When investors talk about Moody’s (MCO), they are usually referencing the company’s credit ratings on the debt instruments of publicly-traded companies. Most people wouldn’t think of Moody’s common stock as a potential investment. Surprisingly, Moody’s is a core holding in the investment portfolios of many astute investors, including Warren Buffett. Buffett’s Berkshire Hathaway (BRK-A) (BRK-B) owns 24,669,778 shares of Moody’s with a market value of $2.8 billion, making it the tenth largest holding in Warren Buffett’s common stock portfolio. You can see Warren Buffett’s entire investment portfolio analyzed in detail here. Buffett has done very well with Moody’s as an investment. His initial investment of $249 million has generated more than $2 billion of pure profits since he initially began accumulating Moody’s stock in 2001.

Source: 2016 Berkshire Hathaway Annual Report, page 19

Buffett continues to hold Moody’s stock, which indicates that he remains bullish on this stock. This article will analyze the investment prospects of Moody’s in detail.

Business Overview

Moody’s Corporation was founded in 1909 by John Moody and was originally in the business of providing comprehensive books of statistics for publicly-traded stocks and bond issues. Over time, the company’s operations have changed to be focused on the understanding, measurement, and management of risk.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 4

The company benefits from a highly diversified business model, both geographically and from an operational perspective. Moody’s revenues come from a wide array of industries and only 59% of the company’s first quarter revenues were generated in the domestic United States.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 7

Moody’s is split into two major operating segments:

• Moody’s Investors Service: its credit rating agency
• Moody’s Analytics: its provider of financial services software and analytics

Of the two operating subsidiaries, the credit rating agency is more important to the overall Moody’s business. Moody’s Investors Service contributed 67% of total company revenue and 84% of its operating income in the company’s most recent quarter.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 6

The majority (nearly half) of the revenues for Moody’s Investors Service comes from the rating of corporate bonds, contributing 49% of the company’s first quarter revenue. Moody’s Investors Service also has a sizeable presence in public projects & infrastructure financing, structured finance, and financial institution credit ratings. More details about Moody’s Investors Service can be seen below.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 26

Moody’s Analytics has less inherent diversification at the segment level than its counterpart in the credit rating industry. The segment has only three sources of revenue:

• Research, Data, and Analytics (54% of first quarter revenues)
• Enterprise Risk Solutions (34% of first quarter revenues)
• Professional Services (12% of first quarter revenues)

While smaller, this segment is also growing more rapidly than Moody’s Investors Service. Moody’s management expects high-single-digit revenue growth in many areas of this business for fiscal 2017. More details about Moody’s Analytics can be seen below.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 29

Moving on, the next section will discuss the growth prospects of Moody’s in detail.

Growth Prospects

Moody’s business pipeline is very robust. Over the next four years, more than $3.3 trillion in non-financial corporate bonds will need to be refinanced, providing ample opportunities for Moody’s to demonstrate its competency in the credit rating industry.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 17

Moody’s other segment, Moody’s Analytics, will benefit tremendously from the increasing sophistication of the financial markets. Financial market participants are increasingly data-driven, and Moody’s enterprise software products are well-positioned to benefit from this trend. I would expect Moody’s Analytics to post strong growth in the coming years, though it is still smaller than Moody’s Investors Service – the credit rating agency. One potential risk for Moody’s is the changing fixed income landscape. Interest rates are rising after a prolonged period of near-zero rates. The Federal Reserve’s March rate hike was the agency’s third interest rate increase since the financial crisis. Further, the Fed has communicated the intent to raise rates two more times before the end of 2017.

Even more telling is the recent dot plot published by the Federal Open Market Committee (or FOMC for short). The FOMC is a panel of expert economists who makes the interest rate decisions of the Federal Reserve, and they communicate their long-term interest rate expectations via a dot plot after each of their policy meetings. Here’s what the dot plot looked like after the committee’s recent March policy meeting:

Source: Yahoo! Finance

Clearly, rates are expected to rise in the coming years. How will this effect Moody’s?

Related: The Effect of Rising Interest Rates on Dividend Stocks

In the past, rising rates have not had a meaningful impact on Moody’s revenue. The only significant downturn in the company’s revenue since 1992 can be seen in 2008, at the onset of the global financial crisis.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 14

While past performance is no guarantee of future results, I believe that investors can reasonably assume that if rates continue to rise, Moody’s will be minimally affected. Lastly, Moody’s will continue to benefit from its expense management initiatives. Moody’s is a business driven by people and technology. As new technology is introduced, the company has significant potential to increase the productivity of its workforce.

Promising initiatives to boost productivity and reduce expenses can be seen across the Moody’s business. Along with segment-specific cost-saving programs, the overall Moody’s business has flattened its rate of headcount growth, densified its office real estate portfolio, and worked to instill a performance culture among its employees.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 10

To sum up, Moody’s growth will be driven by the increasing sophistication of the financial markets and cost management. Changes to the interest rate environment are unlikely to effect Moody’s in any meaningful way. The company has executed well on its growth plan so far and is likely to continue doing so for the foreseeable future.

