MCO (Moody), cheap now due to subprime credit punches?

**grapes** Mon Sep 10, 2007 7:41 pm

MCO (Moody), cheap now due to subprime credit punches?
Some of my recent observation and idea and puzzles :). Wish to discuss with and hear the opinion from gurus here.

Moody (MCO) recently dropped to around $45 from more than $70 before the credit punches July this year.

Moody's in one of the three main credit rating agencies -- Standard Poor, Moody and Fitch in US. This is a standard Warren Buffet toll bridge business, as Buffet also hold this stock since it was publicly available in 2000. Basically, its bussiness is to rate various debts. If you want to sell into debt market, you have to have either (or rather both) rating of Moody or (and) S&P. This business is very good in the sense that they have minimal capital expenditures. Its return on equity is very high, pretax between 50% and 60% all the time past 5 years with minimal debts. (Actually, in MCO's case, you just know return on asset, due to heavy share buyback, more on this later). Currently, there are seven players the US government allow to do ratings, called NRSRO. Four are significantly small and only niche players. Even Fitch is also very small comparing with S&P and MCO. S&P is a division of another public company McGraw-Hill. Only MCO is the pure play public one. The barrier to enter this one is very high. Put it in Buffet's way, moat is very wide.

The recent sell off due to the mortgage market credit punch because Moody is believed to have significant exposure in rating the mortage debts. People fear that (1) SEC will probe their practise and see if they will have some liabilities over there. (2) Moody will lose the momentum in the revenue growth.

Before forming any view, it is informative to know the past numbers of Moody. The following is some information I digged from the past financial statement.

Revenue of 1999 to 2006 is the following:

$564, $602, $797, $1023, $1246, $1438, $1731, $2037.

Pretax earning 1999 to 2006

$278, $284, $381, $517, $656, $771, $934, $753

Here, the revenue and earning growth are very consistant at growthing a little bit more than 20% a year for past 5 years after MCO was public and 16% for 7 years that we have data. The economy downturn at 2002 and 2003 seems has no relevance to this business.

The company has minimal long term debt, 300M. The capital expenditure is virtually nill. Thus, all the after tax earning is free cash flow. Thus, a nature question is where did the company spend those money?

From the balance sheet, it looked like the company pretty much spend all the money to buy back stocks. In lastest 10K the company disclosued since Oct 2000, Moody bought back 2.9 Billion 84.4 million shares. (But it also issued 38.6 million shares for employee compensation.) All in all, the diluted outstanding shares reduced from 328M in 1999 to 292M, roughly 11% with the 7 years total earning offseting buy new issue of stock based compensation. I don't know if this is a good way to allocate capital, (Indeed, I feel the dilution by stock option etc compesation is too much, more than 40% of all the earning. I will talk about it later) but the end result is that earning per share grows even higher than 20% in 7 years.

With current price $45, the p/e is around 15 for past 4 quarters, (or 17times of 2006). Let us take 17, then the earning yield is around 5.8% (6.7%) comparable to 10 year AAA bond and higher than 10 year treasury now. Then how about the growth prospect of Moody?

First, the current fear about SEC's probing of their practise in rating is probably overact. This is a temporary thing and it is very unlikely goes anywhere abover some fines. However, the slow of growth is probably very true. In a generally up trend rates envirnmont, Moody's rating business, main business probably will be a little bit negatively affect. Also, the residential loan packaging rating business will for sure negatively affected. To what extent, I don't know. But the management predict low to mid 10 growth in recently 10Q, 10K filings. Given the past results, it is credible to me. So if the company still continues its using all free cash flow buying back its share strategy, the earning per share can probably grow 15% a year. (This part, I am not very sure due to my limited understanding of the part of financial statements. I will raise some of my puzzles about financial statement later.). In four years, if the market is reasonable to just award Moody 20 P/E (no need to Moody to return to 20% high growth phase), you are likely to double your money. (However, there is a high chance to have a recession in next four years. Who knows how crazy the market can be and if Moody's can sell even cheaper in bewteen.)

Here is a detailed calculation. Assuming revenue/income grows 10% in next 4 years. (Conservative low teen to be 10%).

