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

Good morning, everybody. Thank you for joining day 3 of our Financial Services Conference. Unfortunately, we are virtual again. But hopefully, next year, we'll be back. My name is Manav Patnaik. I'm Barclays' business and information services analyst. And we're very pleased to kick off our day today with Moody's CFO, Mark Kaye. So Mark, thank you so much for being here.

Good morning, Manav, and thank you to yourself and Barclays for hosting.

Great. Just for the audience, I mean, this is going to be a fireside chat between myself and Mark. You should have a Q&A box in there. In case you have any questions, feel free to send them in. If I catch them, I'll bring them up. Otherwise, I'll follow up with you offline. So with that out of the way, Mark, maybe -- there's been a few press releases in the last 2 days. So let's just start there. Today, you announced the closing of the RMS acquisition. And perhaps just to start there, the question we've been getting a lot is why Moody's and why RMS. Like what value are you guys going to add to the asset?

Actually, Manav, indeed, a really good place to start. So just for those on the call today that may be unfamiliar with RMS, the company is a leading provider of climate and disaster risk modeling and analytics. And they play a mission-critical role in serving property and casualty insurers, reinsurers and insurance brokers. And we referred to a number of these RMS products and customers on our August 5th call, sort of RMS' core business. As I think about, Manav, the heart of your question in terms of how Moody's thinks about RMS and the competitive advantages, I think there really are 4 key sub points that I want to talk about here. The first is that RMS' key competitive advantage is the quality, right? They really have best-in-class models, analytics and technologies that really help customers outperform peers. I mean, in talking with Karen White and her leadership team, she often uses the phrase "good enough isn't good enough for RMS." And they're really very focused on bringing the best science and the understanding of risk to the market, not necessarily the cheapest models to the market itself. The second is the commitment to delivering best-in-class solutions to customers because it saves RMS' customers billions of dollars. In 2021, RMS did this study, which is publicly available, and it was validated independently by Oxford Economics that showed that customers that grew their engagement with RMS as opposed to using other vendors models collectively saved or cumulatively saved almost $30 billion over 5 years. Again, the accuracy, the quality being really important. Now the third one is that RMS' recent revenue growth rate can be attributed to their heavy investment in R&D. They clearly potentially sacrificed sales to spend heavily in R&D to bring the risk intelligence platform to the model -- risk intelligent platform to the market. And now that risk intelligence has been launched, RMS is expecting organic growth to increase. And that's really important over time in terms of us as Moody's at being able to meet the commitments that we put out to investors. And then separately, I'd probably add number four, is that RMS and Moody's themselves do have multiple opportunities across a wide range of risks and domains. And as we think about with the acceleration of complex risks like climate, cyber, supply chain, there is really the greater applicability of RMS' data and analytics to fields beyond just insurance. And that's going to be very applicable for corporates, financial institutions, governments, et cetera, because they all need high-quality risk and predictive analytics around these more extreme catastrophic events and climate to build resilience in their models and in their financial planning.

Got it. So I think that last part, I think, I appreciate and understand. But just going back to RMS itself, we've loosely followed it through our colleagues' coverage of DMGT. And they've had many iterations of management and releasing the new product, but it still hasn't grown. Is it possible that kind of the market is mature? Or just in your diligence, how did you get comfortable with the multiple you paid for a no-growth business?

