Why Did Berkshire Stop Selling Moody’s?

[Warren Buffett recently entertained CNBC and its viewers in what now seems to have become an annual three hour session (transcript here).  Amid the inopportune interruptions and political meanderings, some interesting things emerged.  For one, the central reason why Berkshire has stopped selling Moody’s…]

“BECKY:  That’s one of many questions that have come in, but we also have questions that have come in about Moody’s. Achit in Arizona writes in, “In your FCIC interview, you spoke of the inherent advantages of a duopoly that Moody’s and S&P share. Why does Berkshire continue to reduce its interest in Moody’s? Is there too much headline risk” for you?

BUFFETT: Well, I think that duopoly is in somewhat more danger than it was simply because people are mad at the ratings agencies and the ratings agencies totally missed what was going on in the mortgage market and that was a huge, huge miss. I don’t think they were, you know–I think they were just wrong, like a lot of people were wrong about in thinking that housing prices couldn’t go down a lot, but they were rating agencies and they’ve gotten a lot of criticism for it and their business model is sensational when it’s a duopoly. I mean, I have no bargaining power. I’m going to see Moody’s in the week or I think or something about our ratings.

BECKY: Mm-hmm.

BUFFETT: And you know, I dress up and do everything I can to, you know, talk about my balance sheet. But they–they’re God in the ratings field and Standard & Poor’s, and I need their ratings. And if they tell me the bill is X, I pay that, and if they tell me the bill is X plus 10 percent, I pay that. You know, if Coca-Cola charges too much, you know, you may think about drinking Pepsi Cola, but in the rating agency business, you need those two. And if that–either people get so upset with them or whatever it may be, or Congress gets upset, that could disappear. It won’t disappear from natural reasons. I mean, it is a natural duopoly, just like–it’s a little different than Freddie and Fannie were, but they also had some specific advantage. Sometimes you find situations where you get a natural–well, you used to have that in the newspaper business. You had a natural monopoly in big cities. It wasn’t–it wasn’t illegal, it just worked out that way.

BECKY: Mm-hmm.

BUFFETT : And that’s what happened in ratings agencies. But it’s not as bullet-proof as it was. Although, I will say that…

BECKY: Does that explain why you’ve been selling?

BUFFETT: Well, we haven’t sold that aggressively.

BECKY: Mm-hmm.

BUFFETT: I mean, if you look at it during the course of 2010, we sold a very small amount of the–it looked to me that that threat was receding to some degree. But it’s different than it was five years ago…” [Emphasis added.]

[A couple years ago, I suggested that Moody’s Structured Products Group (SPG) would find it difficult to match past peak revenues ($873m in 2007).  In their latest 10-K, 2010 revenues from the Structured Finance Group appear down 5% v. 2009, to $291m.

In the meantime though, revenues from their Corporate Finance Group have held strong, and increased 38% YOY in 2010, to $564m.  Income before tax (for the whole company) was $714m in 2010, compared to $730m in 2008.  Despite a substantial revenue decline in their largest business line from 2008 to 2010, income before tax (for the company as a whole) has held relatively steady, even with a tarnished reputation.  So Berkshire will hold.]

Disclosure: none.

Review: ‘Why Are We So Clueless about the Stock Market?’

Are you clueless about the stock market? Or perhaps better, could you admit to being clueless? For myself, as much as I purport to know about businesses, the stock market frequently baffles the mind. Reflecting the investing world’s immediate hopes, fears, beliefs, and dreams, the movement of prices seemingly offers a window into the shallower parts of our soul. Even for the seasoned observer, the market’s waves of euphoria and despair cast him reeling for clues–a narrative, a story–that can explain and predict its moves.

In the midst of the storm, Mariusz Skonieczny of Classic Value Investors offers the interested observer a map—Why Are We So Clueless about the Stock Market? (Investment Publishing, 2009)

Written with the beginning investor in mind, Skonieczny provides a compact, readable introduction that teaches how to analyze financial statements, value businesses, discern competitive advantages, and scout for bargains in the stock market. Skonieczny also puts his tools to the test by surveying four excellent businesses with durable competitive advantages—Burlington Northern Santa Fe, Thor Industries, Wells Fargo, and Moody’s. These case studies alone are worth the price of admission.

Throughout, I appreciated Skonieczny’s persistent attentiveness to economic moats and competitive advantages. Following Pat Dorsey’s The Little Book That Builds Wealth (Wiley, 2008), economic moats derive primarily from four sources—a) intangible assets, like brands, patents, and regulatory licenses, b) high switching costs, like that enjoyed by Alcon’s ophthalmological surgery equipment, c) network effects, enjoyed by services like Match.com, and d) cost advantages. While these four competitive advantages are rarely quantified on balance sheets, they provide a consistent tailwind for future business returns, particularly when measured over years and decades.

Of course, those same advantages—once fully utilized and recognized by the market—may encourage industry leaders into sloth. And sometimes the sleepy stumble and fall.

If I had one quibble with Skonieczny, it would be with his rather sanguine analysis of Moody’s. As we’ve worried about here and here, despite Moody’s regulatory imprimatur, network effects, and switching costs, their future looks much less certain than anytime since the 1930s. Whether too sleepy or greedy, Moody’s foray over the last decade into all manner of Wall Street’s structured financial products has tarnished its reputation, and perhaps more importantly, its cash flows. As late as 2007, structured finance ratings provided near half of Moody’s Investor Service’s revenues. And until the structured finance markets return (and assuming that they will), Moody’s will not be able to grow their earnings at the 10-20% that they—in the past—easily have.

