In this article, I will discuss a fascinating dividend growth stock that scores high on dividend growth and safety but absolutely miserably on “yield.” My most recent article covering the Moody’s Corporation (NYSE:MCO) was back in August of 2021. Back then, I explained that the stock was a great dividend company, yet the valuation was terrible. Fast forward to May 2022: the stock is still a great dividend play, but the valuation has improved due to the market sell-off and bad company earnings.
In this article, I will update my long-term bull thesis and make the case for a dividend investment in Moody’s. Unfortunately, I will also have to explain why it’s a terrible stock for income-oriented investors. Hence my title.
So, let’s get to it.
A Great Dividend Scorecard
I’m a member of a lot of Meta/Facebook (FB) dividend (growth) groups. The only reason is that I love to observe how retail investors pick stocks for their investment portfolios. After all, people who don’t invest in index funds can pick from an almost endless collection of dividend stocks. It’s like watching people at an all-you-can-eat buffet. You see the weirdest, but also most interesting, things.
I don’t mean this in a condescending way, but sometimes people make some obvious mistakes that I like to address in my articles. It always ends up being based on the high yield vs. dividend growth debate. It’s a lot of fun to collect high dividends every quarter, but it’s also a lot of fun to see that a company one owns announces a big fat dividend hike.
The difficulty is finding a balance between the two. It’s really easy to fall for the “yield trap” – especially for younger investors. My opinion is that we can “always” buy high yield when we want to. If necessary, there’s always a quality REIT or consumer staple with a decent yield. This includes preferred shares in various companies. Why? Because high yield stocks tend to have lower (expected) capital gains – that influences the yield as well.
Finding quality dividend growth is a different story. And, historically speaking, it’s the best source of wealth. Since the 1970s, dividend growers and initiators have led the market by a big margin. Dividend payers, in general, were not bad, but dividend growth is where you want to be if you’re not dependent on a dividend income, of course.
See, if you’re retired and dependent on income, everything changes. That’s where capital allocation changes. Investors take profits on higher growth stocks and move money into assets that pay a regular stream of income to satisfy their daily needs.
That’s where Moody’s dividend scorecard comes in – provided by Seeking Alpha. These are relative grades compared to the financial sector. The company gets high scores on dividend safety, dividend growth, and dividend consistency. The dividend yield, though, is a big fat F. In this case, the company is paying a quarterly dividend of $0.70 per share since raising the dividend by 12.9% on February 10, 2022. This implies a $2.80 annual dividend or 0.95% based on a $300 stock price (post-earnings).
A yield below 1% isn’t that great, but it also isn’t necessarily F-grade worthy. The only reason the grade is an F is that, in the financial sector, the yield is compared to a lot of money center banks and regional banks. These stocks have low growth, but a high yield. Hence, in the “average” sector, I guess dividend growth would be close to B+ or A with a yield grade close to C.
So, let’s look at some numbers.
Explaining Dividend Safety And Growth
Moody’s is operating two business segments. Last year, the company generated 64% of its revenue in Investor Services. The remaining exposure came from Analytics.
Investor Services is where most people know the company from, as it rates everything in its path (more or less). Governments, companies, structured products, you name it. MCO dominates the rating space together with its peer S&P Global (SPGI). A Moody’s rating is the “gold” standard used by various financial players looking to rate i.e., financial risks. Needless to say, a good MCO rating is also necessary for corporates to allow them to have access to capital. As of 2021, more than 35,000 organizations and deals have been rated. This includes 145 countries, 49 supranational institutions, 15,500 public finance issuers, and a total debt volume of $73 trillion.
On a medium-term (<5 years) basis, the company targets low-to-mid-single-digit % growth in this segment’s revenue.
After 2007, the company started to expand into the financial space beyond ratings, establishing Moody’s Analytics. According to the company:
Moody’s Analytics (“MA”) is a global provider of: i) data and information; ii) research and insights; and iii) decision solutions, which help companies make better and faster decisions. MA leverages its industry expertise across multiple risks such as credit, market, financial crime, supply chain, catastrophe and climate to deliver integrated risk assessment solutions that enable business leaders to identify, measure and manage the implications of interrelated risks and opportunities.
Analytics services more than 1,800 asset managers, 2,300 commercial banks, 3,600 corporations, more than 800 real estate firms, 900 insurance companies, and more than 5,300 government agencies.
In this segment, medium-term annual revenue growth is expected to be in the low-to-mid-single-digit % range.
