Planet Money, Ep. #647 (Hard Work Is Irrelevant)

“To get a job [at Netflix] and to keep it, you have to accomplish great things.  Here’s another slide [from Netflix’s presentation on its principles]…’We are a team, not a family.  And we are a Pro sports team, not a kid’s recreational team.’  In other words, if they don’t need you any more or if the business changes, you will be cut.  Don’t expect this to be a job for life…and Netflix lives by this philosophy, even in really good times.  Like when Netflix started streaming movies and that took off […] Netflix was growing so fast, it was about to break the internet.  Streaming online takes up a huge amount of data and Netflix just wasn’t equipped to deal with it if suddenly the entire country started streaming.  Executives figured they had less than a year to fix this problem…so the executives decide they’re going to have to hire someone else to solve this problem and they did.  They hired Amazon.  They used Amazon datacenters and Netflix’s engineers [who made streaming happen in the first place] were not happy…the honest truth was, they were toast, there wasn’t going to be a role there for them.”

JCAP (9/8/17; Constantly Reinventing Yourself)

William Bao Bean (Managing Director of Chinaccelerator talking about Chinese tech companies)

“The end game for [payments in China] is ‘what percentage of the total spending for the entire country, non-enterprise, can I capture?’  And then you apply a fee to that and that’s the revenue opportunity.  It’s huge, it’s massive, you cannot underestimate the amount of money that will be flowing through [TenPay and AliPay] because over time, all payment will go through payment platforms.  They’re connected to the banks, the government wants to keep an eye on it, but they’re not looking to get in the way. […] So, all consumer spending – from your rent to your bills to buying a car – over time, will go through these platforms.  We’ve seen in India something amazing with demonetization.  India is going on mobile payments faster than China did…WeChat added 70mn bank accounts in 3 months…but in India, it’s happening even faster.”

“Online advertising [in China] has always been controlled by a small number of players.  The large players like Baidu, unfortunately Baidu kind of missed mobile, so it’s down to Tencent and Alibaba.  Sina and Sohu are kind of niche, small players at this point and I think Sina’s mostly within the Alibaba camp at this point.  The advertising market is basically controlled by two companies.  It was not transparent until about 2 years ago when Alibaba and Tencent launched programmatic trading and you saw the average click-through rate for the average Chinese banner go from 2% to 0.15%.  Click-through rates were always historically high because they were historically all faked.  The market is much more open now.  The issue the traditional banner is that with a 0.15% click through rate, it’s just not very effective.  So, you’ve see a very quick move to KOLs [Key Opinion Leaders – influencers and bloggers] because it comes down to trust.”

“KOLs are taking from traditional display but traditional display is still huge.  Most of Alibaba’s revenue comes from search within the Taobao and Tmall platform and then Baidu has a lot of search revenue [from display].  But more and more money is going into social, native advertising (KOLs), that’s where a lot of the tech investing is going…the one company that continues to do well from the old days is Netease, they have great games and great execution and they’re actually much larger than Sina and Sohu at this point.”

“Social commerce is the norm in China whereas e-commerce is still the norm in the US and Western Europe, so I’d say the US and Western Europe are about 1.5-2 years behind China.”

“Chinese consumers are notorious for switching to new products. Something that’s massively popular one day, 8 months later could be in deep trouble.  So you need to constantly be reinventing yourself if you want to stay competitive.”

“The key trend in [online travel] is that Chinese traveling habits have moved very quickly away from group travel…FITs [frequent independent travelers] are now the rule.  The market is segmented quite heavily between luxury/independent/backpacker segments.  There are many shoppers that use travel as an excuse to go abroad and buy lots of things.  Chinese consumers represent 40% of total luxury consumption in the world, but over half of that occurs outside of China. […] many of the low cost trips are actually no-cost trips.  The Chinese basically get a free trip to Thailand in return for being made to visit stores.”

“Booking.com has an unfair advantage that they understand online marketing very well globally.  They’re very good at spending money efficiently.  Unfortunately, the rules that apply globally do not apply to China.”

“There’s 2 ways to make money.  There’s entertainment – games and then there’s commerce.  Advertising leads to entertainment and to commerce, so we look at advertising as a subset of the other two.”

“Initial Coin Offerings, it’s a classic bubble.  Usually you have people investing large amounts of money in products that have few or no users and little or no revenue…ICOs are even worse than that.  You’ve got large amounts of money being invested in something where there is no product yet.  It’s a white paper.  And the product will only be released after they raise the money…so you’re going to have highly capitalized companies that don’t have product/market fit yet, and the value of these coins is based on the value of the platforms or services that they’re building.”

