Wednesday, July 06, 2011

Should Moody's Be Part of Your Portfolio?

Moody's (NYSE: MCO) -- the $2.1 billion (12 months' sales) bond rating firm -- has been in the news recently causing grief for countries with fiscal problems -- like Portugal. And now that it appears to be looking out for investors, Moody's management may be hoping we will forget about how it contributed to the financial crisis that burst in 2008. After a 94% rise in Moody's stock in the last year, is its new-found investor orientation a reason to buy its stock?

On Tuesday, Moody's cut Portugal's debt rating to its first-ever "junk" rating. While Moody's is ahead of the other ratings' agencies, it is way behind the real rater -- the credit default swap (CDS) market that sets the insurance premiums for investors seeking to protect themselves against a bond repayment default.

After all, according to Katy Burne of Dow Jones Newswires, at 775 basis points (100 basis points = 1%), the CDS "imply a CCC rating and a 49% cumulative probability of default over five years." Moody's announcement did not change that CDS premium.

Moody's was not just late to the party when it came to the financial crisis -- it was an active participant. As I posted in 2007, Moody's competed to AAA-rate portfolios of mortgages that contained sub-prime mortgages. Without those ratings, investors would not have purchased those gold-wrapped boxes of financial toxic waste.

But that's all in the past -- and now the reasons to buy the stock outweigh the ones not to. Here are three reasons to favor the stock:
  • Strong first quarter performance. Moody's posted 67 cents a share in first quarter 2011 earnings, 24% higher than analysts surveyed by Thomson Reuters I/B/E/S. Moody's raised the midpoint of its full-year earnings outlook by -- boosting its expected 2011 EPS range from between $2.12 and $2.22 by 10 cents  to a range from $2.22 to $2.32. And Moody's raised its dividend 22% to 14 cents per share.
  • Long-term financial strength. Moody's enjoys a 26.6% net profit margin, it has no debt, and its cash has grown at an 8.6% annual rate between 2006 ($484 million) and 2010 ($672 million).
  • Out-earning its capital cost. Moody's earns more after-tax operating profit than its cost of capital and it has solid EVA Momentum, which measures the change in “economic value added” (essentially, profit after deducting capital costs) divided by sales. In 2010, Moody's EVA momentum was 3%, based on 2009 revenue of $1.8 billion, and EVA that improved from $356 million in 2009 to $394 million in 2010, using a 10% weighted average cost of capital.
One negative is Moody's high valuation. Moody's price to earnings to growth (PEG) ratio of 1.67 makes it fairly expensive (a PEG of 1.0 is considered fairly priced). Moody's P/E is 16.5 and its earnings are expected to grow 9.9% to $2.58 in 2012.

After a big run-up over the last year, Moody's is looking like a long-term holding that you might consider buying after a market break. I would not be surprised to see one this month due to debt-ceiling negotiations.


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