The net income will be roughly
750M 825M 907M 998M 1098M

Assuming 60% is used to buy back and 40% is used to cover the shares issued to employee. We have (825 + 907 + 998 + 1098) * 60% = 2297M. If the share price is still $45, we can buy back 51Million. Current fully dilute share 291M, thus we have roughly 240M four years later. Assuming 20 p/e then, 20 * (1098/240) = $91.5. Namely double the price.

I don't worry much about the growth prospect of Moody's. With the economic growth, the debt market will eventually grow larger and larger. As long as the Moody maintain its market share, you don't need to worry about the growth model approaching its limit problem. (Like Dell's problem) What I am not sure is the way the management issueing the stock based compensation to employees and themselves, and my lacking of expertise to read financial statement to understand its effect to share holders like me.

If you are interested, see my next post in this thread.

**lzhang** Mon Sep 10, 2007 9:29 pm

Hi grapes,

I like this pick. Hope it can drop more so we can buy more.

As long as the world business still depends on debts, people are still using ratings, Moody's businesses are solid and growing with the size of the world economy, and the debt offerings.

Disclosure and Disclaimer

The author has a long position in MCO. The position can be changed without further notice.

This is not an investment recommendation to buy or sell any of the securities mentioned therein. All materials presented here are for information purposes only.

**goog** Tue Sep 11, 2007 1:28 pm

I like this one and actually I bought around $45 days ago. Small loss now though.

**lzhang** Tue Sep 11, 2007 1:33 pm

Hi goog,

nice we all end up with the same action, independently. Looking longer term, 3 years from now, 5 years from now, or maybe even 1 year from now, MCO will work out just fine. Any weak in price is just an opportunity for people with longer vision to take advantage of short term difficulties.

goog wrote: I like this one and actually I bought around $45 days ago. Small loss now though.

**grapes** Tue Sep 11, 2007 2:05 pm

Thx lzhang for sharing your position. Following is my puzzle about the stock options dilution part. Hope you can also give me some insights about it.

lzhang wrote: Hi grapes,

I like this pick. Hope it can drop more so we can buy more.

As long as the world business still depends on debts, people are still using ratings, Moody's businesses are solid and growing with the size of the world economy, and the debt offerings.

Disclosure and Disclaimer

The author has a long position in MCO. The position can be changed without further notice.

This is not an investment recommendation to buy or sell any of the securities mentioned therein. All materials presented here are for information purposes only.

**grapes** Tue Sep 11, 2007 2:06 pm

As discussed by previous post, the dilution effect of stock options is puzzling me due to my lacking of knowledge in this side of reading the financial statement. I will post the details here and hope other gurus can help me to figure it out.

Previously I assumed the accumulated earning will be totally used to purchase stock back. However, only 60% will be treasury stock and the other 40% will be used to cover the newly issued options. The reason is that in 2006 10K, it is stated

Quote:

Share Repurchase Program
During 2006, Moody’s repurchased 18.0 million shares at an aggregate cost of $1,093.6 million and issued 6.5 million shares of stock under employee stock-based compensation plans. Since becoming a public company in October 2000 and through December 31, 2006, Moody’s has repurchased 84.4 million shares at a total cost of $2.9 billion, including 38.6 million shares to offset issuances under employee stock-based compensation plans.

Here totaly 38.6 / 84.4 = 42%. However, there are actually broken down numbers for each year, which I found don't adds up.due to my poor understanding. (I hope it is not due to some other reasons). If some guru understand them better, they probably can give a better estimate.

In page 39 of 2006 10K, the consolidated statements of shareholder's equity, one can see the following:

Capital Surplus at 2005 DEC 31 is $240.9M, adding $209M proceed from stock plans, including excess tax benefits, adding $77.3M stock based compesation and adding $(-181.5M) net treasury stock. Reading the row of net treasury stock activity, I find under column Treasury stock, it has (-11.7M shr) and ($-911.5M).

So it looked like as state, they spend $1.093M (911.5 + 181.5) to repurchase shares. (It can also be confirmed from cash flow statements). $911.5M accounted for 11.7M treasury stock. Since they stated they bought 18M in 2006, then the rest of 18M-11.7M = 6.3M should be used to offset the dilution effect of stock options. However, they stated they issued 6.5million last year.

