Earnings Call Transcript - MCO Q1 2023

Operator, Operator

Good day, everyone, and welcome to the Moody’s Corporation First Quarter 2023 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. Good afternoon, and thank you for joining us today. I’m Shivani Kak, Head of Investor Relations. This morning, Moody’s released its results for the first quarter of 2023 as well as our revised outlook for select metrics for full year 2023. The earnings press release and the 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’d 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 the 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, 2022, 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, key business highlights and outlook; after which, he’ll be joined by Mark Kaye, Moody’s Chief Financial Officer, to answer your questions. I’ll now turn the call over to Rob.

Rob Fauber, President and CEO

Thank you, Shivani. Good afternoon, and thank you all for joining today’s call. I will discuss a few key takeaways from our first quarter results and share insights into what is driving our growth outlook. This quarter, I’ll also focus on our Decision Solutions line of business in MA, which is a crucial growth area for us. Mark and I will be glad to answer your questions afterward. The first quarter faced market turbulence due to stress in the U.S. banking sector. As often happens, this increased market uncertainty led to strong demand for our insights and risk assessment offerings, resulting in significant increases in usage this quarter. We continue to unlock the potential of MA and its valuable assets and businesses, including a leading credit and economics research business, a Data & Information business with one of the world's largest databases on companies, and our award-winning Decision Solutions businesses serving KYC, banking, and insurance workflows. Together, MA achieved 10% ARR growth while refining our mission-critical data analytics and workflow solutions. Although MIS revenue declined 11% from a solid first quarter in 2022, the expected rate of revenue decline moderated compared to the third and fourth quarters of last year, as MIS capitalized on strong investment-grade issuance in the first quarter. Improvement in issuance activity, along with decisive expense actions from last quarter, helped us achieve more operating leverage, evident in MIS’s operating margin increasing to nearly 57%. The adjusted operating margin for the first quarter is up about 500 basis points from the margin for the full year 2022. Simultaneously, we are maintaining financial flexibility while funding strategic investments in product development, sales initiatives, modern cloud-based workflow platforms, data interoperability, accessibility, and AI innovation to position ourselves for future growth. Moving on to our results, there are key highlights among the performance numbers displayed. First, MA revenue grew by 6%, or 9% on a constant currency basis. ARR increased by 10%, with solid growth across Data & Information, Research & Insights, and Decision Solutions. As noted earlier, MIS revenue fell compared to a challenging Q1 2022 before issuance volumes slowed throughout the remainder of the year. Most of the decline this quarter was due to corporate finance, particularly in bank loans, followed by structured finance, as some deals were delayed amid market volatility. Therefore, although overall revenues decreased by 3% in the quarter, our adjusted operating margin remained at 44.6%, up approximately 200 basis points from our full year 2022 margin, reflecting the benefits of our cost efficiency initiatives. Our adjusted diluted earnings per share was $2.99, which includes $0.75 from resolving several outstanding tax matters. As mentioned earlier, we saw increased usage across various products in the first quarter. During the recent banking sector stress, traffic to our main website, moodys.com, increased by about 20% from the previous year. This is significant for several reasons. First, our analytical teams are among the most experienced in the industry, which is why we’ve been recognized as the Best Credit Rating Agency by Institutional Investor magazine for eleven consecutive years. This experience allows us to be thought leaders in the industry, especially in times of stress and uncertainty like we encountered in the first quarter. This thought leadership also drives higher demand for our insights and research, reinforcing our value proposition and growth opportunities for both ratings and research. Demand during stressful times extends beyond ratings and research, seen across various MA offerings. For instance, usage of our cloud-based asset liability management solution, which helps banks model and manage their risks, surged nearly 50% during the peak banking stress last month. Additionally, with unprecedented deposit flows moving across banks, the utilization of our KYC screening and risk monitoring solutions increased by almost 30%. We have also doubled the number of in-person customer sales meetings over the last year, backed by nearly a 20% expansion of our sales team since early 2022. The combined effect of increased usage and sales engagement gives us confidence in our low double-digit ARR growth outlook for the full year in MA. In the recent quarter, MA achieved 10% ARR growth, consistent and robust across all business lines. Starting with Data & Information, which includes Orbis, one of the largest databases on companies, along with our ratings and news feeds and 300 million ESG scores, ARR grew approximately 9%. The very strong standalone demand for private company data in Orbis, coupled with the integration of this data across MA’s offerings, is driving growth in other business lines. For example, integrating Orbis company data into our CreditLens lending solution for banks and our ESG scores into insurance and banking underwriting and portfolio solutions are noteworthy. Moving to Research & Insights, which encompasses our leading credit and economic research as well as an expanding suite of predictive analytics, ARR also grew by 9% this quarter. We are witnessing strong and sustained demand for our economic data, research, and models, especially amid stress in and around the banking sector. This includes our new EDF-X platform, which merges our acclaimed risk models with Orbis to assess credit risk for any company globally. We have recently integrated EDF-X alongside CreditView into the moodys.com gateway, enabling direct access to a growing array of Moody’s products and improving customer experience while facilitating further cross-selling opportunities. Finally, Decision Solutions, which includes our businesses focused on KYC, insurance, and banking workflows, reported an 11% ARR growth. Given that this is our fastest-growing segment, I want to expand on these offerings and the drivers of growth. These businesses are critical as they support essential workflows across financial institutions. The synergy of data network effects and high switching costs leads to industry-leading retention rates, typically in the low to mid-90s. We’ve discussed our KYC business in earlier earnings calls. This segment facilitates customer onboarding, ongoing KYC monitoring, and sanctions screening on customer suppliers and other third parties. Its robust growth is attributable to our comprehensive coverage of KYC and anti-money laundering activities, leveraging our extensive datasets on companies and individuals, combined with AI-enabled risk intelligence