The Farce Is Complete: S&P Downgrades Moody's To BBB+ From A-2

Tyler Durden's picture

Pure cannibalization of a dead business model in action. Now all we can do is lean back, grab the popcorn, and wait for the Moody's response, as both companies junk each other (literally) into oblivion. Importanly, we learn that the passed Donk provision on rating agencies is pretty much a dealbreaker for the rating agency model. Once the SEC exemption is over, Mark Zandi better have that government job in hand: "In our opinion, the legislation will likely result in more instances of
defending against litigation and other changes in operating practices
that will likely increase operating costs and thereby reduce
profitability and margins. The legislation, among other things,
addresses the applicable pleading standards for certain litigation
brought against rating agencies. This is contained in a provision
whereby investors may be able to sue a rating agency if they can show
that the agency knowingly or recklessly failed to (1) conduct a
reasonable investigation of the factual elements relied upon by a credit
rating agency's rating methodology, or (2) obtain a reasonable
verification of those factual elements from independent third-party
sources. While we believe it is likely that the new pleading standard
will lead to an increase in litigation-related costs at Moody's and
therefore poses an element of risk, whether the new pleading standard
may increase the likelihood of successful litigation against Moody's
will be determined in the future by the courts."

From Moody's:

Overview

  • We are assigning our 'BBB+' corporate credit rating to Moody's, a provider of credit ratings, research and analytic tools, among other services.
  • We are also assigning a preliminary 'BBB+' senior unsecured rating to Moody's shelf registration.
  • The rating and the stable outlook reflect our expectation that Moody's financial performance will remain healthy despite the potential for increased business risk associated with the financial reform legislation.

Rating Action

On Aug. 3, 2010, Standard & Poor's Ratings Services assigned its 'BBB+' corporate credit rating to Moody's Corp. We also affirmed the existing 'A-2' short-term rating. The outlook is stable.

At the same time, we assigned a preliminary 'BBB+' senior unsecured rating to Moody's shelf registration. According to the company, it will use the proceeds for general corporate purposes, which may include debt repayment, acquisitions, and share repurchases.

Rationale

The 'BBB+' corporate credit rating primarily incorporates our view of Moody's business risk following the passage of financial reform legislation by the U.S. Congress. While we believe potential business risks have increased, we continue to view Moody's business risk profile as "Satisfactory" (see "Criteria Methodology: Business Risk/Financial Risk Matrix Expanded," published May 27, 2009, on RatingsDirect), reflecting Moody's scale as a provider of credit ratings globally and the company's well-known brand. We believe that these factors will likely support Moody's ability to maintain its solid market position. In addition, we expect Moody's to maintain a relatively conservative financial policy with regard to share repurchases, dividends, and acquisitions. As a result, we believe Moody's financial risk profile is likely to remain "Modest," as demonstrated by good levels of profitability, a high level of conversion of its EBITDA to discretionary cash flow, low leverage, and high cash balances.

In our opinion, the legislation will likely result in more instances of defending against litigation and other changes in operating practices that will likely increase operating costs and thereby reduce profitability and margins. The legislation, among other things, addresses the applicable pleading standards for certain litigation brought against rating agencies. This is contained in a provision whereby investors may be able to sue a rating agency if they can show that the agency knowingly or recklessly failed to (1) conduct a reasonable investigation of the factual elements relied upon by a credit rating agency's rating methodology, or (2) obtain a reasonable verification of those factual elements from independent third-party sources. While we believe it is likely that the new pleading standard will lead to an increase in litigation-related costs at Moody's and therefore poses an element of risk, whether the new pleading standard may increase the likelihood of successful litigation against Moody's will be determined in the future by the courts.

Moody's management has stated that it plans to adapt its business practices in an effort to offset any potential new litigation-related costs associated with the legislation. Nevertheless, we believe that Moody's will likely face higher operating costs, lower margins, and increases in litigation-related event risk that we believe may present risks to the company's reputation. (See discussion under "Litigation" in our "Encyclopedia Of Analytical Adjustments For Corporate Entities," published July 9, 2007, on RatingsDirect as part of our Corporate Ratings Criteria.) While we believe the additional costs that Moody's may incur related to the legislation and to additional regulation around the globe may lead the company to experience margin compression, we believe Moody's is likely to maintain a good EBITDA margin at least in the 40% area on average, which is reflected in our investment-grade rating on the company. Per our criteria, potentially increasing business risk and lower profitability are key factors in our evaluation of Moody's business risk profile.

