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Moody's Corporation (NYSE:MCO) is a provider of credit services to the capital markets. Moody's provides risk assessment and research on debt and its issuer in virtually all global markets. The company operates through two segments: Moody's Investor Services and Moody's Analytics. Through its Moody’s Investor Services segment, the company is the largest provider of standardized credit ratings, research, and analysis in the world. It currently has a 40% share of this sector. Through its other subsidiary, Moody's Analytics, the company provides credit related services, software, and consulting to debt issuers. This segment also sells research and analytics to third parties.

Moody’s was one of four other companies which were Nationally Recognized Statistical Rating Organizations prior to a 2006 law abolishing that SEC-designated title (S&P, Fitch's, A.M. Best, and Dominion Bond Rating Service were the others). However, Moody's is still heavily entrenched in the financial world as a trusted provider of independent, objective ratings on creditworthiness, especially within the domestic capital markets. It maintains ingrained services and brand, which arguably help insulate the company from heavy competitive entry to the field.

Moody’s, which derives over 80% of its revenue from fees related to credit rating services, also enjoys tailwinds from ever-broadening and increasingly complex global capital markets, which have spurred growing demand for trusted, standardized, independent research and analysis as more entities raise money, and an increasing number of investors purchase fixed income securities and debt instruments. This is especially true abroad, as capital markets continue to be born internationally and in emerging areas. In some sense, a bet on Moody's is a bet on continuing worldwide capital market expansion.

Contents 1 History and Business Overview 2 Key Trends and Forces 2.1 Subprime Lending Embarrassment 2.2 Credit Crisis 2.3 Government Regulation 2.4 Evolution of Global Capital Markets 2.5 Disintermediation 2.6 Availability of Information and Globalization 2.7 Government Monetary and Fiscal Policies 2.8 Retention of Talent 3 Comparison to Competitors 3.1 Major Competitors 3.2 Competitive Landscape 3.3 Operating Metrics 4 References

[edit] History and Business Overview

Moody’s began in the early 1900’s as a provider of financial data on a variety of stocks via a published manual. After the 1907 stock market crash forced the company out of business, founder John Moody soon re-entered the business by providing a simple, standard, and elegant analysis and opinion on a number of companies and issued securities. Within 15 years, the company covered substantially the entire bond market, and its ratings had themselves become a factor in the market. The company persevered through the Great Depression, eventually continuing an expansion into coverage of more areas of the financial world. Moody’s was purchased in the 1970’s by Dun & Bradstreet Corporation and eventually spun off from them in 2000 in a public stock offering.

Moody's provides credit ratings and analysis on:

100 Sovereign Nations

12,000 Corporate Issuers

29,000 Public Finance Issuers

96,000 Structured Finance Issuers^[1]

	Annual income data, in millions	2003	2004	2005	2006	2007
Net Revenue		$1,247	$1,438	$1,732	$2,037	$2,259
Operating Expenses		$584	$652	$792	$778	$1,128
Operating Income		$663	$786	$940	$1,259	$1,131
Net Income		$364	$425	$561	$754	$702

Moody's offers standard ratings of a company's creditworthiness -- the likelihood that a loan extended to them will be repaid -- and opinions on both long-term and short-term obligations. Most of Moody's revenue comes from charging fees to companies seeking its objective rating. The company generates about 80% of its revenue from ratings, with the remainder from research and software.

Corporate and public finance issuers typically pay Moody's an ongoing fee to publish credit ratings on their entities in order to signal their own creditworthiness, and, thus, lower their cost of capital. The ratings are disseminated by means of press release to the public via electronic and print media. For ratings, long-term obligations may be considered either “investment grade” (Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3) or “speculative grade” (Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C). Short-term obligations may be either Prime 1, 2, or 3 or else Not Prime (NP), representing decreasing ability to repay such obligations. Historically, these ratings have correlated with a company's likelihood of defaulting on its obligations to pay back debt, thereby validating the usefulness of such distilled, easy-to-use ratings.

The company's services and ratings are considered indispensable for a company trying to raise money. A positive rating from Moody's allows a company to borrow money at much lower interest rates, lowering the company's cost of capital. Moody's ratings often play an important role in increasing market liquidity, as bond holders are more willing to lend money to a company that has Moody's imprimatur. The ratings cover over $35 trillion in capital from around 41,000 issuers in over 100 countries, and are used by nearly 17,000 users at 2,600 institutions. Given the issuer base and revenue of the company, Moody's makes approximately $39,000 per rated issuer per year.