Consuelo Mack / Wealth Track (5/4/17; Investor David Winters Raises Alarm About The Flood of Money Pouring Into Index Funds)

Consuelo Mack:

“According to the Wall Street Journal, in 2016 82% of new retail investments coming through financial advisors, more than $400bn, went into index funds and ETFs.  And it appears the lion’s share has gone to Vanguard.  Over the last 3 calendar years, Vanguard has received 8.5x as much money as the rest of the mutual fund industry’s 4,000+ other firms.  $820bn for Vanguard vs. $97bn for its competitors.  By one estimate, Vanguard traders put as much as $2bn / day into stocks and their index funds, a huge portion of which goes into the 5 stocks with the largest market caps.  5 tech stocks – AMZN, MSFT, GOOGL, AAPL, FB – have dominated recently and at one point, accounted for 53% of the S&P 500’s YTD gain.”

“The fans of index funds also stress the fact that the performance of index funds has been better…95% of active managers underperformed their benchmark indices over the last 15 years.”

David Winters:

“What’s happened over time is that the fee [on index funds and ETFs] looks low, but they don’t look at the total costs.  And the costs are that there’s dilution from executive compensation plans that have in 2015 are about 2.5% on average for the S&P 500.  And then the other big expense is that stock buybacks have become increasingly used to offset these executive comp plans.  So another 1.6% of the expense of the S&P 500 that’s not apparent is buyback costs…so this whole idea that people have that ETFs and index funds are cheap, they’re actually very expensive and the expenses are ballooning over time […] if you take 4.1% x the market cap of the S&P 500, it’s over $800bn/year.”

“What are the look through expenses of [Wintergreen’s] companies?  It was 3.17% in 2015.  And index fund is 4.2%…and we can own securities that are trading at a fraction of what they’re worth as opposed to owning securities that everyone owns for the momentum.”

[But Wintergreen also charges a 1.95% management fee… 🤔]

“The fabulous growth stocks have dominated the returns of the market, so these index funds just have to keep buying more and more of them…so instead of diversification, you end up with concentration.”

“We really like BAT.  It’s our largest position.  They’re doing this transaction to hopefully take total control of the Reynolds American Tobacco Company.  BAT is the most global tobacco company, it’s very well run.  The CEO is first rate.  The company generates lots of cash, it generates money all over the world.  And you get paid to wait and they grow the business.”

Consuelo Mack / Wealth Track (9/8/17; Trennert & Zweig)

Jason Zweig:

(on the shrinking number of public companies)

“It almost compels institutional investors to invest ever more in private equity, which of course drives up prices and drives down future returns.  We’ve already seen the historical advantage of private equity as an asset class shrinking and I would expect that all of these people are chasing performance they probably won’t catch. […] I think for fund managers who invest in very small stocks, their job is probably getting harder than ever.  We had roughly 7,500 companies 20 years ago, now we’ve got roughly half that.  So you have larger and larger amounts of money chasing fewer and fewer companies.”

Jason Trennert:

“10 years ago, 80% of the market share of trading in NYSE-listed stocks happened on the NYSE.  Now, it’s only 20%.  There’s over 30 other sources of liquidity or exchanges out there.  When you see something like the flash crash, what was disconcerting was how few people knew what the source of the problem was.  In the old days, you’d go right to the exchange and you’d have a good idea.”

Waking Up, Ep. #34 (The Light of the Mind)

[Discussing consciousness, etc.]

Sam Harris:

“You have this distinction between understanding function and understanding the fact that experience exists…You have something like vision.  We can talk about the transduction of light energy into neurochemical events and in the mapping of the visual field onto the relevant parts of the visual cortex, and this is very complicated but it’s not, in principle, obscure.  The fact that it’s ‘like something to see’, however, remains totally mysterious no matter how much of this mapping you do.  If you built a robot that could do all the things we can, in no point in refining its mechanism would we have reason to believe that it’s now conscious, even if it passes the Turing Test […] and yet, it seems to me that we still won’t know whether these machines are actually conscious unless we’ve understood how consciousness arises in the first place.”

David Chalmers:

“‘Is the universe a simulation?’  [This idea’s] been getting a lot of currency recently…Nick Bostrom’s put forth this statistical line of reasoning that suggests ‘maybe we’re in a simulation because there’s going to be a lot of simulations developed in the history of the universe through simulation technology.  Maybe the simulated beings will outnumber the simulated ones.  Maybe we’re one of them.’  This is very reminiscent of Renee Descartes’ old experiment that maybe we’re being fooled by an evil genius into thinking all this stuff exists when it doesn’t.  The standard line is that if we’re in a simulation such as the matrix, it’s all an illusion […] My take on this is that that’s actually the wrong way to think about the simulation hypothesis.  If we’re in a simulation, it’s not that there’re no tables or chairs or trees, it’s rather that they exist in a somewhat different form than what we at first thought.  There’s a level of computation beneath what we take to be physical reality.”

