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

Hi, everybody. It's Andrew Steinerman, your business and information services equity research analyst here at JPMorgan. I'm here at our conference center. You'll be with us right here next year, November '22. This is the Ultimate Services Investor Conference, our annual conference, gathering to get the best info services companies and, of course, the best info services investors. This is the Moody's session. I'm here with CEO, Rob Fauber. It's going to be a great fireside chat, dialogues, as to all kind of engage in questions. Hopefully, I know the right questions to ask Rob. Rob has been CEO a brief period of time. He just became CEO at the beginning of this year. He's been with the company since 2005. Rob, welcome. I'm sure it's been already but feels like a very, very busy year.

Yes. Andrew, thanks very much for having me, and I have full of confidence in your questions.

Okay. Great. So in your first year as CEO, go over what you feel has worked well. And then, of course, I'm going to ask you, what do you feel like still is on the to-do list hasn't yet worked well?

Yes. So Andrew, I was obviously fortunate to take over a very well-run business. Ray was a really great leader of this organization for a long time. I worked for Ray for a number of years, and we had a great relationship. I learned a lot from him, and he left me a business that was in great shape but I also think poised for kind of the next chapter of growth. And I know we're going to end up talking about that today. In terms of kind of where have I then focused the organization, I'd say 3 really strategic priorities, Andrew, over the past year to really reinforce and accelerate growth. And the first of those is deepening our understanding of customers. And the reason that's so important is, in this environment, I'm sure, as you can imagine, with the pandemic and everything else that's unfolding, customers' needs are changing around risk, and they're changing fast. And risks are more complex. They're more interrelated. There's a wider range of risks that organizations are dealing with. And we really need to understand what opportunities that presents for us. So that's one. The second is investing with intent to grow and scale, and we really want to build market-leading businesses like we've got in ratings. We believe that we are doing that with our enterprise risk solutions business that serves not only banking but now insurance, and we've largely converted that over to a SaaS business. We're doing the same thing in know-your-customer and financial crime where we serve a very large, high-growth market, and we are very well positioned competitively. And we're also looking to do the same in climate and ESG. The third area is collaborating, modernizing and innovating. And we are really working together across the company probably like never before because that's what our customers are asking for. They're asking for more interoperability. They're asking for more integration of content to give a more holistic view of risk. We're modernizing our workflow platforms, especially in the rating agency, to help our analysts become more efficient. And we're innovating across all of our businesses to support both our customers and our people.

That's awesome. My question is, how do you track and measure innovation at Moody's? Like how do you know that -- the priorities you just gave make total sense to me, but how do you know that you have enough innovation to reinforce and accelerate growth?

Yes. So Andrew, this year, you probably heard us talking about an internal investment fund that we've created by finding operating efficiencies across the company. And we wanted to be very thoughtful about how we deployed that, right, because you've got to make sure that you're allocating expense dollars and capital dollars in the highest and best use and really focusing on the best opportunity. So we created something called a growth board, and that is -- there's a few things that that growth board does. But first of all, it provides some governance around the kinds of investments and innovations that we're making, and people have to have a business case. We go through kind of a design thinking discipline with the growth board, and that also then allows us to develop some new skill sets and capabilities. It drives some cultural change as we have people that, again, are focused on these design thinking skill sets. And it's really a great opportunity to develop our people around some of these new opportunities across the company. So it provides a real discipline, Andrew, in terms of how we're funding innovation, and it also allows us to have a real insight into the pipeline across the company, so we can understand what does the innovation pipeline look like around financial crime, around ESG and climate, around some of these other areas? And we -- to think about the progress that we're getting, this goes kind of how do you measure it. You can't measure innovation just on revenues, and that's kind of a lagging way of thinking. Obviously, yes, we want to -- you're going to see revenues from new products, but you really got to start to look at what kinds of customer feedback do we get in that design thinking process. When we're in the beta, what kinds of usage patterns are we seeing and indications of customer demand. So that is -- we try to make sure we're looking at these things with the kind of metrics that will give us a sense of are we getting traction with the customers, even before we're making sales and generating revenues.