and our new PassFort Lifecycle platform for cloud-based workflow orchestration. Shifting to insurance, the addition of RMS has substantially strengthened our capabilities in underwriting risk and capital management, as well as regulatory reporting workflows for insurers and reinsurers. Similar to banks, insurance companies are increasingly adopting automation, digitization, and third-party data integration to enhance their risk management. The RMS intelligent risk platform is a cutting-edge cloud-based solution supporting a growing range of workflow, data, and modeling capabilities for insurers. The latest product on this platform is our Climate on Demand solution, which integrates RMS's climate and physical risk models with our comprehensive Orbis and commercial property datasets. This product offers a sophisticated on-demand financial quantification of physical risk, enabling a comprehensive assessment of a company's exposure to extreme weather events and climate change through its clients, suppliers, and properties. This solution is beneficial not only for insurance underwriting but is also generating significant demand from banks, corporations, government entities, and professional services, as anticipated when we announced the deal nearly two years ago. Next, our banking workflow solutions are similar to those offered to insurance, encompassing lending, risk management, credit portfolio incorporation, asset liability management risk, and financial planning, which includes impairment, accounting, and regulatory capital reporting. One of our significant recent product launches, contributing to double-digit ARR growth in banking, is CreditLens for commercial real estate. This integrates our market forecasts and commercial property data with our SaaS lending solution, CreditLens, greatly enhancing our ability to serve the commercial real estate lending market. Overall, what differentiates our offerings from competitors is not just the software but the integration of our proprietary data and analytics through modern cloud-based architecture. This is supported by advanced machine learning and AI used in several of our solutions, enhancing customer effectiveness and efficiency. Our integration of data analytics, cloud-based technology, and innovation has earned us the top spot in Chartis RiskTech100 as of November. Now, let’s briefly discuss a typical customer relationship, specifically with a top 50 regional bank in the U.S. Our workflow solutions combine data analytics and cloud-based software, assisting banks across their value chain by interlinking often isolated use cases across departments, from lending to risk management to finance and planning. Typically, we start by serving one use case and expand the relationship over time as the bank aims to connect its functions using our interrelated data, models, and solutions. Our relationship with this bank began in 2019 when they used our models, including the EDF model I mentioned earlier, as foundational capabilities to establish a common risk language within the institution. They deployed our models to support a new internal risk rating program for consistent and unbiased credit assessments. Over the next two years, we deepened the partnership by providing a workflow solution that combines these models with economic data and business analytics to upgrade their expected credit loss processes. In 2022, leveraging some of the same data and analytics capabilities, we further broadened the relationship to meet their lending needs with AI-enabled spreading tools and CreditLens loan origination software, including credit scoring. We similarly supported their forecasting and stress testing requirements by integrating five other Moody’s products and utilizing data and analytics from elsewhere in the bank. This collaboration expanded licensing for several existing products and subscriptions for new ones, achieving fivefold growth in ARR from this relationship within three to four years. This ARR aligns within different MA business lines, with 65% in Decision Solutions and 35% in Research & Insights for the same customer focused on lending, risk, capital management, and finance and planning. There remains growth potential, and we are actively discussing supporting their KYC needs. This example illustrates how we have cultivated relationships with banking clients in recent years, accelerating growth by providing comprehensive solutions that utilize capabilities across all MA lines of business and more broadly across Moody’s. This embodies our integrated risk strategy, enhancing the value and stickiness of our solutions. Turning to MIS, issuance was stronger in Q1 2023 compared to Q4 2022. Although volatility and uncertainty impacted structured finance and bank loan markets, we observed robust activity in the investment-grade sector. In the first quarter, issuance represented nearly 30% of our full-year outlook, aligning with typical historical seasonality patterns. Growth was more pronounced in investment-grade issuances compared to leveraged finance. As discussed in our last earnings call, we expected markets to favor higher-quality credits before those lower on the credit rating spectrum, such as high-yield and bank loan issuers. If market conditions continue to improve, leveraged finance issuance should also rise, influenced by various factors, including macroeconomic risks, policy actions, market sentiment, credit spreads, economic growth, and private equity activity, among others. Recently, we’ve received questions regarding MIS’s growth drivers, particularly over the long term. Mark and I thought it would be beneficial to outline our perspective on the elements contributing to MIS revenue growth over time. While short to medium-term outlooks may be affected by cyclical factors, we believe the long-term growth formula for MIS revenue remains strong. First and foremost, debt issuance growth in the long term is linked to global GDP growth as issuers invest and expand their businesses. We anticipate global GDP growth in the 2% to 3% range over the long term, consistent with historical averages over several decades. Secondly, the value proposition of ratings particularly for MIS remains robust, supporting an annual pricing opportunity in the 3% to 4% range. Lastly, there are enduring tailwinds from the ongoing development of capital markets globally, including gradual disintermediation in developed markets like Europe and higher growth rates in smaller developing capital markets. Together, these elements provide insight into what we regard as the long-term growth profile of this business. While I recognize that growth rates might vary over shorter periods, our framework remains relevant in reflecting this aspect. As we look forward to the remainder of the year, we are optimistic about our business prospects, bolstered by strong demand for our solutions and a solid product development pipeline. Accordingly, we are reaffirming most of our guidance, including select updates to expenses and our diluted and adjusted diluted EPS metrics. GAAP diluted EPS is now anticipated to be between $8.45 and $8.95, and adjusted diluted EPS between $9.50 and $10. To conclude, our growth and resilience as a firm rely on our people throughout the organization, and I want to express my gratitude for their dedication and efforts to serve our customers, support one another, and deliver for our shareholders. This wraps up my prepared remarks, and Mark and I are ready to answer your questions. Operator, over to you.