“Consciousness can’t be explained in terms of standard physical processes. […] Standard neuroscience addresses the easy problems of behavior pretty well but doesn’t really give us a grip on the hard problem of experience.  The basic worry is that physics is all classed in terms of mathematical structure and dynamics, which is perfectly well suited for explaining things like behavior, but will always leave a gap to explaining ‘why is there consciousness’ because [consciousness] is not a problem about that structure or dynamic.  If you grant the argument that consciousness can’t be explained in terms of ordinary underlying physical ontology, then you have to add something to the picture, and either you add something separate to the physical processes (which is a form of dualism…we need new properties in our picture besides space and time, mass and charge)…the other possibility is that we enrich physics at a bottom level with consciousness, maybe as part of the intrinsic character of space and time and mass.  They’re all fairly radical possibilities, I concede that.”

“One line [of argument] that I’m attracted to is if you upgrade your brain a bit at a time, one neuron replaced by a silicon ship at a time and stay awake throughout, then maybe there’s a case that consciousness is going to be preserved by this process and you’ll end up with consciousness at the other end.”

[Re: Harvey/Irma disaster relief efforts, here are three charities that have been given top marks by charitynavigator.org: Helping Hand for Relief and Development, GlobalGiving Foundation, and ShelterBox USA.] When referring to the insurance industry, folks often talk about “hard” and “soft” markets – periods of strengthening and weakening premium prices, respectively – as though they […]

Invest Like the Best, Ep. 53 (Meb Faber – Factors, Dividends, and Angel Investing)

Meb Faber:

“I saw a stat the other day that the average Robin Hood account checks his balance ten times a day…and so, all that does is create horrific behavior.”

“There’s a lot of [fintech companies] getting funded that have great revenue that are essentially predatory.  So a lot of these savings and investing apps that millennials are attracted to and I’ve mentioned these publicly, like Acorn and Stash and a lot of these that charge a dollar a month, which doesn’t sound like much until you realize that the average account is a hundred bucks.  So, they’re paying 12% in fees….we’re still in silly season on a lot of these fintech companies and valuations getting funded.”

“If you go buy Warren Buffett’s stocks through 13Fs every quarter back to 2000, he’s outperformed the market by 5%-6% per year…that beats 99% of all mutual funds and it’s even higher if you go back to the ’90s/’80s/’70s/’60s because he had a smaller asset base and he beat by 10% per year.  How many people would invest in that guy?  Everyone.  And you pay no fees, there’s low turnover every quarter, he crushes it.  Well, he’s underperformed 8 of the last 10 years.  A lot of that’s just because value has struggled in this period vs. destroying it from 2000-2008.  So…if you blinded people to who was running this and just showed this performance track record, that person would be out of business 6 years ago.  So forget 8 out of 10, 2 out of 3, 3 out of 4, gone.  You’re not in business anymore.

The biggest part of [Buffett’s] alpha is not his investment approach, which is pretty simple – value, quality, sticks to his strategy and doesn’t waiver.  So, here’s my idea…we’ll call it the “Forever Fund.”  There’s a 10 year lockup.  And there is a declining redemption fee structure, so you redeem in year 1, you’re going to pay 10% penalty, maybe 5%.  And it declines each year…so there’s a penalty for being an idiot.  However, that sales charge doesn’t go to the fund company, it goes to the investors in the fund.  So, maybe once a quarter or year, you get a “good behavior” bonus for not being an idiot and holding your money long term in this fund…you probably get sued out the wazoo.”

JCAP (8/12/17: Snap-on Your Parachute)

Tim Murray (on shorting SNA):

“[Snap-On] is a company that’s been around for about 100 years.  They make hand tools for auto mechanics and also diagnostic equipment for repair of cars […] The Snap-On credit division is a group of franchisees that sells to independent mechanics…in the ’90s, they started providing financing to both their franchisees and their end customers.  And then in 2009-2010, Snap-On Credit took over the joint venture [the JV partner was CIT, which was running into problems during that time] that was offering credit.”

“Each [franchisee] has a truck that they lease from the company, they have around $100k in inventory, they can provide payment programs for their end customers, and they a route of around 300 customers.”

“The reason to short them is their excessive use of credit to make sales.  They have accumulated bad debt, which is a greater problem than revealed in the provisions.  It has reached a critical point and we expect that the bad debts to rise from 3% of their loan book to 6% and at the same time, that this will see the revenue to the Snap-On Tools division go down and the amount of earnings from the finance division go down because there will be less loans made.”