That makes total sense. So I might be super annoying. I know you guys have not given a '22 issuance outlook. And even if you did, as you know, research department can only do their best in having a forecast for the issuance outlook anyhow. But could you just talk about what you might call the wild cards of the issuance outlook? And I'm going to mention -- I'm sure you know, Rob, that S&P thinks the issuance will be down 2% next year, not including bank loans. I think that's a pretty big caveat to not include bank loans. But just -- we're probably in a moderate issuance decline environment going into next year. What do you think are kind of main drivers for that?

Yes. And, Andrew, not annoying question at all. It's a great question and one we're spending a lot of time trying to think through, obviously, as we get to the end of the year. And we'll give some definitive guidance, as we always do, in our fourth quarter earnings call. But you're right. The -- we talked about probably more headwinds than tailwinds as we go into next year. And I sound like a little bit of a broken record because I was saying the same thing last year because we were focused on -- and we had something like 80% growth in investment grade last year, right? And so we said that's going to be a really tough comp. Investment grade is going to be down. We didn't foresee, like the rest of The Street, growth in leveraged loans that we think is going to end up being something like 100% for the year. There's a lot of drivers that are supporting all of this leveraged loan issuance. And so Andrew, I'm kind of saying the same thing, which is, geez, the market conditions are quite constructive, right? You've got a benign default outlook in spec grade. You've got tight spreads. You've got economic growth, which is very important to the spec grade sector. You've got private equity funds with tons of cash to be able to put to work and lots of M&A activity. That's all supporting this leveraged loan volume that we're seeing now, but it's hard to imagine -- it's just a very tough comp, right, up 100%. And last year, with investment grade up 80%, investment grade is going to be down 35% this year. That said, Andrew, investment grade down 35% after being up 80% is still very, very strong investment-grade issuance when you look at it on a 5-year basis. And so that may be the same with leveraged loans, right? Even though it's a very difficult comparable, we may still have a very robust environment for leveraged loans. And I would also say we might want to think about leveraged loans and high yields kind of together because sometimes we see issuers go back and forth, depending on kind of investor preference. So that's a big wild card. One other I might cite, Andrew, is there's just been a historic amount of support for the markets from central banks around the world during the pandemic. That's starting to get withdrawn. We're seeing that with the Federal Reserve, obviously, here in the United States. So that just creates the potential for missteps or misalignment between central bank actions and market expectations. And we saw that when we had the taper tantrum. So that's a wild card because if there's a surprise to the market, we may see some market disruption, and that's not factored into any of our thinking today.

So I'm going to ask an early question. I hope that's okay. So you said, hey, think of leveraged loans and high yields together, and I really know it wasn't that long ago that leveraged loans weren't rated. So obviously, they're quite a notable rated category today. Are all leveraged loans rated? Or is this still a penetration story happening in leveraged loans? Because when you tell me think about leveraged loans and high yield together, I'm like, high yield? That's rated.

Yes, yes. So we've seen more and more leveraged loans get rated over the past years, and these are loans that are going into the institutional market. Andrew, there's also a private credit market. We just put out a research report in MIS about it, talking about the size of that market. A lot of that paper is not rated. Now oftentimes, there'll be loans from credit funds that won't get rated, and then they end up going into the institutional loan market at a high-yield market where we do rate it.

But I didn't quite catch it. Is there still a penetration story in leveraged loans or most leveraged loans are rated now?

I think there's pretty comprehensive coverage of the institutional leveraged loan market today.

Okay. And it's now that you're going to intrigue me. Tell me a little bit more about the private credit market action, I don't know what that means. And I think you're saying that could be a whole new rating opportunity.

I don't know if it's going to be a rating opportunity. So this is -- you've got credit funds that have arisen over time. They're making direct extensions of credit, and a lot of that paper is not rated today. There's not -- there's just not demand for rating. It's possible over time that the underlying investors in those credit funds may want the paper rated, and we're having those conversations, but that's -- today, that's a largely unrated market. But I guess my point, Andrew, was while that may be unrated, oftentimes, we'll see a migration where it's -- the exposure -- the credit starts in a private credit market, then it moves into the institutional markets where we are rating it. So growth in that private market, even if we're not rating it, may give a sense for a pipeline of credit that may be coming to the market in leveraged finance.

You're saying it could be raw material. I get it. I get it.

It could be.

