Published on June 17th, 2018 by Josh Arnold
The rating agencies in the U.S. have enjoyed an enormous bull market since the Great Recession ended almost a decade ago. Their stocks have all moved significantly higher as their business models have adapted to a world that is moving towards greater analytical capabilities for investors using real-time data, in addition to the core ratings business.
In this article, we’ll take a look at the three largest publicly-traded ratings agencies in the US – Morningstar (MORN), Moody’s (MCO) and S&P Global (SPGI) – and rank them according to their total return potential. Fitch Ratings is also a major ratings agency, but it is not publicly-traded.
Morningstar, Moody’s, and S&P Global are all on our list of 1,263 dividend-paying financial services stocks.
Rankings are derived from our Sure Analysis Research Database, which ranks stocks based upon the combination of their dividend yield, earnings-per-share growth potential and valuation to compute total returns. The stocks are listed in order below, with #1 being the most attractive for investors today.
Read on to see which ratings agency stock is ranked the highest in our Sure Analysis Research Database.
Ratings Agency Dividend Stock #3 – Morningstar, Inc. (MORN)
Morningstar, Inc. was founded in 1984 by Joe Mansueto in his apartment in Chicago. The following year, Morningstar produced its first ratings for mutual funds and since then, it has grown into a financial services powerhouse that provides a variety of related services to individual and institutional investors alike. The company today is approaching $1B in annual revenue and has a market cap of $5.6B.
The company’s recently report Q1 earnings were very strong as it saw revenue rise 16.2% over the comparable quarter last year. Organic revenue was the driver as it contributed 13.7% of the total gain, due in part to the company’s relatively new PitchBook service, which was acquired just over a year ago. Earnings-per-share more than doubled as a much lower tax rate as well as some operating leverage contributed as a result of much higher revenue.
Source: Investor presentation, page 48
This slide from the company’s recent shareholder meeting shows the enormous amount of growth the company is achieving and the very important fact that it is broad-based. Its license business continues to be the primary driver of revenue growth and with the success of the PitchBook business – which continues to post double-digit gains in revenue – Morningstar’s growth looks set to continue.
Morningstar’s earnings-per-share history over the past decade paints a picture of a stable, yet growing company. It has seen average earnings-per-share growth of 6% in the past ten years, which is no small feat given the wide array of economic conditions that have existed in the US in that time frame, as well as the rapidly-changing landscape of the ratings business. To that end, we see Morningstar as producing 6.1% average earnings-per-share growth annually going forward.
This year will see Morningstar gain from a substantially lower tax rate as well as the PitchBook business, which is still growing its subscriber base very rapidly. However, after this year those gains will be part of the comparable base and thus, earnings-per-share growth will normalize. We see low to mid-single digit revenue growth, a slightly lower share count and some margin expansion from operating leverage as driving this growth, consistent with its past results. Our 2018 estimate is $3.80 per share and looking out to 2023, we see $5.10 in earnings-per-share.
Morningstar will continue to grow its dividend but to be fair, it is not an income stock. The yield today of just 0.8% should rise slightly over time as the payout is raised, but we see it as staying under 1% for the foreseeable future.
Morningstar’s average price-to-earnings ratio has always been very high as investors seem unwavering in their desire to pay a premium for the company’s shares. Today’s price-to-earnings ratio of 34.5 is well in excess of fair value, which we see as 27 times earnings. That implies that Morningstar is likely to see a sizable 5% headwind to total returns going forward from a lower valuation.
Morningstar looks to be a stock with a well-cemented position in an ever-changing industry, but one that is overvalued as of now. Shares have roughly doubled in the past year so we think investors would do well to wait for a better entry price. In total, we see annual returns at just 1.8%, consisting of the current 0.8% yield, 6% earnings-per-share growth and a 5% headwind from the valuation resetting. Morningstar’s future is bright but much or all of its projected growth appears to be priced in right now.
Ratings Agency Dividend Stock #2 – Moody’s Corporation (MCO)
Moody’s was founded in 1909 and the company’s first product, Analyses of Railroad Investments, was an immediate success. The company rather quickly expanded into other sectors and the Moody’s we know today was born. Its enormous growth has afforded the century-old company annual revenue of $4.7B and a market cap of $34B.
The company’s recent first quarter earnings release showed yet another quarter of tremendous growth. Earnings-per-share growth came in at 35% on an adjusted basis as revenue rose 16%. The company’s operating expenses rose sharply but that was mostly attributable to costs associated with the Bureau Van Dijk acquisition. Operating income was favorably impacted by 4% as Moody’s global reach is providing a tailwind from a weakened dollar. Non-US revenue grew 33% during the quarter and now makes up almost half of the company’s total. Finally, management reaffirmed its guidance for $7.65 to $7.85 in earnings-per-share for 2018.