In sum, they purchase 18.0M shr @$1.093M. But it looked like a mystery to me how do you put which amount to treasury stock and which amount to capital surplus. To me, it should be the amount of newly stock issued (namely, from option exercised in 2006). The above calculation gives the number of 6.3M shares.

However, in page 54 Note 11 stock-based compensation plans, one can find from the table that share exercised is 5.8M and share granted 3.0M. What is more, here the granted share is 3.0M, how come they say in previous Share Repurchase program that they granted 6.5M? That is another contradiction to me.

**grapes** Tue Sep 11, 2007 2:23 pm

Hi, goog and lzhang,

Will you share your two's homework before you bought the shares. The main thing worries me is that I am not really sure about the accounting of share dilution effect. I hope there will be nothing like one day the share price goes up and the management exercise a lot to dilute.

Also, any other such kind of Buffet growth style pick your two thing interesting now?

**lzhang** Tue Sep 11, 2007 3:15 pm

Hi grapes,

You read the 10-K very carefully, but I do not think those information really matters here.

the 6.5M vs. 6.3M shares difference might be just rounding.

In year 2006 they granted 3M options, and they did not say granted 6.5M.

Actually they said they had bought back 6.5M or so shares to meet its share-based compensation obligation, including 5.8M options exercised, which, I believe, were granted in earlier years. The remaining 500K~700K shares were used for other purposes, like restricted stocks (400K), ESPP, etc. (See pg 55)

**grapes** Tue Sep 11, 2007 4:46 pm

lzhang,

Maybe you are right, that kind of detail is not very relevant.

I went to back to the 10-K of several years back, the 60% or so ratio roughly holds true.

2005, accumulated buyback is 66.4M shr and accumulated issuances is 32.1M

2004, accumulated buyback is 26.4M and accumulated issuances is 13.0M. (Note this and previous years are before a 2:1 split).

2003, 23M vs. 9.8M

2002, 19.5M vs. 6.1M

Thus, my first post calculation probably won't be off the mark to much due to miscaculation in this front.

Another insight from here is that in 2002, when the stock price valuation is low, the share buy back really help a lot for the price to shoot up. And in high valuations times, all the free cash flow is used to offset newly issued shares. In 2004, bought back 3.5M, issued 3.7M and in 2003, bought back 3.5M and issued 3.2M. In fact, it looked like in 2004, all the money the company earning went to the employees and management, except for a 10% dividents of the earning. But still the market reward it a very high valuation.

I have to say this phenomenan is very very interesting. Fortunately, 2007 is more like a 2002 from valuation point of view.

lzhang wrote: Hi grapes,

You read the 10-K very carefully, but I do not think those information really matters here.

the 6.5M vs. 6.3M shares difference might be just rounding.

In year 2006 they granted 3M options, and they did not say granted 6.5M.

Actually they said they had bought back 6.5M or so shares to meet its share-based compensation obligation, including 5.8M options exercised, which, I believe, were granted in earlier years. The remaining 500K~700K shares were used for other purposes, like restricted stocks (400K), ESPP, etc. (See pg 55)

**goog** Tue Sep 11, 2007 5:00 pm

Hi grapes,

This was not true. Employee stock options were not priced at 0. They need to pay (lower than market price though) to exercise.

In 2004, MCO had $425M net income. The net cash spend for stock buy back - issuance was $116M.

grapes wrote: In fact, it looked like in 2004, all the money the company earning went to the employees and management, except for a 10% dividents of the earning.

**lzhang** Tue Sep 11, 2007 5:11 pm

Hi goog,

Are you sure? stock options are usually granted to employees, like salaries, as compensation to people's work. What you have paid is your work. It is not ESPP.

goog wrote: Hi grapes,

This was not true. Employee stock options were not priced at 0. They need to pay (lower than market price though) to exercise.

In 2004, MCO had $425M net income. The net cash spend for stock buy back - issuance was $116M.

**goog** Tue Sep 11, 2007 5:23 pm

Hi lzhang,

I guess you misunderstood me.