Operator, Operator

Thank you. Our first question comes from Owen Lau with Oppenheimer.

Owen Lau, Analyst

Good afternoon. And thank you for taking my question. So last quarter, Mark, you provided the seasonality of the P&L in detail. We appreciate your help and it was very helpful. Could you please do the same and give us an update this quarter? Thank you.

Mark Kaye, CFO

Owen, good afternoon, and very happy to do that. Our central case assumption is that the near-term capital market activity is going to continue to be impacted by some of the recent stresses we’ve seen in the banking sector as well as sort of those ongoing inflationary and recessionary concerns before improving as we progress into the latter half of the year. While we have to acknowledge that there’s been strong sequential improvement in issuance volumes from the fourth quarter to the first quarter, we remain cautiously optimistic and are thus maintaining our full year MIS revenue guidance of low to mid-single-digit percent growth. Based on the strong first quarter investment grade and infrequent financial institution issue activity, we have slightly derisked our year-to-go forecast. We now expect first half MIS revenue to decline in the mid- to high single-digit percent range and second half MIS revenue growth in the mid to high teens percent range. And that’s, again, based on our expectation for market volatility to partially abate in the latter half of 2023. It’s also worth noting that this outlook is now more in line with the historical seasonality where the proportion of transaction revenue tends to be greater in the first half versus the second half of the year. We’re also pleased to reaffirm our expectation for full year 2023 MA revenue to increase by approximately 10%. It’s too early to assess if there are any near-term headwinds related to the disruption resulting from or in the banking sector. And as you heard from Rob, we are experiencing increased product utilization, customer engagement of our risk solutions during this period of financial market uncertainty. And given that MA revenue is highly recurring, approximately 94%, we still expect absolute dollar MA revenue to progressively increase over the course of the year, with second half revenue growth anticipated to be slightly stronger vis-à-vis the first half. That means we’re forecasting MA’s second quarter adjusted operating margin to be flattish to our actual Q1 results before improving in the second half of the year and as we fully realize the benefits of our restructuring program and additional cost-saving initiatives. On total Moody’s operating expenses, the guide here is for an increase in the lower end of the mid-single-digit percent range. It’s revised just slightly upwards on the expanded restructuring-related charges as well as our expectation for sort of a modest FX headwind. And then finally, we don’t anticipate the future resolution of uncertain tax positions to sort of reoccur to the same extent in future quarters.

Operator, Operator

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

Andrew Nicholas, Analyst

I wanted to ask a little bit more specifically on the impact from SVB and kind of the broader banking sector turmoil on the sales pipeline in MA. I think, Mark, you just said that it was a little bit too early to tell, but if there is any color you could provide on anything outside of usage increases. It seems like that would bring in additional sales opportunities but also understanding that some of these end markets or these clients would have other things that they’re focused on spending money on in the near term. Any additional color on how you’re thinking about that would be great.

Rob Fauber, President and CEO

Andrew, it’s Rob. I’m going to take a moment to look at the situation. We have been considering what happened in March with the banking sector from three perspectives. First, there was a lot of activity for our rating teams, as expected. We rate around 800 banks worldwide, including about 65 regional banks in the U.S. This led to significant credit work and market engagement, and we observed an increase in the use of our research. We also evaluated what this could indicate for MIS issuance. January and February showed stronger issuance than March. March did see a bit of a market slowdown, and we contemplated how this might affect the remainder of the year. Ultimately, we opted not to alter the issuance outlook for the year. Thirdly, regarding your question on M&A, we maintain relationships with over 2,500 banks globally. So far, we haven’t noticed any significant slowdown in sales cycles, but we are aware of the situation. Banks are currently assessing their investment strategies and timing. We are monitorings bank consolidation closely. In past financial crises, we highlighted that bank consolidation could lead to attrition or downgrades for us. We have seen a small amount of unique attrition due to recent bank failures, but we believe that, in the medium term, demand for bank risk management will increase. New regulations will likely create additional demand for our products and services. While we are aware of the current situation, we feel that, over the medium term, this will positively contribute to growth.

Operator, Operator

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

Kevin McVeigh, Analyst

Thank you, and congratulations on the results. I’m not sure if this is for Mark, but can we revisit the margins? There seems to be significant operating leverage. I understand some of it is due to restructuring, but could you provide more insight into what is driving the leverage outcome throughout the year? It would be helpful to dive a bit deeper into Moody’s and the MA and MIS segments, if possible, Mark.

