Downgrade Moody's?

Failure to properly account for risk was a major contributing factor to the financial collapse. Over the past year, risk evaluators have been playing catch up. Armed with updated risk models and renewed vigor, credit rating agencies are on the rampage. The highlight of the year occurred when Standard & Poor's rocked the market with its downgrade of the United States' long-term credit rating. (For related reading, see A Brief History Of Credit Rating Agencies.)

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Despite the U.S. downgrade, the broad market bottomed not long after. If the influence of and over-reliance upon corporate credit rating companies is fading, are credit rating agencies themselves worthy of a downgrade?

Slash and Heat Up
Financials had a rough year; the Financial Select Sector SPDR (ARCA:XLF) is down more than 18% year-to-date. Part of the reason financials have performed so poorly comparatively is due to ratings agencies aggressively dinging banks' credit quality. Notwithstanding the rest of the market having rebounded after the U.S. credit rating downgrade, the SPDR S&P Bank ETF (ARCA:KBE) is still down around 24% during 2011.

Meanwhile, credit rating agencies have been on a tear. S&P's parent company, McGraw-Hill Companies (NYSE:MHP), has risen about 22% year-to-date. In addition to financial services, McGraw-Hill has several diversified business units. S&P competitor Moody's (NYSE:MCO), a pure play on credit rating agencies, is up more, climbing up around 26% this year.

Marginal Annual Revenue Growth
The misaligned aspect of Moody's outstanding price performance is that annual revenue growth has been marginal. Top-line growth relies heavily on strong debt issuance, where companies use Moody's Investor Services to rate their credit quality. Profitability did speed up earlier in the year before faltering last quarter as debt issuance slowed, income tax provisions rose and costs increased. A big part of the softer sequential revenues was in corporate finance, where issuance dropped from a record $200 million to $129 million. Margins compacted as the slower revenue growth couldn't cover higher costs.

On the positive side, Moody's Analytics is performing very well. The Analytics division, which provides research, data and analytics, is performing well; it is the lone segment that's mostly immune to issuance cycles. There are other bright spots. Taking into account the mess Europe is in, covered bond issuance may be relatively strong in the coming months because it is considered one of the safer ways to raise capital, and Moody's would benefit. For yield searchers, Moody's is aggressively raising its dividend. After the second dividend hike this year, Moody's yield is now 1.9 percent. That's not a yield to write home about, yet it is a solid dividend in the financial services group. (To learn more, read Investment Valuation Ratios: Dividend Yield.)

The Bottom Line
There's another significant macro factor to consider when looking at credit rating agencies. The huge number of layoffs for financial firms has dramatically trimmed headcount. As a result, an interesting dynamic is developing. The customers of credit rating agencies have fewer employees, and that means a lower cap on the number of licenses issued and a reduction in users per customer. Simply put, as big financial institutions like Bank of America (NYSE:BAC) and HSBC Holdings (NYSE:HBC) shed workers, fewer people are using the services and licensing fees are decreasing. That's a very negative trend. The offset is that this presents a selling opportunity for credit rating agencies. These same customers that previously would have used in-house staff for risk management, modeling and metrics have reduced capabilities and must now go outside the firm for services.

Whether Moody's can capitalize remains to be seen. Going forward, Moody's faces a challenging issuance environment in the U.S. and Europe. Credit agencies will continue to serve an integral role in capital markets, but at some point, Moody's revenue growth will have to support the premium valuation that the stock implies. Unfortunately, the Analytics division, where most of the growth is, does not represent the primary revenue source. Moody's may not be on negative credit watch, but investors might want to look elsewhere for credit quality. (To read more about the credit rating agencies, see Research Report Red Flags For Brokers.)

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At the time of writing, Matt Cavallaro did not own shares in any of the companies mentioned in this article.