Moody`s Corp (MCO) — Q2 2023 Earnings Call Transcript

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 second 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 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.

Thanks, Shivani. Good afternoon, and thanks to everybody for joining today's call. As we typically do, I'm going to touch on a few key takeaways from our second-quarter results and provide some insights into what's supporting our growth outlook. I also want to continue to highlight some of the exciting growth opportunities within the Decision Solutions line of business. And this quarter, I'm going to spotlight our insurance business. Then I'm going to talk about how we are positioning ourselves for what I tend to think of as a generational opportunity provided by generative AI. And as always, Mark and I will be happy to take your questions. We delivered strong performance across the firm this quarter. MIS achieved its first quarter of revenue growth in six quarters amidst a steady improvement in issuance. In fact, revenue grew 6%, outpacing a 3% increase in issuance. And the improvement in the issuance environment was led by a 54% increase in investment grade activity. This, combined with the ongoing gradual recovery in high-yield bonds, has led us to raise MIS' revenue guidance for the full year to high single-digit growth, up from our prior guidance of low to mid-single-digit growth. We continue to sustain a 10% ARR growth in MA, selling into strong demand for our suite of mission-critical data analytics and workflow tools. And this quarter, we're introducing some additional top line disclosures for our banking, insurance, and KYC businesses so that we can provide you with more insight into the robust performance of Decision Solutions. The stronger-than-expected revenue growth in MIS is driving the increase in our full year adjusted diluted EPS guidance of $9.75 to $10.25. We continue to balance our expense control measures while furthering our investment in the business. We're capitalizing on our unique ability to integrate proprietary data sets and advanced capabilities from across our businesses into tailored cloud-based solutions. We're innovating and investing extensively across the company to build further on this momentum with several key initiatives focused around generative AI technology turbocharged by our recent partnership with Microsoft. Our businesses continue to scale, and we spent considerable time talking with investors about how to think about the Moody's of today. We've got several great crown jewel businesses; anchoring those businesses, of course, is MIS, the global agency of choice for issuers and investors. But in MA, we have one of the world's premier subscription-based fixed-income and economics research businesses, a data business powered by what we believe is the world's largest database on companies and credit, plus three cloud-based SaaS businesses serving banking, insurance, and KYC workflows. These businesses help banks, insurers, corporates, and public sector entities engage in risk management. We leverage a tremendous set of proprietary data analytics and domain expertise across a range of areas: credit, companies, properties, securities, people, economies, ESG, climate, and more. We think of that as our risk operating system, and we thread that content through our solutions, which makes our customer value proposition both sticky and differentiated. With that backdrop, let me touch on MIS for the quarter. The headwinds of the first quarter have largely dissipated, leading to more constructive market conditions and a surge in investment-grade issuance. In fact, May was one of the busiest months on record for investment-grade activity, as both corporate and infrastructure issuers came to the market opportunistically. Investment-grade activity opens the door for issuance further down the rating scale, which has led to the ongoing recovery in high-yield bonds. We saw the strongest issuance quarter since the beginning of 2022 in high-yield, which drove an almost 50% increase in our high-yield revenue versus the prior year period. Based on this stronger-than-expected performance in both investment-grade and high-yield, we're raising our issuance and revenue guidance for MIS for the full year. The backdrop to the market recovery remains fragile, and of our first-time mandates signed in the second quarter, only about 25% have issued, as some corporate treasurers and CFOs wait for more market certainty regarding inflation, rates, and the economy. Muted M&A activity is also contributing to a limited supply of leveraged loans, negatively impacting CLO creation since over 60% of these loans typically get securitized. In other structured finance asset classes like CMBS and RMBS, higher all-in funding costs are restricting asset creation, resulting in fewer deals, leading us to take down our structured finance issuance forecast for the year. Despite softer issuance markets over the past year, we've been strengthening our position in the markets of the future. Our strategic investments in emerging markets have been ongoing for years because although these markets account for about 50% of global GDP, they represent less than 