Earnings Call Transcript - MCO Q3 2022

Operator, Operator

Good day, everyone, and welcome to the Moody’s Corporation Third Quarter 2022 Earnings Conference Call. At this time, I would like to inform you that this conference is being recorded and that all participants are in a listen-only mode. At the request of the Company, we will open the conference up for questions and answers following the presentation. I will now turn the call over to Shivani Kak, Head of Investor Relations. Please go ahead.

Shivani Kak, Head of Investor Relations

Thank you. And good afternoon, everyone, and thank you for joining us today. I’m Shivani Kak, Head of Investor Relations. This morning, Moody’s released its results for the third quarter of 2022 as well as our revised outlook for full year 2022. The earnings press release and a presentation to accompany this teleconference are both available on our website at ir.moodys.com. During this call, we will also be presenting non-GAAP or adjusted figures. Please refer to the tables at the end of our earnings press release, filed this morning for a reconciliation between all adjusted measures referenced during this call in U.S. GAAP. I call your attention to the safe harbor language, which can be found towards the end of our earnings release. Today’s remarks may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In accordance with the act, I also direct your attention to Management’s Discussion and Analysis section and the risk factors discussed in our annual report on Form 10-K for the year ended December 31, 2021, and in other SEC filings made by the Company, which are available on our website and on the SEC’s website. These, together with the safe harbor statement, set forth important factors that could cause actual results to differ materially from those contained in any such forward-looking statements. I would also like to point out that members of the media may be on the call this morning in a listen-only mode. Rob Fauber, Moody’s President and Chief Executive Officer, will provide an overview of our results and outlook, after which he’ll be joined by Mark Kaye, Moody’s Chief Financial Officer, to answer your questions. I will now turn the call over to Rob Fauber.

