Let’s take a look at another high quality company. Moody’s is primarily a provider of credit ratings. Virtually any party seeking financing through the capital markets needs to have their debt offering rated. If they don’t do this, they limit the number of investors willing to accept their debt, which usually results in higher financing costs. Beyond providing a vital service, it is growing, it has very high returns on capital, it has very low capex needs and, despite the bursting of the credit bubble, it has a very wide moat.
Moody’s publishes credit ratings on a wide range of debt obligations and the entities that issue such obligations in markets worldwide, including various corporate and governmental obligations, structured finance securities and commercial paper programs. The company ranks the creditworthiness of borrowers using a standardized ratings scale which measures expected investor loss in the event of default. Moody’s sells this service to debt originators and issuers who use Moody’s ratings as an independent and trustworthy rating of their ability to service the debt. In 2012, Moody’s derived 69% of its revenue from credit ratings and associated services. Moody’s derived the remaining 31% from research, data and software for financial risk analysis and related professional services. Moody’s was founded by John Moody in 1909 to produce manuals of statistics related to stocks and bonds and bond ratings. Following several decades of ownership by Dun & Bradstreet, Moody’s Investors Service was spun off and became a separate company in 2000. Warren Buffett immediately became a large shareholder.
Investors, both individual and institutional, look to credit rating agencies to provide an independent assessment of the relative or absolute credit risk of a particular debt obligation or obligor. For decades, rating agencies typically rated debt transactions on an unsolicited basis and sold subscriptions to their ratings to investors. The industry underwent a sea-change in the 1970’s when the ratings agencies shifted from charging issuers to pay for ratings rather than investors. This demonstrated that issuers needed the ratings agencies more than the ratings agencies need the issues. Another monumental change occurred in 1975 when the SEC designated MCO, S&P and Fitch as Nationally Recognized Statistical Rating Organizations (NRSRO). This designation, in effect, gave them the official blessing of the US government.
The industry has the following characteristics:
- Total Addressable Market. As stated above, virtually any party seeking to tap the global credit markets needs a credit rating. Over recent decades, global fixed-income markets have grown significantly. In the more recent past, credit market disruptions together with the persistent economic slowdown have caused a global decline in issuance activity. The main drivers of the growth are: debt market issuance driven by global GDP growth and disintermediation of credit markets in developing countries. Per Bloomberg, demand for credit ratings reached a record last year as companies sold an unprecedented $3.95 trillion of bonds.
- Competitive landscape. The competitive landscape is defined by market share stability. Moody’s main competitors are Standard & Poor’s Ratings Services, a division of The McGraw-Hill Companies, Inc. Fitch Ratings, a jointly owned subsidiary of Paris-based Fimalac SA and New York-based Hearst Corporation. The industry is effectively a oligopoly. There are a number of smaller firms, as discussed below, but they command a much lower market share. Ignoring for the moment the disruption caused by the 2008 credit crisis, Moody’s and S&P have each had approximately 40% of the market for an extended period of time. This stability has been maintained despite a number of changes in the industry: disintermediation in financials services, the rise of securitizations, etc.
- Pricing Power. The industry underwent a sea-change in 1970 when their revenue model shifted from charging investors for ratings to charging the issuers themselves. This demonstrated the clout that the ratings agencies now had in the marketplace. They could charge companies who wished to issue debt or else they would face higher borrowing costs in the market.
In sum, the major credit ratings agencies had great business models in the year leading up to the Great Recession. “The rating agencies were essential to the smooth functioning of the mortgage-backed securities market. Issuers needed them to approve the structure of their deals; banks needed their ratings to determine the amount of capital to hold; repo markets needed their ratings to determine loan terms; some investors could buy only securities with a triple-A rating; and the rating agencies’ judgment was baked into collateral agreements and other financial contracts,” states the Report of the Financial Crisis Inquiry Commission.
Quantitative Evidence of a Moat
- High ROIC: The low capex nature of its business ($1,183 mil EBITDA versus 2012 Capex of $45 mil) and the low working capital requirements of its model allow MCO to produce superior returns on invested capital: 61% in 2000, and 10-year average ROIC of 145%. All that’s need to run the business are PCs and some office furniture.
- Here are some other eye-popping numbers:
- ROE (10 yr) 84.6%
- Operating Margin (10 yr) 46.7%
- Sales CAGR (10 yr) 9.1%
- EPS CAGR 10.9%
- FCF/Share CGR 9.8%
- Capex/Net Income 12%
Recall that the industry suffered its worse downturn ever during this period.
- Stability of Market Share: One of the hallmarks of a great business is very little competition. As discussed above, MCO and S&P have maintained ~40% market shares for decades. This was only briefly disrupted by the financial crisis of 2007-08.