10% of cross-border issuance. We recognize this opportunity for long-term growth. We've held our annual Emerging Markets Summit, which attracted participants from over 90 countries. We closed on the acquisition of SCRiesgo, a domestic credit rating agency serving Central America, further strengthening our growing Moody's Local franchise across Latin America. We're positioning MIS as a leader in assessing decentralized finance, digital bonds, and asset tokenization. This month, we rated the European Investment Bank’s first-ever digital green bond, and we continue to grow our sustainable finance franchise within MIS with good momentum in second-party opinions. We've completed over 92 second-party opinions through the first half of this year, including marquee issuers like NL and the government of Mexico. We've delivered 36% growth in SPO volumes versus the same prior year period. Moving to MA, I described decision solutions as three cloud-based SaaS businesses serving banking, insurance, and KYC workflows. We will provide revenue and ARR metrics for each business going forward, and all achieved double-digit revenue growth in the second quarter, with together they delivered 10% ARR growth, with KYC leading at nearly 20% ARR growth. Our insurance business, serving both life and P&C markets, collectively generates around $500 million in ARR and represents a significant part of the broader MA portfolio. Insurers are undergoing significant transformation as they work to digitize and automate manual workflows, presenting new opportunities for us. Our AXIS and RMS risk engines play a crucial role in our offerings, with AXIS widely used for actuarial and finance modeling. The demand for our fully automated service that allows insurers to send their actuarial modeling jobs to a cloud-based infrastructure is increasing. Moreover, this quarter we held our most successful global insurance conference ever, Exceedance, with over 500 customers attending, where we announced several important new product innovations. With our cloud-based Intelligent Risk Platform, we now have over 100 customers utilizing it, allowing for more granular, high-definition models. We’ve partnered with NASDAQ to provide our customers seamless access to a wide array of CAP models, enhancing the capabilities of our IRP as a broader industry workflow platform. We have over 900 insurance customers globally, with significant opportunities for cross-selling. Our top 10 largest insurance customers purchase about six to seven product families across all of MA, and our next 90 largest insurers buy four to five product families on average. Meanwhile, our remaining 800 customers buy only one to two products, indicating a strong cross-sell opportunity. One example of how we are growing our insurance relationships includes a significant U.S. insurer that initially spent $15 million annually with us but has grown to over $30 million due to our products, including AXIS and RMS. In KYC, we've seen strong growth as our customer base has expanded, with less than 10% of our insurance customers using KYC products in 2021, now up to about 20%. We are optimistic about further potential here. We are recognized for our innovative solutions, recently winning Chartis' inaugural Insurance 25 Award for our solutions spanning climate risk modeling and financial analysis. Artificial intelligence is fundamental to many of our products, and it has been for years. We’ve developed in-house tools like QUIQspread, an AI machine learning tool that digitizes financial data, and it’s integrated into several products, including our CreditLens loan origination offering. Our AI review product, trained on over 12 million actual KYC analyst decisions, currently processes over 110 million names this year, significantly reducing false positives and improving efficiency. NewsEdge utilizes deep learning and natural language processing to enhance data retrieval and sentiment generation across multiple domains, processing nearly 1 million new stories from over 20,000 sources daily. Our historical foundational AI experience uniquely positions us to capitalize on the immense opportunities presented by generative AI. We partnered with Microsoft to combine our proprietary data analytics with Microsoft's generative AI technology, which will allow us to create new offerings that provide deeper insights into risk. Earlier today, we published a teaser demo of one of our first generative AI innovations, the Moody's Research Assistant, an interactive chat feature across our data sets to provide customers with integrated perspectives on risks. This assistant will access multiple data domains and deliver personalized results to users. We are beginning to preview this innovation with customers to showcase its extraordinary value, powered by Microsoft's technology and anchored by Moody's proprietary data. I want to acknowledge our employees. During June, over 3,000 Moody's teammates participated in 150-plus volunteer projects across 32 countries, delivering over 8,600 volunteer hours to make a difference in our communities. Our people are living our values, and it’s impressive to see. That concludes my prepared remarks. Mark and I would be very happy to take your questions.