Rob Fauber, President and CEO

Thanks, Shivani. Good afternoon. Thanks to everybody for joining today’s call. And like I did last quarter, I’m going to start with a few takeaways. And as everybody’s aware, during the third quarter, macroeconomic and geopolitical conditions continued to deteriorate. And that further suppressed the global debt issuance markets from the already subdued levels that we have seen in the first half of the year. At the same time, these conditions supported increasing customer demand for data and analytics to identify, measure and manage risk. And against this backdrop, our MA business continued to perform well, with strong revenue growth of 14%, while MIS revenue declined by 36%. Overall, Moody’s generated $1.3 billion in revenue, with an adjusted operating margin of 39%. We expect that low issuance volumes, particularly in the leveraged finance space, will persist through the remainder of the year. And as a result, we’re revising several of our 2022 outlook metrics, including our guidance for total Moody’s revenue, which is now expected to decline in the low double-digit range. We’re also updating our outlook for full year adjusted diluted EPS to now be between $8.20 and $8.50. In response to the expectation for continued economic headwinds, we’re also taking decisive steps to reduce our expense run rate by at least $200 million by year-end. The cost savings will be realized across the Company and include a more than doubling in the size of our previously announced restructuring program, as well as various additional cost efficiency initiatives. Collectively, these actions put us in a position of strength as we head into 2023. I’ll provide some additional details later in the call. For the third quarter, MA recorded strong revenue growth of 14% and a 9% increase in annualized recurring revenue or ARR. With over half of MA’s business outside of the U.S., foreign exchange rates had an outsized impact on MA’s revenue growth, lowering it by 7 percentage points. For MIS, the 36% decrease in revenue against the record prior year period was driven by a 41% reduction in issuance. This resulted in a 16% decline in Moody’s revenue, and the negative impact of foreign currency movements on total Moody’s revenue was 4 percentage points. Expenses grew just 1% in the third quarter as we continue to execute efficiency initiatives and emphasize cost discipline. The net impact of lower revenue and controlled expenses translated to adjusted operating income of $497 million for the quarter, and adjusted diluted EPS of $1.85. Let me provide some additional context on the conditions impacting the issuance levels and our revised full-year outlook for MIS. At the beginning of the year, like others in the market, we anticipated that elevated levels of inflation would be transitory and slowly abate over the course of 2022. Instead, the conflict in Ukraine further impacted market confidence and commodity price shocks pushed inflation higher. These factors prompted central banks to raise interest rates further and faster than expected, reaching levels we haven’t seen for more than a decade, which has resulted in ongoing uncertainty and volatility in the capital markets. Meanwhile, corporate balance sheets remained robust following a surge in opportunistic pandemic-era financing, allowing issuers to stay on the sidelines given market conditions. We expect that these macroeconomic and geopolitical conditions will continue to mute issuance levels, at least through year-end. In light of this, we’re updating our guidance for 2022 MIS rated issuance to decline in the mid-30s percent range. Full year MIS revenue is now projected to decrease by approximately 30%. While the outlook for next year will depend on the pace and scope of market stabilization and recovery, we’re confident that conditions will improve over time and that the key growth drivers for issuance will resume. This year, only a little more than a quarter of the first-time mandates that we signed have gone to market, meaning there’s a backlog waiting to tap the markets. To leverage those opportunities, our teams have been engaging extensively with investors and issuers. We haven’t been sitting still. We’ve been building our domestic rating franchises, including in Africa with the majority acquisition of GCR and across Latin America through Moody’s Local. We’ve made significant progress in digitizing our content to improve the customer experience and to drive increased usage. As we look ahead, our pricing opportunity remains intact, with over $4 trillion in refunding needs that will likely be refinanced over the coming four years. In short, we're continuing to deliver on our differentiated strategy to be the agency of choice for our customers. While current conditions for MIS are challenging, as those ease, issuance will accelerate, and we will be well positioned to capture growth and operating leverage through our extensive market presence. Now turning to MA, which despite the challenging market conditions, delivered another impressive quarter of revenue growth and margin expansion. 59 consecutive quarters of revenue growth, MA has proven to be acyclical and the third quarter was no different. MA reported 14% revenue growth, or 9% on an organic constant currency basis. With best-in-class retention rates and growing customer demand, MA also achieved 9% ARR growth for the third quarter, inclusive of RMS. We’re confirming our top line revenue guidance for 2022. MA full year revenue is expected to increase in the mid-teens percent range, despite a 5 percentage-point headwind from foreign exchange rates. We expect ARR to accelerate to low-double-digit percent growth by year-end. We’re also raising the MA adjusted margin guidance to approximately 30%, a 100 basis-point increase over our prior guidance, reflecting ongoing expense efficiency. Let me take a moment to highlight our fastest growing business, KYC and Compliance Solutions. In recent years, we’ve invested organically and inorganically, acquiring, developing, and integrating data analytics and technology to create a world-class set of solutions. This combination supports new use cases around counterparty verification, enabling us to grow with existing customers and add new customers in areas like the fintech, corporate, and government sectors. We continue to receive industry awards and recognition, including most recently a top right quadrant positioning from Chartis. We won the AI breakthrough award for our innovative solution for fraud prevention, one of the increasing number of places where we’re being recognized for the integration of artificial intelligence into our solutions. As we pass the one-year anniversary of the RMS acquisition, let me give a quick update on that. We’re on track to achieve the financial targets announced last August, and I’m excited about the opportunities that lie ahead. We are laser-focused on maximizing our synergy opportunities by launching new products and pursuing markets that leverage our combined capabilities and strengths. For example, this past quarter, we launched our ESG underwriting solution for property and casualty insurers, integrating Moody’s extensive data to help them operationalize ESG risk assessment into their insurance underwriting workflows. I also want to recognize the great work being done by our colleagues at RMS. In my meetings with customers over the last few months, I’ve heard firsthand how important our solutions are in helping the industry address an increasing array of risks, including assisting our customers in quantifying the financial impact of hurricanes Fiona and Ian. Moving to the restructuring plan that I mentioned earlier, on our last earnings call, we said we would take additional actions to manage expenses and improve operating leverage if we observed further deterioration in the external environment. Given our view that the weakness in the issuance market will likely persist through at least the fourth quarter of 2022, our teams have undertaken a careful review of prioritization of ongoing initiatives and identified several avenues for meaningful savings. We are expanding our restructuring program to more than double, providing up to $135 million in savings in 2023 from a combination of rationalizing our real estate footprint and reducing our global workforce to reflect the reality of the current market environment. We have also undertaken a careful prioritization of ongoing initiatives in light of our current business priorities, identifying up to $100 million in additional savings. Collectively, these are projected to lower our 2023 expense run rate by at least $200 million. As we take these decisive actions, we will be mindful to invest and allocate resources to maintain the rigor and quality of our ratings and processes. Look, these are challenging and uncertain times, and we are prioritizing financial discipline today while ensuring we are well-positioned to capture growth opportunities tomorrow. That concludes my prepared remarks. Mark and I would be pleased to take your questions.

