Moody's Corporation (MCO) Earnings Call Transcript & Summary

Good morning. Thank you, everyone, for joining us. I'm George Tong, and I cover business and information services at Goldman Sachs. I'm really pleased to be joined by Mark Kaye, CFO of Moody's. Mark, thank you for being with us.

Thank you very to yourself, George, and Goldman for hosting us this morning.

Of course. So Mark, I'd like to start off at a high level with questions on Moody's strategic vision, and then we'll dive deeper into ratings and Moody's Analytics. Those in the audience interested in asking questions, feel free to submit them through the portal, and we can get to them near the end of the session.

So Mark, just starting off, Moody's has historically targeted long-term high single-digit revenue growth driven by issuance volumes, expanding coverage and growth in Moody's Analytics in addition to pricing. Can you discuss how the pandemic potentially changes the structural growth opportunity at Moody's? And what initiatives you have to drive growth in each of these categories in the current environment?

Thanks, George. I'd be happy to do that. And I'm going to take them one at a time. For issuance, overall volumes have tracked with GDP and we expect that to continue. If you're a believer in long-term growth of the global economy and that the capital markets will have a part to play in funding that growth, which we believe, then you can expect issuance volumes to continue to grow in line with the GDP. For mix, over the long term, we expect the efficiency of the capital markets to incentivize more issuance to shift to the public markets. Most issuers new to capital markets are smaller and likely to be on the transactional revenue models, which benefits the revenue mix. Coverage is important. Not only is it reflective of market share, but also reinforces the relevance of our ratings. The comparability of Moody's ratings across the globe and over time are part of what makes them so relevant. So this is something we focus on. We really compete on the quality of our ratings, the relevance of our ratings markets and the benefits that, that brings them to issuers in terms of their cost of debt as well as the service levels and items like that, that we offer. For Moody's Analytics, our results, retention rates and usage levels across the company clearly demonstrate not just the resiliency of our business, but also the importance of our data, products and solutions in times of uncertainty. Our role as a global integrated risk assessment company has positioned us to be a crucial and valuable resource for our customers and the broader markets, which we believe fosters better understanding of risks across numerous areas, increasing transparency and enabling better decisions. We mentioned on our third quarter earnings call that COVID has been an accelerant with certain trends that we are well positioned for, especially the increase in digitization and the automation across our customer base. And it certainly -- COVID has certainly made everyone more aware of the potential impact of risks that are currently not well understood and which can have a negative and widespread impact on the economy, et cetera.

Makes sense. And I guess, related to recent developments, S&P announced an agreement to merge with IHS Markit, as you know, $44 billion transaction. How does that merger change the competitive landscape and what strategic operational changes do you expect to make given the development?

Sure. So from our perspective, the merger doesn't change Moody's competitive landscape that much. As our suite of products and solutions have relatively little overlap with IHS Markit's offerings, we don't have a focus in derivatives, energy or automotive data. We do have an ESG business, though it appears the greatest synergies for an IHS-S&P tie up, it would likely be in the index side, which is where we don't compete. The area we are focused on that IHS may help S&P the most is certainly in the private data space with modest overlap around counterparty credits, business development and, probably, to a lesser extent, KYC. We do think that this validates the investment that we have made in KYC and that's through BvD, RDC and Acquire Media. And that has allowed us to create what we see as the #2 player in the market, and we hope soon to be #1. In terms of where we plan to invest growth, I'll refer back to some of the comments that I've made earlier, the farms we are focused on expanding geographically and into business adjacencies that we see fits with the natural evolution that we've made into this global integrated risk processor. In terms of how we'll invest, we'll continue with the disciplined approach we've always had, and we can talk more about that as we go through this fireside chat.

That makes sense. So Rob Fauber, currently COO of Moody's, is going to be succeeding Ray McDaniel as CEO at the end of the year. What potential changes to Moody's long-term strategic vision could Mr. Fauber adopt as CEO?