Yes. So maybe let me start with some numbers, and I'll touch on your specific question. So we project RMS to generate approximately $320 million of revenue for the fiscal year that's ending now, September 30, 2021. Of that $320 million, I'd say approximately 95% is really expected to be recurring revenue. And when you combine that with MA's current insurance and asset management business, we're going to have an insurance and asset management franchise that's forecast to produce almost $500 million of revenue this year. In addition to RMS' sizable revenue base, we believe the acquisition provides a few exciting growth opportunities. So the first is we're seeing a growing industry-wide trend among insurers looking to digitally transform their businesses. And at the same time, there's an increased focus on frequency and severity of not just climate-related events, but a range of systemic risks like pandemics and cyber-attacks that are driving insurers to adopt more sophisticated third-party data and analytics software as they modernize their platforms. And that really means, Manav, we've got this opportunity to capitalize on those trends by expanding the distribution of RMS' products. And we can do that through Moody's expansive global sales force, et cetera. Second is the RMS has recently developed, as I mentioned a minute ago, its new SaaS-based platform. They're in the early stages of converting their customers from on-premise solutions to the new SaaS platform. And Moody's has been on this journey previously with our ERS business. So we feel we have pretty good internal expertise in making that transition. And then finally, we're going to look to integrate RMS' data and capability across Moody's offering, specifically in the risk adjacencies that we look at. Maybe I'd add just before I conclude here, if you think about where RMS is very strong today in its perils is really earthquake and wind. And those are typically more mature markets with lower single-digit type growth rates. Whereas I think some of the opportunities -- growth opportunities that exist and where RMS and Moody's can clearly gain share in the future is areas like flood, cyber, winter storms and wildfires where the market share is certainly growing -- market itself is growing much more quickly and where the combined capabilities can be pretty strong.

Got it. You mentioned cyber, which is probably a good segue into the next question. But before we get there, just the ESG benefit of owning RMS, conceptually, that makes sense. But in actuality, like how long before you can come up with these products and start generating that kind of cross-sell revenue, I guess?

Yes. So maybe I'll talk more generally to start just around the opportunities that we see within Moody's Analytics in terms of owning some of these ESG offerings. So ultimately, we believe ESG considerations are going to become a cornerstone of investment and risk management decisions. And let me do a few examples around that. So first, we've seen very strong demand for bank stress testing and physical climate risk assessments for commercial real estate, corporate facility and infrastructure clients. We also launched the Regulatory Data Solutions tool, which has the SFDR principal adverse indicators. That's becoming increasingly valuable because it's going to help investors with reporting obligations under the new EU Sustainable Finance Disclosure Regulations. We've also introduced climate adjusted EDFs, which integrate obviously climate which mirrors directly into our EDF models. And then we have in this one, I think that the management team is particularly really proud of because it's a key differentiator for us, the SME predictive score. And that provides almost 140 million companies under which we can evaluate their ESG offerings. We're hoping to leverage RMS here for a disaster -- climate to natural disaster risk modeling. And you know that's going to add significant capabilities, again, across that climate, cyber, CRE and supply chain risk universe that we're looking at.

Got it. All right. We'll come back to ESG in a minute, but the other news yesterday was, I guess, your $250 million investment into BitSight. And I guess you changed the structure of previous cyber investments. So can you just help us, just what happened there and how we should think about that?

Yes. Thanks, Manav. And yes, it's certainly been a very busy week for us as the management team. So for those, in the corporate site, who've not had a chance to look at this yet is a pioneer of cybersecurity ratings, which really helps organizations manage their cyber risk, mitigates third-party risk. They underwrite cyber insurance policies, and they conduct financial due diligence. BitSight was founded in 2011. And really, its platform supports a very wide range of products for customers to manage their cyber and security performance. And it has a very proprietary method of data collection from over, I think, 120 sources, et cetera. So why did Moody's ultimately decide to invest in BitSight? Well, Moody's investment in BitSight is really going to help establish the standard at scale in cybersecurity risk assessment. And we believe this is an emerging market with significant opportunity for growth. Cyber is a key growth area for Moody's as a globally integrated risk assessment firm. And the investment in BitSight really just strengthens our position in the cyber risk assessment space itself. We've also identified a significant need for cyber ratings. So Moody's has identified 13 industry sectors which we consider having medium or high cyber risk. And those sectors itself account for total rated debt exceeding $20 trillion. The point here is that the investment ultimately is going to provide Moody's customers with cyber risk ratings and analytics at scale. It allows us to quantify the financial impact of that cyber risk and then also to help our customers understand how cyber risk and other risks themselves interact.

Got it. And just like with RMS, insurance is now a $500 million fairly scaled piece of the business. Is that something we should be expecting somewhere down the road that cyber will be a business of that nature?