“The most common way [for a franchisee] to make a sale [to the end customer] is to sell on the revolving account, which is using the working capital of the franchisee where they put in a payment program over 10 weeks at no interest cost to the customer.  For a well-run franchisee, this will be about 70% of their sales […] [the franchisees in turn, are funded by Snap-On Credit.  The franchisees owe no interest for some period of time before the interest steps up to 9%-10%.] […] [25% of sales] are done on what’s called ‘extended credit’ which is lending from Snap-On Credit division to the end customer, with paper negotiated by the franchisee…the amounts are between $2.5k and $10k and the interest rates range from 10% to 27%, so you can imagine for the technician who earns $40k/year, the interest cost when you’re at 27% is cripplingly high.”

“[Starting in 2011] the finance receivables was about 54% of SNA’s annual sales.  It’s now 86% of sales […] credit growth of around 15%/year achieving sales growth in the Snap-On Tools group of about 7%/year, so they had to have credit growth 2x the rate of sales growth rate to achieve those sales.  Last year, credit growth remained at 15% but sales growth fell to 5%, and in the most recent quarter, sales growth has stopped and credit growth is still around the same level.”

“If I’m a franchisee and I wish to make loans to customers, I can overturn a Snap-On Credit decision […] but in order to have the right to overturn that, I have to have a low default rate…so, I’ll swallow losses on other defaults in order to maintain that [low threshold] default rate.  So, typically a franchisee will have a default rate of 5%-15%, but in order to stay in the program, they have to keep it at 3%.  So, if somebody defaults, I will repossess their tools, resell them…and if I make a slight loss, I might accept all of that loss in order to keep my default rate at a low level.”

“[Loading customers with debt] has a downward spiraling effect in the end because each time you make one of these extended credit sales to a customer, you fill them up with debt and that reduces the…ability of customers to buy tools from you in the future.”

“Snap-On’s always had really good cash flow and a really healthy balance sheet, and so when they took over the credit division, they were funding it with their own cash flows and balance sheet initially, and they’ve done that until recently.  Now, they’re taking on more debt to keep this finance division afloat.”

The Nerdist (8/17/17; Neil deGrasse Tyson)

Neil deGrasse Tyson:

“There is no accurate science in Star Wars.  In The Force Awakens, they figure, ‘let’s up the stakes a bit and have the Death Star suck all the energy out of a star; now we can destroy more than one planet at a time.’  Okay, this is evil magnified.  Six planets all at once simultaneously.  Excuse me?!  If you take all the energy out of a star so that the star completely disappears…do you realize that that is enough energy to destroy a thousand planets?  They didn’t do this math.  Had they done the math, it could have been an even more bad ass planet killer.  So, don’t tell me that real science is holding you back.  No.  Real science is grander than even the limits of your own imagination.”

The McKinsey Podcast (9/8/17: Financial Globalization Hits a More Stable, Inclusive Stride)

“In the 10 years since the global financial crisis began, cross border capital flows have fallen by 65%, from over $12tn to just over $4tn in 2016.  Half of that decline is coming from a decline in cross-border lending and other types of banking activity. [The global banks] are reducing their foreign exposure, allowing loans to expire without renewing them.  So overall, there’s been a broad-based retreat to domestic activity.  And the main drivers of this retrenchment have been the need to rebuild capital and recoup losses after the crisis, but also the need to meet new international and regulatory requirements.”

“While you do see a major retrenchment of European and US banks, there are banks from other countries that are expanding abroad in different ways.  For instance, Canadian banks are highly international and they have increased their international businesses over the last 10 years.  Right now, roughly half of the balance sheets of the large Canadian banks are overseas, particularly seen in the US.  We also see the largest Japanese banks expanding abroad in different ways…Probably the biggest change in the global landscape has been the increased activities of Chinese banks outside China.  Their foreign loans have gone from negligible levels 10 years ago to over $1tn in 2016.  This reflects them following Chinese corporations who are investing and also the FDI by Chinese companies as supplied by Chinese banks […] But despite this tremendous growth, just 9% of their total assets in foreign assets outside China.  When you look at banks in all the other advanced economies, it’s at least 20%.”

“Financial globalization is heavily concentrated.  Advanced economies account for 85% of all foreign assets and liabilities.  The top 5 advanced economies account for half of assets.”

Recode Decode (9/11/17: What Amazon should buy next)

Scott Galloway (who called Amazon’s acquisition of Whole Foods):

“[Amazon’s] trying to build a cable pipe of stuff into the wealthiest households in America and create intensity, and a key component of intensity in a relationship is making fluid, not episodic.  It’s very difficult to have that sort of intense consumer relationship with a households if you aren’t in the largest consumer sector in the world, grocery, it’s $150bn.  And the hard part about grocery is the last mile.  And what Whole Foods has done is create 550 flexible, well-lit warehouses in incredibly dense, wealthy neighborhoods.  So, the fastest way for Amazon to get from, not “A”, but from “B” to “E” is to buy this company…they could shut [the stores] down and use them as warehouses and still justify the price. […] The 550 stores probably cover 60%-70% of household that have incomes in the 90th-95th percentile…I think it’s going to be to Amazon what Instagram was to Facebook.”

