MCO [Archive]

**lzhang** Sat Sep 22, 2007 1:06 pm

MCO
Introduction

Moody's Corp. (MCO) came to our attention in recently days due to sub-prime market problems. Moody's, as one of the three major rating agencies, is on the central stage for its sub-prime debts rating practice. Since its revenue depend heavily on the volume and number of debt securities issued, and people believe that the debt market, especially the secondary market for residential mortgage loans, is drying out, and together with other concerns like authority investigation, regulation changes, possible lawsuits, etc., its common stock price has plummeted from all time high of about $76 per share to low $40's in just a few months. Is this radical valuation change justified? Do we see opportunity and value here? All these topics are very interesting to investigate.

Overview

Founded in 1900, Moody's is one of the major rating agencies nowadays in the world. The other two major rating agencies are Standard & Poor’s Ratings Services (“S&P”), a division of The McGraw-Hill Companies, Inc. (MHP), and Fitch, a subsidiary of Fimalac S.A. S&P is Moody's major competitor. There are many other smaller and specialty rating agencies that are competing with MCO and each other, in the US, and across the globe.

Prior to September 30, 2000, Moody's operated as part of The Dun & Bradstreet Corporation (“Old D&B”). In September, 2000, the Old D&B was separated into two publicly traded companies – Moody's and The New D&B Corporation (“New D&B”). The New D&B (DNB) comprised the business of Old D&B’s Dun & Bradstreet operating company (the “D&B Business”). The remaining business of Old D&B consisted solely of the business of providing ratings and related research and credit risk management services (the “Moody’s Business”) and was renamed “Moody’s Corporation”.

MCO has two reportable segments, Moody’s Investors Service and Moody’s KMV (MKMV). MKMV consists of the combined businesses of KMV LLC and KMV Corporation (KMV stands for Kealhofer, McQuown and Vasicek, the founders of KMV), acquired in April 2002, and Moody’s own Risk Management Services before the acquisition. The MKMV business develops and distributes quantitative credit risk assessment products and services and credit processing software for banks, corporations and investors in credit-sensitive assets, to estimate the probability of default of publicly traded or privately held firms, to value and improve the performance of credit-sensitive portfolios, and so on and so forth.

Moody’s Investors Service publishes credit rating opinions on a broad range of credit obligors and credit obligations issued in the world markets, which can be grouped into four business units: structured finance, corporate finance, public finance, and (financial institutions and sovereign) risk (rating). It also publishes investor-oriented credit information, research and economic commentary, including in-depth research on major debt issuers, industry studies, special comments and credit opinion handbooks.

Most of MCO's revenue (more than 80%) is derived from rating services. For many years, revenue from ratings on structured securities is more than 30% of the total revenue (up to more than 40% in recent years). It is obvious that the growth of structured finance across the globe is a strong source for MCO's revenue growth in recent years. It is also obvious that MCO's rating revenue depends very much on the number and dollar volume of debt securities issued in the world's capital markets. In recent sub-prime market meltdown and credit market turmoils, the impact on MCO is multi-folded. First and foremost is the creditworthiness of Moody's own rating services. Many of the structured securities (mainly CDO's from sub-prime mortgage loans) had got very high ratings, yet when the mortgage loans default, many such CDO's face substantial losses. Second, as investors are shying away from such debt products, the originations of those offerings will drop and so does MCO's rating revenue. Third, due to the recent market turmoils, there might be new regulations that might harm MCO's credit rating business and revenue.

All those problems are just short-term problems and are very unlikely to affect MCO's long-term business. In a rising interest rate environments, no matter how you slice and dice the debt, its value will decrease. As the pie of the world economy is getting larger and larger, and in the meanwhile, the world's debt offerings are getting more and more complex, the demand of MCO's rating services are getting larger and larger. That being said, it is not to say the road is less bumpy. Regulation can potentially change the landscape of MCO's business, but we can not see anybody can solve the problems in the world's debt markets once for all by any magic solution. Maybe the current business model is still the way to go, and MCO just needs to improve its services. As an established player in this field, MCO has crucial reputation, which is hard to establish, yet currently it looks like the reputation of MCO is damaged. We believe the current problem is temporary and not caused by MCO's rating practice, but rather a problem that is inevitable for any market economy. Right now, and in the foreseeable future, when people ask for credit ratings, they are still looking for the ratings from MCO's and S&P, even if you allow other players to participate.