Competitive Advantage & Recession Performance

Moody’s most important competitive advantage comes from operating in an oligopoly along with S&P (SPGI), and Fitch. While Moody’s is a smaller company than its larger peer S&P, there is still a significant amount of value that comes from having your bond issues rated by Moody’s.

Imagine this – you work in the treasury department of a large corporation and you are looking to raise capital via a new debt issue. By having your issue rated by Moody’s, you can reduce your bond’s yield to maturity (essentially the interest rate on your borrowings) by 30 basis points, on average.

30 basis points (0r 0.30%) does not seem like significant cost savings. But, thanks to the power of compounding, 30 basis points saves $15 million on a $500 million bond rating over 10 years – savings of ~7% of lifetime interest expense. This phenomenon is illustrated in more detail in the following slide.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 24

Companies actually save money by hiring Moody’s to rate their bonds. This provides stable demand for Moody’s credit rating services (the largest part of its business). As a company that operates in the financial industry, Moody’s might not seem to be the most recession-resistant company to add to your portfolio. It’s important to remember that Moody’s is a financial services company, and is not actually in the business of lending money to its customers. Moody’s avoids the leverage (and risk) that investment banks and financial institutions assume by acting as creditors in the financial system. Thus, Moody’s performed much better than many of the large banks during the last recession. Moody’s adjusted earnings-per-share during the 2007-2009 recession can be seen below.

• 2007 adjusted earnings-per-share: $2.50
• 2008 adjusted earnings-per-share: $1.86 (25.6% decrease)
• 2009 adjusted earnings-per-share: $1.69 (9.1% decrease)
• 2010 adjusted earnings-per-share: $2.15 (27.2% increase)
• 2011 adjusted earnings-per-share: $2.49 (11.6 increase)
• 2012 adjusted earnings-per-share: $3.05 (22.5 increase)

Looking at the trend above, Moody’s experienced a 32.4% decline in its adjusted earnings-per-share in the last major recession. While this is not an amazing performance, it is still superior to many banks. Thus, I believe that Moody’s should not be viewed as an exceptionally recession-resistant stock or a cornerstone defensive portfolio holding, but it will still likely perform better than many of its peer in the financial industry during the next recession.

Valuation & Expected Total Returns

Moody’s future shareholder returns will come from valuation changes, earnings-per-share growth, and the company’s current dividend yield. Moody’s reported adjusted earnings-per-share of $4.81 in fiscal 2016. The company’s current stock price of $116.54 is trading at a price-to-earnings ratio of 24.3 using 2016’s adjusted earnings. While this might seem like an elevated valuation multiple, the S&P 500’s price-to-earnings ratio is 25.5 right now. So Moody’s is trading at a discount to the stock market, on average. Further, Moody’s forward-looking valuation (that is, using management’s expected guidance for 2017) is much more attractive.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 12

The company is expecting adjusted earnings-per-share of $5.15-$5.30 in fiscal 2017. Using the midpoint of this guidance range ($5.225) and the company’s current stock price ($116.54) gives a forward price-to-earnings ratio of 22.3. The following diagram compares Moody’s current valuation to its historical averages.

Source: Value Line

The current valuation of Moody’s is above its long-term historical averages. Valuation contraction might reduce Moody’s shareholder returns, although these effects will be minimal over long holding periods. Moody’s shareholder returns will be primarily driven by the company’s earnings-per-share growth. Moody’s has compounded its revenues by 7% and its earnings-per-share by 13% over the past 5 years.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 8

Looking ahead, Moody’s expects a similar rate of company-wide growth for the foreseeable future. Management is forecasting ‘high single digit to low double digit % growth’ in earnings-per-share over long periods of time.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 9

With that in mind, I believe investors can conservatively expect 8%-10% earnings-per-share growth for Moody’s moving forward. The company’s per-share earnings growth will be boosted by its generous share repurchase policies. Moody’s is anticipating spending $500 million on stock buybacks in the present fiscal year, which amounts to ~2.2% of its current market capitalization.

Source: Moody’s Presentation at the Barclays Americas Select Franchise Conference, slide 11

Moody’s shareholder-friendliness extends beyond its share repurchases – the company has paid a steady or rising dividend since 2001. With that said, dividend payments will not be a significant contributor to this company’s total returns because Moody’s is a low yield dividend stock. The company currently pays a quarterly dividend of $0.38 per share which yields 1.3% on the company’s current stock price of $117.11. So altogether, Moody’s shareholder returns will be composed of:

• 8%-10% earnings-per-share growth
• 1.3% dividend yield

For long-term shareholder returns of 9.3%-10.3% before the effect of valuation changes.

Final Thoughts

Moody’s has been an exceptional investment for Warren Buffett’s Berkshire Hathaway, resulting in profits of more than $2 billion since the position was initiated in 2001. Due diligence suggests that Moody’s still has strong growth prospects and enjoys a defensible competitive advantage from operating in the credit rating industry – a veritable oligopoly. However, Moody’s valuation is above its historical averages, so value-conscious investors might want to wait for a more attractive opportunity to initiate a stake in this high-quality business.