Summary

  • Moody’s has evolved into a company that offers more than just ratings.
  • The company is in a great spot to deliver continuous free cash flow growth in the future used to acquire new growth and to boost shareholder distributions.
  • Unfortunately, the valuation has become very lofty, which is a reason for me to stay away as it could hurt the stock price performance over the next 1-2 years.

The Moody’s Corporation (MCO) is one of the world’s largest companies operating in the financial data & stock exchange industry. Known for its ratings, the company offers more than an educated opinion on leverage. The company is rapidly expanding its capabilities in other areas and transforming itself into a complex data selling player with high growth rates and deep emerging market penetration. This is resulting in convincing free cash flow growth used to fund acquisitions and to grow shareholder value through dividends and buybacks. Unfortunately, the company’s valuation is very lofty, which makes it tough to become extremely bullish on the company as its peers are offering a lot of value at often lower – more reasonable – valuations. In this article, I will give you the details.

Even more fascinating than the company’s rating business is its Analytics segment – I think. This segment has 92% recurring revenue. 58% of total segment sales are generated outside of the United States. This segment increasingly moves to a subscription-based model instead of one-time projects and services. Like all of its industry peers, Moody’s is boosting its analytics portfolio. Currently, this segment mainly covers news, financials, private companies, and climate. This will be expanded to risk scores, economic modeling, industry insights, portfolio monitoring, and ratings. This makes total sense as Moody’s has a load of data it uses for its own business purposes.

In August, Moody’s announced the acquisition of RMS for $2.0 billion. MCO will fund this acquisition using cash on hand and new debt. The RMS business is expected to complement the company’s Analytics platform and especially its focus on insurance data and analytics.

With all of this in mind, let’s move to free cash flow, which perfectly shows the company’s ability to generate value. In the case of MCO, FCF is higher than net income in most years, which indicates ‘quality’ earnings. Long-term FCF growth is also the result of a business model that can easily be leveraged – especially when the company starts to roll out new products in its Analytics segment. In this case, we’re looking at $2.4 billion in 2022 FCF. That’s roughly 3.4% of its current $70 billion market cap. This means that long-term double-digit dividend growth is more than likely to continue.

In February of 2021, the company hiked the payout by 10.7%. Even if FCF were to remain flat, the company would be able to continue double-digit dividend growth for more than a decade.

All of this value creation has led to a 1,300% total return over the past 10 years. This crushes the S&P 500 and puts MCO right at the top of its industry with its peer S&P Global. Please bear in mind that the other companies are also peers in the same industry but not focused on ratings but rather stock market transactions and related services.

Valuation

The best thing about the company’s business is the fact that it scaled its scope without raising debt to unsustainable levels. While net debt has accelerated over the past 10 years, the net debt/EBITDA ratio is expected to fall to almost 1.0x in 2022 as a result of higher FCF generation used to repay debt and because acquired growth is accelerating EBITDA growth. Not only is the company raising its EBITDA margin, but we should expect EBITDA to further benefit from accelerating sales.

Unfortunately, and this is the sad part, the valuation is very lofty. Using a $70 billion market cap and $3.9 billion in expected net debt next year, we get a $74 billion enterprise value. That’s roughly 23x next year’s expected EBITDA.

While the company hasn’t been cheap since the Great Financial Crisis, I think that 23x EBITDA is simply too expensive. Mainly because the company has great peers with a focus on data and a better valuation in most cases. As I have covered almost all of them, you can access them here, here, and here if you want all details.

It also doesn’t help that its dividend yield has fallen to one of the lowest levels ever.  The expected 2022 FCF yield of 3.4%, however, is within the longer-term range. It’s not high, but investors aren’t massively overpaying for free cash flow.

Takeaway

I like Moody’s. It’s a great business that benefited from rapid debt growth across the globe. Even better, while 2020 and 2021 are exceptional years, the company expects that growth will last in its rating segment.

On top of that, I expect that the company will boost sales in its Analytics segment fueled by steadily increasing recurring sales. Given Moody’s ability to generate free cash flow, the company continues to be in a great spot to acquire new businesses and to hike both dividend and buyback volumes.

So far, this has led to a massive total return performance, beating all of its peers and the market as a whole. Unfortunately, the valuation has become very lofty. Given that a lot of peers have higher dividend yields and similar approaches when it comes to selling data, I will refrain from buying MCO at current levels. That does not mean that the stock won’t continue its uptrend as rates are low and investors are looking for high growth.

So, while I will maintain a neutral rating for the time being, I think MCO is the right investment for investors with a very long time horizon who don’t mind the potential risks that come with buying a lofty valuation.

Author: Leo Nelissen

Source:  Seeking Alpha