I don't expect large changes to Moody's long-term strategy due to the CEO transition. Rob has been an integral part of the formulation of our current strategy as is the entire management team, which is really reflective of our collaborative culture. Rob has been with the company for 15 years, most recently as COO, where he has overseen both MIS and MA as well as the strategy in marketing areas. He started at Moody's heading corporate development. So throughout his career here, he has been at the forefront of Moody's strategic direction. As a result, Rob has a deep knowledge of our business, and he understands the needs of our customers. This positions him well, in my mind, to maximize our strengths, innovation and efficiency across the company. Rob has always bought a great degree of energy, enthusiasm and maybe, most importantly, empathy to everything he's done. And I'm really excited by the prospect of working with him in this new role.

Great. In the past, you've talked about China as a very attractive long-term growth opportunity for Moody's. Can you describe currently what's available to Moody's to expand in China and which options are most appealing?

We believe that we are well positioned in China with a high degree of optionality. We see it as advantageous to participate in the Chinese domestic market through our investment in CCXI, the leading domestic Chinese agency. You can see on Slide, probably, 35 from memory, in our third quarter investor presentation of our third -- of our current stake in CCXI, which is 30%. And that shows that we have -- overall, CCXI has over 1,700 rated credits or 42% issuance coverage. Most importantly, we'll look to participate and engage in the domestic markets in a way that is supportive of the goals of the Chinese government and regulators as they open up and develop their economy. Outside of the JV, Moody's does have an approximately 40% share of the cross-border market, which we estimate is approximately $207 million in revenue. We also have a strong Moody's Analytics business in China. We have set up a Commercial Strategies Group, as we mentioned on our third quarter earnings call, to help identify and accelerate additional growth opportunities for MA in the Chinese market. MA's data, analytics and technology will also further support and be supportive of the development of China's capital markets. Additionally, in early November, we announced our investment in MioTech, which is a leading provider of alternative data and insights serving the ESG and KYC markets in Greater China. And then furthermore, last year, we also made an investment in SynTao Green Finance, which provides ESG data and ratings to the Chinese market. Collaboration with SynTao will allow us to leverage our respective strengths and provide a range of solutions for investor and issuer ESG needs in China. This includes joint research, product development and technical cooperation. So in total, I think we already have a very strong platform in China. And going forward, we'll continue to evaluate a range of options to expand our presence there. And we certainly look forward to contributing constructively to China's sustainable growth and to further development of its capital markets.

Makes sense. So Moody's has given a lot of attention to various ESG products that it offers solutions that it provides to its customers. Could you perhaps discuss what the company has done lately to improve its only carbon footprint?

So in 2020, Moody's established new environmental sustainability commitments, which included the setting of science-based targets to reduce our greenhouse gas emissions on the path to achieving net zero by 2050, procuring 100% renewable electricity and expanding the carbon neutrality efforts. In keeping with Moody's leadership in ESG and climate reporting, we have taken the step of posting our decarbonization plan on our Investor Relations website. We are also one of the first financial services companies to support and respond to the Task Force on Climate-related Financial Disclosures, that's TCFD, on their recommendations, and Moody's was featured as a case study in TCFDs 2020 status report. And I'm proud to say that all of our hard work has paid off. And this morning, it was announced that Moody's has been awarded an A by the CDP for our leadership in corporate sustainability. This recognition of our efforts is very encouraging. But of course, there's more work to be done, and Moody's hopes to lead by example on ESG.

Right. Let's dive deeper into the ratings business. So Moody's expects global debt issuance volumes to be up high teens in 2020. What debt categories do you believe present the most upside and downside risk to your current full year growth expectations?

Our full year guidance, which we gave on our third quarter earnings call, does imply a moderation in the pace of corporate issuance in the fourth quarter. That is based on the view that many issuers have taken care of their 2020 issuance needs earlier in the year given favorable conditions and to get ahead of previously expected volatility around the U.S. election. That said, issuance conditions remain favorable, and we have seen M&A activity begin to pick up a bit. So that could be an area for some upside. Additionally, while both the U.S. and European corporate issuance have been relatively strong, European issuance has been up to a lesser extent. So that could be another opportunity or another area with incremental capacity. Alternatively, the recent increase in the spread of the virus could impact economic activity and increased uncertainty, which would weigh obviously on investment-oriented issuance or issuance from asset classes more correlated with the real economy such as Structured Finance. Another area we are watching is Municipal Finance. As state and local governments are unfortunately seeing large deficits due to lower revenues, therefore, to fund critical programs and services, we may see continued issuance from unique borrowers.

