Moody’s Stock Price Prediction: Tycoon In A Dead-End Industry

 

 

This article was written by Mingyue Liu, a Financial Analyst at I Know First.

Moody’s Stock Price Prediction: Tycoon In A Dead-End Industry

“It’s simply not for me to evaluate an independent rating agency’s processes. But I will say that there was reason to be anxious–absolute reason to be anxious.” (Jay Carney)

Summary:

  • Moody’s SWOT analysis
  • The acquisition of BvD: too late, too small
  • Rating industry Porter’s Five Forces analysis
  • Bearish outlook for MCO

MOODYS CORPORATION

Moody’s Corporation (Moody’s) is a provider of credit ratings; credit, capital markets and economic related research, data and analytical tools; software solutions and related risk management services, quantitative credit risk measures, financial services training and certification services, and research and analytical services to financial institution customers.

Moody’s operates in two segments: Moody’s Investors Service (MIS) and Moody’s Analytics (MA).

The MIS segment is mainly comprised by its ratings operations. This unit generates revenues mainly from fees for the assignment and the ongoing monitoring of ratings on debt obligations and the entities that issues such obligations.

The MA segment develops a wide spectrum of products and services that support financial analysis and risk management activities of institutional participants in financial markets. It consists of three lines of business: data and analytics business, enterprise risk solutions and professional service.

While characterized with low or no service differentiation, rating industry is actually very specialized. The Big Three, Moody’s, S&P, and Fitch, rate bonds differently. Compared to its close competitors, Moody’s is more focused on estimating the expected loss in the event of default, instead of the probability of default.

Moody’s SWOT Analysis

Strengths

  • There are high barriers to enter rating industry. Barriers to this industry exist in both tangible and intangible ways. On the one hand, regulation is currently limiting entry. On the other hand, it’s safe to say that reputation is vital in this market. It’s easy to understand why borrowers would choose a neutral rating from the Big Three over a favorable rating from a “nobody”. Moody’s, with its long-established standardized rating process, enjoys a solid customer base.
  • Moody’s has a wide moat, strong market share. Moody’s is one of the Big Three in this oligopolistic market. According to Annual Report on Nationally Recognized Statistical Rating Organizations released by SEC in December 2016, Moody’s accounted for 32% of the total non-government securities ratings, while S&P and Fitch held 35% and 20% of this market, respectively.
  • The company displays solid financial performance. The company generated free cash flows of $1,065 million and $1,111 million for 2015 and 2016, respectively, showing fabulous performance of core business.
  • Moody’s is the only one in the Big Three to be free-standing. This also gives Moody’s the edge over its peers. For example, bond rating is an important source of the company’s revenues, while this service of S&P’s is much less known, because it’s embedded in S&P’s wider financial information activities, and S&P itself is part of McGraw-Hill.

Weaknesses

  • Rating industry is inherently devoid of innovation. This may provide Moody’s a stable demand, but it also limits to minimum the company’s opportunity to grow further. On the contrast to stock analysis market, bond rating market is featured with strictly standardized assessing process, and customers are very much less open to varied opinions.
  • This industry is excessively sensitive to economic crisis. During the 2008 crisis, stock price of Moody’s plunged from over $70 to less than $20. What’s worse is that people seem to lack faith in rating agencies since then, because they were publishing favorable ratings on bonds that proved to be garbage.

MOODYS CORPORATION

Opportunities

  • Emerging markets provide potential growing opportunities for the company. Through its 30% stake in CCXI, Moody’s is the only U.S rating agency that is able to rate domestic Chinese debt. CCXI is an affiliate of China Chengxin Credit Rating Group, which is the first and largest credit rating company proved by People’s Bank of China, the central bank of China. China is widely believed to be a major market for fixed-income products, with inter-bank debt market over 8 trillion RMB (roughly $1.16 trillion) by August 2015. A market of this scale provides Moody’s a promising outlook.
  • Trump tax proposals are expected to be a net plus. After his election, Donald Trump has proposed for several tax plans to be implemented. According to his proposals, corporate tax rate would be 15%, down from 35%, and businesses would be taxed only on income earned in the U.S.
  • Moody’s has announced on May 16, 2017 to acquire BvD (Bureau van Dijk). BvD is a major publisher of business information based in Amsterdam, and it specializes in private company data, corporate ownership including beneficial owners, M&A data and financial strength metrics.
  • Market research shows a positive outlook for disintermediation, which will drive issuance. According to a market analysis published by Amundi in December 2016, 75% of Eurozone’s economy is financed by banks, versus 25% in the U.S. As banks would move loans from balance sheets to the public markets, this trend would drive higher issuance in Europe, providing Moody’s a bigger market to rate.