Source: Q1 earnings presentation, page 7
This slide from the company’s Q1 earnings presentation shows the remarkable success Moody’s has enjoyed in the past few years. Revenue continues to grow around 10% per year while margins have remained roughly flat recently. In addition, Moody’s has converted, on average, 28 cents of every dollar of revenue into free cash flow in the past five years, more than doubling the average of S&P 500 companies. This has allowed it to spend cash to assure future growth, something that won’t end anytime soon.
Moody’s earnings-per-share record is very strong in recent years and we certainly don’t see that trend ending. Indeed, we are forecasting 7.3% in earnings-per-share growth annually going forward, building upon its $7.75 for 2018 to produce $11 in earnings-per-share in 2023.
Moody’s will achieve this growth by continuing its long tradition of buying growth, as evidenced by the Bureau Van Dijk purchase, as well as a small amount of organic revenue growth. The company’s operating costs have kept a lid on earnings growth in the past and we believe this will continue to be the case as no strategic shift has occurred. However, Moody’s, like the others in the sector, is enjoying long term tailwinds as investors demand ever-greater amounts of information to make investing decisions. The core US business for Moody’s is growing rather slowly so this growth story is leveraged to the global business. However, that portion of the company is growing nicely and should continue to do so in the foreseeable future.
The company’s current price-to-earnings ratio of 22.7 is well in excess of the company’s fair value, which we see as 17.9 times earnings. Thus, Moody’s looks meaningfully overvalued here, implying a 4.9% annual headwind to total returns from the valuation that should normalize over time.
The dividend should grow at about the same rate as earnings-per-share, meaning we are forecasting a dividend of $2.24 per share in 2023. That should keep the yield right around 1%, where it is today.
Moody’s is a strong growth story that is unfortunately trading well in excess of its fair value today. We are forecasting 3.4% in total annual returns moving forward, consisting of the 1.0% current yield, 7.3% earnings-per-share growth and a 4.9% headwind from a lower price-to-earnings ratio moving forward. Moody’s looks positioned for more growth going forward but with that growth already being priced in, investors that want to own Moody’s should try to wait for a better entry price.
Ratings Agency Dividend Stock #1 – S&P Global (SPGI)
S&P Global traces its roots back to 1860 when Henry Varnum Poor published an investor’s guide to the railroad industry. A long series of mergers since then has created the company we know today and in its current form, SPGI has $6.5B in annual revenue and a $52B market cap.
S&P Global has an impressive history of dividend growth. The company has paid a dividend each year since 1937, and has increased its payout for 45 years in a row. It is on the list of Dividend Aristocrats, a group of 53 stocks with 25+ consecutive years of dividend increases.
The company’s recent first quarter earnings report was very strong, as revenue increased 8%, operating profit margins expanded and earnings-per-share were up 24% year-over-year. Strength came from the company’s S&P Dow Jones Indices business, which saw revenue advance 25% during the quarter. In addition, the company acquired Kensho and Panjiva, both of which are leading edge analytics firms that will fuel further growth for SPGI moving forward in its data and subscription business.
This slide shows the outstanding performance of the company’s indices business overall as well as from exchange-traded derivatives. SPGI’s data business is the smallest in its portfolio but acquisitions and investments in the space like Kensho and Panjiva should fuel expansion of that segment while the core business continues to grow. These trends make SPGI well positioned to continue to grow in the coming years, and we are expecting robust earnings-per-share expansion as a result.
SPGI has grown its revenue by 7% annually in recent years and earnings-per-share has been even better, averaging 20% growth. This outperformance of earnings compared to revenue is due to the company’s expansion of operating margins as well as its buyback, which has reduced the share count over time. We are forecasting $8.53 in earnings-per-share for 2018 and after that, we see 12% annual growth moving forward.
In addition, SPGI continues to see a low single digit tailwind from a lower share count, something that should continue given it recently announced an accelerated $1B repurchase plan. This year’s results will also be helped by a one-time benefit from a substantially lower tax rate but moving forward, SPGI still has plenty of levers it can pull to grow earnings-per-share.
SPGI has been richly valued by investors thanks to its tremendous growth in earnings over the past decade. Today, the stock is trading for 24.3 times this year’s earnings estimates, well in excess of its historical norm of 20.8. As the multiple reverts back closer to fair value, SPGI should see a ~3% headwind to total returns.
We see robust growth in the payout given that earnings-per-share is set to expand at double digit rates, but growth in the share price will keep the yield close to where it is today. We are forecasting a 1.3% yield by 2023 as the payout grows from $2 today to better than $4 in five years.
SPGI’s forecasted total annual returns are by far the strongest of the ratings agency stocks at 10%. These robust returns will be achieved via the current 1% yield, 12% earnings-per-share growth and a 3% headwind from the valuation reverting back to normal levels. SPGI – like Morningstar and Moody’s – isn’t an income stock and likely isn’t suitable for those seeking high yields but dividend growth should be strong, and capital appreciation potential from here remains high despite the massive, multi-year run the stock has enjoyed.