Yes, sure. So Moody's -- just to talk about numbers for a minute. Moody's invested roughly $250 million in BitSight for a newly issued shares, and that was done at a valuation of approximately $2.4 billion. Post that and post the acquisition of visible risk by BitSight, Moody's will own approximately 12% stake. And now we'll become its single largest shareholder itself. And then ultimately, we believe the end market for cyber ratings like climate and natural disaster ratings itself will be very large. So participating in this space becomes incredibly important for Moody's. And we're very pleased, obviously, with this acquisition.

Got it. And cyber is obviously another piece of the broader ESG agenda. So maybe just to start with, I think you gave us some numbers on the last earnings call, but how do you size how much of ESG revenues Moody's has today? Let's just start with that.

Yes. So if I think about ESG in particular, the second quarter ESG revenues were indeed just shy, I would say, of 30% growth compared to the same period last year. And that's going to reflect growth both on a stand-alone basis and from our integration of ESG risk metrics and analytics into MIS and into MA. We haven't broken down the components specifically at a product level. But for the full year of 2021, we're looking to generate roughly $21 million of revenue on a stand-alone basis and then another $5 million to $10 million from integration into those 2 businesses. Most importantly, though, we are seeing demand for the integration of ESG and climate considerations into a much wider range of customer processes, which then serves to strengthen our customer base. And what you can see here on Slide 55, if we can bring that in a minute, is in MIS, ESG factors are increasingly becoming table stakes. And consequently, while we have always considered certain ESG elements as part of the ratings process, we've now developed a dedicated and transparent methodology to assess the impact of the E, S and G factors on credit ratings. And we've rolled those outflow sovereigns in certain industries in corporates. And we're going to continue to make this a key focus area for our asset classes. If I flip over to MA for a second, there are a number of areas where our customers are also starting to measure their risk and performance across numerous ESG considerations in a holistic way. And again, we see this as a significant opportunity to help them. I mentioned the ESG Score Predictor as an example earlier today. And that's again around providing company-specific data and predictive analytics to produce ESG scores for, again, 140 million SME companies. And that's going to help our customers assess those ESG risks of both their customers, their own suppliers, et cetera. And we feel pretty good about sort of our positioning in this space.

And that 140 million, that SME score you talked about, is the data for that coming from BvD? And because of that, does that mean it's more skewed to Europe?

So great question, Manav. So we are very fortunate in that we have a very deep and very broad database of both corporates and individuals. A big part does indeed come through our Orbis database. But it also means those subscribers to Orbis now have a much more holistic understanding of not just understanding the customer and the supply that you do business with, but also understanding sort of the ESG or sustainability-based characteristics. If I thought about going deep on customers, typically, I'd say today, we have around 5,000 ESG assessments that covers sort of hundreds of unique data points. And those ESG assessments are quite deep in terms of providing scores. The goal line, and I think the objective, which we will meet certainly in the coming, I'd say, 6 months or so is probably to expand those 5,000 ESG assessments to be closer to 10,000. And I wouldn't be surprised if in the next couple of months, we're roughly at 8,000 ESG assessments. So sort of fully covering that universe, including sort of the Russell 3000 of very deep analytics in addition to that very broad SME score predictor that covers hundreds of millions of companies.

Got it. And just one last question on ESG. The slides that you're just showing plus everything you're talking about, it makes it feel like Moody's ESG should be bigger than $20 million to $30 million of revenue. So is it just because these are new products, new offerings and it's going to take some time to ramp up? Or how should we think of what the potential could be?

Yes. So Manav, I feel, by the way, the same way as you do. It should definitely be bigger. I'd probably say that as one of the primary sponsors of ESG within our management team and across the organization. But I think, certainly, the opportunity set for us is huge here. And it's, again, making sure we get the fundamental base correct, which means really 2 things: ensuring high quality of data and then ensuring very high quality of methodology that's applied to the data to generate scores. And then I think we certainly have an opportunity to win in this space, both on the MIS side through sort of the second-party opinions and the sustainability ratings, but also an opportunity to win on the MA side through integrating our ESG products and solutions into our existing MA products because that's what customers are telling us they want.