“In terms of the next possible acquisition, the logical one would be Nordstrom’s because it would be cheap, it’s in Seattle, they know each other well, they are operationally very sound.  And [Amazon] has been trying to establish relationships with high-end brands…and Nordstrom’s has those and has a lot of credibility and a lot of wealthy households.”

“…the bigger prediction is that [Amazon’s] going to launch something call it “Prime Squared”, where they’re going to use AI, your credit card, a fulfillment network, and Alexa to just start sending you stuff…you send what you don’t want back in the empty box…they’ll do this, they’ll get better and better at it using AI and then they’ll announce that the test takes Amazon Prime users from $1,300/year in purchases to $7,000, the stock will become anti-gravity, race to a trillion dollars.”

“The reason by [Uber] isn’t worth $70bn and why Airbnb is going to worth more than Uber at some point is that…to compete with Airbnb, you need to have regional supply and global demand.  If you’re in Austin, you have to have apartments in Austin but people coming to Austin are from all over the world.  So, the most is much greater for Airbnb than it is for Uber.  Uber’s going to have a series of small competitors nipping at their heels regionally in different areas.”

“Google is God.  As we become more affluent and educated, society has become less religious and less dependent on the a super being.  At the same time, our modern day anxieties grow and that creates a void where we need a super being that we trust more than any other entity.  We want something we can send information into the atmosphere, prayer…and we want some divine intervention to send us back an answer.  One in six queries to Google have never before been asked in the history of mankind.”

Waking Up, Ep. 92 (The Limits of Persuasion)

Sam Harris:

“Reason is itself is not this bloodless calculating instrument.  It is also built on very visceral intuitions about right and wrong and consistency and the need to remain consistent and finding certain propositions doubtful.  I think doubt is an emotion.  Detecting the most basic errors in anything is a felt, embodied experience.  So this opposition between reason and emotion, as many people have pointed out, doesn’t hold much water.”

“In terms of the self being an illusion, that’s not really a paradox […] The subject is an illusion, the subject is absent.  The illusory-ness of the self can be established logically.  Everything to be noticed has to have first appeared in consciousness…and this feeling of self is also appearing in some way…and by virtue of appearing in consciousness, that proves that consciousness is prior to it and transcendent of it.  Just as you can see an object across the room and by virtue of seeing it, not feel identical to it.”

 

[FAST – Fastenal] Fastenal’s dense branch network affords scale advantages in distribution and service relative to Grainger, which has 2.5x Fastenal’s sales but only ~1/10 its branches and ~1/7 its field employees.  Local market density is especially important because fasteners, which comprise nearly 40% of the company’s sales and a greater proportion of gross profits, is […]

Several weeks ago, the stock of Ellie Mae, a SaaS that automates the grueling task of underwriting residential mortgages, got hammered when the company reported revenue weakness on lower than expected industry refinancing volumes and longer than expected ramp times for larger enterprise customers, prompting management to dramatically cut its full year revenue growth guidance […]

Moody’s is a Nationally Recognized Statistical Rating Organizations (NRSROs), a title bestowed by the SEC on a handful of credit rating agencies, the top 3 of whom act as an oligopoly in the US debt ratings gambit.  As you well know, Moody’s (and S&P and Fitch) fell into disrepute during the last financial crisis when its ratings on vast swaths of corporate and securitized paper proved worthless, its grossly conflicted issuer-pay model laid plainly bare.  But testament to the company’s resilient business model, and toothless fines and regulatory censures notwithstanding, Moody’s Investor Service (“MIS”, the credit rating agency side of the business that constitutes ~2/3 of revenue and ~85% of EBITDA) has thrived since the crisis, compounding revenue and EBITDA by 10% and 15%, respectively, since 2009 and generating more of each vs. the 2007 peak:

MIS segment, $ millions
	2007	2009	LTM
Revenue	1,780	1,218	2,550
EBITDA	1,021	543	1,555
% margin	57%	45%	61%

Over the last 100+ years since its founding, Moody’s ratings – derived from a consistent framework applied across 11k and 6k corporate and public finance issuers, respectively, in addition to 64k structured finance obligations – have become the veritable benchmark by which market participants, from investors to regulators, peg the credit worthiness of one debt security against another.  NRSRO ratings underpin the risk weightings that banks attach to assets to determine capital requirements, dictate which securities a money market fund can own, and, in ostensibly surfacing the credit risk embedded in fixed income securities, make it easier for two parties to confidently price and trade, enhancing market liquidity.  I was a research nerd in the bond group at Fidelity just prior to and during the crisis.  It’s hard to overstate just how tightly Moody’s and S&P (and to a lesser degree, Fitch) ratings were stitched into the fabric of our ratings and compliance infrastructure and the day-to-day workflows of analysts and traders on the floor.

