This particular lecture is interesting because it encompasses a wide spectrum of the value framework; a special situation (spin-off) and a wonderful business (Moody's). It is also caught my attention because it features Rob Goldstein, partner at Gotham Capital. Before this lecture I was familiar with just one-half of Gotham's high performing investment partnership.
Goldstein does a case study of Moody's (MCO), which went public via spin off from Dunn & Bradstreet (DNB) in September 2000. The challenge is paying up for quality. To find a comp., the Gotham team used Buffett's 1988 Coke (KO) investment as an example of paying a premium for quality.
The second half of this 2 hour+ video is Greenblatt lecturing on "The Little Book" to his CSB class. That will be the second of two posts from this video.
As usual, if you don't want to watch an hour of video, my notes are below. All the charts I've included go to the time of the lecture November 2006, for proper perspective.
- Gotham came across Moody's in 2000 when spun off.
- It is one of the greatest business they've ever seen, but its not cheap.
- Moody's was spun off at 21x forward earnings, 24x trailing earnings. They typically bought at 10x earnings at that point.
- Q: Why compare Moody's to Coke? A: One of the best franchises ever, Buffett bought at a high price but it continued grow and was cheap in retrospect. It's a high hurdle.
- Buffett bought Coke (KO) at 13x forward earnings, 15x trailing earnings. Turned $600m in $7B in 12 years, about 23% annually. Reasons include price increases, buy backs, dividends, P/E expansion.
- Q:What was so great about coke? A: High ROIC, great brand name, safety of franchise, easy to understand, predictable business.
- Three important things about Coke: organic growth, high ROE, lasting competitive advantage.
- Moody's: founded in the 1900's, originally charged investors for bond ratings, but ratings became so important, that debt issuers began paying for the ratings (1970s). Pay for rating or face higher borrowing costs.
- Moody's and S&P each have 40% market share, and most issuers pay both.
- Over past 19 years before 2000 spin off, Moody's revenues grew at 15%, operating profits grew at 17%. Revenue grew almost every year (with one exception).
- Can we extrapolate this forward? What is the BTE? Goldstein believes that there is no chance of a 3rd major player.
- Student brings up Fitch. Goldstein says they are a niche player. They are a big part of the other 20%. No one likes two dominant players but there is nothing they can do about it. Various solution suggested. There is not a practical solution to problem. Also one would be messing with the balanced workings with financial markets.
- Revenue model: Fee on issuance, fee to maintain rating. but fee's are very low relative to face value of debt. Emory's note: This is like the path critical, low cost relative to value, ideal business as mentioned by Jeffrey Ubben of ValueAct.
- Concluded Moody's is a great business.
- Moody's did very well over time due to the rise of bond issuance globally, securitization.
- Moody's was spun-off from Dun and Bradstreet. Pre-spinoff D&B traded at $27.75, post spinoff D&B component was worth $7.50 a share, implied Moody's price was $20.25. Moody's expected to earn $0.95 a share, this is roughly 21x earnings.
- Growth Rate (GR)/Reinvestment Rate (RR)= Return on Equity (ROE). For Coke this works out to 12%/20%=60%
- For Moody's: What growth rate can we assume? Make assumptions about volume and price.
- We can expect volume to grow, based on Asia demand, ect. They settled on 12% operating earnings growth rate, based on historical performance, and they don't see the drivers changing. This also matches Coke, for an easy comp.
- What is the return on capital? Since Moody's gets paid on time or in advance of delivering service, and there is no physical good to deliver, the return on capital is higher than Coke. In fact, it is infinite (denominator is zero), due to the pre-paid nature. Very few businesses can claim to have infinite ROC.
- Coke needed to spend 20% of its earnings on reinvestments, while Moody's needed to reinvest none of it. Coke produces $0.80 on revenue, Moody's produces $1.00.
- Question: Does that mean Moody's is worth 25% more than Coke (all things being equal)? Answer, yes, at this time, but as growth rates decline the story changes.
- For Coke: Rearrange GR/RIR=ROE to GR/ROE=RIR if growth declines to 5% --> 5%/60%=8.3% Reinvestment Rate has declined from 20% to 8.3% as a result of lower growth.
- So to split the difference they decided Moody's was 15% better than Coke (not 25%). This is a more conservative assumption.
- Coke's P/E when Buffett bought it was 13x. If Moody's is 15% better that is a P/E of 15x (13*1.15=14.95)
- They were very comfortable with management. Management were good, and didn't think they were going to screw it up. Buffett owned it, management spoke with him.
- Management compensation was in line, and they said they would return all excess capital through buy backs.
- So to re-cap: Moody's vs Coke: Same growth rate, better ROE, comparable competitive advantage
- What if Buffett paid 18x earnings? He would have still made 20% annually. This is roughly 40% more (18/13=1.385). Goldstein concluded Buffett could have paid a 40% premium and still done great.
- How to justify 21x earnings for Moody's? Buffett's Coke P/E, factor in 15% premium for ROE, and 40% premium to target that reduced 20% compounded annual return rather than 23%. (13*1.15*1.4=20.93)
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- A note on interest rates: They declined from 9% to 6% from Buffetts Coke 1998 purchase to the Moody's 2000 spin-off. A bond would have gone up 42% over this time, which matches that 40% premium we factored in before.
- Buffett made 185% in the first 3 years after Coke purchase, afterword made 18% annually
- In the first year after spin off Moody's was up 50%. Gotham sold too early, but it was 30x earnings. Holding on looks easy after the fact.
- In 2001, profits were up 40%, and the next few years were up 25%. Drove shares higher.
- Greenblatt: We did learn something from selling too early. When we have one of the top five businesses of all time, we need to think three or four more times before we sell, after you've bought it well.