Operator, Operator

Thank you. The first question is from Ashish Sabadra with RBC Capital Markets. Please go ahead.

Ashish Sabadra, Analyst

Thanks for taking my question. I was just wondering, as we think into 2023, if you could provide any initial color on how we should think about issuance. There was obviously an expectation that we may see a big bounce back in issuance. Is that still an expectation as we get into 2023? Or just given the higher interest rate, is it more reasonable to think about a gradual recovery? I was just wondering if you could share some initial thoughts. Thanks.

Rob Fauber, President and CEO

Hi, Ashish. It’s Rob. I’m pretty sure we are going to get multiple questions around issuance environment and issuance outlook. Let me start with a big picture view, and then as the call progresses, we will continue to drill down, and I know we’ll talk about 2023. You’ve heard me say on these earnings calls, that I thought the market could absorb rate increases as long as they were well anticipated and accompanied by economic growth. That is not what we have had this year. The tightening cycle is really the steepest in the past two decades, initially surprising the market, and it has been accompanied by decelerating economic growth. Back on the last call, I talked about factors disrupting the market. Despite those factors, we expected issuance for 2022 to come in roughly in line with the average issuance from 2012 to 2019, excluding the pandemic years of 2020 and 2021. However, given the weakness in the third quarter, we expect overall global issuance to be down something close to 10% from that historical average. What has changed is that we now expect corporate issuance, including investment-grade and leveraged finance, to be down almost 30% from that historical average excluding the pandemic. This highlights the depth of the cyclical contraction that we’re dealing with at the moment. The key is for the market to get some certainty before it can start to reduce volatility. I’ll pause there, and I’m sure we’re going to have more issuance questions as we go forward.

Operator, Operator

Your next question is from the line of Manav Patnaik with Barclays. Please go ahead.

Manav Patnaik, Analyst

Yes. Maybe I’ll follow-up as you anticipated, Rob. You talked about $4 trillion of refinancing needs over four years. I was hoping you could help us understand how that breaks out. It looks like more of it might be in ‘24, but just curious about your numbers. And then, in a typical year, how much was refinancing as part of the divination, compared to the rest of the categories, which might just be more on capital allocation as a group, if that’s correct?

Rob Fauber, President and CEO

We included a slide in the supplemental materials around the maturity walls. It’s about $4 trillion to $4.1 trillion, a significant amount of debt that needs to be refinanced over the coming four years across the United States and EMEA. Interestingly, as we normalized, about $200 billion of debt fell out of the study due to withdrawn ratings in Russia. The refinancing walls actually grew this past year by about 4% on a like-for-like basis. Looking back, if you view the slides from 2019, those maturity walls have grown 28% since then. In analyzing the U.S. spec-grade market, the first two years of our refunding studies show approximately 18% of the five-year total, the highest percentage since tracking began in 2010. If you consider the maturity walls for 2023 alongside projected corporate issuance for 2022, though it represents about 50% of expected global corporate financing activity for that year, it's a considerable figure. Remember that roughly 40% of the MIS business is recurring revenue, adding to the support for that other 60%.

Operator, Operator

Our next question is from the line of Alex Kramm with UBS. Please go ahead.

Alex Kramm, Analyst

I wanted to shift gears to the cost base, understand the restructuring program, but it would be helpful if you could flush out a bit more. The $200 million achieved by year-end, how much of that will actually impact this year’s costs? And into 2023, how much on a net basis will be incremental as we think about the outlook there? And then, more importantly, if we expect growth to accelerate next year, how should we think about incremental margins on the ratings business? Are the low-60s target medium-term still intact? So I know it’s a three-part question, but I think it’s all important.

