In a nutshell

Moody’s Corporation is a long-term compounder with high barriers to entry, huge pricing power and growth tailwinds.

Investment Thesis

The 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

In a nutshell

Fair Isaac Corporation is a well positioned long-term compounder with significant pricing power and an upcoming tailwind propelling it forward. FICO is esentially a global toll taker on consumer debt.

Investment Thesis

Fair Isaac Corporation is a leading credit analytics company. It has become deeply entrenched in the financial system and is widely used by lenders, investors, regulators and others. The company has two segments: Scores and Software.

Its FICO Score has become a standard in global credit consumer ratings. It is used to assess the creditworthiness of a borrower on a scale from 300 to 850 based on the data provided by the three credit bureaus (TransUnion, Experian, Equifax), FICO does not store any data. The Score is the result of FICO’s proprietary algorithm applied to the data. The Formula is based on payment history (35%), credit utilization (30%), length of credit history (15%), credit mix (10%), new credit (10%). The score is then used in credit reports provided by the bureaus to their customers such as mortgage originators, banks, credit card issuers, lenders and others. A higher FICO Score leads to lower interest rates and loan terms.

Before 1960 there was no easy way to lend money because there was limited information about the borrowers, that limitation led to gathering data about relationships and other personal data that weren’t as helpful, so lenders charged a single flat rate to all the borrowers. The accumulation of data and applied scoring systems enabled variable interest rates based on the credit solvency of an individual. In the beginning the scoring systems were simply derived from questionnaires that included lots of questions and details that turned out not so objective, but still valuable to the companies because they could use variable rates and conditions. Since then the scoring systems have helped to personally tailor the conditions and reduce the uncertainty that would be projected into higher interest rates for all the lenders to compensate for the risk that the lenders are taking on themselves.

In 1974 Equal Credit Opportunity Act was passed and it prohibited lending on variables such as gender, race and marital status. FICO’s founders Bill Fair and Earl Isaac, mathematicians from MIT, saw this as an opportunity to create objective scoring. Since the FICO Score became available in 1989 it has become the standard protocol to communicate creditworthiness, although an alternative exists created by the three credit bureaus called the VantageScore, FICO Score is used by 90% of the top 100 U.S. lenders, 99% of credit securitizations, 90% of credit lending use cases. In 1995 Fannie Mae and Freddie Mac institutionalized the FICO Score by making it required for all mortgage originations that they handled. Today more than 230 million Americans can be scored by the FICO Score.

Lenders shifting from fixed flat rates to variable rates required customers to be scored or they would be either denied the loan or provided the loan under bad terms for the borrower. More people started to get scored and as more people got scored the scores became more entrenched in the system creating a huge network effect to the point of a FICO Score being widely used almost without a competition. The dominant position with a huge network effect leads to untapped pricing power.

FICO’s stable growth comes from increasing pricing over time and the growth of volumes of credit ratings done. FICO did not raise prices until 2018 leaving a runway for raising prices from then on. It is still relatively cheap (3,50$ per score) when compared to the tri-merge credit report (50-70$) and even more when compared to the ~5 500$ of closing costs per mortgage as well as ~320 000$ of average mortgage loan. The price increase (likely mid to high teens) is also passed on through the credit bureau to the lender and finally to the borrower. Usually the financial institutions are agnostic to the price increases since they are just passed on. The price increases come with ~95%+ margins. The Scores business is a highly profitable (operating margins north of 85%) monopoly-like business that generates a lot of FCF. A lot of companies also build on top of the FICO score and use their own analytic methods. FICO also has a B2C - myFICO - business that is ~⅓ of the revenue of the Scores segment. It allows the users to monitor their scoring from the credit bureaus data and it is a subscription business. FICO also does partnerships that monitor credit with third parties and FICO receives royalties, it helps to create the network effect for the market to use the FICO score.

FICO’s software business requires a lot of capital expenditures financed by the Scores business. There isn’t so much cross selling between the two businesses but since Scores are already widely used by a lot of the players in the financial industry it makes sense for them to try using the software as well. The software segment is much less cyclical because it is sold on a multi-year subscription with payments based on usage. Some of the software services help with fraud detection which is used in ⅔ of credit card transactions worldwide and can reduce fraud losses up to 50% (fraudulent transactions, identity theft,..) more than 9000 institutions provide data for the for the analytical AI model to assess the fraudulency which creates network effect as well. Other offerings help with loan origination, customer management, financial crimes compliance, marketing and optimization problems. FICO plans to move all the software offerings to its subscription platform. In the software segment it competes with different players in each of the services it provides, it has a 30% operating margin.

Overall the business is very sound. It is not easy to replicate. Even if someone came up with a comparable scoring system it would not be enough to disrupt the FICO Score because of its deep entrenchment in the financial system (network effect). It is hard to disrupt a widely used and trusted protocol (the Score) => dominant market position. Pricing power stems from the dominant position and a big runway for price increases. The business is capital light with just 25 million CAPEX on 1,7B sales (~1,5%) - not much reinvestment is required for the business to keep going and growing. The management uses that excess capital to buy back stock - bought back 20% of outstanding shares over the last 5 years and 25% over the last 10 years demonstrating shareholder centered approach. The valuation may seem to be stretched but going forward the pricing power combined with low reinvestment needs and buybacks (hopefully when the price is right) create a long-term compounding engine. That will become more recognized when the mortgage origination volume picks up again sometime in the future (as expected by the Mortgage Bankers Association) from the recent lows creating a huge tailwind for the business.

Catalysts

price increases
mortgage volume origination growth
buyback programs

In a nutshell

InterDigital is a highly profitable business with a digitalization tailwind and huge optionality.

