Buy Moody's

Presentation by Dylan Haggart & Dave Gregory 03/05/2008

Buy Recommendation


Business Model

• Investor Services (rating agency)

• Perform comprehensive analysis of debt products

• Inexpensive to issuers (~50bps)

• Continuing expansion into rating project finance and bank loans

• Analytics

• Developing products to aid effective fixed income valuation

• Not related to credit turmoil

• 8 year CAGR of 22% (2000-2007)

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis

Investment Conclusion


Business Model

• Core business line is credit rating

• Much more focused than competitor S&P

• More downside in bad times, more upside in good times

• A managerial tradition of little to no long term debt

• Capital Expenditures

• Growth is not funded by continued capex investments

• Constant operating margins

• All products have similar margins

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Business Model• International

• 45% of 2007 revenues are international

• Emerging markets

• Revenues are growing at 30% CAGR

• Revenues generated by the rating agency are:

• Recurring – 42% of revenues

• Monitoring outstanding issuances

• Frequent users (CP, MTN)

• Transaction – 58% of revenues

• Responsible for most of the decline in earnings

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Internal Analysis

•Moody’s adopted a new structure Jan 1st 2008

• Moody’s Investor Services

• 2007 Revenue of $1,780M

• 79% of MCO revenues

• Moody’s Analytics

• 2007 Revenue of $479M

• 21% of MCO revenues

• Effective cost control to combat shrinking margins

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Financial Performance

• Analysis of last five years

• Revenue growth – 16% CAGR

• Operating Margins – Steady between 54% - 52%

• Net Income – 18% CAGR

• A main component in the steady growth has been the credit boom

• The prevalence of structured finance over the past 3 years has been a major factor in Moody’s increasing margins

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Economic Moat

• Duopoly with S&P

• Sustainable – more than one rating is desired

• Perceived by the market as being the “top” bond rating agency

• Reputation is everything

• Act as gatekeepers

• Credit products need ratings to attract investors

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Related Industries

• Investment Banking

• Steep decline in CDO and high yield bond origination

• In the business of creating new structured products

• Investment funds

• May have strategies designed around ratings

• Bond/Security ratings have become institutionalized

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Recent Events

• Decline is share price tied to reduced earnings and forward credit fears

• The credit markets have dried up

• A majority of Moody’s revenues are tied to the creation of new debt securities

• Fears that credit crunch will drag on

• Short term impact only?

• Investment bankers create debt products

• Credit crunch will not last forever

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Structured Products

• Growth in structured products has contributed to revenue growth

• Collateralized Debt Obligations ect.

• Complex structures make them harder to rate

• Fees for rating structured products are higher

• Future outlook

• Again, investment banks are in the business of creating securities

• The majority of these securities need to be rated

• Many structured products continue to be created

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Investment Thesis

• Variable cost business

• Low overhead

• Labour force is non-unionized

• Will cut costs when necessary

• Sustainable Duopoly

• Almost zero capital expenditures

• Credit markets will improve

• Only short term earnings will be effected (1-3y)

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Investment Thesis

• Will continue to effectively cut costs

• Variable cost model allows for quick turnaround

• Analytics business will continue to grow

• Not tied to global credit cycle

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



Investment Risks

• SEC regulation

• Reputational Damage

• They were wrong on CDO’s and didn't recognize the risk

• Increased competition

• The market has peaked and will now decline

• Their “issuer-pay” model might be banned

• Perceived key investor risk

• If Buffet sells his stake

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis



P/E Multiple Analysis


• Historical price to earnings ratios

Five Year Average P/E 25.33x

Pre-Credit Crunch P/E 27.07x

Seven Year Average P/E 26.05x

• Without the credit crunch, where it would be trading

Forward EPS $2.119 for 2008

Five Year Average P/E $53.67Pre-Credit Crunch P/E $57.36Seven Year Average P/E $55.21

P/E Multiple Analysis


Stage One Stage TwoGrowth Rate (U.S) 9% 6%Growth Rate (Intl) 18% 14%

Cost of Equity 9%Terminal Growth Rate 4.5%Tax Rate 40%Long-Term Margins 52%

LTM Stage One Stage Two2007 2008 E 2009 E 2010 E 2011 E 2012 E 2013 E 2014 E 2015 E 2016 E 2017 E

Revenue 2,259$ 2,003$ 2,264$ 2,564$ 2,907$ 3,302$ 3,640$ 4,018$ 4,441$ 4,914$ 5,445$ U.S. 1,355$ 1,102$ 1,201$ 1,309$ 1,427$ 1,555$ 1,648$ 1,747$ 1,852$ 1,963$ 2,081$ Intl 904$ 901$ 1,064$ 1,255$ 1,481$ 1,747$ 1,992$ 2,271$ 2,589$ 2,951$ 3,365$

Net Income 718$ 450$ 532$ 628$ 714$ 813$ 897$ 991$ 1,097$ 1,215$ 1,348$ Cash Investment $52 ($29) $89 $99 $110 $123 $112 $123 $135 $149 $164

Owner's Income 665$ 479$ 443$ 530$ 604$ 689$ 785$ 868$ 962$ 1,067$ 1,184$ Discount Factor 92% 84% 77% 71% 65% 60% 55% 50% 46% 42%PV of Income 440$ 373$ 409$ 428$ 448$ 468$ 475$ 483$ 491$ 500$

PV of Projections 4,514$ PV of Terminal Value 10,656$

Equity Value 15,170$

Intrinsic Valuation Analysis


Sensitivity Analysis

Cost of Equity Versus Terminal Growth Rate15,170$ 3.5% 4.0% 4.5% 5.0%8.0% $16,440 $17,963 $19,922 $22,5348.5% $14,626 $15,790 $17,244 $19,1159.0% $13,149 $14,059 $15,170 $16,5599.5% $11,925 $12,649 $13,517 $14,579

10.0% $10,894 $11,480 $12,171 $13,001

Cost of Equity Versus Stage One Intl Growth15,170$ 16.0% 17.0% 18.0% 19.0%8.0% $19,161 $19,537 $19,922 $20,3178.5% $16,594 $16,915 $17,244 $17,5829.0% $14,605 $14,884 $15,170 $15,4639.5% $13,021 $13,266 $13,517 $13,775

10.0% $11,730 $11,948 $12,171 $12,400

Cost of Equity Versus Stage Two Intl Growth15,170$ 12.0% 13.0% 14.0% 15.0%8.0% $19,191 $19,552 $19,922 $20,3028.5% $16,629 $16,933 $17,244 $17,5649.0% $14,644 $14,903 $15,170 $15,4449.5% $13,061 $13,286 $13,517 $13,755

10.0% $11,772 $11,969 $12,171 $12,379


Conclusion

• An investment in Moody’s is a bet that the fixed income market will continue to grow

• A P/E of 12 isn't justified

• Earnings will drop, but share price shouldn't drop faster

• Valuation ranging from 13.29B to 14.21B from multiples

• Discounted cash flow valuation places MCO between 13.57B and 15.17B

• Currently valued at 9.31B

Business Model

Internal Analysis

Financial Analysis

Economic Moat

Investment Thesis

Industry Analysis

Valuation Analysis


Buy Moody's

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