Because of such industry-wide adoption, a debt issuer has little choice but to pay Moody’s for a rating if it hopes to get a fair deal in the market: an issuer of $500mn in 10-year bonds might pay the company 6bps upfront ($300k), but will save 30bps in interest expense every year ($15mn over the life of the bond)….and each incremental issuer who pays the toll only further reinforces the Moody’s ratings as the standard upon which to coalesce, fostering still further participation. This feedback loop naturally evolves into a deeply entrenched oligopoly.  In terms of total ratings issued, S&P and Moody’s are at the top of the heap.  There are actually 10 NRSROs, but unless you work in credit, you’ve probably never heard of most of them (Egan Jones anyone?)

The government’s determination of NRSRO status is premised on “whether the rating agency is ‘nationally recognized’ in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings” (per this SEC report ^[3]), which criteria itself is in part tautologically attributable to the government’s NRSRO designation in the first place.  And when things go horribly wrong and these ratings are shown to be the reactive measures that they are, the agencies simply appeal to freedom of speech protection under the First Amendment.  

This is a really hard business to screw up.  Who wants to rock the boat?  Certainly not the staid management team at Moody’s, which thrives on 5 year plans, formulaic capital allocation policies, and farcically granular guidance that plays to the myopic expectations of sell-side model tweakers (though I give management props for expensing stock comp in its adjusted profit numbers).  You will never see Moody’s carve out an “Other Bets” P&L for new innovations.  Day One will always be yesterday. [If watching Sundar Pichai saunter on stage to fulsome fanboy applause against jubilant theme music from Fitz & The Tantrums provokes reflexive eye-rolling, then do yourself a favor…watch the 2016 Moody’s Investor Day webcast and take refuge in the sterile quietude of a generic albescent conference room where every cough and throat clear is awkwardly amplified against the AV projector’s fan’s sad whir.]

MIS’ 2016 revenue was about 60% transactional (tied to new debt issuance) and 40% “recurring” [per 10K: annual fee arrangements with frequent debt issuers, annual debt monitoring fees and annual fees from commercial paper and medium-term note programs, bank deposit ratings, insurance company financial strength ratings, mutual fund ratings], a mix that has been reasonably stable during the quiescent issuance environment of the last 5-6 years. Debt issuance in the US, which constitutes nearly 2/3 of MIS revenue, can be choppy from year-to-year….

Source: SIFMA …but the overall stock of debt has been steadily growing…

Source: SIFMA …so, as you might expect, MIS’ recurring revenue has served as a reliable anchor during stormy issuance periods.

MIS segment, $ millions
	Revenue
	Transactional	Recurring
2007	1,204	576
2008	591	614
2009	612	606
2010	800	605
2011	903	666
2012	1,173	714
2013	1,281	779
2014	1,372	875
2015	1,419	902
2016	1,430	930
LTM	1,616	934

Still, recurring profits did little to cushion the punishing issuance swoon during the last recession.  Revenue from corporate and structured finance bond issuance declined 26% and 53%, respectively, from 2007 to 2008, forcing a ~$575mn revenue decline that translated into a $450mn EBITDA hit.

MIS segment, $ millions
	Revenue*	EBITDA
2007	1,780	1,021
2008	1,205	632
2009	1,218	603
2010	1,405	685
2011	1,569	804
2012	1,887	991
2013	2,059	1,116
2014	2,248	1,277
2015	2,304	1,307
2016	2,340	1,255
LTM	2,550	1,555
* excludes a negligible amount of “other”
non-ratings revenue

We don’t know the profit split between transactional and recurring profits (and I don’t even know if such a determination is possible since labor is the biggest component of SG&A and allocating the cost of an analyst’s time between new issuance and maintenance work feels like arbitrary hair splitting).  But, I think we can confidently say that non-recurring revenue per dollar of new issuance is way larger than recurring revenue pulled from each par dollar of the rated installed base, and so big swings in transactional revenue have a disproportionate impact on profitability…though, keep in mind that heavy debt issuance in a given period adds to the stock of outstanding debt and thus the monitoring fees earned in future periods.

Given the lofty contribution margins attached to new issuance, the prospect of a reversal has been a source of trepidation for me.  Transactional revenue growth has proceeded at a strong, though not torrid, 12% pace over the last 6-7 years as issuers have seized on a stubbornly low rate environment to refinance debt and add leverage to their balance sheets.

Meanwhile, outside a commodity-driven hiccup in 2016, high yield default rates are well below the historic average (which should give you pause if you believe in cycles and mean reversion).

[Aside: the below exhibit, which breaks out the uses of funds from high yield bond and bank loans, is interesting in its own right.  In the late 1990s, 20%-25% of companies that raised funds cited internal investment as a reason for doing so vs. just a mid-single/high-single digit percentage today.]