In addition, the final legislation removes many references to nationally recognized statistical rating organizations (NRSROs) from federal regulations, which may reduce investor demand for ratings. However, we believe this change is unlikely to impair Moody's business position over the intermediate term, as the company is likely to successfully defend its market position given its long track record and reputation as a rating agency of choice for investors.
Over the long term, we believe Moody's franchise likely will either be sustained or diminished based on the rigor, timeliness, and transparency of its analytics. In addition, Moody's business processes will likely undergo noticeable changes due to new global regulations and the U.S. legislation's impact on industry risk, which are business risk considerations under our
criteria.

In the June quarter, Moody's revenue increased 6% year over year, mainly reflecting the performance of corporate finance in the U.S. Over the same period, EBITDA increased 1.4%. Increased headcount and spending related to regulatory requirements caused the slight margin deterioration. For the 12 months ended June 30, 2010, Moody's EBITDA margin was strong at 45.7%, and conversion of EBITDA to discretionary cash flow was 47%. Lease-adjusted total debt to EBITDA was 2x and cash balances were $486 million. In the absence of a large increase in share repurchase activity, we anticipate that Moody's is likely to maintain total lease-adjusted debt to EBITDA in the 2x area and below in 2010 and 2011. Also incorporated into this 2010 leverage expectation is revenue growth in the high-single digits and EBITDA growth in the mid-single digits in 2010.

Liquidity

We believe that Moody's currently has exceptional liquidity to meet its needs over the next two to three years. (See "Methodology And Assumptions: Standard & Poor’s Standardizes Liquidity Descriptors For Global Corporate Issuers," published July 2, 2010, on RatingsDirect.) Our view of the company's liquidity profile incorporates the following expectations:

  • We expect that liquidity sources (including cash, discretionary cash flow and significant availability under its $1 billion revolving credit facility) will exceed uses by 2x over the next two to three years.
  • We expect that liquidity sources will continue to exceed uses, even if EBITDA were to decline by 50%.
  • With its cash balance and significant availability under its revolving credit facility, we believe the company could absorb, without refinancing, high-impact, low-probability events.
  • Compliance with financial maintenance covenants likely would survive a 50% drop in EBITDA without the company breaching covenant test measures.
  • In our assessment, the company has well-established and solid relationships with banks and a generally high standing in the credit markets.

Cash sources include $486 million in cash and cash equivalents, about $650 million of availability (not currently backing up commercial paper issuance) under its $1 billion revolving credit facility, and good discretionary cash flow. We expect that discretionary cash flow will exceed $350 million in 2010. Cash uses are mainly for capital expenditures. Capital expenditures were $91 million in 2009 (which represented 11% of 2009 EBITDA). We expect capital expenditures in 2010 to be lower than in 2009. There are no significant near-term maturities.

The revolving credit facility includes a debt to EBITDA finance covenant, requiring Moody's to maintain a debt to EBITDA ratio of not more than 4 to 1 at the end of any fiscal quarter. We believe the company has ample margin of compliance with this covenant.

Outlook

The stable outlook incorporates our view of potentially increased business risk related to financial reform legislation, including, in our view, likely higher costs, lower margins, and increased litigation-related event risk. Also, the stable outlook reflects our expectation of high-single-digit revenue growth and flat EBITDA in 2010 due to higher costs, and can accommodate low-single-digit revenue growth and a modest EBITDA decline in future years. Moody's currently maintains what we view to be a moderate financial policy with respect to share repurchases, dividends, and acquisitions. If Moody' adopts a more aggressive financial policy that pushes its debt leverage above 2.5x (compared to leverage currently at 2.0x) that is inconsistent with our target for the rating level, we may re-evaluate the rating and take what we view to be appropriate rating action.