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Lecture 10 Moody's Corporation Example

Lecture 10 Moody's Corporation Example

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Lecture 10: Analyzing Buffett
’s Purchase of 
Coke in order to Purchase Moody
swww.csinvesting.wordpress.comstudying/teaching/investing Page 1
March 30, 2005
Buying
MCO 
at 21x Forward Earnings orHow We Learned from
Buffett 
’s Purchase of 
Coca-Cola 
 
Go here to download MCO
s 2001 Annual Report If you wish to review Moody
GI
) Introduction:Presentation by AB
,
my partner from XX
Partners 
. He has been with me for the last 15 or 16years. He is a brilliant investor.He will talk about how we are value investors but we also are paying a lot more than we wereaccustomed for some company. Redefining value based on what it is worth rather than lowprice/book or low P/E. And it sort of opens up a similar discussion to what we talked about with
Amex (discussed in prior lectures)
to some degree. It is sort of another tool/arrow in your quiveror in your arsenal
(just like using LEAPS 
). To pay a decent price for a good company. You donot have to go through life doing that. I think it is harder to do, because you have less room forerror.
If you are going to pay up
1
, you better understand the business and know why itshould be worth more.
It is hard to do because you can screw up. This example certainlyshows how important returns on capital are when you are trying to figure out a fair multiple forthat earnings stream.Summary: Return on Invested Capital is key, but what multiple is fair? There is less room forerror in buying great businesses since you must really understand the business.
Rob 
will go through an analysis of a company where we paid up.The second half of the class we will go through screening techniques
Robert Goldstein (RG) 
: We were looking at
 
Moody’s (MCO)
business after its spin-off from
Dun & Bradstreet 
, but it was priced at 21x forward earnings. Was the greatness priced in?
To help answer that question we chose to compare our potential purchase of
Moody’s
 with
Buffett’s
purchase of
Coke 
.
(This is a creative comparison of two companies in separate industries).Buffett 
began buying
Coke 
in 1988.
Buffett 
figured out that by buying a great business, he couldmake a fortune. In 1988,
Buffett 
invested $650 million in
Coke 
stock. He paid 15 times trailingearnings. 12 years later he was up 10 times his initial investment. Obviously, he knew what hewas doing. The question then is why
Coke 
is a great business? It was growing, it had highreturns on capital and it had a very long lasting competitive advantage so five years down the
1
 
Graham neither paid a premium for growth nor even much for the present. Beware of paying a premium for futuregrowth rates. If you do pay over asset/replacement value you are in the realm of franchises and you must determinethe competitive advantages and barriers to entry that will protect future growth and keep it profitable.
 
Lecture 10: Analyzing Buffett
’s Purchase of 
Coke in order to Purchase Moody
swww.csinvesting.wordpress.comstudying/teaching/investing Page 2
road you are still going to have
Coke 
and its advantages
the same as when you initially boughtthe company.To give you a little bit of history: originally
Moody’s
revenue came from bond investors who paidfor
Moody’s
ratings. Then the rating industry changed dramatically in the 1970s because therating companies began to charge issuers as well as investors. And this was a huge deal for
Moody’s
because it meant that rating agencies had gained so much clout, they could chargecompanies who wished to issue debt or else they would face higher borrowing costs in themarket.Today
Moody’s
and
S&P 
both have about 40% of the rating industry. Frequently companies getratings from both rating agencies. Since ratings are very important in the capital market,companies issuing debt will get ratings from both companies since these companies do notwant to be dependent upon one rating agency.
MCO 
’s 2000 FY
Revenue GrowthRateOperating Profit Growth Rate
Growth rate for 19 years 15% 17%In 19 years only 1 year of decline in revenue. Very stable.Does past success = future success?
Sometimes it does and sometimes it doesn’t.
MCO’s
 growth rate is phenomenal considering its long time period.Look at the market share stability. The global public debt market grew rapidly over the past 25years. Basically what was happening was that there was disintermediation in the debt markets.Banks were doing less lending so companies were moving to issue more debt in the publicmarkets, therefore they needed more ratings. You had more securitizations for mortgage loans,car loans
the financial markets were evolving. The market share had not changed much
itwas predominantly
Moody’s
and
S&P 
. It was our conclusion that
MCO 
’s growth was likely to
continue. Europe and Asia emergence can provide future growth. Less competitive pressure.It was easy to understand there would be a lot of future growth and not much competitivepressure. Both rating agencies had to be paid. It was very unlikely someone could enter thebusiness because you need credibility. No matter how profitable the business or fast it was
growing, a competitor could not obtain the confidence of the customer’s CFO nor e
nter themarket easily. It is like paying the Mafia.In December 1999, Dun & Bradstreet
“ 
D&B 
” 
 )
announced that they would split into twobusinesses.
D&B 
was selling for $27 a share and you were going to get ½ a share of
MCO 
andwe assume in a worst case scenario that one share of D&B was worth $15 so the half sharewas at $7.5 per share. You were effectively paying $24 a share. At the time, I expected
Moody’s
to earn $0.95 per share in 2000.
GI 
: At the time we had no idea where Dun &Bradstreet would trade, so the $7.50 we were usingwas very conservative, so we thought this was a worst case of what we were paying.
KO MCO 
 
6/1988 3/2000 
Price $5 $20.25EPS $0.33 $0.85
 
Lecture 10: Analyzing Buffett
’s Purchase of 
Coke in order to Purchase Moody
swww.csinvesting.wordpress.comstudying/teaching/investing Page 3
Forward EPS $0.39 $0.95Trailing P/E 15 24Forward P/E 13 21This meant that at a $0.95 EPS we were paying 21x forward earnings. Much more than
Buffett 
 paid $4.5 to $5 for
Coke 
he paid 13x
 –
15 xs for
Coke 
.
GI 
: This was a new animal for us. We had never seen a business (
MCO 
) this good with a 19-year growth rate and no need to reinvest money. So we went back to the Master,
Buffett 
, andpicked something
(KO)
that worked out well for him. So at first blush, if you looked at (the chart),this is what we saw. Were we getting as good a deal as
Buffett 
did buying
Coke 
in 1988? At firstblush it does not look that way.
XG: 
This is how
Berkshire 
did on its investment in
Coca-Cola 
:
Coke 
returned 80% of its invested capital return to shareholders and the P/E expanded from 13to 40.
1/3 of the gain
came from
P/E expansion
.
Warren 
 
Buffett 
paid $5 for
Coke 
and in 12 years it went to $58 (not including dividendsreceived). Investment at June 2000: $4.75 in dividends x 6% rate of return = $6 in dividends byJune of 2000. $5 to $64 or ($58+ $6) in 12 years. Leave taxes out so you get a 23% CAGR.His initial outlay of $5 turned into $64 in 12 years. That brings us to the next question
why did
Coke 
do so well?Answer:
Coke 
’s ROE was high for a very long time.
COKE 
’s Annual CAGR
10 Years 15 Years
Unit Case Volume 7% 8%
 
Buffett 
buys
Coke 
in 1988 and he stillholds over 200 million shares. Heregretted not selling
in the late 1990’s
.

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