I’m being unhelpfully obvious when I say that credit conditions feel toppy.  But even if mean reversion is impending, 2008/2009 seems an inappropriate analog since not only is the catalyst driving systemic financial concerns that loomed so large back then less relevant today, but also a significant chunk of the company’s pre-2008 profits came from its reckless rubber-stamping of toxic asset-backed securities.

(MIS revenue, $mn)
		2007	2008	2009	2010
Structured Finance	868.4	404.7	304.9	290.8
% change		-0.5%	-53.4%	-24.7%	-4.6%
Non-Structured Finance	911.5	800.0	912.8	1,114.2
% change		18.8%	-12.2%	14.1%	22.1%
EBITDA		1,020.5	568.7	543.0	623.5
% change		4.8%	-44.3%	-4.5%	14.8%

Disaggregating MIS’ revenue streams per above, we see that outside of structured finance, the revenue declines were actually not sooo bad during the worst financial crisis in decades, thanks of course to issuance stoked by aggressive rate-deflating monetary policy measures.  Structured finance grew from just $384mn in revenue in 2002 to $873mn in 2006 (an 18% CAGR) and was so profitable that even while non-SF revenue grew by 14% in 2009, overall MIS EBITDA still declined as SF revenue contracted by another 25% from 2008’s harrowing 53% decline.  I don’t believe MIS has significant revenue streams tied to comparably negligent and profligate underwriting today, and would expect the profit hit from a cyclical correction to be far more muted.  

Also, due to the surge in 7-10 year paper subsequent to the financial crisis – MIS’ non-structured revenue increased by 17%/yr from 2008 to 2012 – the refinancing needs over the next 4 year period (2017 to 2020) are 30% greater than they were from 2013 to 2016, providing an intermediate tailwind to transactional revenue, though 1h17’s whopping 30% y/y growth in corporate finance revs is clearly testament to some pull-forward of refinancing needs. Debt issuance cycle aside, companies have been increasingly tapping the capital markets, rather than banks, for their debt funding needs.  In Europe, bonds constitute just 23% of non-financial debt [bonds + bank loans] outstanding vs. 52% in the US, with the mix shifting in favor of bonds over at least the last decade.

Management thinks that disintermediation (+2%-3%) plus debt issuance prompted by global GDP growth (+2%-3%) plus pricing (+3%-4%) should sum up to around ~high-single/low double digit revenue growth through the debt cycle, which sounds reasonable to me and is consistent with the 9% revenue CAGR MIS has realized since 2011. And on top of that, there’s another 2%-3% contribution from Moody’s Analytics, MCO’s less good business segment that offers a range of risk management, research, and data products and services, and constitutes about 1/3 of revenue and 16% of EBITDA (corporate overhead is already allocated to business segments).  Almost all of the ~$1bn that the company has spent on acquisitions (out of cumulative free cash flow of ~$8bn) over the last decade through 1q17 has gone towards bolstering MA, mostly small tuck-ins.

Then, on May 15, 2017, management announced the €3bn acquisition of Bureau van Dijk.  Moody’s is spending 3x more on this one acquisition than it has on the sum of all previous acquisitions over the last decade.  BvD is an Amsterdam-based company that aggregates data on 220mn private companies across a wide range of geographies and industries and makes it available in hygienic, organized form to 6k corporate and government customers.  This acquisition will be “tucked into” RD&A [In 2016, about 54% of MA’s revenue came from “Research, Data, and Analytics,” which is really just an extension of MIS insofar as it realizes revenue by selling research and data (analysis on debt issuers, economic commentary, quantitative risk scores, etc.) generated in MIS.  The quality of RD&A mirrors that of the ratings segment, with 95% retention rates driving hsd revenue growth (90% organic) from hsd pricing and volume since 2011], boosting its revenue by ~43% (and contributing ~8% to MCO’s total revenue). BvD does not own the data, but rather licenses it from 160mn obscure data providers in various jurisdictions before “cleansing” and standardizing it for subscribers who use it to, for instance, better assess credit risk, conduct M&A due diligence, set transfer pricing reporting policies and docs for multinationals, and identify potential B2B sales leads.  

