Moody’s: Aaa Business Model - [Business Breakdowns, EP.142]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I'm Zach Fuss, and today we are breaking down Moody's Corporation. Moody's was founded by John Moody in 1909 with the idea of broadening access to credit information and codifying how people viewed credit statistics by producing manuals of stats related to bonds. In 2000, Moody's was spun off from Dun & Bradstreet as a separately traded public company. Today, it is nearly a $75 billion enterprise business, producing approximately $6 billion in revenue at 45 % margins. Moody's is one of a triumvirate of credit agencies alongside S &P Global and Fitch, which control 95 % of the global credit ratings market.

1:31To break down Moody's, I'm joined by Brian Yachman, the founder and president of YCG Investments. During this conversation, we explore the business's origin story. We discuss how the financial crisis impacted the trajectory of the business and the role that credit ratings play in the broader investment ecosystem. We hope you enjoy this conversation on Moody's. Ryan, I thought maybe a place to start is just a basic overview of what is the business. I think people know Moody's, they know S &P, they're different businesses, they compete. But what's the general story of this almost 200 -year -old business?

2:07Their main business, it's a credit rating agency. They refer to in their 10Ks as Moody's Investor Services, or MIS. And what they're doing is they're rating the riskiness of debt. So corporations, governments, banks, they hire Moody's to put a rating on their debt because it'll help them better sell that debt in the capital markets to raise money. So we think of it as a dominant global toll collector on all global debt issuance. So this segment, they have about 73 trillion of total debt that is rated outstanding. That's among 25 ,000 organizations. About half is corporate ratings. The other half is evenly split between government, structured finance, and then financial services.

2:50So as you mentioned, their main competitors, Standard & Poor's, or S &P Global, and the two of them are by far the largest. They're both globally recognized, and their networks are far larger than any of the competitors. The next closest would be Fitch, but beyond Fitch, everyone's super tiny. So Moody's and S &P, they each control about 40 % of the global market, with Fitch controlling 15%. So among those big three, you've got 95 % market share. How is the business subdivided? Because I know they don't only do credit ratings. They have a platform of services at this point. How do you think about the different business segments?

3:25There's the Moody's Investors segment, like I already talked about. That piece is more cyclical. But over the long term, the way I actually think about that business is that as more businesses conducted in the world, there's going to be more demand for debt as a way to bring down your cost of capital. And so as debt issuance goes up, Moody stands there as a toll collector on global debt issuance. And so in theory, they should grow at a pace of GDP plus a little faster as they take share from local banks as businesses grow and they want to access the global capital markets. But to your point, this isn't the only piece.

3:55The scope of that network is massive. I mean, they're providing credit data going back in some cases over 100 years. And so using all that data, they created another segment called Moody's Analytics. So they take all that data and then they increase their use cases for that data by providing analytical support and software. And this piece now serves over 15 ,000 customers in 165 countries. It represents 70 % of the Fortune 100 companies and a little over half of the Forbes 1000 list. The genius part of this segment is it does help smooth out the cyclical part of the ratings business because it's evergreen subscription revenue with over 90 % retention rates.

4:34And it's been a consistent grower, growing like over 10 % ever since it began in 2007, 2008 -ish. How big is the business? What are the revenues? And then if we can dive a bit deeper into the margin profile and the growth profile of the ratings and the analytics segments. Total revenue is about $6 billion. And revenues are split about 50 -50 between the two main segments. So to keep it simple, the ratings business is about 50 % plus margins. So figure normalized earnings are at least $1 .5 billion or more in operating income on the rating side. And then the analytics business, it has about at least a 20 % margin business.

5:13And if I'm generous with the ad backs, perhaps a 30 % margin. And so at 30%, that'd be about $900 million operating income. And I should note about half of the analytics business is estimated to be connected to their ratings business, that piece that I price. But the rest of the analytics business is competing against some pretty tough competitors. And so I'm less enamored with that. But all in all, add it all together, that's around $2 .5 billion operating income normalized for the entire company. And so if I'm a customer of Moody's, perhaps it'd be helpful to just think through what the use cases are.