All told, I enjoyed Why Are We So Clueless about the Stock Market? and would readily introduce it to family and friends interested in thinking about stocks as shares of a business.

Disclosure: None

Where have the Buybacks Gone?

A stock represents an ownership stake in a business. But why should that stake ever be worth anything? In the worst cases, imprudent management funnels future earnings back into unprofitable endeavors and overpriced acquisitions, and your stake could become worthless. In the best cases, prudent management deploys capital where it can provide productive returns—either by growing the business organically, making acquisitions, paying dividends, or repurchasing its outstanding stock.

In recessionary periods, attempts to grow a business organically often do not meet with immediate success. However, if a recession depresses the market value of your business, buying back temporarily cheap shares becomes an interesting—albeit fleeting—opportunity. The sharp market declines in the fourth quarter of 2008 created one such opportunity. Yet, as a S&P report recently revealed, members of its S&P 500 spent $48.1 billion in stock repurchases in the fourth quarter, a 66% decline from the $141.7 billion spent during the fourth quarter of 2007. This, despite the fact that cash levels stand at record highs.

So why the pause? Howard Silverblatt, Senior Index Analyst at Standard and Poor’s, attributes the cash conservation to uncertainty about future cash flows. And for a company like Alcoa, such uncertainty seems warranted, for the company recently came to the market with an equity offering at $5.25 per share. This, after spending 2007 buying back the same shares near $40.

These billion dollar mistakes should not be taken lightly. Of course, saying it sounds obvious, but little outrage seems present within Alcoa’s shareholder ranks. If such mistakes are repeated consistently enough, the shareholder will find herself left with a piece of paper destined for the toilet.

And so today’s recessionary times illustrate what may be the most important component of a business’ economic moat—rational capital management. When management directs capital to its most productive endeavors, one finds stagnant textile mills blossoming into global insurance empires. Yet, for most business managers, this discipline seems so rare that a Randian would be tempted to call it heroic; even wide moat businesses like Moody’s, with its long history of stock buybacks, seem to lose their best habits in uncertain times.

If only a select few can manage capital well in uncertain times, the investor must use these times to scout for demonstrations of rational management. As the S&P report shows, Exxon led the way in the fourth quarter, followed by Microsoft and Oracle; included also are such stalmarts as GIS, JNJ, PG, PM, and PEP.

To become a stock owner of a great business does not guarantee investing success; nor does buying a great business at a bargain price. No, investing success requires owning great businesses purchased at good prices whose capital consistently finds its highest and best use, especially in times of economic uncertainty.

Disclosure: No Position.

Moody’s Intrinsic Value

2008 was a tough year for Moody’s Corporation, with free cash flow (FCF) levels falling to 2003 levels, or $450 million. In our previous analysis, we argued that Moody’s economic moat has shrunk over the last couple of years, as its credit ratings for structured finance products proved unreliable for predicting distress and default risk. So far though, Moody’s credit ratings for municipal and corporate debt have been reliable. The question for today—what price would Moody’s Corporation command from a private buyer in light of recent events?

In the past, we have introduced Seth Klarman’s three methods for valuing a business—by determining its liquidation value, the net present value (NPV) of its future cash flows, or its value relative to similar businesses trading in the public markets. Since Moody’s has a negative book value and has no comparable standalone competitors in the public markets (Standard & Poors is embedded within The McGraw Hill Companies), the NPV approach here is appropriate. And with the help of Morningstar’s FCF data, a NPV analysis is not a difficult exercise.

Since 2001, Moody’s has grown its FCF from $291.5 million to $450 million (FY 2008). As many know, in order to value future cash flows, an investor must make a reasonable estimate what they will be. In Moody’s case, estimates could vary widely, as its FCF in 2007 was $802 million. If we use past growth rates of FCF to estimate Moody’s future, we will get very different growth rates using the FCF data from 2002-2007 vs. those from 2001-2008. The former period shows a FCF growth of 20.4%, and the latter 6.4%.

For today’s analysis, I will use the latter—a 6.4% FCF growth rate—as it likely better approximates Moody’s business prospects over the next decade. Following upon a period of robust growth in its structured products ratings division—a division whose revenue has now fallen by half YOY—it is hard to imagine Wall Street’s structured products returning to their previous levels in the near future, much less to grow at their past rate.

Assuming then that Moody’s will grow its FCF from 2008’s $450 million at 6.4% per year for the next decade, and then assuming that it will continue to grow at 3% for the following decade, Moody’s should throw off $16.3 billion over the next two decades for its owners. If we discount those cash flows at 9% (an estimate of average stock market returns over the long-term), the NPV of those sixteen billions should be $6.578 billion. However, if today’s buyer offered $6.578 billion, he would be assuming a business with nearly a billion dollars in negative book value. Knocking $994 million off the expected purchase price would value Moody’s equity and future cash flows at $5.583 billion. With 235.2 million shares outstanding, the prospective buyer should be willing to pay $23.74 per share for Moody’s.

Of course, at $23.74, the buyer’s assumptions better be correct, because he’s paying fair value for the business and its earnings power. For investors like Warren Buffett, paying fair value typically does not offer a sufficient margin of safety; to warrant investment dollars, Buffett wants to buy dollars for fifty cents. Here a 50% margin of safety would suggest that the investor only purchase Moody’s below $11.87 per share. As of Tuesday’s close (4/7/09), Moody’s traded close to its intrinsic value, at $22.20 per share.

Disclosure: No position

Moody’s Shrinking Moat

Moody’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