Management claims that this business benefits from network effects, by which I assume they mean that the license fees BvD pays to suppliers are pegged to the number of users of that data and so more users compel more suppliers to make their data available to BvD, which in turn draws more users.  Going off the high-level historical financials provided by Moody’s, BvD has performed like a truly kick-ass asset, with revenue expanding at a steady 9% CAGR (all organic) over the last decade, growing every year right through the recession, and EBITDA margins expanding from 39% in 2006 to 51% in 2016. But great assets go for great prices.  MCO is paying a lofty 12x revenue and 23x EBITDA at a time when its own stock traded at “just” ~14x at the time of announcement.  €3bn is triple what private equity firm EQT paid for BvD less than 3 years ago.  One might argue that if we extrapolate the last decade’s 12% annual EBITDA growth out 5 years (which might actually be reasonable given the seemingly predictable, consistent nature of the business) and apply estimated out-year synergies ($40mn revenue / $40mn costs), we’re looking at €295mn in 2021 EBITDA, which puts the multiple at ~10x, but even management concedes that it is reaching on valuation and falling short of their typical 10% cash yield target on this one. The revenue synergies seem fairly modest (14% of revenue, 5 years out) and sensible on the surface.  For various reasons BvD has found it difficult to break into the US market (unlike regions outside the US, financial data on private companies in the US is sparse…plus, BvD who?) and still derives 3/4 of its revenue from Europe.  

Moody’s can bundle BvD’s datasets into MA’s analytics products and sell a more robust bundle to its US customer base.  [Notably, MA already feeds BvD’s data into the loan origination solution it sells to financial institution clients and some MA customers already use BvD data to drive their credit models] and cross-sell MA products into BvD’s customer base.  Finally, BvD’s dataset on smaller, private companies gives MIS the opportunity to provide credit ratings to the underserved SME market, though this seems like a more distant aim. [Here’s a high-level summary of Moody’s business mix post-BvD; MA gets a nice margin lift and its EBITDA increases from ~17% of consolidated to nearly 1/4.]

(MCO LTM + BvD 2016, $ millions)
	MIS	MA	MA+BvD
Revenue	2,550	1,272	1,560
EBITDA	1,555	290	438
% margin	61%	23%	28%

Still, most of management’s justifications – the acquisition reduces the volatility of the ratings business, is accretive to per share earnings, accelerates growth forecasts, gets the company access to new revenue opportunities like transfer pricing and tax planning that have little to do with the core ratings business – have jack to do with value creation and reek of generic Wall Street pandering.  And while BvD’s business seems good enough on its own merits that I don’t think the acquisition will be grossly value destructive, it’s tough to credibly claim that much incremental value has been added at this lofty purchase multiple.

Outside of RD&A, there are two other business lines: 1) Enterprise Risk Solutions (11% of post-BvD revenue; risk management software and services…basically, financial institutions use Moody’s tools to create credit, market, and operational risk tables and make them available to their regulators; has grown revenue by ~11% organically over the last 8 years) and 2) Professional Services (4% of post-BvD revenue; financial training and certification, mid-single digit organic revenue growth since 2008….seems like a pretty mediocre business, but one which management insists is an important entry point to the customer). Taken as a whole, Moody’s Analytics is just “meh” compared to other data and analytics peers, in my opinon.  Great analytics businesses tend to have self-reinforcing data feedback loops, which are not very relevant to MA.

[Here is what I wrote about Verisk: The company sits at the center of a network that procures data from a wide variety of sources on one side (claims settlements, remote imagery, auto OEMs, name your buzz word – smart cars, smart watches, smart cities) analyzes it, and spits out predictive risk and customer insights to their clients on the other (insurers, advertisers, property managers).  The agreements through which a customer licenses VRSK’s data also allows the company to make use of that customer’s data, so essentially the customer pays Verisk for a solution that costs almost nothing for the company to deliver and Verisk gets to use that customer’s data to bolster the appeal of its own products, which improved solutions reduce churn and attract even more customers (and their data) in a subsidized feedback loop.]

Its solutions seem more akin to templated reporting and risk management to sate regulatory requirements than data-fueled machine learning algorithms to drive business outcomes.  Management continuously talks about realizing synergies from tuck-ins and driving operating leverage, but the fact of the matter is that MA margins have gone nowhere for years and I think it’s fair to say that this side of the company has disappointed expectations. So, stepping back…nearly 80% of MCO’s pro-forma EBITDA comes from a ratings business that has long established itself as the de facto credit risk benchmark, relied upon by all significant players in the fixed income ecosystem.  But while MIS is a structurally advantaged business that will continue heaping value over time, because 60% of MIS is high-margin transactional revenue tied to new issuance, it is also unavoidably cyclical, and conditions today seem about as good as they will get.  Through the cycle, MIS is a steady high-single digit revenue / low-double-digit EBITDA grower generating prodigious free cash flow (30% of revenue converts to free cash flow).  Most of it will be mechanically dedicated to buybacks and dividends, which is probably just as well since its tuck-in acquisitions have had little to show, and I suspect the same will be true of BvD.  At $134, the stock trades at 18x/23x my estimate of pro-forma LTM EBITDA/cash EPS.  The EBITDA multiple is about as high as it has been in decades (matched only in late 2005/early 2006) on what in retrospect will likely turn out to be cyclically peak earnings.  Moody’s is a great business and is priced accordingly, though with a long enough time frame, a buyer will probably do just fine even at the current valuation.

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