Makes sense. So Moody's has indicated a desire, sticking with the ratings business to increase its mix of transaction revenues, given favorable long-term growth expectations and economics. Can you elaborate on why transaction-based pricing should improve the economics in the ratings business and by how much? And also talk a little bit about what debt issuance environment could a higher transaction revenue mix hinder Moody's revenue performance?

I think I'll take a step back here and clarify. We are not necessarily trying to further increase the mix of transactional ratings. What we have said is that we have an orientation towards more transaction-based pricing, as we believe that is the most optimal pricing framework both for Moody's and our customers. Relationship-based pricing only makes sense really for a specific set of customers that plan to have regular significant amounts of issuance. That includes financial institutions and large, typically investment-grade corporates. Our orientation towards transaction-based pricing is driven entirely by data. Our data shows that over the long term, that pricing framework generates more revenue than relationship-based pricing. While relationship-based pricing does smooth out some of that downside in certain periods, it does not do so to a great enough extent. And the instances are not frequent enough to offset the opportunity cost of revenue lost during periods of strong issuance. This year is a good example of that dynamic, which you can see in our third quarter investor deck. In the second quarter CFG issuance outperformed transaction revenue, but by the third quarter, CFG transaction revenue outperformed issuance due to that favorable mix of infrequent issuers coming to the market. This is even more noticeable in the financial institutions line of business, which saw revenue increase 12% year-over-year despite a 12% decline in global issuance over this time period. And that was, again, due to a favorable mix of infrequent issues.

Makes sense. So diving deeper into the individual debt issuance categories, U.S. investment-grade issuance hit record levels this year, lifted by Fed intervention in the credit markets to help cushion the impact of COVID. What are your expectations for U.S. investment-grade issuance over the next several quarters? And to what extent do you think corporations have prefunded their balance sheets, which could thereby limit growth in this category over the long term or near term?

Sure. We have only given 2020 guidance issuance as of now, which you can see, I think it's on Slide 29 of our investor presentation. But from that, the investment-grade issuance guidance we provided with the third quarter earnings, we are expecting a moderation in the pace of new supply in the fourth quarter. This is largely due to the surge in issuance we saw year-to-date and our expectation that issuance accelerated -- or issuers accelerated their refinancing plans ahead of previously anticipated volatility around the U.S. elections. We've not put out our 2021 issuance guidance yet. We can expect to do so -- or you can expect us to do so on our fourth quarter earnings conference call in keeping with our past practice. We have given some of the puts and takes that we expect to impact 2021 and the factors that we will evaluate as part of our forecast formulation. For issuance overall, we said in the third quarter earnings call that, on balance, we expect headwinds to probably outweigh the tailwinds. For the headwinds, 2019 and 2020 were both strong issuance years, which sits 2021 up for tough comparables. Issuers cash and liquidity positions are now quite elevated, which may reduce their refinancing needs as they defer issuance or pay down debt, just depending on how next year unfolds. More positively, there are some potential tailwinds. We've recently seen an uptick in M&A activity, so that could continue into next year with more participation from sponsor driven and distressed M&A; sustained central bank support, another round of fiscal stimulus; and a continued low rate environment would likely also be supportive. Increased capital return, which has remained subdued in 2020, would be another sort of positive factor in support of issuance. The virus itself does remain a significant variable, which we expect will continue -- which we expect will continue to be a central factor in the trajectory of any economic recovery and drive corporate sentiment around investment and balance sheet management.

Makes sense. If we drill deeper into the global high-yield market, issuance certainly was very strong in the third quarter of 2020, and that actually caused Moody's to lift its guidance for full year 2020 high-yield volume growth from up 5% to up 25%. How sustainable is strong double-digit growth in high-yield issuance? And how much of the issuance do you think represents a pull forward of refinancing activity of upcoming maturities?