Mark Kaye, CFO

Kevin, I’ll talk at the Moody’s level for margin, and I’ll give some insight into how the full year is progressing and certainly happy to take other questions on MA margin later on in the call. So as a management team, we’re committed to improving Moody’s margin and accelerating the top line growth here. Our guidance for the full year is for an adjusted operating margin in the range of 44% to 45%. And that implies around 200 basis points of margin expansion at the midpoint. And that reflects our view that the cyclical market disruption we experienced last year as well as some of the concerns in the banking sector, they’re likely to abate over the coming months. And in addition, over the past several months, to the point you made, we have taken prudent yet aggressive actions firmwide to streamline our expense base. And we’ve done that while concurrently ensuring sufficient investment and resources to maintain the high ratings quality within MIS as well as to support innovation and organic investment in MA as we execute on our strategic roadmaps. So if I translated that into numbers using our actual Q1 results as a baseline, for the full year 2023, you could expect approximately 100 to 150 basis points related to increased operating leverage from both MA and MIS, and that’s net of ongoing hiring activities and strategic investments; approximately 350 to 400 basis points related to the expense benefits from some of those actions we’ve taken to lower and control costs associated with either real estate rationalization, reduction in staff or other efficiency initiatives; and then with the partial offset there of approximately 300 basis points from incremental costs associated with the annual salary and promotional increases as well as a reset of our incentive compensation.

Operator, Operator

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

Toni Kaplan, Analyst

I wanted to ask the MA ARR question a little bit differently. I wanted to understand the sort of sustainability of double-digit ARR growth, how you see that playing out. Great usage numbers that you gave, that was really helpful. Is there a component of price that is linked to usage or is it more that in your negotiations on price, you sort of point to usage and try to drive price that way? And then also just how you see the sustainability of the growth continuing, just if you do see budget tightening or cutting back, how has that sort of been in the past during challenging times for your customers? Thanks.

Rob Fauber, President and CEO

Hey Toni, it’s Rob. I’ll take that one. There are two parts to it: sustainability and how that translates to pricing. Let me start with some key secular trends driving growth across our business. These are our selling themes and how we engage with our customers. The first is digital transformation. Many of our customers are undergoing digital transformation in all parts of their institutions, and we play a vital role in assisting them. As I’ve mentioned before, it’s about becoming more effective and efficient. The second trend is a comprehensive 360-degree view of risk. I’ve had many discussions with customers who want a better understanding of all aspects of the counterparties they're dealing with, whether they are customers, suppliers, or parties they’re lending to or investing in. We have a significant opportunity to provide that 360-degree view of risk. The third trend relates to regulation. In financial services, which represents a large part of our customer base, there are constantly new rules and regulations being introduced. Our customers look to us for help with regulatory compliance, and many of our solutions cater to that need. Finally, we are increasingly discussing how to incorporate climate and ESG considerations into various workflows. There is a strong demand to understand the financial implications of exposure to weather and climate change, as I mentioned earlier. We're having these conversations with our customers, bringing together products and solutions that address these challenges. We are optimistic about our positioning and the medium-term growth drivers supporting it. Regarding pricing, we adopt a value-based pricing approach. We want our customers to derive significant value from our products, supported by our customer success teams that enhance the utility they receive from those solutions. This approach helps facilitate ongoing pricing increases and upgrades throughout the institution. That’s generally how we view it.

Mark Kaye, CFO

And Toni, this may have been implicit in the question you were asking, but part of the reason we introduced ARR in the first quarter of last year is that it’s a fabulous leading indicator of performance because by design, it provides that 12-month forward-looking view into our growth trajectory and thus also progress towards achieving our medium-term targets.

Operator, Operator

Your next question comes from the line of Alex Kramm with UBS. Please go ahead.

Alex Kramm, Analyst

I wanted to revisit the discussion about regional banks. I heard your remarks on M&A, and I tend to agree that it could present an opportunity in the future. However, I would pose a similar question regarding MIS. It may not be as straightforward. If regional banks are experiencing increased stress and regulations, do you think there's a chance that some of their lending could shift to capital markets as we've seen historically, including in Europe and potentially in the U.S.? I realize their lending typically involves smaller ticket sizes focused on mid-market, but I am curious if there might be opportunities in that space. Additionally, there could be prospects in structured finance as these banks navigate new regulatory challenges. Any initial insights would be appreciated.

Rob Fauber, President and CEO

Hey Alex, it’s Rob. I think that’s a reasonable perspective, although it’s probably too soon to draw conclusions. As mentioned, we haven’t changed our issuance outlook at this point, whether up or down. However, we are considering the possibility of banks looking to capital markets as a funding source, especially in the U.S. and Europe. This could lead to an increase in issuance and may also result in further disintermediation, as banks and borrowers alike are turning to these markets. It’s something we will monitor, but it’s likely too early to make a definitive call.

Operator, Operator

Your next question comes from the line of Ashish Sabadra with RBC Capital Markets. Please go ahead.

Ashish Sabadra, Analyst

I just wanted to focus more on the banking vertical than in MA. I was wondering if it’s possible to quantify how big your exposure is and particularly on the regional banking side. And then obviously, you talked about the increased focus on risk management being positive over the midterm. But I was just wondering how hard your conversations or the sales conversations trending with those banks? Are we seeing increased focus on risk management even in the near term? Thanks.