Mark Kaye, Chief Financial Officer

Alex, good afternoon. I anticipate we may get a couple of questions on expenses during our Q&A session today. I’ll start off by talking about the restructuring program and addressing some of your margin-specific questions. The market disruption and downturn has been more severe than we anticipated early in the year, and we’re thinking it will extend at least through the fourth quarter. Therefore, we’re taking actions consistent with our prior commitments around financial prudence and expense management. Specifically, through year-end 2023, we expect up to $170 million, or approximately a $95 million increase in aggregate charges from the additional real estate rationalization and staff reduction. This includes further utilization of alternative lower-cost locations, where skills and talents exist while ensuring the focus and resources remain firmly allocated to maintaining the high quality of our core ratings business while continuing to invest in strategic growth areas within both MIS and MA. For the full year 2022, the additional personnel-related actions and the exit and cease use of certain leased office space will plan to record up to approximately $85 million in estimated pre-tax restructuring charges. This will include the $33 million pre-tax restructuring charge recorded year-to-date. The remaining portion of the up to $107 million in restructuring charges will be recorded in 2023. These actions are projected to result in annualized savings in the range of $100 million to $135 million, double the $40 million to $60 million forecast under the previous restructuring program. We’ve also evaluated further opportunities for cost reduction, including adjusting compensation policies, certain salary bands, reducing select non-compensation expenses and reassessing business strategies. So, combined with the savings from the upsize restructuring, that will generate at least $200 million run rate savings for 2023. We plan to use these savings to support business profitability and margins as we strive to meet medium-term financial targets, alongside some reinvestment towards strategic efforts, including workplace enhancements. While we’ll provide official guidance for 2023 in February, these expense actions are anticipated to stabilize MIS’s 2023 adjusted operating margin in at least the mid-50s percent range while continuing to expand MA’s adjusted operating margin as well.

Operator, Operator

Your next question is from the line of Kevin McVeigh with Credit Suisse. Please go ahead.

Kevin McVeigh, Analyst

Great. Thanks so much. And congratulations on the proactive expense management. I don’t know who this would be for, but can you give us a sense of what level of conservatism you have in the 2022 guidance based on the adjustments you’ve made so far?

Rob Fauber, President and CEO

Yes. Hey Kevin. Thanks for joining us today. The way we’ve put together the guidance for the remainder of the year assumes a continuation of what we’re seeing now through the fourth quarter. Our revised guidance for issuance implies that fourth quarter issuance will be down in the low-40s percent range. If we have another quarter of unfavorable mix due to softness in the leveraged finance markets, that would mean MIS transaction revenues could be down greater than that, in the low-50s percent range. Triangulating this to revenue, it suggests that fourth quarter MIS revenue will decline in the mid-30s percent range. This feels about right and reflects our assumption that this environment will continue, making it a holding pattern until the market gains confidence around inflation peaking and the pace and trajectory of Fed rate increases.

Mark Kaye, Chief Financial Officer

Yes. Briefly, it’s worth highlighting that the confidence intervals around our modeled outlook are wider than in prior periods, reflecting heightened market uncertainty and volatility. In contrast, MA has shown significant resilience to current market disruption as customers enhance their level of risk resiliency, underscoring the mission-critical nature of our products.

Operator, Operator

Your next question is from the line of Toni Kaplan with Morgan Stanley. Please go ahead.

Toni Kaplan, Analyst

I wanted to ask again about the long-term issuance outlook. You highlighted the refinancing needs that remain supportive. Is there anything you’ve seen that would suggest companies will try to deleverage in the coming years or anything that could change the structural versus cyclical debate? I know you think it’s cyclical, but any data points you’re observing that might influence that decision?

Rob Fauber, President and CEO

Yes, Toni, sure. Looking at the big picture, there are certainly deep cyclical issues currently. We’ve discussed macro uncertainty, and issuers are working off excess supply of issuance from the two pandemic years. However, there are key structural supports for recovery in issuance markets. I mentioned refinancing walls, which are significant. Some are concerned that low interest rates during the pandemic would eat into those walls, but they remain intact and are growing, providing support for transactional revenue. The relative attractiveness of debt financing has not changed as no significant changes to tax codes have emerged. We’ve also seen corporate cash balances decrease— about a 7% decrease over the last year. Currently, U.S. corporates are in reasonable shape from a leverage standpoint. Looking at free cash flow to debt across rated U.S. corporates, it’s about 11%, the best since 2011, offering room for additional leverage. Lastly, we’re witnessing stability of spreads around historical averages, with demand from issuers to access markets.