Got it. All right. I think we've pushed it long enough, but everyone wants to know what the issuance update looks like. The -- last week, I read was one of the busiest investment-grade weeks ever. And high yield has been doing well. CLO has been doing well. Just how are things stacking up today relative to your expectations?

Yes. So during our second quarter earnings call in July, we forecast activity for the remainder of 2021 to really moderate from historical highs that we saw in the first half of the year. We're not looking to bring forward guidance today, but it's worth me reiterating that we projected at that time for aggregate global rated issuance to grow in the low single-digit percent range for the year, with issuance really to be down in the mid-single digits percent range in the third quarter and then possibly up in the mid-single digits percent range in the fourth quarter. This forecast incorporated meaningful issuance increases to your point in high-yield bonds, leverage loans and I would say structured finance really as a result of favorable market conditions. And conversely, we also expected that full year investment-grade supply to decrease by approximately, and you can see this on the slide, approximately 40%. So what we've read in recent published reports, including those published by Barclays, issuance did slow down during the summer months prior to Labor Day. But CLO creation remains very well positioned, and momentum has built in leveraged finance activity from earlier in the quarter. Rob is going to provide a comprehensive update in the third quarter earnings call at the end of October. Happy to spend a little more time on CLOs if you want to or happy to move on.

No. Let's touch on CLOs as well because that's obviously a favorable mix category for you guys and the leveraged finance. So just any update there would be helpful as well.

Sure. Full disclosure upfront, we can't discuss activity relative to our expectations ahead of the next quarter earnings call. But I will say that we do remain very encouraged by the CLO and leveraged finance issuance thus far in the quarter because it's been an active CLO market on the back of what I think is very robust leveraged loan supply and CLO refinancing. If I go back to our publicly disclosed guidance from July, we had mentioned that we expected the increase in leveraged loan supply to drive CLO creation. And as a result, we substantially increased our structured issuance outlook to be approximately -- up approximately 75%. Also, to the point you just made about leveraged finance, there is indeed a greater proportion of infrequent issuers in leveraged finance versus the investment-grade sector. And that also means that many of the leveraged finance issuers tend to pay a higher per issue fee than some of our frequent issuers. And that's coming through as well as we spoke about earlier this year.

Got it. And then just broadly, last year, obviously, investment-grade was on a tear. This year, it's down naturally. The other structured categories were down last year. They're on a tear this year. Like, just broadly speaking, based on your guidance, like by the time we end the year, are we back to kind of a normal base? Or is there still a lot of moving pieces to consider?

Yes. Manav, I'm going to bring up one slide on the screen here from our investor -- third quarter investor presentation. And I think this one tells exactly the story that you've outlined and certainly what we've seen this year. This is on Slide 17. You'll see here in 2020, investment-grade transaction revenue and issuance is incredibly strong. And we've seen almost the exact opposite this year relatively at least through the second quarter. And you can see this down 68% in terms of issuance growth year-over-year. Conversely, last year, we saw really weak leveraged loans, structured finance and relatively weak high yield. And this year, we've seen significant growth in those sort of 2 segments. If I encourage investors to go back to sort of the 2 primary drivers ultimately moving issuance forward over the long term, and that's really going to be GDP and improvements in GDP. And the second one is going to be disintermediation. And those 2 trends, really, over time, are going to be the primary drivers of issuance, sort of separate to -- into your movements between leveraged finance and high-yield and potentially investment grade.

All right. That makes sense. And then maybe just a last question on the MIS side, and that's around margins. Just obviously, there's some mix shifts that continuously happen. But how should we think about kind of the long-term trajectory of MIS margins and how mix impacts that?

Yes. So for the full year 2021, we've guided MIS' adjusted operating margin to be approximately 61%. And that's because our improved top line outlook is partially offset by higher incentive compensation accruals and the acceleration of investments in some of our key strategic initiatives in the second half of the year. MIS' first half margin was greater than our full year guidance of approximately 61%. And that does imply that the second half of the year will not be as strong as the first from a margin perspective. That also means that we do expect in the second half of the year issuance to moderate and as the timing of our strategic investments are weighted to the third and the fourth quarter. And the focus of those investments really are to advance our ESG capabilities. We spoke about the increased coverage earlier as well as to improve our technology stack because we do remain committed to sort of utilizing technology, ultimately to increase and improve operating leverage in the future.