Okay. So let me ask the same question just in a broader way. Could you tell me a broad area of credit where there's still an increasing penetration of ratings on rated products today? I assume you can say something within structured, right?

Yes. I mean a lot of structured is rated. It's rated by more rating agencies. The fundamental parts of the market have pretty high usage of ratings and therefore a pretty comprehensive coverage by the rating agencies, including us. But there are parts of the structured market where you'll see 1 rating, for instance, instead of 2 or 3.

I got that. Yes. No, I totally get that. When I look at the history of your MIS, your ratings revenues business, it outperforms issuance. Obviously, one of the elements that puts this ratings revenues higher than issuance is price increases. When you think -- and I also think, historically, one of it was the penetration of leveraged loans being rated. So my question is, now that we have kind of more of the credit activity rated, what are other elements, again, on top of price, that will help your MIS revenues over the next couple of years grow faster than issuance?

Yes. And, Andrew, you probably -- this is something we talk about from time to time on these earnings calls, right, when we talk about mix. So let's think about the revenue growth algorithm in MIS for a moment. So you've got 2 sources of revenue. You've got transactional revenue. I'm going to talk about it in a minute, which let's call that roughly 2/3 of the business. Now that moves up and down, depending on issuance volume. But about 1/3 of the business of revenues are coming from recurring revenue, right? This is the stock of credit that we are surveilling. So 1/3 of the revenue is recurring, and you've seen that that has typically been growing. So that provides some built-in growth there. Then you've got the transactional revenue. And you're right. So you start with issuance volume, then we think about mix. And so depending on where the issuance is coming from, it can have a different commercial profile. So we see issuance coming from investment grade or financial institutions. That's typically more of a relationship-based kind of commercial construct versus yield.

Like fixed.

Right. Exactly. So leverage finance, CLOs, CMBS, that's all favorable to mix and helps us outperform issuance in terms of revenue. And then you've got pricing. And you're right, we've talked about, on average, across the company in any given year 3% to 4% of pricing, and that continues to be consistent. And then you've got first-time issuers into the market. And we're earning fees on first-time issuers, in addition to their issuance. And this year, we're going to have well over 1,000 first-time issuers. That's important because we get the fees on the first-time issuers, but it's also contributing then to the recurring revenue.

Okay. Perfectly. Switching over to MA, Moody's Analytics. I would say that you've already developed kind of a scale base of businesses here with lots of interesting data sets, commercial real estate, ESG, KYC, et cetera. Do you think that Moody's Analytics is at scale today? Or is this an opportunity to greatly scale these data segments?

Yes. There's more opportunity, and you're seeing that in the organic growth rates of the business, Andrew, that's showing the momentum that's in the business. And the reason for that is the drivers of the underlying markets that we're serving. And, Andrew, let me kind of anchor around what's going on with the customers for a moment because I think it'll give you a sense of the nature of demand here. So our customers are dealing -- and I mentioned this earlier. They're dealing with a whole range of new risks, right? Nobody was focused on carbon transition 5, 7 years ago; the physical risks of climate change; cyber attacks; the rise of financial crime. So our customers want a more holistic 360-degree view of the risk of who they're doing business with. And let me give you an example. We've got corporates who have thousands -- tens of thousands of suppliers. Historically, they were focused on the financial viability of those suppliers. And now they're focused on sustainable supply chain, ESG and reputation, wanting to understand the cyber risk profile. What's the risk of extreme weather events that could impact my suppliers. And so we're seeing a demand for all of this coming together. And it's those kinds of things that are -- there are other market dynamics, but that gives you a sense of the kind of demand driver that we're seeing for the integration of our data and our content.

Right. So you use that word a lot, the integration of our data and content. My question is, is this just a good cross-selling opportunity? Or do you feel like your clients get it, and they'll pay more, in aggregate, when you provide that holistic view of risk? So if you're buying 5 data content areas from here, are they going to pay more than buying them individually?

It's both. It's a cross-sell opportunity. But ultimately, Andrew, there's also an opportunity for us to be able to connect the dots in a way that the customers are expecting from us. I mean that's what they look to Moody's for, right, is insight about risk. So as you pull this together and you're thinking about the risk of my supply chain, how can you, Moody's, help me have a more holistic view of -- again, back to this idea of who I'm doing business with? So I think, Andrew, it's really both.