Yes. So high-yield issuance has been very strong year-to-date. And you can see this in, again, our third quarter investor presentation, with volumes through September 30 of approximately 40% above the same period in 2019. Based on the 2020 full year guidance for high yield we provided with the third quarter earnings, we are expecting the pace of issuance to moderate considerably in the fourth quarter. We also can see, based on the data that we've provided, the use of proceeds information year-to-date, where refinancing and liquidity have become bigger drivers of issuance in 2020. Increased M&A, capital spending and the return of capital could be sources of additional high-yield issuance going forward. Additionally, while we have seen significant recoveries in spreads in certain parts of high yield, spreads have remained elevated in certain industries more directly impacted by COVID-19. And spread typing in those industries could create supportive conditions for additional issuance as we look forward.

Makes sense. Your guidance also calls for a 10% decline in global loan issuance volumes this year because of the low interest rate environment. How long do you think pressures in loan issuance will persist given the potential for rates to stay relatively subdued over the next several years?

George, you're absolutely correct. Our full year guidance as of October 29, we expect MIS-rated bank loan issuance to be down 10%. Potential issuers are seeing a higher effective yields for bank loans due to wider spreads. While loan spreads have recovered considerably, they remain relatively elevated compared to the pre-pandemic levels through at least the third quarter. This is especially true in sectors hard hit by the pandemic. The widest spreads reflect lingering concerns around default risk with many loans being towards the lower end of speculative grade as well as a preference for fixed rate debt, given the expectations of rates to remain lower for longer. An improvement in default expectations, which we expect to peak in the first quarter of 2021 and a better outlook for the industries impacted by COVID-19 could help tighten spreads, which would be supportive for additional issuance. And lastly, I'd add maybe a pickup in M&A-driven issuance, especially from financial sponsors and the change in sentiment around interest rates. That would, of course, be supportive of more future leverage loan issuance.

Right. Makes sense. And then lastly, looking at the Structured Finance category, that's certainly been in decline now for several quarters and CLO volumes, in particular, have been soft because of declines in loan issuance. How long do you expect this trend to persist? And what are the other structured categories that could potentially mitigate the weakness that we're seeing there?

Yes. So Structured Finance is more directly impacted by the real economy, as it needs asset generation to create collateral to drive deal pipeline. There has been a modest increase in activity from the second to the third quarter of this year, but we likely need to see both an improvement in the real economy, for example, consumer finance and tighter spreads for issuers to be materially more active in the credit markets. One area of optimism for 2021, M&A activity is growing and this is typically a market that executes through bank loans. Another area to point out for potential optimism is CLO spread tightening continues for AAAs. In fact, Carlyle just printed data, I think, 100 or just over 105 basis points last week, which, to my knowledge, is the tightest spread we've seen since the start of the COVID-19. Tighter spreads coupled together with the end of revolving periods for some of the 2016 to 2018 vintage CLOs could spur refi volume into next year. We are already seeing some pipeline activity in this regard. Encouragingly, we have seen recent bank forecasts that do project a return of CLO volume for 2021.

Makes sense. So sticking with MIS, what would you say your pricing initiatives are within the ratings business? And how does pricing change in the current environment? Could you perhaps compare the benefits of infrequent versus frequent issuers with regard to pricing? And how pricing trends are progressing within the various debt categories?

Great question. The pandemic has not changed our thinking about pricing. Issuers have been confronted with several challenges and concerns this year. And their primary focus has remained on successfully executing their issuance at the base price possible. A Moody's rating is very important for issuers and helps them achieve that goal, especially in this environment. We primarily talk about pricing at the MCO level, so across MIS and MA. What we have said in the past is that real price increases have averaged 3% to 4% for the total company. We have not seen anything to indicate that, that should not continue to be the case going forward. In terms of frequent versus infrequent pricing, and as we spoke about earlier, we have an orientation towards transaction-based pricing in MIS as we believe that, that is the most optimal pricing framework over the long term. Relationship-based pricing only really makes sense for a specific set of customers that plan to regularly have significantly large amounts of issuance. And that includes financial institutions and typically large corporate investment-grade issuers.

Makes sense. Let's switch gears and talk a little bit about Moody's Analytics. The acquisition of Regulatory DataCorp, or RDC, certainly complements your Bureau van Dijk business, BvD, and helps expand Moody's position in the very high growth, know-your-customer industry. Can you provide an update on your longer-term growth outlook for RD&A following the acquisition of RDC?

