Morgan Stanley Initiates Moody's & McGraw Hill - Why 1 Selected 'Overweight'

On March 26, Morgan Stanley initiated coverage on credit rating stalwarts Moody's Corp.

and McGraw Hill Financial, Inc.

, parent company of the Standard & Poor's rating agency. Now that the overhang of post-financial crises regulatory and legal issues have diminished, Morgan Stanley has turned positive on the ratings industry. Tale Of The Tape - Past 5 Years

Both $28.4 billion cap McGraw Hill and $20.6 billion cap Moody's have dominant, wide-moat franchises, which are ~3x larger than Fitch Ratings, the third ranked firm by revenue. Morgan Stanley - McGraw Hill: Equal-weight, $119 PT Base Case MS $119 PT is based upon a sum-of-the-parts (SOTP) analysis, "with 25x Ratings net income, 24x Capital IQ net income (average of FDS, MORN, & TRI), 27x Indices net income (MSCI multiple), 21x Commodity and 17x Commercial." Morgan Stanley's base case price target represents a 14.75 percent upside from its March 26, close of $104.26 per share.

Notably, the MS base case price target is also 9 percent above McGraw Hill's 52-week high of $109.13 per share.

MHFI - Dominant Benchmark Businesses  MS believes McGraw Hill controls an attractive collection of businesses, including:  "A top two rating agency, a dominant index franchise, a market data platform with high share of investment banking and private equity customers, and a leading price and information provider to the energy industry."  Over the long-run, "return on investment for each of these assets should be above average." MHFI - Margin Expansion Opportunity  MS views MHFI as "more focused" after having shed non-core assets, such as Aviation Week and McGraw Hill Construction, (both highly cyclical businesses).  MS noted that MHFI margins "lag its primary competitor, but there is likely still room to cut corporate overhead."  Now that legal expenses are no longer a margin headwind, "exactly how much margin expansion the company can generate will be a key part of the story."  MS forecasts a 10 percent CAGR for MHFI moving forward vs 14 percent for Moody's. MS - McGraw Hill Price Target Risks 1. Slower than expected debt issuance. 2. Loss of share at Capital IQ. 3. Decline in energy prices reduces demand at Platts. 4. Increased government regulation. Morgan Stanley - Moody's: Overweight, $124 PT Base Case MS $124 PT for MCO is based on a discounted cash flow valuation, "with a WACC of 7.8% and a terminal growth rate of 2.4%;" and represents a 21.4 percent upside from its March 26, close of $102.15 per share.

Notably, the MS base case PT is also is also 19.4 percent above Moody's 52-week high of $104.58 per share.

MCO - More Exposure to Credit Ratings  About 85% of Moody's revenue comes from its high margin credit ratings business.  MS expects issuance growth to accelerate into 2017, and "it should drive 14% EPS CAGR over five years."  If industry multiples continue to expand to historic levels, MS believes there is even more upside. Countercyclical Nature of Moody's Analytics  Moody's Analytics "is bigger and more countercyclical than it was during the last crisis, and [MS believes] Enterprise Risk Solutions could provide a nice buffer in a downturn."  MS feels the countercyclical aspect "would lead to only a ~15-20% decline in net income this time vs 37% in 2007-2008."  That is the logic behind MS viewing "Moody's as having more leverage to the upside and more downside protection than McGraw Hill." MS - Moody's Price Target Risks 1. Long stretch of low rates may temper upcoming issuance. 2. Significant legal penalties. 3. Increased government regulation. MS - EPS vs Consensus Estimates MS - Moody's Superior Upside/Downside

Key Revenue Metric MS made it clear that both of these "duopoly" ratings agencies franchises were positioned to "clip coupons," (by receiving fees), on an increasing amount of debt issuance; and likewise, would suffer from a reduction in corporate debt issuance. While both of these ratings agencies have multiple revenue streams, debt ratings are clearly the goose that lays the golden eggs.