5:47How does it all kind of work? What is it that this business really does and does well? So in total, they're providing ratings to well over 25 ,000 organizations. To give you an idea of the way it works, they receive transactional revenue from the first time that they rate the bond. and those are paid by the debt issuer. And then they will receive annual debt monitoring fees, surveillance revenue, and it's from continuously monitoring the bond after issuance. So this is where you'll see upgrades, downgrades, or maintaining initial ratings. They typically will reassess quarterly, but they'll reassess also if there's big announcements like an acquisition or whatever big announcement might lead you to want to check the business out again.

6:26And then the fees that they're paying will vary based on the size and complexity. They no longer publish that data, actually. But historically, they've said that they raise prices at around three to 4 % per year. And it had been seven basis points the last time it was published. And you can also look at S &P Global's rack rates. And so when you look at it, my guess is they're probably charging around eight basis points today. Now onto the other side of the business, we've got Moody's Analytics. In short, all Moody's Analytics is doing is they're selling subscriptions to access all their data and analytics around this data.

7:00You have all sorts of people investing in debt that want analytics around various debt offerings, and they really want to understand risk, counterparty risk, credit risk, et cetera. Moody's, they're providing analytics that predict expected default frequency. There's literally daily updated market implied ratings using all these formulas and such to provide real -time ratings. And then in addition, there's default and recovery rating analytics, early warning signals to help you get a better idea of what are the odds of defaulting on your loans, predict if they might default in the next year or two.

7:33They have data on financial records and ratings history and credit trends for yields and spreads going back to the 70s. And so all these investors, they want to have all this data, this information and understand risk so that it can accurately value and price the debt. Now that we've kind of highlighted the core competencies of the business, I think it'd be helpful to take us through a business that started in the mid -1800s. It's now a dominant credit agency. How did we get from railroad data business to what the business is today? Well, in the late 1800s, there was a great investor enthusiasm.

8:10And by 1900, John Moody, obviously where the name Moody's comes from, he saw he could fill a niche and provide data on stocks and bonds for all sorts of industries at first. And by 1903, it was nationally recognized. But then came the 1907 financial crisis, and John Moody actually ran out of capital and closed up shop. It actually turned out to be a blessing in disguise because the US had experienced a railroad boom and everyone was desperate for credit analysis on their bonds. So in 1909, John Moody created the first widely accessible publication that was rating purely railroad bonds. And then came along the Great Depression, which that's where Moody's really gained the regulatory competitive advantage.

8:53Because in 1936, regulation was introduced mandating that US banks could only own bonds if they were designated as investment grade by, at the time, what was the big four. Those were Moody's, Poor's, Standard, and Fitch. And so as regulation often does, it creates a moat and it strengthened these incumbents. and it began to create, if you will, languages that were being used in the capital markets to rate and communicate the riskiness of bonds. And then it gets even better. In 1975, the SEC issued rules around capital requirements based on the ratings of now what became the big three credit rating agencies, because by then standard had now merged with poor.

9:36And so these three ratings companies essentially became deeply entrenched in the financial system. So it began with a regulatory advantage. Ironically, then the government says, hey, they're too strong. Let's try to break it down. But by then it was too late. Now they had this global language being used in the capital markets and nothing they could do could disrupt it. And so now today, virtually all fixed income investors measure risk using these three companies' conventions or protocols. So we call this a protocol network effect. And I should mention, Moody's was acquired by Dun & Bradstreet in 1962.

