Moody’s Poised To Benefit From A Diversified Business Model (NYSE:MCO)

Introduction

It’s time to talk about the second-largest rating agency in the world, the Moody’s Corporation (NYSE:MCO).

My most recent article on the company was written on November 20, when I went with the title “Moody’s Is The Perfect Stock For My Portfolio.”

Since then, the stock has returned 2.7%, lagging the S&P 500 by roughly 800 basis points.

The only reason for this underperformance is the company’s poor post-earnings reaction on February 13 when its stock price dropped more than 7%.

Personally, I’m very happy the stock is dropping, as I like the company’s long-term value – just not so much at current prices.

Hence, in this article, we’ll discuss what happened in 4Q23, how the company plans to grow on a long-term basis, what this could mean for investors, and what the company has to tell us about the macro environment.

After all, not only do I care about MCO as a business but also about its view on the economy, as credit quality has become a cornerstone of my research in the current high-rate environment with sticky inflation.

My thesis is that credit defaults are one of the biggest economic risks, as the Fed is not in a great position to lower rates given inflation headwinds. As a result, we are seeing that delinquency rates in various areas, including commercial real estate, are rising.

I believe that either credit risk or elevated unemployment could cause the Fed to eventually cut rates faster than expected, potentially triggering a second wave of inflation.

So, with all of this in mind, let’s dive into the details!

What Happened In 4Q23?

In the fiscal year 2023, the company reported a notable 8% increase in total revenue compared to the previous year.

This growth was accompanied by a significant rise of 16% in adjusted diluted earnings per share, indicating improved profitability on top of solid topline growth.

Digging a bit deeper, the Moody’s Analytics (“MA”) division experienced a significant 10% growth rate in annual recurring revenue (“ARR”) throughout the year, with retention rates averaging in the mid-90s.

Within MA, Decision Solutions, Data & Information, and Research & Insights segments displayed revenue growth rates of 11%, 10%, and 7%, respectively.

On the other hand, Moody’s Investor Service (“MIS”) segment witnessed a remarkable 19% growth in the quarter and a 6% growth for the full year.

This growth was particularly notable in sectors such as Corporate Finance, Financial Institutions, and Public, Project, and Infrastructure Finance, where double-digit revenue growth was achieved.

Furthermore, throughout 2023, the company experienced notable achievements despite facing a challenging operating environment.

Moody’s generated approximately $450 million in incremental revenue growth across its entire company, driven by a base of recurring revenue surpassing $4 billion.

Despite only modest growth in Moody’s Investors Service rated issuance, the company demonstrated resilience and strategic positioning and received over 150 external accolades and awards, including recognition as the Best Credit Rating Agency for the 12th consecutive year by Institutional Investor.

Looking ahead to fiscal year 2024 and beyond, Moody’s Corporation expressed optimism about its growth prospects and momentum during its earnings call.

The management outlined plans to accelerate investment in key areas, including GenAI, new product development, and technology infrastructure.

These strategic investments are aimed at further capitalizing on growth opportunities and enhancing the company’s competitive position in the market.

In terms of financial guidance for 2024, Moody’s Corporation provided adjusted diluted EPS guidance in the range of $10.25 to $11.00.

• In terms of revenue growth expectations for the Moody’s Analytics segment, the company projects an approximate 10% increase in revenue for the fiscal year 2024.
• Similarly, Moody’s Corporation expects revenue growth for Moody’s Investor Service segment in the high single to low double-digit percent range for 2024.

So Much Future Growth Potential

I already highlighted it briefly in the first part of this article, but Moody’s is very upbeat about its future, as it benefits from a number of trends it wants to use to grow on a prolonged basis.

For example, Moody’s made significant investments in its solutions and expanded its customer base in 2023.

Initiatives included the expansion of Moody’s Local, the development of dedicated teams in digital finance and private credit, and the addition of over 12,000 unrated entities to its CreditView research service.

The company also launched GenAI-enabled tools such as Research Assistant to enhance customer decision-making and expanded its company database to meet the growing demand for risk management solutions.

Moody’s also integrated predictive analytics and credit scores into Orbis, its comprehensive company database, further strengthening its offerings.

During its earnings call, the company emphasized its three-pronged approach to driving future growth, focusing on acquiring new customers, expanding existing relationships, and continuous innovation.

With a strong customer base comprising 97% of the Fortune 100 and 87% of the Forbes 1000, Moody’s aims to deepen relationships and diversify into new segments such as the corporate and public sectors.

The company’s net expansion rate in the financial services sector stands at a healthy 109%, indicating its ability to deliver value and retain customers.

Moody’s is committed to leveraging GenAI and its content sets to expand and deepen customer relationships further.

