A Wonderful Business at a Wonderful Price - Moody's Case Study

In my “Revisit the Buffett Partnership” article series, I shared with the readers my favorite discovery that the Oracle crushed the Dow in 1966 by buying wonderful businesses at wonderful prices. Examples specifically related to 1966 included American Express and the Walt Disney Company. These pleasant experiences led to the following revelation that Buffett penned in the 1967 letter:

“Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess - I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a "high-probability insight". This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side - the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.”

I’ve always thought that the best way to assimilate Buffett’s wisdom is to reverse engineer his investment decisions. This article is an attempt to understand Buffett’s purchase for Moody’s common stocks during the late 1999 and early 2000 time frame. Obviously, we will never be able to completely figure out his thought process and his intrinsic value calculation but even an educated guess based on diligent research should be beneficial, to say the least.

There are no better sources to understand the rationale behind the Moody’s investment than Buffett’s own words. After some research, I found the following excerpt from the May 2010 Financial Crisis Inquiry Commission Staff Audiotape of Interview with Warren Buffett:

Interviewer: I understand sir that in 1999 and in February of 2000 you invested in Dun and Bradstreet.

Warren Buffett: That’s correct. I don’t have the dates, but that sounds right.

Interviewer: Yes sir. And am I correct, sir, in saying that you made no purchases after Moody’s spun off from Dun and Bradstreet?

Warren Buffett: I believe that’s correct.

Interviewer: What kind of due diligence did you and your staff do when you first purchased Dun and Bradstreet in 1999 and then again in 2000?

Warren Buffett: There is no staff. I make all the investment decisions and I do all my own analysis. And basically it was an evaluation both of Dun and Bradstreet and Moody’s but of the economics of their business. And I never met with anybody. Dun and Bradstreet had a very good business and Moody’s had an even better business. And basically the single most important decision in evaluating a business is pricing power. You’ve got the power to raise prices without losing business to a competitor, and you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent (laughs), then you got a terrible business. And I’ve been in both and I know the difference.

Interviewer: What attracted you to the management of Moody’s when you made your initial investments?

Warren Buffett: I knew nothing about the management of Moody’s. I’ve also said many times in annual reports and elsewhere that one of the many, but with reputation of for brilliance in him gets hooked up with a business with a reputation of bad economics, it’s the reputation of the business that remains intact. If you’ve got a good enough business, if you have a monopoly newspaper, if you have a network television station, I’m talking in the past, you know, your idiot nephew could run it. And if you’ve got a really good business, it doesn’t make any difference. It makes some difference maybe in capital allocation or something of the sort, but the extraordinary business does not require good management. I’m not making any reference to Moody’s management, I didn’t know them, but it really, you know, if you own the only newspaper in town up till the last five years or so, you have pricing power and you didn’t have to go to the office.

So Moody’s is a business that Buffett understands very well – it provides credit ratings, research and analysis of debt instruments and other securities for the capital markets. Moody’s has a wide moat. The capital market needs rating agencies and it takes a very long time to build reputation. So the credit rating business was dominated by Moody’s and Standard & Poor's. During the 10 years prior to Buffett’s purchase, the global market for fixed income securities had more than doubled in terms of outstanding principle amounts, and newly issued fixed income securities were becoming more complicated. As one of the two dominant players, Moody’s has tremendous pricing power and better yet, this pricing power increases as volume expands. Furthermore, Moody’s has a very high return on tangible assets and requires very little capital investment. It’s such a great business that Buffett said he did not talk to Moody’s management because he didn’t care too much.

As with many other great businesses, the tricky part is to figure out a great price to pay for such a wonderful business. In the case of Moody’s, Buffett probably saw the opportunity coming when Dun & Bradstreet announced its plan to spin off Moody’s as a separately traded public company. The announcement was made during December 1999 and going through Berkshire’s quarterly filings back 14 years from sec.gov, I found that Buffett made the purchase of the pre-spin-off Dun & Bradstreet during the fourth quarter of 1999 and the first quarter of 2000. Â He bought 24 million shares at a cost of $499 million.

The terms of the spin-off is such that for every two shares of the old D&B (to become Moody’s after the spin-off), the shareholder would receive one share of the new D&B. So Buffett’s 24 million shares essentially entitled him of 24 million shares of Moody’s and 12 million shares of the new D&B after the separation.

Let’s take a look at the financials from the 1999 D&B annual report:

This is remarkable. Moody’s revenue only accounts for about 28% of total D&B’s consolidated revenue but it generated more than half of D&B’s consolidated operating income, even excluding the $41 million restructuring charge.

Obviously, Buffett was more interested in Moody’s business, so let’s do a back-of-envelope calculation of what he paid for Moody’s. He bought 24 million shares of pre-spin-off D&B for $499 million, or about $21 per share. Moody’s operating income was about $1.7 per share whereas D&B’s operating income was just about $1.0 per share. If we apply an 8 times multiple for D&B’s operating business, we get about $8 per share for the D&B operating business. That leaves $13 for Moody’s, or 7.6 times operating income and about 13 times after tax earnings. This is very cheap for a business that has tremendous pricing power and had the following performance in the previous three years:

Of course the above analysis is just a quick estimate. The Oracle, not surprisingly, got himself an amazing deal by disposing all 12 million shares of the new D&B he received after the spin-off for about $30 per share, a very good sales price to say the least. This effectively reduced his purchase price of Moody’s to $139 million, or $5.8 per share. Â A few years later, Moody’s stock price shot up to over $60 per share. Not a bad investment at all.

Moody's is a great case study for me because it is a combination of Buffett’s wonderful business approach and Joel Greenblatt’s special situation framework. It is not uncommon to have a situation where a subsidiary with exceptional economics is masked by the parent's poor performance. When the parent company attempts to unlock the value of that subsidiary by spinning it off to shareholders, we should pay great attention.