Qualitative Evidence of a Moat
Are past results predictive of future results? Not usually, but the credit ratings industry is highly concentrated and has been for many years. Year in, year out, the Big 3 issue 95%+ of the ratings, generate 95%+ of the revenue and 95%+ of the earnings. MCO generally commands about a 40% market share. What are the barriers to entry that make this industry so impervious to competition?
The company has customer captivity through three drivers:
- Natural Oligopoly – Investors, both individual and institutional, look to credit ratings agencies to provide an independent assessment of the relative or absolute credit risk of a particular debt obligation or obligor. If there were a large number of agencies offering ratings, issuers could shop for the most favorable rating. Customers would have the upper hand and the agencies would lose their independence.
- Regulatory Reliance Upon Ratings – This natural oligopoly is further strengthened by government regulations requiring a credit rating from Moody’s or another NRSRO. The two primary uses of credit ratings in financial regulation are in (1) determining capital requirements of financial institutions and (2) restricting financial institutions’ asset allocations. The SEC alone has approximately 25 rules and forms that call for a credit rating from an NRSRO.
- Social Proof – As more and more investors use an agency, its ratings are seen as more valuable until they become almost universally viewed as a “good housekeeping seal of approval.” That is, a credit rating from a leading agency becomes a highly desirable and trustworthy signal of financial rectitude that is widely recognized. Once they reach a point of popularity, their opinions become the coin of the realm. This can be seen plainly in state, federal and international regulation which require investment managers and financial institutions to use credit ratings to establish investment risk standards for their portfolio holdings. Nobody ever got fired for buying a bond with a high rating from MCO or S&P. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. A competitor can’t tarnish the brand – only MCO can (and did as we shall see).
Moody’s also has economies of scale. Moody’s and S&P can spread the costs of software development, administration, legal, compliance, marketing and support staff across a large number of ratings. It would be enormously difficult for a new entrant to get to scale and could only hope to compete against the Big 3 in a niche.
Impact of the Financial Crisis of 2007-2010
From 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple-A. This compares with six private-sector companies in the United States that carried this coveted rating in early 2010. In 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every working day. The results were disastrous: 83% of the mortgage securities rated triple-A that year ultimately were downgraded.
Large and unanticipated losses in structured finance securities prompted widespread criticism of MCO and the other large CRAs. The conclusion reached by the FCIC was typical: “We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.” Report of the Financial Crisis Inquiry Commission, p.xxv.
Moody’s revenue dropped 22% in 2008 – the first year-over-year decline in its history. Revenue did not return to 2007 levels until 2011. Total net income has still not returned to 2007 levels although diluted EPS has bounced back due to share buy-backs.
As a result of Moody’s role in the crisis, regulators and Congress threatened action and a number of lawsuits were launched. This is discussed in more detail below.
While still formidable, following the Great Recession, MCO is no longer the bulletproof franchise it once was.
Moody’s can generate triple digit returns on invested capital because there are no fixed assets needs beyond furniture and computers. This in turn drives a capex investment rate of just 12%. While not as low as the microscopic rate of 7% at See’s, it is still very low. For comparison purposes, here are the 10-year reinvestment rates at some other wide moat companies:
- Coke 25%
- Google 60% (just 36% over the last 5 years)
- Omnicom 22%
The only large company that I have seen that comes close is CH Robinson at 11%. We will discuss this company in a future entry.
This minimal reinvestment need allows Moody’s to return over 100% of earnings to its shareholders.
Growth Opportunities Inside the Moat
Even after 100 years of business, Moody’s still has significant growth opportunities inside its moat. The largest is increasing disintermediation of finance in the developing world. Continuing a trend that began decades ago in the developed world, companies are not relying on banks for financing but are accessing public debt markets instead. Investors rely on ratings from Moody’s and S&P to assess the credit worthiness of the borrower. Without a credit rating, the issuer will be forced to pay a higher interest rate.
While its not the best policy to rely on management projections, here we believe it is acceptable given the company’s track record. Management is projecting low double digit growth as a result of GDP growth, disintermediation and price increases.
Capital allocation at MCO has been very shareholder-friendly. Over the last 5 years, MCO has earned approximately $2.6 billion. Approximately $2 billion of this has been returned to shareholders as dividends and share repurchases.
MCO does not provide revenue per rating. Therefore, it is difficult to track annual price increase. Management guidance has indicated that investors can expect a 4% increase in 2013. More broadly, Buffett has discussed the pricing power of MCO many. For the reasons stated above, customers often have no choice but to use the services of MCO or S&P. They have no bargaining power. MCO could name just about any price, and the customer would have to accept it.