Got it. And I guess we'll shift to MA and maybe just start with the margin question there as well. You gave the mid-30s target over the next several years after the RMS acquisition. Maybe just help us frame what's going to drive that? And what does several years mean?

Yes. So maybe let me begin by stating that we expanded MA -- we have expanded MA's adjusted operating margin by almost 500 basis points from 2017 to 2020 and 600 basis points when you look at our 2021 guidance pre-RMS. MA's margin expansion is the product of both revenue growth, where we've delivered a 12% CAGR since 2008 as well as our continued focus on effectively managing our expense base. Our transition to SaaS-based products definitely helped operating leverage within the business. That's key to sort of our long-term improvement in RMS. And I know you and I spoke about that just a little bit ago. I also wanted to add that over the past couple of years, we have implemented a number of successful cost efficiency initiatives across MCO, which has resulted in the ability to self-fund between $80 million and $100 million of reinvestment back into the business. And this is applicable to both MIS and MA. And that's allowed us to, again, both grow and expand the margin concurrently in MA.

Got it. Before RMS, which I suspect will take up a lot of our questions going forward, but BvD, RDC, those were the high growth area, I mean, still high-growth areas. If you could just help us appreciate what that combination means and what the outlook for those 2 are.

Yes. So maybe let me start firstly within BvD. One of the areas I actually wanted to spend a minute just to highlight is maybe KYC and financial crime. I think there are a lot of trends in this space at the moment, digitization, increased regulatory demand and sophistication. And like we've mentioned on a recent earnings call, digitization has only been accelerated by the pandemic. And in fact, it's really transformed the know your customer and customer onboarding processes substantially as people have transitioned to this virtual environment and moved away from offices. Additionally, we have seen financial crime become much more sophisticated. And evolving regulation now requires organizations across all industries to know more about their customers and suppliers than ever before. And that means that as market needs have evolved, we have been very purposeful in responding and have combined our data and analytics assets to really leverage information on the hundreds of millions of entities and ownership structures as well as the detailed profiles on approximately 14 million politically exposed individuals. We've done significant work with AI to bring these pieces together. And that's allowed us to reduce false positives, to increase automation and to receive continued positive customer feedback because of our ability to map our data or our world-class data sets on entities and people while analyzing things like adverse media, et cetera. And it's all about generating insights. I'd say this solution set is very unique to Moody's. And that's as I think about BvD and Orbis and how we built sort of that ecosystem to be a very strong moat for us in the future.

Got it. And just on the BvD side, historically, obviously, stronger in Europe. You made the acquisition of Cortera that, I guess, gave you some of the data at least in the U.S. Is U.S. still a focus? And would you be willing to do acquisitions -- further acquisitions in there to bulk that up given the success BvD's had in Europe?

So I think BvD itself typically or traditionally has been a very European-centric data set. I think that data set has now expanded significantly to include a large number of U.S. entities and individuals. In addition, we obviously did the acquisition of Cortera, which again further enhanced sort of that accounts receivable or trade credit information. And that's, again, allowed us to put a very comprehensive package that's very attractive from both a European and a U.S. data set -- to both European-, U.S.- and Asian-based customers. So we feel good about that, Manav.

Okay. Just to touch on the ERS business, it's always been one that I think investors have struggled to fully appreciate sitting in the Moody's Analytics business. So how do -- how would you answer or help people appreciate what ERS helps Moody's with?

