Moody’s Shrinking Moat

moodys-logoMoody’s Corporation is “a provider of (i) credit ratings and related research, data and analytical tools, (ii) quantitative credit risk measures, risk scoring software, and credit portfolio management solutions and (iii) securities pricing software and valuation models” (10-K from 3/2/09).  They operate their business in two segments—Moody’s Investor Service (MIS), which primarily rates debt securities in the global capital markets, and Moody’s Analytics (MA), which provides “quantitative credit risk scores, credit processing software, economic research, analytical models, financial data, securities pricing software and valuation models, and specialized consulting services” (10-K from 3/2/09). The foremost competitor for MIS is Standard and Poor’s, owned by McGraw-Hill Companies, though Moody’s also shares the ratings market with Fitch, Dominion Bond Rating Service Ltd. of Canada, A.M. Best Company Inc, Japan Credit Rating Agency Ltd., Rating and Investment Information Inc. of Japan and Egan-Jones Ratings Company.

The consensus view among stock market participants is that Moody’s Corporation has one of the widest economic moats around. Having provided credit analysis for a century now (going back to founder John Moody’s 1909 Analyses of Railroad Investments), and proven its value in predicting potential distress, the credit rating from MIS has become a necessity for large public companies seeking capital in the debt markets. The particular beauty of Moody’s business is that its standard credit analysis relies upon formulas back-tested against deep deposits of credit data from a wide variety of economic environments. Their value comes not from innovative analysis, but from having the most reliable and demonstrated tools in the room. Even if a competitor had access to such a database, and even if they found a better set of predictive metrics, few would pay to take their views seriously until they had acquired a history of predictive analysis.

Of Moody’s two segments, MIS clearly brings in the majority of Moody’s revenue ($1.2 billion for MIS in 2008 v. $1.755 billion total). Moody’s Analytics (MA), despite robust revenue growth in 2008 (14.9%), offers some products for which competition is stiff—consulting, economic research, and financial data. Though Mark Zandi’s economic analysis at economy.com may add insightful commentary, his voice does not add enough to command meaningful revenues for Moody’s. The best part about the MA business is that it is easily scalable; all the content is already prepared, so incremental revenue yields much fatter profits. Though MA may not offer an indispensable product like MIS, its growth prospects and its easy fit with its primary business appear to provide Moody’s owners with desirable returns on invested capital.

Ultimately though, the crucial aspect of Moody’s economic moat is their reputation for providing a useful and predictive judgment about credit risk. So how wide and deep does their reputation currently extend? In short, not as wide and deep as five years ago.

As many know, in recent years, Moody’s expanded its credit ratings to include structured finance products (e.g., RMBS, CDO). Given their relative novelty, and their concentration in excessively levered, overpriced “assets” (i.e., houses), Moody’s ratings proved unreliable for predicting distress and default rates. And their reputation as a whole took a significant hit. As they acknowledge in their 10-K, “Moody’s reputation is one of the key bases on which the Company competes. To the extent that the rating agency business as a whole or that Moody’s, relative to its competitors, suffers a loss in credibility, Moody’s business could be adversely affected.”

Here today, it is difficult to assess how damaged Moody’s reputation may be. Though structured finance made up the largest share of MIS revenues in 2007 ($873 million), it still composed less than half of their overall revenues ($1.78 billion). In other segments—corporate finance, financial institutions, and public finance—MIS credit ratings have not yet proven unreliable indicators. Yet, with their recent mistakes in structured finance, Moody’s has created an opening for a new competitor with better (or even passable) tools to steal share.

Later this week–Moody’s Intrinsic Value

Disclosure: No position

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5 responses to “Moody’s Shrinking Moat

  1. Do you think Pier One Imports PIR has a small moat?

    It’s obviously cyclical with housing and the economy it seems but do you think it has anything competitive over simalar competitors?

  2. I classify Pier One as a specialty retailer, and I suspect that there can be durable moats there–think of Berkshire’s Borsheim’s, for example.

    Looking at the ten year profitability numbers for Pier One, margins are headed in the wrong way.

    So the numbers suggest that the moat is small and narrowing, and my general impression is that they are not the trend-setting force in home decor that they may have once been.

    Thoughts?

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