Threats

  • Lawsuits may have negative effect on Moody’s. In January 2017, The Department of Justice, 21 states, and the District of Columbia reached a nearly $864 million settlement agreement with Moody’s. In April 2013, Moody’s, along with Standard & Poor’s and Morgan Stanley, settled fourteen lawsuits alleged that the agencies inflated their ratings on purchased structured investment vehicles.
  • The Big Three are facing competition from more specialized agencies. Even with little or no competition from new entrants, Moody’s is faced with specialized rivals, who are small rating agencies that focus on niche markets. For example, Thomson Bankwatch and IBCA specialize in rating financial institutions, and AM Best in insurance companies.
  • Credit rating agencies are super sensitive to economy crisis caused by financial instruments. 2008 crisis was proved to be a catastrophe to credit agencies such as Moody’s. Customers lost confidence in Moody’s overnight. I believe this still remains one of the major concerns that contribute to the company’s potential downturn.
  • Bond rating users start to acknowledge the importance of non-rating signals. Financial market is becoming increasingly sophisticated, so are the rating users. As rating agencies follow a standard pattern to rate debts, utilizing a certain basket of rating signals, investors are now using non-rating signals such as rating outlooks and the Watchlist for an indication of the likely direction of future rating actions.
  • Moody’s would suffer from softening in issuance. Unfortunately, this is expected to be the case. According to investment banks views provided by Moody’s, U.S. investment-grade bonds issuance is expected to be flat to down 10% over the next year, and leveraged loans issuance is expected to be down 5-10% over one year.

Acquisition of BvD: Too Late, Too Small

MOODYS CORPORATION

 

I am skeptical about management’s wishful thinking for 1+1>2. Moody’s announced in May 2017 to enter an acquisition of BvD for $3.27 billion. BvD is a quality business with over 90% of its revenue recurring. It specializes in private company data. The company has been generating 9% annual growth rate since 2006, most of which was from volume increase instead of price. BvD’s platform currently covers over 220 million private companies globally and supports more than 6 thousand institutions. Management published estimates of revenue and expense synergies to be $45 million by 2019, increasing to approximately $80 million by 2021.

However, I believe this is not as smart a transaction to Moody’s as it appears to be. The $3.27 billion is divided into two parts: 1.3 billion of offshore cash and 2 billion of new debt financing. BvD revenues were $281 million in 2016 and EBITDA was $144 million, indicating a purchase price at 11.6x trailing revenues and 22.7x trailing EBITDA–much higher than usual cases. As I see it, Moody’s is paying for more than the company is worth.

It may appear to naked eyes that BvD could be a powerful weapon of Moody’s. However, even with all synergies coming true, BvD could only provide a 1% plus to Moody’s revenues for 2019. Let alone it still remains questionable whether BvD’s business in Europe could be seamlessly integrated into Moody’s without generating any extra costs, who operates mainly within the U.S.

To elaborate my position, I will include in the following session to explain why I believe the acquisition of BvD is “too late, too small”.

Tycoon in a dead-end industry

Moody’s is for sure a big name in rating industry, and I do believe it’s leading this race of rating agencies. The only problem is whether it is winning a game that is worth winning. Based on Porter’s Five Forces analysis, my answer is NO.

MOODYS CORPORATION

  • Threats from new entrants: Low. As I have mentioned in the previous session, threats from new entrants is low. Reasons lies in both regulation and the existing intense competition in the industry.
  • Threats from substitutes: High. Rating agencies provide services with low or no differentiation. For example, the Big Three are nearly interchangeable, and there is no clear sign of customer loyalty in this industry.
  • Bargaining power of customers: Strong. For starters, this is an industry filled with service suppliers and all peers provide similar services. In addition, customers can switch to another agency with low or no extra costs.
  • Bargaining power of suppliers: Weak. Reasons include what have been mentioned above. What’s more, rating industry is not open to “colorful” opinions. If you compare this industry with stock analysis industry, you will get the sense. Customers are looking for standard, universal, and authoritative services, which forces a narrower gap between raters.
  • Industry sustainability: Low. It may come as a shock that rating industry has been a spent bullet, but it is what it is. As I mentioned, this industry is not open to innovation in rating process. Furthermore, ratings are static compared to the fast-changing financial world. Even professional rating agencies such as Moody’s cannot capture every sense of market movement. Also, there is an inherent drawback of ratings that raters would take into account only the “rating signals”, but non-rating signals such as rating outlooks are becoming important as well to sophisticated investors. Another event that flawed the whole industry was the great depression. In January 2017, the Department of Justice, 21 states, and the District of Columbia reached a nearly $864 million settlement agreement with Moody’s, as the company’s role as an accomplice of the great depression. Will the market picks up its confidence in raters and rely on them like nothing happened? I really doubt it.

Conclusion: Bearish Forecast for MCO

However what a big name it may be in rating industry, Moody’s suffers from the gloomy environment. As a result, I hold Bearish expectation for the company. My opinion resonates with I Know First forecast from AI-based algorithm. The company may have an eyewink of peace in a short-term, while the market is trying to figure out outcomes of the expensive acquisition. However, due to the downturn of rating industry, Moody’s would suffer, even as a giant.

The predictability increases in the long term, indicating that MCO is a sell in the long term.

MOODYS CORPORATION

I Know First Algorithm Heatmap Explanation

The sign of the signal tells in which direction the asset price is expected to go. (positive = to go up = Long, negative = to drop = Short position). The signal strength relates to the magnitude of the expected return. We use the signal strength for ranking purposes of the investment opportunities.

Predictability is the actual fitness function being optimized every day and can be simplified explained as the correlation based quality measure of the signal. This is a unique indicator of the I Know First algorithm. It allows the user to separate and focus on the most predictable assets according to the algorithm. Ranging between -1 and 1, one should focus on predictability levels significantly above 0 in order to fill confident about/trust the signal.

MOODYS CORPORATION

To subscribe today and receive exclusive AI-based algorithmic predictions, click here.

MOODYS CORPORATION