Mark Kaye, CFO

This is Mark here. In terms of the overall quantification of the banking business, last year for banking-related products that we sold were around $400 million. That would have been around 14% of the MA. You could anticipate continuing to see ongoing growth of products that we sell to banks, which extend per the comments you heard from Rob this morning, not just banking-related products themselves. And the focus that we have in and especially in the banking space, really extends across those three primary segments, sort of the origination of that credit, the ability for asset liability management and then finally, to support finance and risk-related reporting. And the idea that banks themselves can use that data and analytics not just within individual departments within those disciplines but across the firm really creates very high switching costs and allows our data to be embedded ultimately into the network that the banks have.

Rob Fauber, President and CEO

Yes. And maybe I’ll just add to that. Kind of in the immediate term, obviously, we highlighted the increased usage that we saw in our products, but we were literally doing kind of daily stand-ups where we were in touch with our banking customers and prospective customers around a few different themes. And one, as you can imagine, our banking customers were in a period and still are of enhanced kind of credit and counterparty monitoring. And there, we’ve got obviously a number of tools that can help. We have a set of asset liability management solutions. And I noted the significant increase in usage by our existing customers, but that also gave us an opportunity to engage in a number of new discussions. And then third is around KYC. And while it’s hard for banks to deploy a new KYC solution kind of in the span of a week, just given what was going on, we’ve seen an ability to have an increased conversation around KYC at a broader set of financial institutions. So in general, there are some immediate term opportunities and we see some medium-term opportunities.

Operator, Operator

Your next question comes from the line of George Tong with Goldman Sachs. Please go ahead.

George Tong, Analyst

It appears MIS outperformed your expectations in the first quarter, but your full year guide was reiterated. How much does this reflect conservatism versus a more moderate issuance outlook for the remainder of the year, perhaps to reflect aftershocks from the regional banking crisis at the end of the first quarter? Could you talk about some of the issuance trends you’re seeing real time?

Rob Fauber, President and CEO

Yes, it's Rob. I'll begin. In our webcast presentation, I noted that the issuance for the first quarter through March was about 29% of our full-year outlook. This is fairly consistent with the average we’ve experienced over the last decade, not taking into account the pandemic and last year. Our expectations for this year are probably closer to 25%. So by not increasing our issuance outlook, you could view that as a way to reduce risk in our issuance forecast for the remainder of the year, which seems reasonable considering the seasonal patterns I just mentioned. There are a couple of straightforward reasons why we didn’t adjust our issuance guidance. First, while there are some positive signs, we decided it’s too early to change our full-year issuance outlook. January and February were strong months, but March was inconsistent. Second, we still face considerable risks with three quarters left in the year, as highlighted by the issues in the banking sector in March and the upcoming debt ceiling challenge. Therefore, we believe it’s premature to make any changes. In terms of current market conditions, they appear quite positive. We will see how corporate earnings unfold and what the interest in mergers and acquisitions will be. The market feels more optimistic in late April compared to March. M&A activity has been inconsistent, primarily in defensive sectors, but there seems to be some demand building up. We've heard bankers discussing the growing pipelines for the second half of the year and into 2024. Investment-grade issuance started strongly but slowed down in mid-March due to the banking situation. We will wait until early May to assess the economic data that will be released. If that data is favorable, we might see an increase in corporate issuance. Lastly, banks have had opportunities to begin addressing the significant LBO backlog on their balance sheets, which is crucial for unblocking those markets. Overall, the tone remains constructive, but we will have to see how things develop.

Operator, Operator

Your next question comes from the line of Jeff Silber with BMO Capital Markets. Please go ahead.

Jeff Silber, Analyst

I wanted to focus a little bit more about some of the uncertainty going on in the banking sector but maybe take it to the next level. I know there’s a lot of concern about the impact on the commercial real estate sector. I know you’ve got exposure there in both lines of your businesses. Can we just talk about what’s going on there?

Rob Fauber, President and CEO

Yes. Let me tackle this. So Jeff, first of all, good to have you on the call. Let me tackle this maybe two ways. One, just kind of how we’re thinking about the U.S. banking system; and then second, I think there’s a question about kind of what’s going on with bank lending and just give you maybe a little bit of insight into that. But on the first, MIS put some great research out on this and has been, so I would steer you to that. But a few things that our teams are focused on. They’re focused on ALM risks. They’re focused on stability of deposit funding, profitability pressures, and as you mentioned, Jeff, commercial real estate exposure. And when we think about what’s going on with lending standards, I think it’s fair to assume that bank lending standards are tightening. I think that was already going on to some extent before March. The banks are going to be the most cautious around property, land, development loans and commercial real estate more broadly, in particular, I think the office sector. Just to put it in perspective, today, U.S. banks hold about half of the U.S. commercial real estate debt outstanding. And I think smaller banks are more concentrated in commercial real estate as a percent of total capital than the larger banks. So I think you are going to see some caution there for sure. In terms of corporate credit, I would expect the tightening to be felt at the smaller end of businesses. You’re seeing that with some of the survey data that’s come out in March. When you think about commercial loans, credit cards, auto and personal loans, those will probably be less impacted just because a lot of that lending is done outside the banking system. And same with mortgage lending, while it’s impacted by rising rates, I think it will be less impacted by what’s going on with bank lending standards, given that a lot of it’s been backstopped. So you got a sense of our exposure to banks overall. We have a business serving commercial real estate. And I will say there’s a lot of interest from banks to really get high-quality data and analytics and insights to help them really understand what they need to do around that asset class.

Operator, Operator

Your next question comes from the line of Craig Huber with Huber Research Partners. Please go ahead.