Evaluation

We list MCO's financial results from fiscal year 1998 to Q2 year 2007 in this spreadsheet. We can see its business model is very simple and clear. The revenue and earning growth are fantastic during this 10-year period at about 20% and 23% per annum, respectively. It is not to say that the future growth is free of ups and downs. Stock price is subject to people's expectations and psychological behaviors so we expect even much wilder changes in stock price. As value investors, we primarily focus on its intrinsic business value. To have a more realistic idea of what could happen to its revenue and earnings, we look through longer historical data. In its 2006 annual report, it has a graph for revenue and operating income from 1987 to 2006 on page 4. In this longer period, its operating income increased from about $63M in 1987 to about $1,096M in 2006, or 16.2% per annum. However, from 1993 to 1997, its operating income dropped from $150M in 1993 to $116M in 1994 and finally recovered two years later to above the 1993 level in 1997. Even we do not think the residential mortgage market has such huge effect on MCO's earnings, we believe that after many years of phenomenal growth in its rating businesses, especially in structured finance, we do expect some kind of pullbacks, at similar magnitude as that from 1993 to 1997.

With all the information we have, we evaluate MCO's business value with the following procedure. We assume its net income grows at a nominal rate of 23% per annum from 2008 to 2017, and its net income stays flat after 2017. For each year, we multiply the nominal income by a scale factor to adjust for our expectation. For example, the expected net income for 2008 is about 77% of current year, that for year 2009 and 2010 stays almost flat, and finally it resumes its growth in 2011 and beyond. The PV of net income from 2008 to 2016 is about $6.8B (discounted at 10%), and the PV of net income of 2017 and beyond, assuming flat net income, is about $12.8B. So we have a total valuation of $19.6B, or about $70/share. At price of about $43/share, MCO's common stock is about 39% discounted to its value, or a 63% upward potential from this price level.

There are many uncertainty factors to affect this valuation. We believe the major one is the uncertainty on its long term growth rate, 23%, used in this analysis. Based on the 10-year standard deviation of the growth rate, 10.69%, we estimate the uncertainty of the growth rate is about 10.69/√8=3.78%, which translates into about $18/share uncertainty, or about 25% error on the $70/share valuation.

Its 20-year average operating income growth rate is about 13.6%, which is considerably lower than the 23% we use here. If we use the 20-year average growth rate, and follow similar valuation procedure, we have much higher valuation at about $100/share, as shown on the fifth spreadsheet. The uncertainty on this valuation is about $30/share.

For the ten year period, its number of common stock outstanding decreased at about 2.23% annual rate. If we take this share purchase effect into account, we could have $10/share valuation increase. So the $70/share valuation looks very conservative.

Conclusion and Discussion

Based on our estimation, the value of the stock is about $(70±18)/share, so at price level of about $43/share, the price of MCO is about 39% discounted to its value, even we believe this $70/share valuation is still on its low side of business value. From this rough estimation, we think time is on the Company's side with very wonderful long term perspective.

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.

References

10-Q:
http://www.sec.gov/Archives/edgar/data/1059556/000119312507170649/d10q.htm

10-K:
http://www.sec.gov/Archives/edgar/data/1059556/000119312507043002/d10k.htm
http://www.sec.gov/cgi-bin/browse-edgar?type=10-K&dateb=&owner=include&count=40&action=getcompany&CIK=mco

2006 annual report:
http://library.corporate-ir.net/library/12/123/123831/items/236881/annualreport2006.pdf

Spreadsheets:
http://spreadsheets.google.com/pub?key=pBWqCNQoWBZqVgIHSo4oYfA

**xxyygorich** Sat Sep 22, 2007 7:05 pm

do you happen to have the data for the period of 1993 - 1997 handy?

**lzhang** Tue Sep 25, 2007 1:23 am

Hi,

I do not. All I have is the graph in this annual report. If you want to spend time on it, you might find detailed data from old DNB reports. But there are no such reports or filings online which can be easily retrieved, you might have to go to library or ask the company directly.

All in all, what is important is to have a picture of future. The graph might have enough information to estimate what could happen in the future, for revenue or operating income. For stock price, nobody knows for sure...

The thing for sure is that its stock price is subject to much more ups and downs than the revenue and income...

xxyygorich wrote: do you happen to have the data for the period of 1993 - 1997 handy?

**xuedong_zhang** Thu Oct 04, 2007 11:21 am

Good article.
Warren Buffet also have this stock in his holdings, and the
position is not small

lzhang wrote: Hi,

I do not. All I have is the graph in this annual report. If you want to spend time on it, you might find detailed data from old DNB reports. But there are no such reports or filings online which can be easily retrieved, you might have to go to library or ask the company directly.

All in all, what is important is to have a picture of future. The graph might have enough information to estimate what could happen in the future, for revenue or operating income. For stock price, nobody knows for sure...

The thing for sure is that its stock price is subject to much more ups and downs than the revenue and income...

xxyygorich wrote: do you happen to have the data for the period of 1993 - 1997 handy?

**lzhang** Thu Oct 04, 2007 12:03 pm

I won't care if he has the position or not.

It should be clear that the investment decision making is based on your own judgment, not on somebody else. Remember his advice is more important than his picks.

In his Buffett Partnership letter, dated 01/24/1962 (pg 7),
Mr. Buffett wrote: You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism.

