If you had to sum up a great company, what would it be?

One that produces a lot more capital than it takes? One that has a competitive advantage over its competitors?

Essentially you’re looking for a Warren Buffett stock – a wonderful business.

Now, if that is what you’re looking for, surely the best hunting grounds to find a Warren Buffett stock is to look at the stocks Warren Buffett holds himself.

So let’s jump right in…

Honey Straight From the Hive

In Berkshire Hathaway’s 2016 Annual Report, Buffett included a table of the 15 investments that had the largest market value, which I’ve included below.

Note* (Kraft Heinz is excluded because Berkshire is part of a control group and therefore must account for this investment on the “equity” method.)

As you can see from the Cost** and Market column, Moody’s Corporation (NYSE:MCO) was one of Warren’s best investments. From the figures above, we can see Warren made around 837% on his $248 million Moody’s investment as of 2016.

Thanks to the credit rating agency’s 50% price climb this year, Warren’s holdings today are closer to $3.5 billion.

What peaks my interest about Moody’s is its insane returns on invested capital (ROIC) – a sign of a competitive advantage.

For most companies with a competitive advantage, or moat as Buffett calls them, they might generate a ROIC of somewhere between 20-50%.

When Buffett started acquiring Moody’s in 2001, the company was generating a ROIC of 663%!

The company continued to generate triple digit returns on invested capital until 2009. Throughout that same time, you could have bought Moody’s for as much as 30-times earnings and as little as 10-times earnings.

Either price, you still would have made money. But could you buy Moody’s today and still be confident that you’re buying a high returning powerhouse bound to appreciate in the future?

Business Overview

For those of you unfamiliar with Moody’s operations, they are a credit rating agency. Going back to the early 1900s, rating agencies primarily rated the credit worthiness of railway bonds.

At the time, smart railway companies decided to issue bonds to the public. With the money they could build new railway lines and invest in more trains, improving their earnings. But like today not every railway businesses were a success. Some went broke.

Thus to make sure they were making a sound investment, investors paid rating agencies like Moody’s to analyse the railway companies and assess their cash flow levels. To make the investors decision easier, credit rating agencies gave each bond a grade.

For example, Moody’s rating system is from Aaa, the lowest risk of default, and C, the highest risk of default.

Soon enough, railway companies caught on. Investors would only buy their bonds if Moody’s or some other rating agency rated their bonds. And thus, instead of investors paying the rating agencies, companies were fitting the bill.

This is the first, and arguable the most important business under the Moody’s name.

As stated in their 2016 Annual Report, “Moody’s Investors Service brings together nearly 1,600 analysts to evaluate debt covering more than 120 countries, approximately 11,00 corporate issuers, 18,000 public finance issuers and 64,000 structured finance obligations.

There second segment is Moody’s Analytics (MA). The MA segment generates a wide variety of products and services, from research, data analytics and software.

While the company only has two segments, they have a mired of subsidiaries.

For example, Amba Investment Services is Moody’s investment research and quantitative analytics business.  Moody’s also has a stake in Korea Investors Services, Korea’s leading rating agency.

If all of this sounds simple, it’s because it is. The credit rating business is extremely lucrative, especially for the two largest players, S&P and Moody’s.

Financials

So how much are these ratings worth?

Well it depends. According to Marc Joffe, former senior director at Moody’s Analytics, the city of Connecticut paid S&P and Moody’s combined fees of $31,700 to rate a $45 million bond issues.

For other clients, the fees could be either greater or less.

In 2016, Moody’s generated $2.39 billion from their rating credit business. It made up approximately 66% of total revenues for the years. Below is a snapshot of Moody’s current financials.

A negative equity balance, mounts of debt and trading at 102-times earnings, what is this trash!

Before you storm off, understand 2016 was a very bad year for Moody’s. The company had to weather a settlement charge of $863.8 million in the fourth quarter.

The sum was a civil punishment relating to misguided credit ratings given to certain financial instruments during the 2008 financial crisis. The group also had to undergo a $12 million restructure and paid out more than 50% on earnings in tax.