10:11And the two of those companies, they largely operated as independent companies. And as time went on, there was pressure by Wall Street to spin it out of Dun & Bradstreet because it was outperforming the rest of D &B's business. And so Moody's went public on the New York Stock Exchange in the year 2000 under the ticker MCO. Now, since that time, Moody's has made a bunch of acquisitions. The first was in 2006. They expanded ratings to China, taking a 30 % interest in CCXI. That's only a tiny piece. It only contributes about $16 million to income. And then to help smooth over the cyclicality of the ratings business, Moody's management got the idea around 2007 -08 to form Moody's Analytics.

10:52And so that's where they took the data from the ratings business to create that subscription business that we talked about. And now they've grown the analytics business depth and breadth by going on an acquisition buying spree. So in 2017, they acquired Bureau Van Dyke for about $3 .5 billion. That's where they got Orbis to get all that private company and M &A activity data. In 2018, they bought Reese, which provides CRE data. In 2019, they added ESG data. In 2020, they bought Know Your Customer or the KYC suite, the anti -money laundering product. That was for about $700 million. And then the last major acquisition was in 2021, they bought RMS or risk management solutions.

11:35And that was for about $2 billion serving the P &C industry. And so I guess it kind of makes sense to me why the business is in such a dominant position, but I guess I have a tougher time appreciating how they established that positioning and what true barriers to entry this business has at this point. I want to first off admit that after the Great Recession, we didn't want to touch this business with a 10 -foot pole because we were afraid that they'd go under during the CDO debacle. And we thought for sure they were going to get nailed. Well, they survived all those lawsuits. And then we thought, well, gosh, if they can survive that, they can probably survive just about anything.

12:12And so to your point, then it got us really thinking, well, all right, where did all that strength come from? What is making them so indestructible in our view? Well, as I mentioned before, it began with the regulatory advantage, but that's not what they're holding on to anymore. Because after the Great Recession, the government tried to bring them down by opening up competition and expanding that list of the nationally recognized statistical rating organizations. and they've changed it from three recognized to 10. And there's probably around 20 out there that are trying to compete. But during that timeframe, none of the big three lost any market share at all.

12:46They just maintain their stranglehold on the credit rating business. And really what it is, is it's because it's trying to disrupt a language. So imagine trying to get humans everywhere to learn dozens of languages. We just don't have the time. And so languages tend to coalesce around two, three, or four major languages. Thinking in those terms, I mean, imagine trying to disrupt English, Mandarin, Spanish. And so the bottom line is these companies have become the global language of the bond business. And we call it a protocol network effect. We consider it one of the most difficult competitive advantages to disrupt.

13:20And like I was saying, protocol network effects, they tend to develop because a crowded information marketplace would be pretty inefficient because it would require everyone to maintain background on all sorts of various analytical methods. You need to know not just that BAA1 is comparable to BBB +, but you got to do that for like 15 others. It's not going to happen. Now, on the other hand, if it was a monopoly, there'd be no checks and balances. And so the market tends to support a few different systems, in this case, those big three. But fun fact, there has never been more than four credit rating agencies with significant market share over the industry's more than 100 -year history.

13:58And that's pretty significant. One of the things we look for are businesses with limited supply and contrast that with something like the media industry. You've got Alphabet. YouTube uploads 82 years of fresh new content per day. 82 years of new content every day. And that's not even to mention all the content being created by Netflix, Disney, Hulu, TikTok, Meta, their Facebook and Instagram video games. All of those things are competing for eyeballs. Well, we take comfort here with Moody's that we're owning a business where you don't have all this unlimited supply competing. I mean, we all know how the laws of demand and supply work.

14:35But in this instance with Moody's, demand should continue to grow as the world conducts more business and they'll just act as a toll taker on that. And then there's really no other supply coming online, which makes that network effect super powerful. So coming back to it like being a global language, I want to contrast that with the Consumer credit bureau business, because I saw you guys did a really excellent one on Equifax. And the credit bureau business, I think it's great. In the US, it's dominated basically by Equifax, Experian and TransUnion. But if you look across the world, there are many country -specific winners in that space.