Looking ahead to 2024, Moody’s plans to increase its operating expenses by $60 million, focusing on three primary investment areas.

These include further development of GenAI-enabled capabilities, particularly in Moody’s Analytics products, investment in product development to meet growing market demands, and technology platforming to strengthen data interoperability and improve customer experience.

Essentially, Moody’s aims to accelerate its innovation and technological capabilities to capitalize on market opportunities and drive sustained growth.

The company also expects more constructive market conditions in 2024, with an increase in MIS-rated issuance expected in the mid to high single-digit percent range.

According to the company, it observed a busy start to the year, with over $150 billion in investment-grade issuance recorded in January alone, indicating robust market activity.

This heightened issuance activity is expected to continue throughout the year, contributing to Moody’s revenue growth projections.

Its peer, S&P Global (SPGI), confirms this, as it sees $12 trillion in global corporate debt maturities over the next five years, up 11% compared to the same research last year.

As we can see below, the wave of maturities will only grow larger over the next two years.

On a side note, the wall/wave of maturities is also the reason why I’m careful with long-term predictions, as I believe that an environment where companies have to refinance at much higher rates could have serious implications for credit quality.

Going back to Moody’s, it’s interesting that the company’s outlook is based on the expectations of a “soft landing” in the U.S. economy and anticipated rate cuts starting in the second quarter of the year.

The company’s outlook also considers broader market trends such as digitization and transformation programs across financial institutions, growing demand for third-party risk management solutions, and the ongoing expansion of the private credit sector.

Valuation

There’s good and bad news.

Using the data in the chart below, the good news is that analysts agree with Moody’s, as they, too, expect elevated long-term growth.

This year, EPS growth is expected to be 7%, potentially followed by 18% growth in 2025 and 16% growth in 2026.

The bad news is that the valuation is quite lofty.

Moody’s is currently trading at a blended P/E ratio of 37.1, which is well above its long-term normalized valuation multiple of 23.1. Over the past five years, the stock has a normalized P/E ratio of 30, displayed by the pink line in the chart below.

If we combine a 30x valuation with expected EPS growth and its 0.9% dividend yield, we get an annual total return outlook of 6.7%, which is why I am sticking to a Buy rating.

However, while I want to own the stock, I am not a huge fan of buying the stock at these levels and believe that an overbought market could provide us with buying opportunities in the next few months.

Needless to say, waiting for a correction comes with the risk of missing more upside, which is a risk I’m willing to take.

The current consensus price target is $399, 8% above the current price.

Since 2004, MCO has returned 13.6% per year, beating the 8.5% annual return of the S&P 500 by a wide margin.

Going forward, I expect MCO to keep outperforming the market.

Takeaway

If there’s one thing I’ve learned from diving into Moody’s, it’s this: while the recent dip in stock price might be unsettling, it’s an opportunity to reassess.

The company’s solid long-term value remains intact, but current prices might not be the best entry point. Looking at their growth in 4Q23, particularly in their Analytics and Investor Service segments, it’s clear that Moody’s is positioning itself for continued success.

Their strategic investments in innovation and technology, coupled with optimistic growth projections for 2024, paint a picture of a company poised for further expansion. However, the lofty valuation suggests caution.

While I maintain a Buy rating, I’m keeping an eye out for a potential market correction to seize better buying opportunities.

Ultimately, Moody’s track record speaks for itself, and I expect it to continue outperforming the market in the long run.

Pros & Cons

Pros:

• Strong Growth Trajectory: Moody’s reported a notable 8% increase in total revenue in fiscal year 2023, with significant growth across its Moody’s Analytics and Moody’s Investor Service segments.
• Robust Future Growth Potential: Moody’s is optimistic about its future growth prospects, fueled by strategic investments in technology, product development, and expanding its customer base. Initiatives such as GenAI-enabled tools and expansion into new segments indicate long-term growth opportunities.

Cons:

• Lofty Valuation: Moody’s is currently trading at a blended P/E ratio of 37.1, well above its long-term normalized valuation multiple. While analysts expect elevated long-term growth, the current valuation might be considered expensive.
• Market Overbought: The stock market is currently overbought, potentially limiting immediate buying opportunities for MCO. Waiting for a correction comes with the risk of missing out on more upside, although it may present buying opportunities in the future.
• Intense Competition: Moody’s faces intense competition from other rating agencies such as S&P Global and Fitch Ratings. These competitors offer similar credit rating services and may attract clients away from Moody’s, impacting its market share and revenue potential.
• Regulatory Challenges: Regulatory changes or increased scrutiny on the credit rating industry could pose challenges for Moody’s. Stricter regulations or compliance requirements may increase operational costs or restrict certain business practices, affecting profitability.