Friday, 7 February 2014

Rating the rating agencies: McGraw Hill and Moody's

When I wrote up McGraw Hill Financial's last quarterly report back in October (see link here) I concluded that:

'...it is possible to get to a US$75+ share price target today...It has been a very strong run since the lows, earlier in the year, following the DoJ allegations.  There is still upside operationally, but headlines around the DoJ case (timing, potential fine level, media coverage) is likely to prove as influential for the share price over the next 12 months'

Since then - and aided by the publication of this week's results - the shares have crept up a little bit further than even my target price and are now resting at US$80 i.e. almost double from the DoJ investigation low of essentially a year ago. 


So what has gone really well for them?  In earlier reports I touched at length about the mix of oligopolistic/strong pricing power ratings, indices and information businesses they have.  Despite toughening comparisons, the Q4 period just reported on continued to see growth...but sourced a little more from other variables at their disposal: better control of the cost base and a lower tax rate. 

 
Issuance trends (directly associated with the growth of new ratings business) were still solid, but more focused on Europe.  The 0-6% growth in issuance for 2014 is again sequentially slower...but not a disaster compared to some of the sales growth trends seen in other industries.


The above has all helped contribute to fairly punchy guidance, especially with regards to free cash flow (US$1bn free cash flow = a 4.5%+ yield) and implied operating leverage. 

 


Looking at the numbers, McGraw Hill Financial trades on just over x11 prospective FY14e EV/ebit, has 10% of its market cap in cash and a 1.5%+ dividend yield.  That seems good value still...except the issue of the DoJ case still lingers.  The next update here in March.  I am still assuming a 'no admission of liability' fine which takes a good chunk of the cash...and away we go.  On that basis, you would probably be a buyer at US$75 now...and keep your fingers crossed the DoJ are in the mood to settle. 

And what about Moody's who managed to avoid the DoJ's disapproval a year ago?  What were the key headlines from their Q4/FY out today?

Well many of the financial/operating trends were akin to McGraw Hill: strong operating leverage and falling expenses. 


Moody's earnings guidance is a little duller than their peer at 10% versus the aforementioned 13-16% given by McGraw Hill...but hardly shabby.

This is why the company's share are up strongly today.  Interestingly - as with McGraw Hill Financial - pushing through that US$80 share price level. 


Ratings-wise, Moody's also trades at just over x11 prospective EV/ebit but yields slightly more (5.5% free cash flow yield, akin 1.5% dividend yield) but by not having a DoJ legal case overhanging them are anticipating buying back shares equivalent to their free cash flow yield during 2014.  Shorter-term its multiples are slightly more attractive for a buy in the mid US$70s. 

Of course events can knock these companies off course, but the repeat nature of much of their business aligned with a relatively small number of peers provides a good underlying combination for continued progress.  In a shabby global trading period, there will be many other financial organisations that exhibit more volatility. 

Watch for the mid US$70s.  At the margin Moody's slightly preferred due to its lower legal risk.  Mr Buffett appears to agree - he is a shareholder in this name too (albeit with a reduced position - well it has doubled etc in the last year).

 

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