15:10And that's because they're collecting all this proprietary credit data on individuals, and then they're selling that information to local banks to make better loans. But most banks then focus their efforts in a domestic market, both because the local knowledge is valuable there in lending, and also because the governments have that implicit, explicit bank guarantees that result in all sorts of regulations that dissuades overseas growth. So a US credit bureau's proprietary data is incredibly useful for a bank doing business in, say, Texas, but it doesn't really help a Chinese bank decide whether to lend money in Shanghai.

15:44So this means credit bureaus have to build their business market by market. And then they have very little advantage when entering a new country. Compare that, though, what I like way better with the case of Moody's is it's a global network effect, not just a local network effect. And the more global that ecosystem is, the more difficult it is to disrupt. And so then once those winners emerge, they basically just continue to plot along. So, for example, an India company issuing corporate bonds is going to be highly incentivized to buy ratings from the big three because global investors are going to derive away way more information and comfort from them as that shared trusted global language than they will from some less familiar domestic upstart.

16:24And then you've made reference to the network effects of the business a handful of times. Can you just unpack that for us a bit? A crucial point to bring up about this global network effect is that, as I mentioned, people are paying seven to eight basis points to get their bonds rated. And you might ask, how sustainable is it that they could keep raising prices three to 4 % per year, or at least keeping pace with whatever inflation might be. Well, this is the key here. People are doing it because it reduces their cost of debt. Because you see, if you don't have a rating, the bond markets essentially rebel.

16:57And then the cost of debt goes up 30 basis points, possibly actually as much as 50 basis points. That's according to a Moody's independent study. And it's also according to Heineken, they decided to issue bonds for the first time in 2012. and they themselves saw the cost of debt went down about 30 to 50 basis points once they started getting rated. And so think about it. If you're as boring of a business as Heineken, that's pretty well -known and understood, it's even plausible that the savings are even larger for much more complex, less well -known or riskier businesses. And so it makes it cheaper and it creates all this liquidity because if you get a rating, now you're opening up all the number of people that are able and willing to invest.

17:38But without a rating, you immediately cut off much of the market. They might have rules in place that they're not allowed to invest without a rating, or they're just nervous to. And so I guess the main point is the way that network economics work is that the value of a network scales exponentially with size. So it's not that each new user to the network just adds value in a linear fashion. It actually grows exponentially because each new user creates all these different connections. And so Moody's has now opened up this wide gap between what it's charging for its services and the value that it creates for its customers.

18:13And so ultimately, it's a no -brainer. It's going to save companies money by hiring them. And so beyond that global network effect, what are some of the other points of competitive differentiation that you think are important to highlight? Well, I'd point out that it's a small price relative to the overall budget of a company. And it's also a small portion of the cost of issuing debt. So if you're paying eight basis points out of say maybe 75 to 100 basis points, that's important because it means you're less incentivized to look for alternatives. It's also, as I mentioned before, it's far below the value providing an umbrella for them to keep raising prices.

18:49Imagine if you're going to get both a Moody's and an S &P Global rating, combine that together, let's say eight plus eight, that's 16. they still can take it to 30 to 50 before you would even consider to look at another alternative. I'd also point out that they're networked across time. When you look at the analytics piece, the more information that they've collected over time, the more value it becomes as it provides more historical context. You can't just create a hundred years of data. So it gives them all this unmatched historical context. And you can try and backtest your system to create it, but it's just never the same of having all these actual data points that they've collected over more than 100 years.

19:26Another major advantage is the principal agent rule. In this case, the agents, they're the employees. They're acting on behalf of principals or the owners. The employees are incentivized to stick with the conventional choice. So imagine, let's say you're commissioned with raising money in the capital markets. Would you want to go to some startup guy who says, hey, I'll charge you nothing. Just let me rate your bonds. Well, the issue is you'd be like, I'm risking my career because if I do it and it goes well, I might only get a pat on the back. But if it goes bad, I might lose my job. And so you're likely going to just go with status quo.