Okay. That's great. I know you talk about 3% to 4% price. I forgot if you say that as total company or MIS. But aren't price increases in MA higher than MIS?

That's across the company. And I think some of what you see when we talk about pricing in MA is we're also talking about upgrades, and we put that together. And that number is higher than 3% to 4% per year.

Right. Okay. Fair enough. I'd love for you to speak about RMS, the acquisition, obviously a huge, sizable climate modeling acquisition. It has been a sleepy company. Obviously, we know the competitive landscape well. For RMS to do better, what sort of needs to happen? And is there a white space opportunity where you could be, let's just say, vending market that wasn't vended before?

Yes. So let's go back and talk about why did we do this, and there's 2 primary reasons, Andrew. The first is we believe we've built the core players serving the global insurance industry. That's our business serving life insurers and their business serving P&C. And then not only are we going to be able to cross-sell, but we're going to be able to develop new products serving our mutual customer base. So take our ALM solution for life, and we're going to be able to develop one for P&C and sell that into P&C. And the really interesting thing is through the combination of the 2 businesses, we've been going on joint sales calls already. We're a very important vendor to global insurers. We've been having some very rich discussions at very senior levels of these insurance companies, and they're excited about the things that we're going to be able to bring to bear. When I speak with an RMS customer, I say, "Hey, great news. You're now going to have the full capabilities of Moody's at your disposal." So that's one area. The second area is taking their weather and climate risk capabilities, in particular. Now they've got other disaster risk capabilities, but there's a lot of -- we see a lot of growing demand for that across banks, corporates and governments. So banks are waking up to the fact that they've got climate risk in their portfolio. As insurers are starting to not insure things, corporations, as I talked about, are looking at their supply chains and trying to figure out where do we have real weather risk in my supply chain, so I need to be thinking about what that means and how I need to be mitigating through that. And governments, and you look at this infrastructure bill and what's proposed in the Build Back Better bill, are trying to understand the vulnerability of their communities to wildfire, sea level rise, heat stress, water scarcity. And they're going to be making some major investments in climate adaptation and climate resilience, and the RMS tools are uniquely well positioned to help think about the return on those investments. So we think of that as kind of unlocking the climate opportunity across a much broader customer base. Those things together are going to make this not a sleepy opportunity, Andrew.

Right. You didn't quite answer the question. And a lot of white space, right? You're not just trying to win business away from competitors, right?

And that really is my point is that last bucket, Andrew, that's new stuff. That's new demand that's not being served today. We're getting calls from our customers asking us if they can help them with this.

Right. Because I'm going to sort of phrase it back to you a little cynically. Like I know the cat market a little bit, and I know a lot of it is already dual source. And like can you tell me like, dude, I'm trying to move from a secondary product provider to a private provider. I'm like you win some, you lose some.

That's not the strategy, right? The strategy is I've got a bank customer who underwrote a loan that's a 10-year loan, and it's secured by a warehouse in the hills of California. And in year 3, there's no more insurance. And that bank owns the climate risk. Banks are waking up to that, Andrew, and so we're seeing interest in understanding what is the real climate risk across their portfolio. That's new demand.

I like it. No, I like it. Okay. So let's talk about MA margin expansion. For years, we've gotten so maybe accustomed to market expansion at MA, scaling business. Then we do RMS, which is at least currently a lower-margin business. I surely know you have interest in getting the margin back up. But my question is, besides for just, let's just say, the mathematics of putting in RMS at current margins, should we -- after that, should we get back to 100 basis points a year of margin expansion that we were used to? I understand the math, but I'm saying after the math of the first year, how will you get back to the old algorithm?

Yes. So we did put out some kind of medium-term guidance about the MA margin, talking about kind of mid-30s, and we certainly believe that is achievable. I would note, Andrew, I don't think you're giving credit -- giving us some credit for this, but we've done a really nice job of underlying -- of margin expansion in the underlying business, and we tried to help investors see through that with the investments we made this year. So the answer is yes, Andrew, that we're going to continue to be able to drive margin. The one caveat to that is it may not be an exactly straight line because, like you saw with RMS, we said, "Hey, there's a kind of a generational opportunity for us to invest in a scaled climate business." We believe strongly that we need that capability to serve our customers, and so are were willing to take the margin down to make that investment, and we're going to continue to bring it back up from the ways that we've talked about. When you think about something like the KYC market, and our business is growing organically in the mid-20s, and retention rates are in the 90s, there's a real speed to market imperative, right? Because once you get that new logo, you're very likely to keep it. It's hard to unseat the incumbent if you look at the retention rates. So you're going to see us continue to make investments. Some of those investments may be in a quarter -- 1 quarter or 1 year may be dilutive to the margin. But we are going to have the ability to get to where we're talking about over the medium term. It just maybe not an exact scenario.