Good afternoon and thank you for taking my question. So it looks like MA has more investments into product development such as AI Rob talked about, but it dragged down the operating margin in the second quarter and also full year guidance. So I think it will be great if you can maybe give us an update on the seasonality of your P&L by segment and how we should think about that? Thanks.

Sure. Good afternoon. Thanks for the question. So last quarter, we anticipated that near-term capital markets and activity would be constrained before progressively improving in the second half. While issuance was indeed lower in certain asset classes than expected, such as structured finance, we did observe higher-than-anticipated investment-grade volumes due to strong investor demand for our high-quality credits. Taking that into account along with our expectation for stable market conditions for the remainder of the year, we are lifting our full year 2023 global MIS-rated issuance to the mid-single-digit range and our MIS revenue growth to the high-single-digit percent range. Our MIS revenue growth for the remainder of the year is expected to be in the low to mid-20s percent on average versus the relatively low year-to-date 2022 comparable period. This also means we anticipate our MIS 2023 year-to-go revenue in absolute dollars to be comparable to the pre-pandemic levels we observed in the second half of 2019. On the MA side, our reaffirmed guidance for full year 2023 MA revenue is to grow approximately 10%, and our mid-90% retention rates imply that second half revenue will be in the low-double-digit percent range, reflecting strong ongoing demand for our subscription-based products. We forecast that MA adjusted operating margin will step up compared to the second quarter and then improve again in the fourth quarter as MA fully realizes the benefits of our restructuring program and additional cost saving initiatives. Our full year 2023 total Moody’s operating expense growth remains within that mid-single-digit percent range, balancing expectations for higher incentive and stock-based compensation costs with improvements in our issuance outlook. The full year 2023 operating expense guidance translates to a low-single-digit percent decline in MIS and high-single-digit percent growth in MA.

No problem. Thanks a lot. Very helpful, Mark.

Hi, thanks. Good morning. So 2Q debt issuance and ratings revenue performance was strong and led you to raise your full year guidance for MIS. That said, debt issuance in July so far has been relatively weak. How much of a pull forward in debt issuance into 2Q do you believe happened? And does your guidance reflect simply a flow-through of 2Q outperformance, or does it assume a stronger 3Q and 4Q than you previously expected?

Hey, George, it’s Rob. This is probably a question on the minds of many looking at first half, second half, and triangulating to our full year guide. We certainly saw stronger investment-grade issuance in the first half than we expected. We do think that was due in part to some pull forward in advance of the debt ceiling. The stress in the U.S. banking sector dissipated faster than we expected, leading to a return of market confidence. As we look into the second half of the year for leverage finance, our current run rate appears sustainable. We expect a low-20s percent increase in issuance for the second half of 2023, which combined with what we saw in the first half gets us to this mid-single-digit outlook for the year.

Got it. Very helpful. Thank you.

Thank you. If I can just ask you about all these GenAI initiatives you highlighted, are those all incremental expenses or how are you thinking about that in terms of spend and budget versus what you were already doing before?

Manav, good afternoon. We expect to realize meaningful productivity gains and efficiency as we progressively incorporate GenAI into our Moody’s ecosystem, from technology and software development organizations to our customer support and research teams. It’s too early to provide estimates around the extent of these efficiencies, but initial pilots are promising. We’ve seen material productivity benefits through both error reduction and coding time acceleration. Another benefit is the opportunity GenAI brings to our rating analysts where the use cases are vast, transforming part of our analytical workflow and helping them focus on forming valuable opinions.

I’d also say, in terms of your question about investments, we’re able to leverage much of our existing investment. Most of our solutions are on the cloud, and we have expertise across the firm around AI. While there will be incremental compute costs associated with running these models, it’s still early for us to detail how the pricing structure will look.

Got it. Thank you.

Great. Thanks so much. Just to follow up on the Generative AI a little bit, is there any way to think about where you are in the process in MA versus MIS? Do you think there is a long-term margin perspective as you leverage AI across both MA and MIS?

It’s important to discuss both sides here. From a delivery perspective, we see a compelling opportunity. We’re early days, engaging with customers to understand the demand for our generative AI products. We’re building a firm-wide infrastructure to deploy these innovations, which aligns to our capabilities across the organization. MIS teams are actively engaged with our AI enablement team and searching for ways to process information and deliver new insights. We believe this will turbocharge our analysts while also creating productivity gains.

Makes sense. Congratulations.

Yes. Hello, everyone. I can't believe I'm asking another GenAI question, but can you share if you can isolate AI-enabled revenues today? And how long do you think it’ll take to scale?

That’s a great question. I don’t have that answer today, but it’s something we can follow up on. We’re currently in preview mode with customers for feedback. Pricing and packaging are still being determined, but our research assistant will likely be an add-on feature to our existing offerings. We think there’s a unique revenue opportunity here that extends beyond just making our products better and could yield significant results.

Very helpful. Thank you.

Thanks for taking my question. I wanted to focus on the free cash flow, that guidance was raised by almost $200 million, which was much better than the EPS guidance range. Can you discuss that and from a capital allocation perspective, how should we think about the rest of the cash?

In the second quarter, our free cash flow result of $549 million was significantly higher than the prior year period due to an improvement in working capital, and we also had stronger net income. This quarter, our free cash flow to GAAP net income conversion was almost 150% compared to just 66% in the prior year. We are pleased to increase our share repurchase guidance to $500 million, returning over $1 billion to shareholders this year through share repurchases and dividends. We continue to prioritize maintaining a BBB+ rating to balance the cost of capital with financial flexibility.