20:01And then on the other side of the trade, there's a lot of fixed income is invested by agents with little or no personal ownership in the underlying bonds. And so they likely, they just want to see a rating from at least two of the big three, and then they can blame the rating agencies in the event the bonds default. They can say, well, it's not my fault. It was rated that way. And then of course, they created this new standard or protocol. They created this ecosystem. The fact that they created the other business, the analytics side, with all these proprietary analytical services and tools, that further strengthens it because they can now better understand ratings from a historical, a current, and a future perspective.

20:39And so it enhances the usefulness of these ratings. And then keep in mind, it requires an investment in training to learn that language. So then that all further increases switching costs. So you now have a network effect with high switching costs. And that exists to some extent on both sides of the business. On the analytics side, the network effects are the relationships from where they collect all that data that gives them the breadth and the depth and the data network effect. And then it has switching costs because people don't want to waste their time constantly switching between data providers.

21:11I mean, they would be hard to overcome even if the system was terrible. So for example, think of the Dow Jones. It's a poorly constructed index, and it doesn't even really convey any useful information. And even though it was superseded by the S &P 500, amazingly, the Dow Jones is still widely quoted on a daily basis. So bottom line, we believe these rating agencies, Moody's and S &P in particular, have basically an unassailable collection of competitive advantages. And we just think it's extremely unlikely that they're going to lose that global market share dominance over time. We talk a lot at YCG about seeking to find a high degree of certainty of terminal value.

21:50And here the terminal value seems very high. And that's super key when you consider much of the value of discounted cash flows of a business are the value 30 or more years out. And I mean, how many people own a business that they can actually say they're confident will even be around in 30 years? And so we're constantly looking for a collection of those multiple businesses with high terminal values. How does this set of competitive advantages translate into the financial profile of the company. Perhaps you can give us some more detail on how the money they make flows through to the bottom line.

22:21It's a super profitable business. For starters, it's about a 40 to 45 % margin business overall. They're on pace for 37 % margins this year because of the cyclical nature of the rating side. But historically, it had a 45 % margin business last year and analysts estimate 42 % margins by 2025. For us at YCG, one of our favorite metrics to look at, we call it ROTA or return on tangible assets, meaning EBIT divided by property, plant and equipment plus inventory plus working capital, networking capital. So what is your return on the tangible assets? In other words, what does it take to run the business in terms of capital?

23:00Well, since they don't have any inventory, you're only looking at about a billion in total capital needed to generate about $2 .5 billion in income, a 250 % return on tangible assets. To put this in perspective, there's plenty of businesses out there where this metric is a meager 15%, 25%. My guess is the average S &P 500 business probably averages out to 30%, 35 % maybe. So what this means is Moody's is super profitable. And if there is at least a runway for growth, and we sure believe there is, then it shouldn't require much capital to obtain that growth. And a major portion of that revenue growth then drops to the bottom line.

23:38Because realize most businesses, they have to keep reinvesting their cashflow to obtain the growth. But here, they're basically able to act as a toll taker on their existing capital base. Or said another way, the earnings in this business are higher quality than most because the return on invested capital should grow over time. And you can see also in their free cashflow conversion, earnings quality is super high. I'd say about 100 % of net income becomes free cashflow, if not slightly more. And so if you have a 40 % to 45 % margin business, that implies 40 to 45 cents of every dollar of revenue becoming profit that can be delivered to shareholders via dividends or share buybacks.

24:15And then it's worth pointing out that as of recently, with all these acquisitions on the analytics side, the analytics total revenue actually just barely overtook the ratings biz in 2022. So it makes up just slightly over 50 % of revenue. This is important because what it means is the business has now increased its recurring revenues. So they've gone from 56 % recurring revenues pre -COVID to 68 % recurring revenues overall today. In case you're curious, that's 42 % recurring on the rating side, 94 % recurring on the analytics side. But this also means the ratings business is now making up less of the overall operating profits.