Moody’s Stock: Lacking Stability (NYSE:MCO)

At the start of 2022, I observed that Moody’s (NYSE:MCO) was seeing momentum in analytics, as the company has seen a strong 2021 on an operational front. Strong growth was accompanied by tuck-in acquisitions on the KYC and ESG front, all making perfect strategic sense.

The overall valuation has gotten a bit steep, which can be explained in a low interest rate environment, given the performance of the business, yet the risk-reward was not compelling enough for me to get involved. After all, shares were exchanging hands at $390 in January, within imminent reach of their absolute highs.

Great Success Story

After playing a very dubious role (quite an understatement) in the financial crisis in 2008, Moody‘s has seen its mojo come back. The company has become much more broaden than simply a rating agency. In fact, that company has seen strong growth, more diversified operations, as the predictability and low interest rates have fueled shares a great deal.

In February 2021 the company posted solid results for the year 2020. Revenues rose 11% to $5.4 billion, despite the pandemic, as adjusted earnings rose 22% to $10.15 per share. The company guided for earnings to rise in a modest fashion to $10.50 per share in 2022, as EBITDA of $2.7 billion easily supported a $3.7 billion net debt load.

The initial guidance for 2021 has been far too conservative after first quarter sales rose 24% and second quarter sales were up another 8%, with the company hiking the midpoint of the earnings guidance to $11.70 per share. With a $75 billion enterprise valuation in the summer at $380, Moody‘s traded at 14 times sales and 32 times earnings.

The company announced a $2 billion deal to acquire climate and natural disaster risk modeling and analytics company RMS in a deal adding $320 million in sales and $55 million in operating earnings. The resulting sales multiple looked cheap, but margins were not that impressive, as lifting those was probably the goal behind that acquisition.

After posting a 13% increase in third quarter sales, I pegged pro forma revenues at $6.2 billion, or $6.5 billion if we factor in the contribution of RMS. The company guided for earnings of $12.25 per share (again excluding RMS), as a $3.3 billion EBITDA number easily supported $5.1 billion in pro forma net debt.

With 187 million shares trading at $390 in January, a $73 billion equity valuation, or $78 billion enterprise valuation looks a bit rich. The performance was strong, leverage is modest, yet a 32 times earnings was simply a bit much. While I truly believe that Moody‘s warrants a premium here, the question is how high this premium should be, as I concluded to come appealed at a 25 times earnings multiple based on where interest rates were seen at the time.

A Huge Pullback

On the back of a stronger dollar, and higher interest rates, the company has seen its share price fall to $240 per share, a near 40% pullback from the highs earlier this year, as shares are now back to their 2019 levels.

In February of this year, Moody‘s posted its 2021 results which were strong with revenues up 16% to $6.2 billion as operating earnings rose to $2.8 billion. GAAP earnings rose to $2.2 billion, for earnings equal to $11.78 per share, as adjusted earnings came in at $12.29 per share, with the difference being the result of amortization charges. Net debt has risen to $5.5 billion, still very manageable. The company was a bit cautious for 2022, seeing adjusted earnings between $12.40 and $12.90 per share, with GAAP earnings seen ninety cents lower as the guidance implicitly factored in some softer macroeconomic conditions already.

The rest of the first half of the year was relatively quiet, other than the announcement and closing of some real small bolt-on deals, on which no financial details have been announced. In May, Moody‘s posted a 5% fall in first quarter sales as the company has been hit by a decline in rated issuance volumes, as the first quarter of 2021 was particularly strong, a year in which revenues were up 24%.

The company cut the adjusted earnings guidance to a midpoint of $11.00 per share. Second quarter sales actually fell 11% to $1.38 billion, driven by weakness in Moody‘s Investors Service business, the largest and most cyclical segment of the business. Net earnings were cut almost in half to $327 million, as the stability of Moody‘s is not showing up, and that is what investors paid for.

In the meantime, net debt inched up to $5.9 billion as the company earmarked some money to share buybacks, as EBITDA is set to come under quite a bit of pressure this year. This makes that leverage ratios will shoot up, and while it is not a major concern yet, it limits the ability to engage in large buybacks here or pursue larger M&A without blowing up the balance sheet or being forced to issue shares at lower prices.

And Now?

Right now, Moody‘s shares have fallen to $240 per share as 185 million shares outstanding have reduced the equity valuation to $44 billion, or $50 billion if we factor in net debt. For the year, the company sees full year sales down in the high single digits, which suggests that revenues are seen around $5.6 billion, which compares to a $6.5 billion pro forma number following the RMS purchase last year. Adjusted earnings for the year are now seen at $9.45 per share, a 25% cut from the initial guidance for the year.

This is painful, but of course shares have fallen 40% on the back of a 25% pullback in earnings, which means that a 32 times multiple has fallen to 25 times. This makes that the earnings yield of 3% has risen to 4%, yet that is not enough to compete with risk-free rates just yet, as Moody‘s is not able to report revenue growth here, as the business is clearly feeling real operational hardship. The moves are in line with peers as well, albeit that Moody‘s has a slightly larger cyclical segment, and with that I mean revenues tied to actual transactions and the financial state of markets. For instance, we have not seen any decent IPOs as of recent, nor a lot of M&A activity.

On the other hand, if markets recover, earnings power around $12 per share will reduce the multiple to 20 times, yet that is not the situation yet, and of course interest rates are very high, making it very difficult to pay >20 times earnings multiple, even for a great business here.

Understanding that multiples are just part of the story, with earnings power temporarily impaired, I feel that $200 might be a nice level to slowly buy the dip in the shares, given that sell-off and bargains are seen all over the place, making the allocation of capital here a challenge.