[edit] Key Trends and Forces

[edit] Subprime Lending Embarrassment

Too put it bluntly, Moody's and the rest of the ratings agencies were grossly incompetent in their rating of collateralized debt obligations, structured investment vehicles, and mortgage backed securities . Their inability to correctly identify the inherent risk in these securitized debt instruments led to many investors believing they had purchased risk free cash flows. A great majority of these securities were rated AAA - the same debt rating as a treasury bond. As the New York Times pointed out during the first round of defaults, "When a security goes from AAA to junk within a few weeks, it does not inspire confidence in the rating process." ^[2] The lack of faith in Moody's and its peers was apparent when certain CDO's were trading at 10 cents on the dollar despite having a AAA rating.^[3]There has been much speculation regarding the regulation and transformation of this industry in the face of its devastating failures.

[edit] Credit Crisis

The current credit market seizure is very detrimental to Moody's business. Considering the amount of business they do is directly related to new debt issues, a frozen credit market is the worst possible environment. Revenue coming from its credit ratings service fell 37% to $298 million. This represents 69% of the total revenue for the quarter. This portion was much larger in previous quarters, over 80%.^[4] This shows a fundamental shifting of its business model because of the slowdown in the credit markets. This is especially true in the U.S., where revenue from structured finance fell 69%. CEO Raymond McDaniel claimed that roughly $200-250 million of revenue from structured finance transactions is "just gone."^[5] Moody's has already started to significantly downsize its workforce.

[edit] Government Regulation

In many countries, rating agencies have been or may become subject to numerous guidelines, restrictions, and standardized practices. Various nations may themselves also provide government-backed or operated rating services. This provides a formidable competitor in a number of regions or else makes it more difficult for a single ratings firm to distinguish itself in reputation or quality differential. In the face of the current crisis, there have been calls for the entry of government oversight into this industry. Senate Banking Committee Chairman Christopher Dodd has been apt to assign blame to the credit rating agencies for their misguiding of investors to inherent risks; all the while, collecting premiums for their services.^[6]

[edit] Evolution of Global Capital Markets

The world’s businesses need capital, and they often raise it through the issuance of debt. Those on the other end of the deal providing the capital rely on objective, trusted opinions to understand how much risk they are assuming and what may represent an appropriate interest rates. Moody’s provides such a service, and, as such, when more businesses need capital, more demand is generated for Moody’s ratings. The growth in the global issuance of rated debt has grown at a compound annual rate of approximately 23% since 2002, providing a tremendous tailwind for Moody’s.

Capital markets have also become more complex and rapidly changing, providing both a challenge and an opportunity for the company. While increasing complexity and change makes it more difficult for Moody’s to provide reliable and consistent ratings, it also boosts the demand for ratings from investors, who face the same daunting task of analyzing complex securities and obligations.

Increasing complexity is evidenced by the growth of structured finance products, which have grown 27% since 2002. Structured finance products typically involve an entity (corporation or government) using "safer" and more reliably credit-worthy assets such as accounts receivable as collateral for debt. Such a transaction enables the company to obtain a lower interest rate on issued debt by isolating the "safe" collateral asset from the company itself (the not-as-safe alternative). For instance, a company rated Baa3 overall by Moody's may be able to use its accounts receivable (a "safe" asset) to obtain an investment grade (say Aaa1) rating on debt. The number of assets used in such transactions has increased in the past two decades. Whereas only around 20 asset classes were “packaged” for securitization in 1990, over 200 are currently, indicating greater scope of present-day capital markets. These structured obligations are typically highly complex and more specialized than standard issuances of corporations and governments and thus investors enjoy the benefit of a trusted, easily understood rating from Moody’s.

The trends of general growth and increasing complexity in the global capital markets will likely continue worldwide. Markets continue to emerge, global economic expansion continues to fuel demand for capital and, hence, ratings, and firms and investors seek more and more sophisticated means of securitization of asset classes, which bring in more ratings fees for Moody’s. Moody’s continues to expand internationally to capitalize on these trends, though the majority of its revenue still comes from the United States, the world’s largest and most advanced capital market.

[edit] Disintermediation

Disintermediation refers to the trend of firms continuing to bypass the “middleman” of a financial intermediary (e.g. investment bank) to raise capital. In a typical transaction, a firm looking to raise money will hire a bank to underwrite the issuance of securities and find investors to purchase them. Each year, however, an increasing number of firms each year are simply doing it themselves to avoid the steep fees of banks (for example, Google took itself public).

Moody’s benefits from disintermediation because the trend makes an objective rating of a company’s creditworthiness even more important to investors. Without a trusted financial intermediary to deal with, investors are even more sensitive to ratings, so firms looking to “go it alone” are more likely to use Moody’s services in order to obtain reasonable financing and attract investors.

