2023 and FY2024 estimates; I place little credence in FY2025 estimates because much can change in 2 years and only 5 brokers have provided estimates. I, therefore, think the forward adjusted diluted PE levels reflected above will increase slightly thereby making MCO's valuation more unattractive.

Final Thoughts

My MCO exposure is in accounts included in the FFJ Portfolio (410 shares in a 'Core' account and 250 shares in a 'Side' account).

MCO's assumption is for the cyclical market disruption to persist through at least the first half of 2023 resulting in weak results through the first 6 months of FY2023. While management is optimistic the second half will improve, adjustments may be required if an improvement in business conditions does not materialize.

Despite the short-term headwinds, more than $4T of debt is to mature over the next few years. Refinancing a significant portion of this debt will require rating reviews. I, therefore, expect the MIS segment results to eventually recover and view the challenges in the MIS segment to be short-term in nature.

Given the muted outlook for the MIS segment, I was hoping we would see pressure on MCO's share price. Instead, MCO's share price has rebounded from its ~$230 52-week low set in mid-October.

I notice an increase in the number of number companies lowering guidance. Secondly, downsizing is spreading from the tech sector to other sectors. Thirdly, the FED's fight against inflation has not yet ended; I expect the high-interest rate environment (relative to the last 2 -3 years) will be with us longer than many expect. However, recent share price behaviour reflects a disconnect. I think we are experiencing a 'bear market rally'. The probability of a broad market correction is reasonable, and therefore, I will patiently bide my time in the hope of an improvement in MCO's valuation.

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.