Craig Huber, Analyst

Can you please touch on your outlook for bank loans versus high yield here for the remainder of the year? What’s embedded in your outlook for debt issuance? I do want to ask you, your incentive compensation numbers for the quarter and also for all four quarters for last year, what was that, please?

Rob Fauber, President and CEO

Yes. So, we haven’t changed any of the outlook. So for leveraged finance, we’re looking at high yield, up 25% and leveraged loans still remaining roughly flat. And I gave you a little bit of color on kind of what we’re seeing in the market. Hopefully, that gives you some sense.

Mark Kaye, CFO

And in the first quarter of 2023, our incentive comp was $89 million compared to $76 million in the prior year period. Also just look, Craig, that we’re now including commissions as part of our incentive compensation figures that we provide as sales-based commissions have actually grown alongside revenues relative to historical levels. So put it in context, for the full year of 2023, we expect incentive compensation to be between $340 million and $360 million or approximately $85 million to $90 million per quarter for the remainder of the year. And that is 15% higher at the midpoint than the total incentive compensation we accrued for in the comparable full year period in 2022, and that’s simply a result of resetting our incentive comp baseline for the year based on annual financial targets. And just because I have the mic for a second, on the expense side, I wanted to get out the updated expense ramp of between $10 million and $30 million between the first and second quarter of this year, with expenses remaining relatively stable then through the rest of the year.

Rob Fauber, President and CEO

Yes, Craig, I would like to add a thought regarding our outlook, which remains unchanged. Specifically, I'd like to discuss the factors influencing leveraged finance. Generally speaking, leveraged finance holds significant potential for improving our outlook. If these markets begin to operate more effectively again, I believe there's considerable capital available and a strong demand. This could lead to an increase in sponsor-driven M&A activity. We do not currently have an aggressive forecast for M&A in our outlook, so if we see an increase in activity, it could positively impact our expectations.

Operator, Operator

Your next question comes from the line of Andrew Steinerman with JP Morgan. Please go ahead.

Andrew Steinerman, Analyst

It’s Andrew. I went to today’s slide 12 and I added up the three growth drivers, and this is for kind of aggregate MIS, long-term revenue growth and I got 6% to 9%. I was hoping that was the right thing to do to add the three together. I was wondering for the 6% to 9% long-term MIS growth, when you say long-term, what’s your timeframe for long term? And then kind of lastly, I want to make sure that the medium-term numbers that you gave us in January, that’s kind of 5-year MIS revenue growth of low singles to mid-singles is still in place.

Mark Kaye, CFO

So, our long-term MIS revenue growth algorithm doesn’t have a set base here, so we’re not looking to define either the base here or the end period from which future performance could be extrapolated. Instead, the model is focused much more on historically well-established trends that we believe will be relevant in the long term and contribute ultimately to revenue growth. On the medium side, we’re really looking at that 3- to 5-year window, and we’re really reflecting the MIS revenue projection over that defined period of time. And then lastly, we are not withdrawing medium-term MIS revenue guidance.

Rob Fauber, President and CEO

That is correct.

Operator, Operator

Okay. Thank you very much.

Mark Kaye, CFO

So we expect the full year 2023 operating expenses to increase at the lower end of the mid-single-digit range. And you are absolutely right, that is above our prior forecast of low single-digit percent growth or the higher end of low single-digit percent growth. The primary driver for this, I’d call it, slight revision is really the expansion of our restructuring program and updates to foreign exchange rate assumptions. And given from an adjusted basis, which is what the margins are really computed off of, we would back out that restructuring piece. I also wanted to note, the operating expense segment guidance would be along the lines of a low to mid-single-digit percent decline in MIS and are very consistent with what we said in January and then a high single-digit percent growth in MA, also consistent with what we said in January.

Operator, Operator

Your next question comes from the line of Jeff Meuler with Baird. Please go ahead.

Jeff Meuler, Analyst

On KYC, just as you think about the sustainability of the long-term growth, how do you think about TAM or market penetration? I guess, 1,700-plus existing customers that you cite on the website, that seems awfully low to me at least. And then in the near term, with PassFort Lifecycle, just help us understand how far along you are with clients upgrading to it, and if the upgrade cycle’s really significant to near-term revenue trends. Thank you.

Rob Fauber, President and CEO

Yes, we were indeed having a great discussion. To address your question, there are a couple of perspectives to consider. Firstly, we have the opportunity to enhance our penetration in the addressable market. As you mentioned, PassFort serves as our workflow front end, which now lets us integrate our data, analytics, and models into a comprehensive solution, just like we do in banking and insurance. This opens up new avenues for us, and we've noticed significant enthusiasm from our customers. Regarding market growth drivers, there is still a considerable amount of Know Your Customer (KYC) processes being handled internally by financial institutions, indicating a substantial opportunity to automate KYC workflows. Additionally, we are witnessing a shift from just knowing your customer to understanding your counterparty. We need to find a better term for this, but it's part of a broader trend in third-party risk management, where businesses want to perform due diligence to understand their partners better. In the supply chain sector, for example, clients are reaching out to us, recognizing the need for enhanced insights into supplier risk. This shift is expanding our market and fostering growth. In fact, a recent survey we conducted revealed that around 70% of firms are increasing their focus and spending in the area of supply chain. I hope this provides a clearer picture.

Operator, Operator

Your next question comes from the line of Russell Quelch with Redburn. Please go ahead.