Investment Thesis

InterDigital “($IDCC)” is one of the largest pure R&D and licensing companies focused primarily on wireless, video, artificial intelligence and related technologies. Their technology has been licensed to ~7B devices and it owns ~32,000 patents. These patents are predominantly to cellular wireless standards - 3G, 4G, 5G, 6G, Wi-Fi technology, video technologies and standards. Customers include Amazon, Apple (for each 500$ 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

In a nutshell

Siemens Energy is toll taker on infrastructure servicing with issues in its wind segment behind the company is set up to grow its network effect by entrenching itself deeply into the energy infrastructure.

Investment Thesis

Siemens Energy (ENR) is a leading company active in the energy technology and service value chain. The company is a leader in some segments in the electricity generation and has a dominant position in other segments. Demand for its offerings are hugely leveraged by the megatrends in electricity power demand – electrification, AI energy needs and decarbonization.

ENR was spun out from Siemens in 2020. ENR comprises four segments:

• Gas Services (~31% of revenue, FY28 target - revenue LSD / MSD, net margin 12-14%, backlog €45b ~80% service, #2 in Gas turbines > 10MW)
  design, manufacture, and service of gas and large steam turbines, large generators, and heat pumps.
• Grid Technologies (~26% of revenue, FY28 target - revenue LDD, net margin 13-15%, backlog €33b, #1 Solutions, #2 Products)
  solving the complexity of integrating renewable energy into the energy grid infrastructure.
• Transformation of Industry (~14% of revenue, FY28 target - revenue HSD, net margin 10-12%, backlog ~€8b ~30% service, #1 Steam Tech. Generation)
  reducing greenhouse gas emissions in industrial processes.
• Siemens Gamesa (~29% of revenue, FY28 target - revenue LSD / MSD, net margin 3-5%, backlog €38b 50% service, #1 Offshore, #3 Onshore)
  design development, and installation of products in the renewable energy sector with a focus on onshore and offshore wind turbines.

Overall, the world's growing hunger for power, limited by the current industry’s capacity and the shift to decarbonization, requires a lot of investments. Current environment – electrification, decarbonization, increasing population and living standards, growth in data centers, aging infrastructure, global warming – serves the business well as tailwinds in each of the segments propel ENR forward. The shift from coal to gas as well as the need for peaking as renewables grow in numbers serves GS. Aging infrastructure in advanced economies needs to be replaced (as much as 50% by 2030) which is good for GT as well as the digitalization trend which helps GT’s digital solutions. Solving decarbonization helps ToI’s business by forcing more firms to seek solutions that help them reduce CO2 emissions. Finally, demand for wind energy should serve Siemens Gamesa well.

The wind energy segment – Siemens Gamesa – ran into issues within its wind turbine manufacturing segment caused by cost inflation and quality related issues that led to big losses in the segment that significantly brought down the whole company. I believe the issues are over as the contracts are being structured with escalation clauses for inflation (hard to hedge years in the future, these costs should be passed on to the owners and the demand for ENR’s products should make it transferable) and the quality issues are being managed as stated in Q1 2024 earnings call:

“I am happy to share that we have not suffered any further setbacks in onshore wind, and that offshore ramp up is progressing in line with our plans.”

and

“We have materially completed the root cause analysis for the priority one quality issues [in onshore wind], and for 80% of these we have short-term measures in place. We have already defined long-term corrective actions for half of the quality issues for half of the quality issues, while we continue to implement remediation and mitigations actions.”

The company also began taking orders for its onshore wind segment. As the company distances itself from the issue and it becomes clear that they are profitable (or break-even) on the wind business (break-even target FY26) interested investors will likely return.

Siemens Energy has many competitive advantages. As a 178 year old company it has a long track record of delivering engineering excellence and trusted service, plus it has a strong balance sheet with €7,2b in cash. All that is important for contractors that sign a long-term service agreement with ENR to make sure that the company is going to be around for a long time to service the equipment. It is especially valuable for states (national grid operators) that the contractor will be around long in the future. With the already consolidated market (offshore wind just GE / ENR and Vestas), recent war conflicts in the world focused states on energy security and motivated them to minimize the reliance on unreliable suppliers, thus I think (at least for the state backed projects) there won’t be many foreign entrants especially from China, Russia and the like. Despite ENR and GE Vernova being almost the same business with the same revenue, backlog, forward potential margin, GE Vernova trades at 2,6% FCF yield compared to ENR’s 3% as well as GEV EV/EBITDA of ~63 compared to ENR’s multiple of ~11 and even grew faster.

Brand name of a company that has been around for that long can’t be replicated and creates barriers to entry as well as a network effect. As demand for its products grow, propelled by tailwinds (as we are early in the supercycle of renewing the grid), Siemens Energy builds infrastructure that has to be also serviced by them which comes with high margins (above 20%). So even if they sell the assets at a slight loss they still get the sticky high margin contracts. Owning the assets and servicing them comes with high pricing power as well and with the current backlog of ENR ~€123b ENR can cherry pick the contracts with best terms and conditions (one of which could be price increases). It is also relatively low capital intensity with CAPEX to sales = ~4,4%. With a network effect in place each additional infrastructure piece placed down by ENR leads to high value in the future. ENR’s products play a major role in the future functioning grid that generates energy with ENR’s products, is connected to the grid by ENR’s products, is moved around with ENR’s products and all that is serviced by ENR – a huge ecosystem. Basically a future where Siemens Energy is everywhere around you, but you don’t notice it in daily life.

Catalysts

Siemens Gamesa becomes break-even
The company hiting management targets
Ramping up the production
New service agreements