I’ve done a bit of research on the two companies over the past week. The big picture is not hard to see — both companies are dominant franchises in the credit rating business, each with around 40% market share. The competitive advantages are easy to spot. Investors seek a reputable source for information as important as the creditworthiness of an investment, and, as such, firms have an effective mandate to pay the rating fees for coverage. In a sense, to “signal” the creditworthiness and financial standing of the company and, thereby, lower their cost of capital.
Because both companies are so heavily entrenched in the capital markets, investors and firms alike are willing to pay up for ratings. Ratings firms do not, then, compete on price. Rather, they compete on quality, reputation, flexibility in product coverage, and geographic extent — indeed, the fact that both firms cover companies all over the world provides a common metric for any investment, and confers yet another competitive advantage over would-be entrants to the field who would have to play catch up. Both firms sport high margins and the benefit of pricing power (the best hedge against inflation, might I add).
And what’s more interesting are the tailwinds enjoyed in this essential duopoly. Worldwide capital markets are growing at a tremendous clip (with issues up over 23% compounded in the past five years) and become increasingly complex. Emerging markets continue to emerge and grow and more established markets increase their activity. The complexity, despite its connotation, is a good thing for the ratings firms. With the growth of complex issues like structured products, investors are even more sensitive to the need to have a trusted rating from a reputable source. Because S&P and Moody’s can provide this, they stand to reap the rewards of complexification.
Okay, so I just made up the word “complexification.” But I didn’t make up disintermediation (go ahead and Google it). That term refers to another tailwind involving the more and more popular trend of companies skipping the middle man investment bank and going it alone to raise capital. This is a good thing for Moody’s and S&P since those actually providing the capital will place a heavier emphasis on an independent rating given that an established bank has not underwritten the deal.
Moody’s, S&P (McGraw-Hill): Great companies. Emerging markets, disintermediation, complexification. Good things for great companies. But how about the price(s)?
Well, Moody’s, for instance, generates strong free cash flow with very little capital expenditures given that it is not capital intensive, and trades at PE around 25. Given that one may consider it a growth company, this is actually probably a reasonable price to pay. My own DCF puts the shares anywhere between $65 and $90, and that range is arguably conservative. For a great company with durable competitive advantages in a growing industry, that’s not too shabby.