Feeling Moody? MCO-- a classic value play

This is a core Buffet holding and is a highly hated company these days---> scapegoated for the subprime housing disaster. Spurious lawsuits are being launched v.s. Moody's by institutional investors along these lines of thinking.

I love it when this happens. This kind of emotional overlay provides an opportunity to inexpensively buy a company that deserves to be very expensive:

1. is over 100 years old and mid-large cap.
2. has one of the highest long term profit margins, ROIC and ROA in any publically listed company in US history suggesting consistently superb management.
3. is one company of a duopoly (S & P is the other). This provides a WIDE economic moat due to the high barrier to entry. Recent attempts to legislate a change to this situation have failed.
4. has a global footprint.
5. is buying back its own stock aggressively.
6. has no operating debt and lots of cash in the bank

This article by Yarnell "Thinking like a Business Owner" says it better than I can:

Moody’s: a case study

To find a great franchise that is currently out of favor, one need look no farther than to the center of the storm raging in the credit markets. Founded in 1900, Moody’s (MCO) has a dominant and durable franchise as a member of the credit rating oligopoly that reigns supreme in the growing global fixed-income market. The credit rating business has high barriers to entry by virtue of both its required government designation and the well entrenched positions of its participants established over many decades. Moody’s essentially collects a royalty on the growth of the capital markets. This powerful and well managed franchise demonstrates superior economic characteristics in terms of high return on equity, high profit margins and low capital requirements resulting in reasonably predictable owner earnings. Moody’s generates substantial free cash flow which its management is sensibly using to repurchase its shares.

It is easy to extol the virtues of Moody’s, but one must consider any potential risks as well. Facing the prospect of legal challenges and legislative changes in the wake of the credit crisis, the business is viewed by some as vulnerable to a fundamental change. However, given that all the participants in the industry face the same challenges, there is no readily available alternative, and over any meaningful period of time the bond market that fuels the global economy will undoubtedly grow (even if it experiences a temporary setback), Moody’s franchise will remain relatively unscathed.

Given Moody’s reasonably predictable profits, it is possible to place a reasonable estimate on its intrinsic value. Last year Moody’s generated about $700 million in owner earnings and in 2004 it generated about $500 million in owner earnings. Owner earnings have grown about 25% compounded annually over about the last 10 years. The next ten years will not see that level of growth. A more conservative estimate of Moody’s value involves going back to the 2004 estimate of owner earnings as a base, using 10% for the rate of growth in those earnings and choosing a 9% discount rate, one arrives at a discounted present value of about $15 billion. If one uses a growth rate of 15%, then one arrives at discounted present value of over $18 billion. The current market value of the company is just under $12 billion. Therefore, one can purchase one of the strongest business franchises in the world for a price reasonably below a conservative estimate of its intrinsic value. Even if the fundamentals of the company weaken in response to the current credit crisis, the margin of safety in the purchase will mitigate against permanent loss of capital. This makes Moody’s a company worth owning at a price worth paying. It is not surprising that Moody’s is currently out of fashion.

If the price of the company weakens, whether in response to the credit situation, general market conditions or any other reason, it may present an opportunity to own more of a great company. The business-like investor can build wealth over time by accumulating great companies at increasingly attractive prices.

The author owns shares of the company mentioned in this article.

I plan to bid for some MCO shares over the next few days. I think that a margin of safety exists making this a good long term bet. I'll hold it for 3 years before losing my patience with this investment.

l