You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.

xuedong_zhang wrote: Warren Buffet also have this stock in his holdings, and the
position is not small

http://www.ticonline.com/buffett.partner.letters/1962.01.24.pdf

**xuedong_zhang** Mon Nov 12, 2007 1:50 pm

Hi, lzhang:

In MCO's conference call, the management team said the revenue and operating income is expected to increase about 10% per year.
Seems using historical growth rate for valuation (16%) in your article may overvalue the MCO

lzhang wrote: I won't care if he has the position or not.

It should be clear that the investment decision making is based on your own judgment, not on somebody else. Remember his advice is more important than his picks.

In his Buffett Partnership letter, dated 01/24/1962 (pg 7),
Mr. Buffett wrote: You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism.

You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.

xuedong_zhang wrote: Warren Buffet also have this stock in his holdings, and the
position is not small

http://www.ticonline.com/buffett.partner.letters/1962.01.24.pdf

**lzhang** Mon Nov 12, 2007 2:00 pm

Hi xuedong_zhang,

But the growth is negative in my valuation for the next 3 years, so the overall growth is much less than 16%. And the growth stops after 20 years or so.

If you believe MCO can grow its revenue and income indefinitely at 10% per annum rate, you can buy it at any price, because its future earnings will eventually overwhelm its current price, if you discount it at any rate below 10%.

xuedong_zhang wrote:

In MCO's conference call, the management team said the revenue and operating income is expected to increase about 10% per year.
Seems using historical growth rate for valuation (16%) in your article may overvalue the MCO

**xuedong_zhang** Mon Nov 12, 2007 2:14 pm

Sorry, I don't understand the valuation of a stock in your article, so fogive me if my question is naive

the price for the valuation should be the current price instead of future price, right?

So if MCO can grow its revenue indefinitely at 10%, I still need
a stock valued about PV=10 to achieve my goal of 1x% yearly return.

lzhang wrote: Hi xuedong_zhang,

But the growth is negative in my valuation for the next 3 years, so the overall growth is much less than 16%. And the growth stops after 20 years or so.

If you believe MCO can grow its revenue and income indefinitely at 10% per annum rate, you can buy it at any price, because its future earnings will eventually overwhelm its current price, if you discount it at any rate below 10%.

xuedong_zhang wrote:

In MCO's conference call, the management team said the revenue and operating income is expected to increase about 10% per year.
Seems using historical growth rate for valuation (16%) in your article may overvalue the MCO

**lzhang** Tue Nov 13, 2007 2:24 pm

Hi xuedong_zhang,

It is a simple one. I discount the future earnings with 10%, which I believe is reasonable. Then I assume it will grow its earning for the next 10 years or so with the growth rate they demonstrated for the last 10 years, or 20% (which might be a naive assumption. But if they can demonstrate any kind of performance for N years, I'd expect they are going to demonstrate the same kind of performance of the next N years, as simple as that). However, with the expected fall back in the debt issuing, etc., we do expect its revenue and earning would come down for the next three years or so. So the overall growth is much less than 20% for the next 10 years, which is reasonable. After the 10 years period, I assume its growth stops, which is not very likely.

So the valuation here is very conservative. But we also need to consider other factors to slow down its earnings. So on balance, we think the total assumption is reasonable.

I do not think any honest management will talk about income growth above 10% indefinitely, which is simply impossible. The 16% rate lasts for 20 years (as they have demonstrated for the last 20 years), and then 0% growth after that. So I think that is also reasonable assumptions here.

xuedong_zhang wrote:

In MCO's conference call, the management team said the revenue and operating income is expected to increase about 10% per year.
Seems using historical growth rate for valuation (16%) in your article may overvalue the MCO

**xuedong_zhang** Tue Nov 13, 2007 10:43 pm

Thanks, lzhang. I enjoyed your articles.

lzhang wrote: Hi xuedong_zhang,

It is a simple one. I discount the future earnings with 10%, which I believe is reasonable. Then I assume it will grow its earning for the next 10 years or so with the growth rate they demonstrated for the last 10 years, or 20% (which might be a naive assumption. But if they can demonstrate any kind of performance for N years, I'd expect they are going to demonstrate the same kind of performance of the next N years, as simple as that). However, with the expected fall back in the debt issuing, etc., we do expect its revenue and earning would come down for the next three years or so. So the overall growth is much less than 20% for the next 10 years, which is reasonable. After the 10 years period, I assume its growth stops, which is not very likely.

So the valuation here is very conservative. But we also need to consider other factors to slow down its earnings. So on balance, we think the total assumption is reasonable.

I do not think any honest management will talk about income growth above 10% indefinitely, which is simply impossible. The 16% rate lasts for 20 years (as they have demonstrated for the last 20 years), and then 0% growth after that. So I think that is also reasonable assumptions here.

xuedong_zhang wrote:

In MCO's conference call, the management team said the revenue and operating income is expected to increase about 10% per year.
Seems using historical growth rate for valuation (16%) in your article may overvalue the MCO