We have not yet given revenue guidance for RD&A beyond 2020. But we have commented on BvD and RDC sales growth expectations, which you can see, I think, on Slide 49 or Slide 50 of our third quarter investor presentation. The next slide shows the outlook we gave in February, that pro forma sales for BvD and RDC's compliance or financial crime products were approximately $150 million in 2019, and we're expecting that to double by 2023, which is nearly a 20% compound annual growth rate. The know-your-customer and financial crime market is quite large and is growing quickly in the high teens. We believe a combination of BvD, RDC and Acquire Media creates a truly unique data set and comprehensive suite of solutions. We also expect to be able to create new and enhanced solutions leveraging our AI machine learning to drive more automation and further increase the value proposition for our customers. Additionally, given other -- given the other proprietary data and information we have, including ESG, corporate data, et cetera, down the road, we're going to be able to answer more and more questions for companies about who they're doing business with. Internally, we're talking about this as really know-your-everything. If we take a step back just for a second, you'll also see in our investor presentation that RD&A has seen consistent growth with an 11% CAGR since inception, approximately 60% of which has been organic. More recently, RD&A has grown at a nearly 19% CAGR from 2015 to 2019, which excluding BvD, would still be around 9% to 10%. So it's very strong. We also have demonstrated the consistency of our RD&A sales. You can see in the investor deck, RD&A sales growth, excluding BvD, shows remarkable consistency driven by the strength of our products and solutions as well as our measured approach to pricing, where price increases are primarily driven by corresponding price or product upgrades. And those have been very good drivers underpinning our businesses or RD&A's business success.

Makes sense. So sticking with the MA business, Moody's has been converting enterprise risk solutions, or ERS revenues to be more SaaS-based in nature. Can you discuss your progress with this initiative and how you expect the growth broadly in ERS to evolve over the coming quarters?

We have been actively shifting our business towards a subscription-based or SaaS recurring business model. On a trailing 12-month basis, recurring revenue is nearly 80% of total ERS revenue, which is up from approximately 60% in 2015. We still do onetime sales contracts, though they're primarily in international markets such as the Middle East and Asia, which have not yet adopted the Software as a Service model to the same extent as what we've seen in the U.S. and Europe. We expect the transition to recurring revenues is going to continue going forward, though it may not always progress in a linear fashion due to previously mentioned strong performance for onetime sales in certain parts of the world. We have been seeing strong traction with our SaaS-based loan origination solutions, that's the CreditLens product, the insurance product. And with the addition of RiskFirst, we have a best-in-class suite of products for asset and liability management. Going forward, there does remain significant runway for growth from a number of accounting and regulatory rules requiring implementation over the coming years and that's going to include CECL, IFRS 9, IFRS 17, et cetera.

Makes sense. If we switch gears and talk a bit about profitability and margins, Moody's guided to operating margins of 50% this year compared to 47% last year with benefits from very strong margin flow-through from the ratings business. Can you talk about how a normalization of ratings revenue growth next year in 2021 could impact margin performance overall?

Great question. It's probably too early to comment definitively on 2021 MIS revenue growth expectations at this point. We'll provide our outlook together with the fourth quarter earnings call in February when we have more information. It is possible. There could be some normalization in issuance volumes next year, but conditions remain really very supportive for issuance with low rates and tight spreads. Additionally, while there could be an overall moderation of volumes, there could be a favorable mix of issuance should high-yield bonds, which you spoke about, bank loans, Structured Finance show strength, which are traditionally areas of greater infrequent issuance. So there are several factors we're evaluating. The other side of the margin equation is, of course, costs. And there are a number of variables to consider, first and foremost, which is the pandemic. When the pandemic is over or politically over and it's safe to travel again, we'll determine when we can start visiting customers in person. We will resume traveling to engage with customers in person when we can, and we'll continue to believe that is probably the most effective way to build and sustain certain relationships over the long term. That said, we have learned a lot about remote working during the pandemic and there is, indeed, some travel especially internally focused. And to some extent externally that can be certainly substituted with virtual engagement, which is something that we're doing actively today. One area of expenses we continue to expect continued savings around and realized is real estate. We announced in the second quarter, we expect between $5 million and $6 million of annualized real estate expenses to come out starting in the latter half of this year. We will be prudent -- sorry, please go ahead.