[edit] Availability of Information and Globalization

Advances in technology, such as the Internet, have facilitated access to information about investments throughout the world. This trend has enabled firms to more readily raise money in foreign markets and investors to invest in foreign issuers. The globalization of the financial world also boosts demand for Moody’s services as it demands a credible and universal rating system by which issues from very different geographic regions can be compared. In a sense, Moody’s provides a convenient and trustworthy way for sizing up all opportunities and making sense of the vast amount of information flowing among market participants.

[edit] Government Monetary and Fiscal Policies

Governmental monetary policies affecting interest rates have substantial effects on the demand for debt. When interest rates are high, the cost of debt hampers its demand. This, in turn, means fewer ratings for Moody’s. Fiscal policies and government spending can also affect such demand by impacting budget surpluses or deficits and, hence, general economic growth or recession. For instance, in periods of general recession, businesses have less demand for capital.

Moody’s has nevertheless demonstrated a consistent growth trajectory and is less affected in the long-run by changes in interest rates, government spending, and monetary policy based on its demonstrated top and bottom line growth for over 20 years.

[edit] Retention of Talent

Virtually all of Moody’s SG&A (selling, general, and administrative) expenses are employee-related, and the company, like any financial services firm, depends heavily on its ability to attract and retain intelligent, skilled analysts, employees, and, of course, executives. Competition for talent in the financial sector is highly competitive, and both increases in the competitive salaries or decreases in the supply of qualified employees could have adverse affects on the company’s costs, and, hence, its bottom line. Based on its SG&A expenses of $1.035 billion in 2007 and its weighted average employees of 3,600, the company spent approximately $287,500 per employee last year.

The human capital of the company is arguably its most important asset and most significant capital need. Indeed, the company requires little in other capital; Moody's spends a mere 2% of revenue on capital expenditures but is assuredly highly dependent upon ongoing employee-related costs.

[edit] Comparison to Competitors

Moody's and its largest competitors--particularly McGraw-Hill's S&P and Fitch--each enjoy competitive advantages and distinguished brand names in what may be considered an oligopoly with large barriers to entry and high switching costs for firms and investors. Such advantages have conferred tremendous pricing power and profitability on Moody's and S&P.

[edit] Major Competitors

The entire credit rating market is an estimated $4.5 billion per year industry, growing at a double digit pace. The company’s major competitors are Standard and Poor’s, Fitch, A.M. Best, and Dominion Bond Rating Services. Standard and Poor’s is arguably the largest, though its approximate 40-41% market share maintains only a small margin over Moody’s 40% share. Fitch, A.M. Best and Dominion are each substantially smaller based on market share. A.M. Best is more focused and specialized within the insurance industry, and several smaller firms have created their own niches by specializing in a particular industry or type of issue.

On 12 June 2008, Moody's announced that they may be doing a massive overhaul to their rating system for municipal bonds. This could have far reaching effects, as speculation has mounted that thousands of municipal bonds would be upgraded in the process. Since 2000, S&P has already upgraded 5000 muni bonds to bring them into line with corporate bonds of the same risk level.^[7]

[edit] Competitive Landscape

In September 2006, President Bush signed the Credit Rating Agency Reform Act of 2006, an attempt to promote competition within the credit rating industry. The act is partly the result of the failure of the major rating agencies to pick up on Enron’s and Worldcom’s deceiving credit standings prior to their falls. Previously, credit rating agencies were bestowed competitive advantages by virtue of their having to be designated by the SEC as Nationally Recognized Statistical Rating Organizations. While over 130 credit rating agencies existed last year, only Moody’s and its four major competitors had earned such a distinction. The 2006 Act eliminated this title, and makes possible the ability to register simply as a “statistical rating organization” by the SEC if staying within certain set standards and after three years of experience in the field. While the Act has not yet proven to be materially adverse, it is difficult to predict the long-term consequences of government action that seeks to promote competition within an industry.

[edit] Operating Metrics

As the two dominant, comparable players in the credit rating industry, Moody's and McGraw-Hill's Standard & Poor's (S&P) can be compared along several operating metrics. All figures for S&P are for that segment of McGraw-Hill alone, and do not include figures from the company's other segments.

2007 Operating Metrics

	Operating Metrics	Moody's	S&P
Revenue ($mil)		$2,259	$3,046
Operating Margin		50.1%	39.5%

[edit] References

1. ↑ http://www.moodys.com/moodys/cust/AboutMoodys/AboutMoodys.aspx?topic=intro
2. ↑ http://www.nytimes.com/2007/11/02/business/02norris.html?_r=1&ref=business&oref=slogin
3. ↑ The Economist
4. ↑ Moody's 1st Quarter 2008 Release
5. ↑ http://www.bloomberg.com/apps/news?pid=20601103&sid=ajbCLW7ZFBik&refer=us
6. ↑ Bloomberg
7. ↑ Wall Street Journal

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