Friday, January 22, 2010

Moody's intrinsic value

This piece attempts to value Moody's (MCO) share price.

My original purchase assumption was that Moody's will earn at least $2.00 eps once credit bubble pops and normal environment returns. This was when the company earned $2.58 in 2007. I did figure that regulatory environment will be tough and their moat may weaken. I figured that even if they turn out to be one of many players, they still have a good chance to get a decent size of the pie. I also thought that Moody's is exporting capital markets to world (think of Coke's world wide expansion!) and is in early stages of global capital expansion. Needless to say, credit market world has changed.

Now it is time to reevaluate what the security is worth. First, Warren Buffet is selling Moody's for the past few quarters. One obvious reason is that he thinks security is fairly valued considering future prospects of the company. It is also possibe that his decision is precipitated by a moral responsibility of being a part owner of the company (up to 20% owner at peak) and not able to influence it's role in credit crisis. If I have to bet, it is not in Mr. Buffet's genie to sell undervalued security. So it is likely a combination of all of the above.

Moody's moat at it's core comes from trust it's customer's place on it's ratings. The credit crisis has shaken that. Moody's is addressing some of the issues but changes are not as drastic as the problem requires. The regulatory environment will be changed and it's shape unknown.

Now lets look at numbers. In 2008, Moody's earned around $1.8 eps. Estimating future growth is tough. World will likely not get back to high levels of leverage any time soon. In particular structured finance business will likely dry up and not return to any where it was in 2006 and 2007 (as stated by CEO in 2008 annual report). Further, 2008 is a baseline year as stated by CEO in 2008 annual report. Company will likely have more competitor's in future in it's regular plain vanila bond rating business. For example, Morningstar has come out with ratings on bonds. Regulation is likely to tighten. If you add all up, Moody's will likely grow few points ahead of inflation because of it's Analytics business and some rating business growth with world economy growth. I will pull up some numbers here. Lets say 5 to 7% revenue growth with 10% eps growth (because of share repurchase).

These figures are not bad. Moody's throws out lots of cash. But the big rub is that shareholders do not benefit from high free cash flow. Moody's repurchases shares regularly instead of giving high dividends. Further, this occurs even when stock price is high. For example, from Oct to Dec 2006, company repurchased 2.2 million shares at around $65 per share. It is not difficult to figure out even in boom period that this price is not a screaming bargain. Share repurchase benefits option holder more than regular share holder. So not much can be expected in terms of value creation due to capital allocation of excess cash. So a lower valuation is warranted.

Over the next few years, Moody's non rating business will grow faster than ratings business due to consumption of risk analysis products. This segment has lower operating margins than the ratings business. As of Q3 2009, op margin of Moody's Analytics business is 34% (still healthy) compared to 40% for ratings business. So op margin expansion is not likely.

Another piece of interest is that 2009 has had good growth in Corporate Finance segment of the Moody's ratings business. This is the ratings on investment grade and speculative grade bonds due to company's refinancing. Likely, this level of activity may not not occur every year since company's have refinanced to avoid any near term maturities.

I think it is not unreasonable to give 15 to 20 as P/E without doing DCF. So this translates to valuation between $27 to $36 based on 2008 eps. Mr. Buffet is selling in lower end of this valuation indicating future prospects are not that great. It is best to take note of when Buffet sells based on past experience.

Please leave your thoughts...

Tuesday, January 12, 2010

Warren Buffet's role in Kraft

A lot is written about why Mr. Buffet pays part of Burlington North Fe transaction in equity. Check this link if interested ( But the more interesting question is why Mr. Buffet is opposing Kraft's offer of issuing more equity to buy Cadbury's.

Buffet in the past two decades has chosen to be passive investor. His key was to associate with good managements rather than to direct or influence management actions. This has worked well for him in general. His rationale was that managements usually do not listen even if such advice is provided from within the board room. Usually CEO ego takes precedence over advice from elders!

However, investment in Moody's may have changed his opinion. Mr. Buffet was criticized for not taking more active role in Moody's operations during the boom years even though Berkshire owned 20% of the company. In effect, Berkshire was a silent partner in company's role in the credit crisis. In the annual meeting, Mr. Buffet was questioned about this and he gave the same standard answer that managements will not listen.

I think that Mr. Buffet has had second thoughts on this issue. While being a passive investor is still his first choice and correct choice most of the time, he has a responsibility to exercise his responsibility as an owner in circumstances when value is destroyed or when the direction of company is wrong. Ben Graham in intelligent investor asks all investors to take an active role in the companies in which you invest. I think Mr. Buffet may be taking more such active role in future and that is good for all investors who invest along side him or with him.

Please leave your thoughts....