I hear you that you already have a stated medium-term margin for MA, but do you feel like that is a milestone? Or do you feel like that's a cap?

We'll let you know when we get there.

Okay. How about this, like...

One thing I would say, Andrew, in all seriousness, the beauty of these recurring revenue models, obviously, right, it's high incremental margins. And so that's why we're so focused on building scale in these businesses, getting the -- focus on the growth first, and the margin will come.

Right. And do you feel like maybe there's too many businesses in MA right now? Or do you feel like, no, we could scale all those businesses appropriately?

Probably there's too many businesses. I think what you've seen us do is try to be clear about where we're going to focus the investment, and KYC is a real focus. We obviously made a significant investment in insurance and climate. We've been doing some things in commercial real estate. We're trying to invest in these high-growth end markets where we think we have a strong, competitive position.

I wanted to ask you about MIS margins. Obviously, this is the already very high margin business. Do you feel -- but you do say, hey, high incrementals. But my question is, do you feel like this is more about we're going to retain these high margins? Or do you feel like there's margin expansion opportunity also in ratings?

Yes. So we've had a lot of margin expansion over the last several years, as you know, Andrew. And back when the margin was at 60%, I was saying I think there's some modest incremental margin opportunity. And now, here we are at -- we're guiding towards 62%. So there's not a lot of headroom from here, but what I would say is there's -- there are some incremental efficiencies that are available in the business as we continue to technology-enable the platform, but there's also some costs that are going to come back into the business. We're going to have a bit more travel. We're investing in ESG, in the rating agency. So I continue to think that all that means there will be some modest opportunity over the medium term.

Right. But I'm going to sort of ask the question one more time in aggregate. So you're saying like there's modest opportunity for margin expansion in MIS. In MA, you said, 'Hey, we already gave you the target. We'll get back to you if it could go higher when we get there." But if you look over the medium term and your mid-single-digit organic revenue growth compounder or higher, won't it be hard to not show margin expansion? Like is it margin expansion kind of inherent in your business?

I mean that's, obviously, like I said, one of the great things about the recurring revenue model are the incremental margins and scale, and the SaaS conversion will all be positive for the margin. We'll probably give you a better sense -- a better answer on this at Investor Day, Andrew.

Okay. I'll be there. One last question. So I hear from that, you're back at the Ultimate Services Investor Conference. We're going to be here in the JPMorgan building. What are we going to be talking about then? It's like so much talk heading into this year is about issuance. We're not going to be talking -- I guess we always have to talk about issuance. But what have we not talked about today that you feel like by the time or a year from now that investors should really be focused on that narrative?

Yes. So I will be thrilled if you invite me back, Andrew.

You will be invited.

I hope we're continuing to talk about the fact that -- I think from where we sit right now, I think there's more opportunity in front of us than at any time in our company's history because we still -- we have a wonderful ratings business, and we continue to feel good about the outlook for ratings over the medium term, right? Whether it's -- what's going to happen with issuance in any given quarter or year. But over the medium term, the drivers look good in the rating business. But back to this theme of we're serving some very high growth -- attractive high-growth markets. And what I'm hoping we're talking about is, "Hey, look, the bedrock of the business is this wonderful ratings business. It's our heritage and credit." Gosh, you've built some scaled businesses in some very attractive markets and that we're able to talk about kind of the market-leading positions that we're building in those areas, whether it's financial crime or climate or supply chain. And also, hopefully, Andrew, we're talking about more and more examples of how we've been able to bring that together for our customers in a way that is differentiating us. So that's what I hope we're talking about next year.

Me, too. Rob, thank you for the time today. Appreciate it.

Thank you, Andrew. Always a pleasure.