Over the next few years, EBITDA growth is expected to be in the double-digit range. Between 2016 and 2014E, annual compounding EBITDA growth is 10.4%. This is also based on rising profitability. In 2016, the company had an EBITDA margin of 45.5%. That’s expected to rise to more than 50% after 2023. It will more than likely allow free cash flow to make it above $3.0 billion. The annual compounded FCF growth rate between 2016 and 2024E is 12.2%.
FCF is basically net income adjusted for non-cash operating items and capital expenditures. It’s money a company can spend on dividends, buybacks, debt reduction or just keep it to acquire companies in the future.
If we use 2023 as an example, the company is expected to do $2.6 billion in free cash flow. That’s roughly 4.7% of the company’s $55ish market cap.
This explains why dividend safety and dividend growth are both rated A+. A 4.7% FCF yield allows the company to grow dividends by double digits well into the future. And it also means that dividend safety is very high. Even if free cash flow were to drop 50%, the dividend would be safe.
The 10-year average annual dividend growth rate of MCO is 16.1%. The five-year average is 11.4%. I expect that average to hold on a longer-term basis.
The company also engages in buybacks, as it lowered the number of common shares outstanding by 2.6% between 2017 and 2021. That’s not a lot, but it does add up over time.
This allowed investors to enjoy above-average returns. Over the past 10 years, for example, the stock returned 778% (including dividends). This is after a 38% drawdown and well above the 254% return of the S&P 500, which isn’t a bad return either.
The fact that the stock is coming down is great news, as it finally gives us a somewhat decent valuation.
The stock market isn’t in a great spot. The S&P 500 is roughly 14% below its all-time high while I’m writing this. We’re encountering a mix of slowing economic growth, a strong Federal Reserve hiking cycle (into weakness), high inflation, Chinese lockdowns, supply chain issues, and the war in Ukraine that is putting a floor under already high inflation (mainly food).
Additionally, and I already briefly mentioned it, the stock is down more than 5% after earnings, to $300.
The company is suffering from high market uncertainty as companies have dialed-back borrowing in times of uncertainty. According to Seeking Alpha:
The company pruned its FY2022 adjusted EPS guidance to $9.85-$10.35 from its previous range of $10.75-$11.25; bringing the new range far below the average analyst estimate of $11.88.
Revenue for Moody’s Investor Services (“MIS”) fell 20% Y/Y in Q1 2022 as geopolitical concerns, rising yields, and elevated market uncertainty affected issuance in all asset classes. Foreign currency translation hurt MIS revenue by 1%, the company said.
Corporate finance revenue of $417M dropped 31% Y/Y, largely due to the decline in leveraged finance issuance after a record period in 2021. While global investment grade activity slowed in Q1, Moody’s (MCO) said it saw a notable rebound in March.
While the company more than likely will lower 2022 expectations, the long-term trend is not likely to suffer. If anything, it’s good to get a lot of negativity priced in.
As a result, the stock now has a $55 billion market cap. Net debt is expected to average $4.9 billion in the years after 2022, which is roughly 1.3x expected EBITDA. That’s very low, and it allows the company to focus on dividends and buybacks. Moreover, the company has $235 million in pension-related debt as well as $190 million in minority interest. All of this gives us an enterprise value of $60.3 billion. That’s 17.2x next year’s expected EBITDA of $3.5 billion.
17.2x next year’s expected EBITDA isn’t overvalued. However, it also isn’t very cheap. The good news is that the implied free cash flow yield of 4.6% is a good deal. If economic growth and uncertainty improve after this year, companies will more than likely accelerate debt offering and double-digit growth returns. At that point, a 4.6% yield is a good deal. The same goes for 17.2x expected EBITDA (fair valuation).
So, here’s how I would deal with the stock.
Although the market environment has changed a bit given higher economic uncertainty, a Federal Reserve that’s about to hike into weakness, the war in Ukraine that is still raging on, and inflation remaining an issue, I still like MCO. After I said last year that the stock was too expensive, we’re now seeing that the valuation has come down to what I consider to be a “fair” value.
For dividend investors, the stock offers a yield close to 1% and what I believe will remain long-term double-digit dividend growth with support from buybacks.
The company has a healthy balance sheet, and while growth has taken a big hit due to uncertainty in the first quarter, I have little doubt that Investor Services and Analytics will provide the company with long-term double-digit EBITDA and free cash flow growth.
The problem is finding a bottom. Everyone tries to buy as low as possible, which makes total sense, but finding the lowest price is often impossible.
Interested dividend growth investors should break up their initial investment. For example, buy 25% now and add over time. If the stock falls further, investors get to average down. If the stock rallies, investors have a foot in the door.
Given ongoing uncertainty, I think that’s the most efficient way to deal with this stock for dividend investors.
(Dis)agree? Let me know in the comments!