Yes. So if I think about ERS, and maybe I'll take this from the perspective of how we're growing in the current environment and how we're sort of transitioning to cloud. So maybe I'll start with the third point first. So transition to cloud within ERS has been pretty instrumental to our growth as it's facilitated the introduction or integration of our solutions. But it's also allowed us to be able to update our products much faster and to create savings that then customers can redevelop or reinvest in their own business. A good example of this, Manav, is really DataHub product, which is designed to meet customers where they want to be met in terms of data delivery. APIs have and they'll continue to be a critical component of our interoperability and our speed to market and getting data into the hands of customers. But really, the DataHub is just a different approach to be able to provide that same thing. In terms of more broadly how the business is expected to progress, customer preferences for SaaS-based solutions over installations, I think, will naturally lead to continued decline in our onetime revenue. But it's going to lead over time to an increase in that recurring revenue. And we do believe there's still going to be some small percentage of customers who are going to need on-prem solutions even as SaaS computing becomes more widely adopted. We also see an opportunity over the medium term, medium term sort of defining that 3- to 5-year period. As a result, I'd call it a 4 drivers. First, buy-side asset managers leveraging our platforms in the risk technology and portfolio design space. Second, a growing array of our offerings for insurers, including solutions to ensure they are compliant with upcoming regulatory requirements like IFRS 17. Third, I would say, U.S. financial institutions seeking to ensure compliance with upcoming credit loss reporting requirements. And then finally, just our ability to deepen our relationship with existing lenders by adding additional modules and capabilities that are going to generate additional value.

Got it. And you had referred to the SaaS transition of ERS before. Where are we in that process? And you talked about, obviously, the transaction business declining and the subscription growing. How much longer of that should we be expecting?

I think the transition to SaaS has gone very well. I definitely think we're past that sort of halfway point. We have seen, obviously, a change in customer behavior through the sort of 18 months so far pandemic. Again, a preference away from onetime sales much more to recurring sales. And you can see here on Slide 48 from the investor deck just how that shift has positively happened between 2015 and sort of the second quarter of 2021.

Got it. All right, Mark, let's just end with the capital allocation and perhaps more specifically just on the M&A pipeline. I know you guys have obviously done a lot of these kind of investments, tuck-in acquisitions. RMS would be perhaps on the little bit larger side of the tuck-in to medium-sized deal. So 2-part. One, I guess, is there a lot more of these kind of assets out there that's in your pipeline? And then the second part would just be, if something bigger were to come across, like would you have the appetite for that? Or are you staying away from those at the moment?

So first, Manav, I can't believe the time has gone so quickly. On M&A, worth reiterating our criteria and our areas of focus do remain unchanged. We're going to continue to prioritize acquisitions in the areas that we touched on today, KYC and compliance, private company data, CRE, ESG, et cetera. And these markets really contain high-value data and analytics that are critical to our customers' workflow and risk processes. We are continually addressing the increasing number of use cases within these markets with our curated data analytics insight. And that's ultimately going to serve our customers' evolving risk assessment needs in a better way. As you can imagine, our corporate development team does see many deals in the market, but we are very thoughtful, we're very selective. We maintain a very disciplined approach when executing those transactions. And then just to provide a little bit more detail on the acquisition criteria, acquisition, it's got to first target before anything else strong industrial logic and fit within our integrated risk assessment strategy. And then assuming that investment is going to pass that industrial logic, it's then going to have to meet our long-held clear and rigorous financial targets, which, again, remain unchanged. And you can see that here on Slide 15. And then finally, just to make sure, post-acquisition, we do have clear accountability in reporting to the Board on a quarterly basis how those acquisitions are performing vis-a-vis our internal base build and models.

Got it. And so maybe just to wrap that up, I mean, in terms of the question on larger M&A, like what are your leverage targets? I know as a rating agency, you tend to be a little bit more conservative. But for the right opportunity, what would you be willing to stretch to?

Yes. I'm going to take a pass on this one. So we don't provide specific long-term targets. The way that we'd like to talk to or have spoken to our investors and would like to talk to our investors about this is just around continuing to manage our balance sheet, including our leverage around sort of that BBB+ rating. And we believe that's going to enable us to strike the optimal balance between attractive issuance rates and balance sheet flexibility. Easy example, Manav, would be last month, we issued a 10-year and 20-year note, respectively, at 2% and 2.75%. So we feel very good about that outcome.

Got it. All right, Mark, thank you so much. We're out of time here, but I really appreciate you sharing your insights with us.

Absolutely. Again, thank you again for having -- very much appreciated.

All right. Thank you, everybody, for joining.