If we remove the settlement cost, restructure and lower the tax rate to 31%, then Moody’s generated profits of $1.05 billion, despite total expenses climbing more than $900 million.

OK, so that’s earnings explains. What about their balance sheet?

Throwing off the numbers is Moody’s massive increase in accounts payable, which jumped from $566.6 million in 2015 to $1.44 billion in 2016.

But again, this is explained by settlement charges, as shown below:

Also skewing the numbers for current liabilities is around $300 million of long-term debt coming due. In 2017, Moody’s had 6.06% notes due, adding to total liabilities.

But as you can see, Moody’s can easily meet their current debt schedule, with the next 2.75% senior notes coming due in 2019.

To get a better picture of the company’s amazing returns take a look at the table below.

From 2001-07, revenues, profits and free cash flow compounded by 16%, 18.6% and 14.7% annually. Then, from 2008-16 all three again compounded at annual rates of 8.3%, (5.8%) and 10.4%.

While Moody’s has had a great run, is the company no longer the high compounder it once was?

Not according to investors. As I mentioned, the stock has been bid up more than 50% year-to-date, as Moody’s impresses investors with quarterly earnings.

For the 2017 financial year, Moody’s is on track to generating $4.1 billion in sales, $1.14 billion in profits and $774 million in free cash flow.

That means the company could grow profits by more than 313!

But does that mean the company is worth the $28 billion it trades for?

Moat

How do you get a moat from rating debt? I’ll give you a clue, it’s not by being the low cost provider.

The way Moody’s and S&P create moats is by being correct.  If, over time, Moody’s system of evaluating creditworthiness proves right, meaning the entity either defaults or doesn’t based on Moody’s rating, then their moat gets stronger.

Investors are more willing to buy bonds rated by Moody’s than by some rating agency they’ve never heard of. Scuttleblurb summarised the situation in the following:

“…a debt issuer has little choice but to pay Moody’s for a rating if it hopes to get a fair deal in the market: an issuer of $500mn in 10-year bonds might pay the company 60bps ($3mn) upfront, but will save 30bps in interest expense every year ($15mn over the life of the bond)….and each incremental issuer who pays the toll only further reinforces the Moody’s ratings as the standard upon which to coalesce, fostering still further participation.

This self-feedback loop naturally evolves into a deeply entrenched oligopoly. In terms of total ratings issued, S&P and Moody’s are right at the top of the heap. There are actually 10 NRSROs (Nationally Recognized Statistical Rating Organizations), but unless you work in credit, you’ve probably never heard of most of them (Egan Jones anyone?).”

Of course Moody’s and S&P don’t get it right all the time. No one does. But if they can be right more often than not, then investors favour rating from Moody’s and S&P, thus forcing debt issuers to pay for those ratings.

Valuation

In the last 10-years, Moody’s free cash flow generation has never slipped below $450 million. However it has been volatile at times.

Due to timing reasons, over the last 10-years Moody’s has grown free cash flow by a compounded annual rate of only 3.3%. This is because, during 2007, Moody’s business was booming.

They were rating mortgage backed securities and collateralised debt obligations all over the place. If we use a starting date of 2008, when such activities because less profitable, Moody’s free cash flow generation compounded by 10.5% over nine years.

If we look at Moody’s growth over a 16-year period, free cash flow has compounded by 8.4% annually.

But even using this and projecting it into the future could be misleading. Instead we have to reason our own growth rate into existence.

To me, a reasonable rate would be 4% to 5% over the next five years. Moody’s doesn’t have to do anything exceptional to meet this rate. All they need to do is keep doing what they’re doing.

But I won’t keep you in suspense much longer. Moody’s, by my estimation, is clearly overvalued.

The stock would have to drop 34% to $98.43 per share, just for the company to trade at our estimated value.

Even if Moody’s was to compound free cash flow at 15% over the next five years and 5% thereon, the company would still be too expensive for us to call it a sure thing.

Clearly, Moody’s was an attractive buy when Buffett put his ruler over it in 2001. But in 2017, based on conservative measures, the business is simply trading far above its true worth.

 

-Härje

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