Stable and Predictable Cash Flows
In 2012, recurring revenue streams increased to 50% of total revenue. The recurring revenue includes fees from monitoring outstanding securities, subscription-based products, and software maintenance fees. This makes MCO less subject to market volatility and a less risky investment.
- How would a competitor penetrate the moat? How would a deep-pocketed competitor take on MCO?
Fortunately, we have an actual case study to see how a new entrant would take on not just Moody’s but its fellow oligopolists as well. Following the 2008-09 credit crisis, Jules Kroll saw an opening to start a new ratings agency. This was a time of much flux in the ratings area, with new laws and regulations, new pressures from users of ratings, and new competition. If ever a startup could penetrate the industry, the time was now. Even better, Kroll had made a fortune when he sold his corporate intelligence for $1.9 billion.
The Kroll Bond Rating Agency was born in 2010. Its hallmarks were integrity and accuracy. To demonstrate their incorruptibility, they used a subscription revenue model. KBRA bypassed the onerous NRSRO process by acquiring an existing NRSRO.
By mid-2012, KBRA had approximately 50 professionals and $25 million in revenue and hoped to be cash flow positive by the end of the year. They have carved out a niche in rating commercial mortgage-backed securities (CMBS). KBRA has taken advantage of S&P’s problems in this area to move into third place in terms of the number of CMBS deals it has rated, behind Moody’s and Fitch. S&P, had been frozen out for more than a year after admitting a flaw in its financial modeling of CMBS, but it has shaken up its team of analysts and is back, which is why the war of words has heated up.
Even the best opportunity in the last 50 years to breach MCO’s moat, has barely made a dent in earnings.
These changes have helped the seven smaller firms gain market share from the big three in some asset classes. Kroll Bond Rating Agency issued grades on $21.2 billion of commercial mortgage-backed securities last year, the third most behind Moody’s and Fitch, according to Commercial Mortgage Alert, an industry publication. Toronto-based DBRS Ltd. has seen its CMBS rating market share increase 125 percent to $16.5 billion.
The government unleashed a number of reforms of the credit rating industry in the wake of the mortgage meltdown. A principal aim of the reforms was to increase competition. To date, as we saw above, they seem to have backfired as competition is as limited as ever.
‘Of course. the immediate future is uncertain; America has faced the unknown since 1776.’ Warren Buffet in BRK 2012 Annual Report.
Moody’s and the CRAs have proven remarkably resistant to legal attacks. As of the time of this writing, there have been no judgments against them for their role in the credit crisis. The CRAs first line of defense in these cases is the First Amendment. As strange as this sounds, they argue that their ratings are opinions which are given constitutional protect – like a newspaper editorial. The other line of defense is the relatively high burden imposed upon plaintiffs. They must prove that the CRA acted with intent to commit fraud. This is difficult to prove without a smoking gun.
In February 2012, the Justice Department did file a civil lawsuit against S&P. It is seeking $5 billion in civil damages. This amount is roughly equal to 5 years of earnings. The government’s case was filed after years of investigations. That could indicate the Justice Department has not unearthed enough evidence to meet the higher standards of proof required to bring more serious criminal charges. By inference, does the lack of a lawsuit mean MCO is out of the woods? Or is the Justice Department merely waiting to see how the S&P lawsuit plays out before turning on MCO?
In any case, the track record of the CRAs in the courtroom makes us fairly sanguine about the future.
Frankly, we question whether the government’s pursuit here may eventually impair the functioning of the global bond market and, given the decade’s long dominance of the leading rating agencies, does that eventually result in a large, overarching settlement
In a nutshell, Moody’s drives high return on capital and, as a service company, has little to no capex (primarily PCs and office furniture). The result is prodigious free cash flow that is available to be returned to the owners as dividends or share buyback. It sells a service that its customers have to have and have no bargaining power. Finally, none of this is likely to change as it is sheltered from competition by being in a naturally occurring duopoly with stable market shares. Even with the blood of the 2008-2009 debt crisis on its hands, no new entrants have been able to breach its moat.
If we return to the characteristics of a good business that Seth Klarman listed in our initial post, Moody’s hits all of them:
- Strong barriers to entry Check
- Limited capital requirements Check
- Reliable customers Check
- Low risk of technological obsolescence Check
- Abundant growth possibilities Check
- Significant and growing free cash flow Check
Almost, all businesses we look at will be inferior to See’s and Moody’s. We will add Moody’s to our watch list and establish it as our benchmark. From now on, when analyzing a company, we will ask: How good a business is it relative to Moody’s?