Usually the stock option is priced at the market price of grant date. Say MCO grant options at $15 and all the shares are exercised at $20. Employees has to pay $15 to exercise and sell in the market for $20. For each share, MCO get $15 cash/share from employees. If MCO decided to buy back the same number of shares, it will cost the company $20/share. So after the exercise and buy back, the share numbers are the same but the company spend $5/share ($20-15).

lzhang wrote: Hi goog,

Are you sure? stock options are usually granted to employees, like salaries, as compensation to people's work. What you have paid is your work. It is not ESPP.

goog wrote: Hi grapes,

This was not true. Employee stock options were not priced at 0. They need to pay (lower than market price though) to exercise.

In 2004, MCO had $425M net income. The net cash spend for stock buy back - issuance was $116M.

**lzhang** Tue Sep 11, 2007 5:33 pm

Hi goog,

OK. But that is the same as you exercise any options, not only granted option. Yes, I agree on that option holders need to pay the striking price.

In any case, the money the company used to buy those shares won't affect its operating results. On the other hand, under the new accounting rules, the company needs to expense the option costs when it grants those options. This part will affect the operation results.

goog wrote: Hi lzhang,

I guess you misunderstood me.

Usually the stock option is priced at the market price of grant date. Say MCO grant options at $15 and all the shares are exercised at $20. Employees has to pay $15 to exercise and sell in the market for $20. For each share, MCO get $15 cash/share from employees. If MCO decided to buy back the same number of shares, it will cost the company $20/share. So after the exercise and buy back, the share numbers are the same but the company spend $5/share ($20-15).

lzhang wrote: Hi goog,

Are you sure? stock options are usually granted to employees, like salaries, as compensation to people's work. What you have paid is your work. It is not ESPP.

goog wrote: Hi grapes,

This was not true. Employee stock options were not priced at 0. They need to pay (lower than market price though) to exercise.

In 2004, MCO had $425M net income. The net cash spend for stock buy back - issuance was $116M.

**goog** Tue Sep 11, 2007 5:39 pm

I was just saying that MCO didn't spend all the income to cover the options granted as stated by grapes.

lzhang wrote: Hi goog,

OK. But that is the same as you exercise any options, not only granted option. Yes, I agree on that option holders need to pay the striking price.

In any case, the money the company used to buy those shares won't affect its operating results. On the other hand, under the new accounting rules, the company needs to expense the option costs when it grants those options. This part will affect the operation results.

goog wrote: Hi lzhang,

I guess you misunderstood me.

Usually the stock option is priced at the market price of grant date. Say MCO grant options at $15 and all the shares are exercised at $20. Employees has to pay $15 to exercise and sell in the market for $20. For each share, MCO get $15 cash/share from employees. If MCO decided to buy back the same number of shares, it will cost the company $20/share. So after the exercise and buy back, the share numbers are the same but the company spend $5/share ($20-15).

lzhang wrote: Hi goog,

Are you sure? stock options are usually granted to employees, like salaries, as compensation to people's work. What you have paid is your work. It is not ESPP.

goog wrote: Hi grapes,

This was not true. Employee stock options were not priced at 0. They need to pay (lower than market price though) to exercise.

In 2004, MCO had $425M net income. The net cash spend for stock buy back - issuance was $116M.

**grapes** Tue Sep 11, 2007 7:16 pm

goog,

You are right, probably I should not draw the conclusion as total 2004 earning all goes to buy back. But still, how do you get the 116M figure? In the consolidated statement of share holder equity, row net treasury activity, it looks like 100M is for giving out 0.5M treasury and 121.3 million spent for buying back 3.7 M share. I have to say the positive 0.5 here is a funny number for buying back treasury. (Normally, it should be positive. Anyway, $221.3M from that year is all used to buy back shares to cover the new issuance of 3.7M shares. Put it another way, in 2004, they earned $425M, giving 221.3M to employee and retained the rest.

So the management did not reward all earning to theirselves, but just 50% as usual.

goog wrote: Hi grapes,

This was not true. Employee stock options were not priced at 0. They need to pay (lower than market price though) to exercise.

In 2004, MCO had $425M net income. The net cash spend for stock buy back - issuance was $116M.

grapes wrote: In fact, it looked like in 2004, all the money the company earning went to the employees and management, except for a 10% dividents of the earning.