Russell Quelch, Analyst

I wanted to start with a question on pricing and to what degree you expect that to be a driver of growth in 2023, particularly in MIS. I was wondering if that would be above the 3% to 4%, given there’s the long-term projection on slide 12.

Rob Fauber, President and CEO

Yes. So Russell, it’s Rob. There is really kind of no change to, I think, either the pricing opportunity or our approach to pricing either in MIS or MA. And let me just kind of recap for just a second. On some of our previous calls, I did mention in MIS, as we do every year, last year, we conducted a detailed review of our pricing across sectors and regions. Again, that’s what we always do. Based on that work, we anticipated that the rate of increase in list prices for 2023 would reflect a bit more of an increase. That said, our actual pricing realization really, as it always does, then depends on issuance mix because we do not just apply an increase kind of ratably across the entire customer base. So, I can’t really get into more detail than that. I’m sure you can appreciate that but I am comfortable with our pricing opportunity for 2023 within that broader 3% to 4% opportunity across the firm.

Russell Quelch, Analyst

Okay. Thanks. Yes, this might be a silly one but let’s go for it. You spoke to ESG and climate integration as being kind of one of your four structural growth drivers for the business. And we just heard from one of your peers that growth in this area is being negatively impacted by politics in the U.S. in the near term. I appreciate your business and solutions are servicing a slightly different user base for a slightly different use case. But are you seeing a similar near-term negative impact on new sales growth here?

Rob Fauber, President and CEO

Yes, Russell, we're trying to clarify what our ESG and climate solutions actually measure. It feels like there's a significant shift happening in the industry because customers want to understand what these scores mean. Let me begin with our rating agency efforts. We've introduced over 10,000 Credit Impact Scores, which are essential. We've engaged in discussions with all our issuers regarding how environmental, social, and governance factors affect their credit profiles. We've made it clear because investors need to grasp this connection. There’s a distinct link between these scores and our credit rating approach. ESG factors have always been part of our credit ratings; we’re just being more transparent about it now. Additionally, there’s a demand for integrating ESG and climate considerations into many processes throughout the company. One common request from clients is for insights into their supply chains, especially since they deal with vast numbers of entities. It’s not only about scores for public companies but also understanding the ESG profiles of their suppliers. Furthermore, a key reason for our significant investment in RMS is the urgency to grasp how extreme weather and climate change affect physical risks. Customers frequently ask for help in quantifying physical risks related to weather and climate, as well as understanding the financial ramifications of transitioning away from carbon. Therefore, we are focused on financially quantifying these factors for our clients and integrating them into various workflows we support.

Operator, Operator

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

Kevin McVeigh, Analyst

Just one quick follow-up. Wonder if you could just refresh your thoughts on buyback, particularly given it seems like there’s some incremental cash flow from some of the tax benefits you show in the quarter, but just any thoughts around the buyback?

Mark Kaye, CFO

Thanks, Kevin. So, our capital planning and allocation strategy is unchanged. We are committed as a management team to anchoring our financial leverage around a BBB+ rating. And as I’ve spoken about before, we believe that’s appropriate balance between ensuring ongoing financial flexibility and lowering the cost of capital. However, given that our gross leverage as of quarter end is above that 2.5 times, we are continuing to be prudent in managing our leverage and liquidity levels and ensuring financial flexibility. So practically, that means we’re maintaining, for now, our slightly more conservative approach to share repurchase guidance in 2023. We still plan to return approximately $800 million of global free cash flow or about 53% at the midpoint of our projected free cash flow guidance range to our stockholders. That, of course, is subject to available cash, market conditions, M&A opportunities, other ongoing capital allocation. And if I broke that down into subcomponents, that would be $250 million approximately in share repurchase, and that’s inclusive of the $41 million we did in the first quarter as well as to distribute approximately $550 million in dividends through a quarterly dividend of $0.77 per share, which is 10% higher than the first quarter 2022 quarterly dividend. And then one final but important point I just wanted to highlight is we still have approximately $800 million in total share repurchase authorization remaining. And that gives us some flexibility to evaluate our full year 2023 share repurchase guidance while continuing to monitor the operating environment as it develops.

Operator, Operator

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

Manav Patnaik, Analyst

I just wanted to follow up on your earlier comments on RMS and ESG as well. But just on ESG, could you just remind us what your total ESG revenues were at the end of last year and this quarter and the growth rates? And then, something similar on RMS. I know you gave some qualitative color, but just as a total RMS, like how is that growth rate doing versus when you first acquired it?

Rob Fauber, President and CEO

Manav, I'll begin with RMS by recapping 2022 and sharing our outlook for 2023. Overall, we are very optimistic about our ongoing synergy and integration efforts, and we believe strongly in the value of the data, analytics, and expertise of our team. Last year, we achieved mid-single-digit sales growth, which was our target. This year, including synergies, we anticipate that sales growth will reach high single digits. Additionally, we have invested in accelerating the development of our intelligent risk cloud-based platform. This investment is crucial, especially for initiatives like Climate on Demand, where there is significant short-term customer demand. Having the cloud-based platform allowed us to launch it easily. We have also introduced our ESG for underwriting offering, and we recently won our first customer for a new net zero underwriting module. As I mentioned before, we are focusing on understanding physical risk, integrating ESG, and assessing the impact of carbon transition. All three of these aspects are integral to our product development and support our sales growth at RMS.