Operator, Operator

Your next question is from the line of Andrew Nicholas with William Blair. Please go ahead.

Andrew Nicholas, Analyst

Just wanted to clarify a few things on the restructuring program. First, I want to make sure the incremental savings of up to $100 million on non-restructuring-related expense actions reflects actual actions rather than a contingency plan. Also, any insight into the split of those cost savings between corporate expenses versus MIS versus MA would be helpful.

Mark Kaye, Chief Financial Officer

The incremental savings of up to $100 million that we listed are not contingency-based; these are anticipated actions. Thinking about expense levers in the business, we can categorize them into four primary buckets. First, related to our hybrid work environment, enabling us to operate effectively with a smaller office footprint. Second, reductions in non-compensation costs like travel expenses have increased compared to the previous two years. We’re prioritizing reductions through supplier cost avoidances and negotiating favorable terms. Third, compensation and benefits represent approximately 60% of our expense base. As part of the restructuring program, we plan to increase the use of alternative lower-cost locations while maintaining high-quality ratings. Finally, we have naturally occurring expense levers that flex based on performance versus financial targets set for the upcoming year. In summary, we expect savings to benefit both MIS and MA, with a larger effect on MIS due to how we're strategically managing expenses. We remain on track to achieve our medium-term adjusted operating margin target for MA of mid-30s percentage range within three to five years.

Operator, Operator

Your next question is from the line of Kevin McVeigh with Credit Suisse. Please go ahead.

Kevin McVeigh, Analyst

There’s been a lot of questions on corporate issuance, but I wonder if you could talk about your own debt. It seems a little high. Is there anything to call out, like timing? Could you frame that for us?

Mark Kaye, Chief Financial Officer

We remain committed to maintaining our financial leverage around a BBB plus rating for a good balance of financial flexibility and lower capital costs. We’ve strengthened our capital position and reduced our cost of capital over the past two years by structuring our debt maturity schedule and extending our maturity profile to capitalize on previously low rates. As of September 30th, our net debt to adjusted operating income was 2.3 times, well within the BBB plus rating range, considering our cash position. However, our gross debt to adjusted operating income is approximately 2.9 times as of September 30th, due to the current economic conditions compared to our initial outlook. We’re considering executing a small debt repurchase strategy to take advantage of market conditions to decrease our gross debt position.

Operator, Operator

Your next question is a follow-up from the line of Craig Huber with Huber Research Partners. Please go ahead.

Craig Huber, Analyst

Can you dig into your 2022 expense bridge attribution? Also, I’m curious about your currency sensitivity right now on costs.

Mark Kaye, Chief Financial Officer

We’re lowering our 2022 operating expense guidance growth from the high-single-digit percent range to the upper end of the mid-single-digit percent range. Our outlook now assumes additional expense accruals in the fourth quarter of up to $55 million related to the expanded restructuring program. Excluding restructuring-related charges, our operating expenses would have been at the lower end of the mid-single-digit percent growth range, reflecting ongoing expense discipline compared to our previous guidance for increasing lower double-digit ranges. We expect expense growth of about 7 percentage points linked to recent acquisitions, primarily RMS, roughly 3 percentage points from the restructuring, and lower incentive compensation offset by favorable foreign exchange movements of about 4 percentage points. On currency sensitivity, every $0.01 movement between the U.S. dollar and euro impacts full year EPS by about $0.03 and revenue by around $10 million, while every $0.01 movement between the dollar and pound impacts revenue and operating expenses by approximately $2 million.

Operator, Operator

Your next question is a follow-up from the line of Owen Lau with Oppenheimer. Please go ahead.

Owen Lau, Analyst

Could you discuss how the Inflation Reduction Act impacts your share repurchase program?

Rob Fauber, President and CEO

We don’t expect any material impact on the tax side for share repurchases.

Operator, Operator

At this time, there are no further questions. Please continue with any closing remarks.

Rob Fauber, President and CEO

Thank you, everybody, for joining. I appreciate the questions, and we’ll talk to you on the next earnings call. Have a good day.

Operator, Operator

This concludes Moody’s third quarter 2022 earnings call. As a reminder, immediately following this call, the Company will post the MIS revenue breakdown under the Investor Resources section of the Moody’s IR homepage. Additionally, a replay will be made available immediately after the call on the Moody’s IR website. Thank you.