No. So sticking to the topic of margins, your long-term operating margin target is in the high 40s. Can you provide a scenario where your long-term margins may exceed this range, perhaps visit the low 50s range, especially given operating margins are on track to reach 50% this year?

Yes. It's important to keep in mind that this is a long-term target. And we think about margins in a multiyear context, not just one particular year. If we take the performance from any one year, it's really unlikely to give a true picture of longer-term performance, especially 2020, which is an unusual year for many reasons. Our adjusted operating margin for 2019 was nearly 47.5%, so call it, high 40s, which represented considerable upside. We'll continue to reevaluate and revisit the target as necessary. We have our long-term targets listed out in our investor presentation. And we felt that high 40s continue to be appropriate as of the publication of the third quarter presentation in November. When we're thinking about the business, our first priority is to ensure that we can continue to grow over the long term and to do so requires continued investment. We could drive 1 or 2 years of significant margin expansion by pulling back or curtailing our investment, but that would inevitably see an impact to revenue growth. And that said, we do take a very disciplined approach. So we aim to continue to drive margin expansion over time while making the necessary investments. We don't see a specific margin ceiling, and management is focused on continuous improvement. And as we look to the future, and I noted this earlier, we intend to self-fund between $80 million to $100 million of investments next year that will help not only grow business, but improve our efficiency and productivity going forward. And then maybe one last consideration here is that MA has traditionally grown faster than MIS over the last several years. And while we have made considerable progress in improving MA's margin, it does have a lower margin profile than MIS. So can be a headwind to the overall MCO margin. Then, of course, offsetting that is MA's recurring revenue, which is nearly 90% on a trailing 12-month basis.

Right. And sticking to the topic of Moody's Analytics margins, that particular segment has seen very nice operating margin expansion from the low 20s to the low 30s over the past 3 years. What initiatives do you have to further boost margins in MA? And where do you see MA margins converging to longer term?

So as you correctly noted, we have made significant progress in recent years. Based on our approximately 30% adjusted operating margin guidance for 2020, which we provided in late October, MA's margins will have increased by approximately 500 basis points over the last 5 years. We don't have long-term segment margin guidance, but I don't see 30% as a ceiling. Our goal is to drive steady margin improvement over time, while ensuring we are making the necessary investments to continue to grow the business. That doesn't necessarily mean every year we'll show linear expansion. But over time, we expect to continue to be able to drive margin expansion.

Makes sense. And then capital allocation, historically, that's consisted at Moody's of reinvestment, M&A, dividends, share repurchases. Because of the pandemic, the company stepped down from its share repurchase activity this year while sustaining the dividend. As you look beyond this year, what are the targets for annual dividend growth and for share repurchases?

We've had a very consistent capital allocation framework, which we expect to continue going forward. We have a commitment to the dividend, and we have grown it consistently over time. The annualized dividend per share has grown at more than 10% compound annual growth rate over the last 5 years. Historically, we've targeted our dividends to be between 25% and 30% of adjusted net income, which we believe should be the appropriate level for a company with our growth prospects. Beyond the dividend, our main priority is to reinvest back into the business to pursue high return opportunities, either via organic or inorganic investments. We have clearly stated in long-held investment criteria for those investments. And then to the extent we have excess cash after those priorities, we look to return that capital to shareholders using their share repurchases. For 2020, in particular, and I'm mindful of time, after buying back approximately $250 million worth of shares, we did pause our share repurchase program in March, as I mentioned before, out of preponderance of caution given the uncertainty in the market at that time. And then with our latest earnings results in late October, we did announce that we were resuming share repurchases and expected to buy back an additional $250 million of shares through the end of the year, and we'll update you on our plans for 2021 with our fourth quarter earnings early next year as is our usual practice.

Makes sense. Well, it looks like we're just about out of time. Mark, thank you for the insightful commentary and the color. And thank you all for joining us.

George, to yourself and Goldman, thank you very much for having us and for a very well thought out questions this morning. Thank you.

Thank you.