Mark Kaye, CFO

For the full year 2023, we’re projecting ESG and climate-related revenues to also increase in that high-single-digit percent range and that would be off of the actual 2022 full year results of $189 million.

Rob Fauber, President and CEO

And Manav, one other thing I’ll steer everybody to. In a couple of weeks, we’ve got our annual conference called Exceedance. I think it’s the second week of May. And so, if you want to learn a little bit more about what RMS is doing, we’re going to have several important product launches and partnerships that we’re going to announce that week. So that’s a good opportunity for people to dial in and learn more.

Operator, Operator

Your next question will come from Simon Clinch with Atlantic Equities. Please go ahead.

Simon Clinch, Analyst

Many of my questions have been answered, but I wanted to follow up regarding cash flows and buybacks. With the expected issuance, there will likely be significant incremental cash flow resulting from that. Could you elaborate on the priorities for deploying that additional cash flow, if it materializes, and discuss the current pipeline for M&A opportunities and how it's evolving in the current market environment?

Mark Kaye, CFO

In terms of the capital planning and allocation, I would also make the point that that remains unchanged from prior philosophy. First, we’re going to look for opportunities for both organic and inorganic investment in some of the high-priority markets that we’ve spoken about in the call today that ultimately are going to enrich that ecosystem of data, analytical solutions and insights. After deploying any investment dollars, we’re going to look to return that capital to our stockholders through dividends and through share repurchases. Just wanted to comment here, in the first quarter itself on the free cash flow side, the result was higher compared to the prior year period, and that was really due to an improvement in working capital this quarter, despite sort of the lower net income vis-à-vis the first quarter of 2022. And that improvement in working capital was driven by higher 2021-related incentive compensation payments that came through in the first quarter of ‘22.

Rob Fauber, President and CEO

Yes, Simon, it’s Rob. I believe your question was about Moody’s M&A. Regarding that, we have a strong team and clear growth strategies informed by customer needs and market trends. It’s interesting to note that after significant market changes like we experienced last year, there can often be a disconnect between what buyers and sellers expect. It usually takes time to reconcile that difference. Unless sellers are under financial pressure to sell, we tend to see many prefer to wait for better valuations. I've observed a division in valuations: high-growth, profitable companies continue to attract a premium, while high-growth, unprofitable companies do not, along with lower growth companies. This dynamic helps shape the expectations of both buyers and sellers.

Operator, Operator

Your next question comes from the line of Alex Kramm with UBS. Please go ahead.

Alex Kramm, Analyst

I know it’s late in the call but just a quick follow-up on the MA margin. I think you said something about flat in the second quarter. I’m sorry if I missed this. And I assume, looking at your guidance, that we should get some nice inflection then in the back half. Maybe ended like 33% or so in the 4Q. Is that a good run rate then to think about next year? I know it’s early, but maybe just talk a little bit more about the MA margin if you haven’t addressed it. Thanks.

Mark Kaye, CFO

Alex, the MA margin, as we think through to the second quarter is expected to be relatively flattish to the first quarter. And then we do expect it to progressively increase over the remainder of the year sort of in line with both revenue growth and as the benefit from our expense actions begins to take place. It is a little bit too early for us to think about 2024 just yet. On the margin for the first quarter, just two minutes on this. There were two primary impacts in terms of why the margin in Q1 was a little bit lower than last year. First was we accelerated some of the opportunistic investment in the business, and that’s going to be product development, technology, sales deployment, et cetera. But second, there is an element of timing related to both the MA revenue and expenses. On the revenue side, we had a favorable revenue recognition in the prior year period. And then on the expense side, you’ll recall, Alex, that the first quarter of 2022 had a relatively low level of investment because we had accelerated some of that work into the fourth quarter of 2021.

Alex Kramm, Analyst

And then just maybe while I’m on here, on the ARR side, I think again, maybe this is just the currency, et cetera, but like I think the dollar amount of ARR actually dropped quarter-over-quarter. I’m not sure if you addressed that but maybe just flush it out as well.

Mark Kaye, CFO

Thanks for the question. And Alex, your intuition, as usual, is spot on here. So we introduced, just as a reminder, ARR, or annualized recurring revenue in the first quarter of last year. And we continue to emphasize it as a very meaningful growth metric for MA as it removes the impact of uneven revenue recognition from some of these multiyear arrangements as well as sales mix. However, since this is the first time we’ve rolled over the metric from one calendar year to another, it’s probably just worth a second to do a quick refresh of definitions, right? So ARR is a constant currency organic metric, and it utilizes a single set of FX rates for each calendar year. And our ARR table in the back of the quarter’s earnings release translates both current period, which is the Q1 ‘23, and prior period, Q1 ‘22, at the same rates, right, with the idea of expressing sort of this constant dollar growth rate. So, sequential figures within the year are comparable but those that are across years are not. And if I adjust for the FX rates, what you’ll find is that approximately $80 million in ARR in 2023 was not reported simply because of that FX movement. In other words, U.S. dollar appreciation between last year and this year. And so, if we add back that $80 million of revenue to the Q1 ARR to make it more comparable to the 2022 number, you’ll see that growth come through in our reported figures.

Operator, Operator

And we have no further questions at this time.

Rob Fauber, President and CEO

Okay. So thanks, everybody. We appreciate you joining us on today’s call, and we look forward to talking with you next quarter. Take care.

Operator, Operator

This concludes Moody’s first quarter 2023 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. You may now disconnect.