That’s very helpful.

Thank you. Wanted to ask about Slide 9. In the insurance part of the business, are you seeing anything current that explains the ARR only growing at 6%, while revenue growth is at 12%? Any details on KYC growth drivers would be helpful as well. Thank you.

Certainly. In KYC, we continue to see strong growth and are adding both new logos and upselling existing customers. The volume of multi-product deals is up 91%, and sales are strong across integrated solutions. In insurance, the ARR number reflects cross-selling synergies with RMS, which are robust. Mark, do you have additional insights on the ARR performance?

You could expect the ARR for insurance to reach a high single-digit growth by year-end, while KYC could see high teens or even low 20s growth.

Thanks so much.

Hi, good afternoon. It seems like issuers, particularly in the high-yield market are opting for shorter maturities. Are you seeing this across debt categories and how should we think about the impact on MIS revenue?

Between 2020 and year-to-date 2023, the average duration of MIS rated IG bond issuance peaked at about 15 years and has steadily reduced to just under 12 years. For high yield, the average duration is now around six years. Shorter maturities lead issuers to come to market more frequently, resulting in stronger transactional revenue, without fundamentally affecting our fee structure.

Makes sense. Thank you.

Thank you. Can you discuss your debt issuance outlook for full year 2023 by category, particularly high yield and bank loans? And also, can I get the incentive comp number for the quarter?

In the second quarter, the incentive compensation was $99 million compared to $66 million in the prior year period. Year-to-date incentive compensation accrual is $188 million, about $45 million above the first half of last year. We expect total incentive comp for the full year to be between $370 million and $390 million, driven by our improved outlook for full year 2023 MIS revenue.

Regarding leveraged finance, we saw cautiously active markets. There was some activity in high-yield with oil and gas issuers returning, while leveraged loan issuance was softer due to muted M&A activity. For our full-year outlook, we’ve raised high-yield growth to 40% and modified leveraged loans to mid-single-digit growth. Moving to structured finance, volatility and rising funding costs have led to a slowdown in activity, especially in CMBS and CLOs. We revised our outlook for structured finance to mid-teens percent for the year.

Great, thank you.

Yes. Hi. Thank you. I wanted to follow up on structured finance and the competitive environment. Are there areas where you're stronger than competitors, and is structured finance a focus for investment?

Structured finance has a range of active agencies competing in the market, making it more transactional. We have a strong presence in areas like CMBS, but the overall market has experienced a decline in issuance due to concerns in the office and retail sectors. We remain focused on strengthening our coverage and adapting to market conditions as needed.

Great. Thank you so much.

Hey, good afternoon everybody. I was wondering if you could delve more into FIG revenue, which is up 13% versus issuance up 5%. Can you provide more details on what’s going on there?

We’ve broadened our FIG customer base to include alternative investment and various managers, bringing some volatility to the revenue outcomes. We saw opportunistic issuance from the insurance sector this quarter, giving us higher revenue than on traditional issuance models.

Makes sense. Thank you. I appreciate it.

Hi, thanks for taking my question. It’s good to see the improvement in MIS. As you look ahead, what do you consider the biggest overhang right now? Is it the actual rate or the uncertainty?

Typically, I’ve said uncertainty is the most challenging factor. Markets absorb higher rates when they’re anticipated. The market doesn't react well to surprises and volatility, which complicates issuance. We’ve seen issuance firm up as certainty around the rates increases solidifies, but we are still cautiously assessing the remainder of the year.

We feel rates are likely approaching their peaks. We expect the Fed will pause without a sudden increase in unemployment or economic collapse. We anticipate a rise in the global default rate above the long-term average but not to pandemic or financial crisis levels. We're also monitoring macro themes including potential stimulus from China and the U.S. dollar exchange rate.

Great. Thank you.

Hi, Mark. Could you tell us the FX effect on second quarter revenues, both from MIS and MA in total?

In the second quarter, MA revenue was favorably impacted by 0.3%. The impact of foreign currency translation on MCO and MIS revenue is immaterial.

Okay.

Regarding first time mandates, we saw down activity compared to previous quarters, likely due to the softer leveraged loans market. Despite an uptick in our private engagement, first-time mandates are slower than pre-pandemic averages. We’re seeing greater activity with private ratings and monitoring services.

Perfect. Okay. Thank you very much.

Thank you.