Moody's Wide Moat and Profits Revolve Around Its Ratings Business

Analyst

Rajiv Bhatia

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Moody's Investors Service

Moody's Analytics

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Along with S&P Ratings, Moody’s is a market leader in providing credit ratings on fixed-income securities. Given the embedded nature of credit ratings among capital markets participants, regulators, and index providers, Moody’s enjoys a strong competitive position and strong operating margin.

Bond issuance volume is a key driver for Moody’s ratings business, known as Moody’s Investors Service, which makes up about two thirds of the firm’s adjusted operating income. Over the long term, we believe that mid-single-digit revenue growth, driven by GDP and pricing, is a reasonable expectation for MIS. Regulatory issues are part of the backdrop of the ratings business, but regulations can often benefit established players. 

Through both organic investments and acquisitions, Moody’s Analytics has been a key source of growth. It currently makes up about half the firm’s revenue but about one third of the firm's adjusted operating income. The subscription revenue model and high retention rates help offset some of the volatility in the ratings business. Moody’s Analytics offers a gamut of risk-related data and analytics content, including credit research, quantitative credit scores, economics research, business intelligence, know-your-customer tools, commercial real estate data, training services, ESG, and risk-management software to financial institutions. Notable acquisitions include Bureau van Dijk, a European provider of privately held company data, for $3.5 billion in 2017; RDC, a provider of anti-money-laundering and KYC tools, for $700 million in 2020; and RMS, a provider of climate analytics, for $1.9 billion in 2021. While these deals may not appear cheap, we believe they have strategic merit.

The ratings segment is mature globally, and thus we only expect small investments and acquisitions in ratings such as Moody’s minority stake in Malaysian Rating Corp. Berhad and its acquisition of Korea Investors Service. We expect acquisition activity to be concentrated in its analytics segment for the foreseeable future.

Business Strategy & Outlook

In our view, Moody’s warrants a wide moat rating based on intangible assets and network effects in its ratings business. 

Credit ratings provide value to bond issuers as well as bond investors; this creates a network effect. Bond issuers value credit ratings from Moody’s and S&P because of their wide acceptance among asset owners and asset managers. This is particularly important in cross-border bond issuance deals. While a local country’s domestic rating agency could have value for its domestic bonds, a rating from a Big Three firm is critical for a cross-border marketed security as global investors desire broad comparability across global bonds. For example, an investor wants to know that a B1 rating for a company in California is similar to a B1 rating for a company in Chile or a B1 rating for a company in India.

This broad acceptance makes it essential for corporate issuers to get a rating on any debt they issue. By getting a bond rating from a market leader such as Moody's, the bond issuer pays less in interest (often 30-50 basis points in savings per year). The cost of a vanilla corporate bond credit rating is around 8 basis points and is typically much less than the underwriting fees and legal fees (50-100 basis points combined).

Bond investors and bond issuers aren't the only ones who value credit ratings. In our view, acceptance among index providers and government regulators also supports the rating agencies’ wide moat. For example, the Bloomberg US Aggregate Bond Index, which among other uses serves as the index for the $300 billion-plus Vanguard Total Bond Market exchange-traded fund, only considers ratings from either S&P, Moody’s, or Fitch. Among banking regulators, rating agencies are used extensively to determine a bank’s capital adequacy. Also, as the number of ratings increases, the value of ratings research subscriptions sold to buy-side investors increases as well.

In our view, the credit rating agencies such as Moody's have built a moat source through intangible assets. The incumbent players are advantaged by their multidecade record that allows investors to see how credit ratings performed. For example, it would be difficult for a new player to establish what the absolute and relative probabilities of a B1 versus Ba1 versus Baa1 defaulting are over the next 10 years without sufficient sample size and time. Another hurdle for a new entrant would be establishing management relationships with the thousands of companies that issue debt. Given the strong record of incumbents, corporate management teams are unlikely to find much value in investing time and resources with another ratings provider. 

Regulations provide other hurdles. In order to receive a nationally recognized statistical rating organization designation (which bestows many advantages) from the SEC, the agency must be nationally recognized, "meaning the rating agency is recognized in the United States as an issuer of credible and reliable ratings by the predominant users of securities markets." However, this creates a bit of a chicken-and-egg issue because in order for a rating agency to be credible in the eyes of capital markets participants and corporate issuers, it needs to be an NRSRO. Even though the number of firms with an NRSRO designation has increased to about 10 since the introduction of the Credit Rating Agency Reform Act of 2006, we believe the network effects have been strong enough to result in only limited traction of other rating agencies.

Moody’s has leveraged its moat to obtain solid pricing power, typically around 3%-4% per year. Moody’s doesn’t disclose pricing specifics, but peer S&P’s rack rate for corporate finance ratings is 7.20 basis points, which compares with 6.25 basis points in 2016 and 4.25 basis points in 2007 and implies a fee compound annual growth rate of 3% and 4%, respectively.

Overall, we believe Moody’s Analytics is a narrow-moat business based on intangible assets and switching costs. Originally providing quantitative ratings and research reports for its credit ratings, Moody’s has greatly expanded this segment over the last several years, expanding into private company data, know-your-customer tools, and commercial real estate analytics. Roughly speaking, we estimate that Moody’s Analytics is split evenly among credit research subscriptions, Bureau van Dijk, enterprise risk solutions, and other products. Because credit research subscriptions are based on data from Moody’s Investor Service, we believe the moat of this product should be reflected in MIS. In 2017, Moody’s acquired Bureau van Dijk, a provider of private and public company data based in Europe. While BvD boasts strong EBITDA margins (50%-plus), we believe that little data is proprietary and that BvD’s advantage is in its data breadth and quality; we would regard this as an intangible asset moat source. Enterprise risk solutions provides risk-management tools and loan origination solutions to the banking and insurance industry. Moody’s competitors in ERS include various software providers such as Fidelity National Information Services, SS&C, Verisk Analytics, and in-house solutions. Given the complexity of changing software systems, we would view switching cost as a moat source. Moody’s Analytics' other products include commercial real estate solutions with its acquisition of REIS, but it is significantly smaller than market leader CoStar.

Wide

Economic Moat

Moody's

Moody's Corp. engages in the provision of credit ratings, research, tools and analysis to the global capital markets. It operates through the following segments: Moody's Investors Service (MIS) and Moody's Analytics (MA). The MIS segment is a credit rating agency, which publishes credit ratings on debt obligations and the entities, including various corporate and governmental obligations, structured finance securities and commercial paper programs. The MA segment develops products and services, which support financial analysis and risk management activities of institutional participants in global financial markets. The company was founded by John Moody in 1900 and is headquartered in New York, NY.

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Moody's Corp. engages in the provision of credit ratings, research, tools and analysis to the global capital markets. It operates through the Moody's Investors Service (MIS) and Moody's Analytics (MA) segments. The MIS segment is a credit rating agency, which publishes credit ratings on debt obligations and the entities, including various corporate and governmental obligations, structured finance securities, and commercial paper programs. The MA segment develops products and services, which support financial analysis and risk management activities of institutional participants in global financial markets. The company was founded by John Moody in 1909 and is headquartered in New York, NY.

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