Moody’s Corporation is a long-term compounder with high barriers to entry, huge pricing power and growth tailwinds.
Investment ThesisThe rating agency business model is excellent. It benefits from the deep entrenchment into the financial industry, pricing power and low capital intensity.
Rising debt issuance and increasing market share of bonds as percentage of overall debt issuance will be the gas propelling the business forward. Competitive markets drive down the returns on capital of most projects over time, so companies / governments will search for ways to reduce costs in order to deliver returns in excess of the required rate of return. They can achieve that by issuing more debt, changing their proportion of debt to equity, so they lower their overall cost of capital (funding costs). Basically the market will force companies to issue more debt in the long-term in order to be competitive. As market economies mature, the financing shifts from bank loans to the bond market. Developed capital markets enable companies to raise capital through the sale of bonds, which is crowd-sourced, more global, cheaper, more liquid and less restrictive.
The three rating agencies became the standard for debt rating by legislation. The mandatory usage of rating “languages” (rating grades) by the professionals created a protocol for communicating the riskiness of debt that was shared by others (network effect). Thus creating a huge competitive advantage for the incumbents as it would be too impractical for the practitioners to learn all the new languages of the new entrants in contrast with using the already widely shared ones created by the trusted incumbent rating agencies. There has never been a monopoly or more than 4 dominant rating agencies in this market over its 100 year history. Lawmakers made them disclose the methodologies and data of the ratings and even that didn’t put them out of business because of the cost of debt savings when rated by the prominent agencies as opposed to other rating agencies.
Ratings are useful as information filtering and so they are highly valued by the markets. Moody’s analysis suggests that its rating saves the average issuer 30 basis points of interest cost per year relative to no rating. In Heineken’s example it saved 30-50 basis points of yearly interest coverage and that is, for a business that faces low technological disruption, isn’t complex and is conservatively controlled, a potentially underestimation by Moody’s study. So assuming the pricing for a bond rating is ~7 basis points there is a gap between the value created for the customers and its pricing, room for an increase in pricing. If we assume a yearly price increase of 10% it takes ~15 years until the price matches the value provided.
The business model is low capital intensive. Analysts, software developers and office space is their main expense so they are able to return a significant portion of their earnings to shareholders.
Moody’s has huge pricing power, the competition faces high barriers to entry => high certainty of terminal value, has huge growth tailwinds, that growth flows to the bottom line due to the low capital intensity, thus is able to deploy much of the earnings to shareholders and function as a toll taker on global debt.
Catalysts
Central banks cutting rates
Strong M&A activity
Strong refinancing needs
Declining inflation
date: 16/01/2024
price: 473$
InterDigital is a highly profitable business with a digitalization tailwind and huge optionality.
Investment ThesisInterDigital “($IDCC)” is one of the largest pure R&D and licensing companies focused primarily on wireless, video, artificial intelligence and related technologies. Their technology has been licensed to ~7B devices and it owns ~32,000 patents. These patents are predominantly to cellular wireless standards - 3G, 4G, 5G, 6G, Wi-Fi technology, video technologies and standards. Customers include Amazon, Apple (for each 500$ phone InterDigital earns ~1,15$), Lenovo Group, Google, LG Electronics, Samsung Electronics, Sony Corporation of America and Xiaomi Corporation, among others.
Digitalization is a strong tailwind for InterDigital, the more devices that need to talk to each other fill up the electromagnetic spectrum which is owned by the government that auctions it to the wireless carriers. There is a limited supply with a growing demand dynamic. InterDigital owns patents that optimize the allocation of the spectrum thus maximizing the auctioned piece for the wireless carriers, providing huge value. As smartphones, cars and IoT devices need to talk to each other they have to communicate in a standardized way, again with some of the patents owned by InterDigital.
InterDigital derives revenues primarily from patent license agreements, these are fixed-fee, with a smaller portion coming from variable royalty agreements. When entering into a new patent license agreement the prior unlicensed use will be billed for, called catch-up payment/revenue, that is 100% margin, in addition to the license fees and royalties for the agreement. Variable royalty license agreements give InterDigital the right to audit the licensees’ books and records to comply with the agreement, if underpayments are revealed InterDigital seeks the amount owed. But usually the agreements are fixed-fee because the auditing process is resource demanding for a company of ~4B market cap. Its highest expense is R&D ~35% of revenue. InterDigital has over a billion for litigation, it does not play to return that capital to shareholders, because it is essential to stay competitive and enforce infringements.
As much as 50 % of smartphone companies that are using InterDigital patents are not paying for it. These companies are mostly in China and Africa where the institutions are not set up to respect patterns. Although recently Oppo group which is one of the largest smartphone manufacturers in China signed a license agreement with InterDigital. As the company progresses to sign more agreements with those that are not paying, it gets a lump sum payment and a long-term contract, which is an opportunity for growth. Untapped potential lies also in the cloud streaming market where the majority of the players are already using InterDigitals technology but yet have not paid for it, HD video download / upload encoding. It is inconceivable to not get paid in the future. Both of these opportunities are like a huge option that you basically get for free if InterDigital can gain market share similar to other patents and enforce these patterns.
The patents are protected by 20 years but after that there is no patent cliff. Continual patents development, for example they already have patents for 6G which will come after at least 6 years, and continual use of the old patents by companies since a lot of the new devices have to be able to communicate using even the older patents.
The Company faces competition from firms like Qualcomm, Nokia, Ericsson, but these companies all use the patents for their own products in contrast with InterDigital, which is an unbiased, pure research oriented, licensing business. The competition is mainly stagnant in its revenue, with profits all over the place, while InterDigital is growing. Paradoxically they are traded at 6 to 40 times the market cap. InterDigital is comparable to Dolby which trades at a TTM P/E of 30 compared to InterDigital 18.5 and with a higher growth.
The licensing business is long-term subscription-like agreements with some lump sum payments and occasional price increases. It is a stable high margin, 36-37% profit margin, business with low capital intensity, big buybacks, huge optionality in the cloud / streaming business that is trading at a low multiple.
Catalysts
New license agreements / renewals / price increases
New license agreements in the untapped smartphone market
New license agreements in cloud-streaming market
New crucial patents
Growth
date: 17/01/2024
price: 171,68$