Dali Has Entered Stage Left: Rating Agency S&P has Downgraded Rating Agency Moody's

S&P writes:

Overview

•We are assigning our 'BBB+' corporate credit rating to Moody's, a provider of credit ratings, research and analytic tools, among other services.

•We are also assigning a preliminary 'BBB+' senior unsecured rating to Moody's shelf registration.

•The rating and the stable outlook reflect our expectation that Moody's financial performance will remain healthy despite the potential for increased business risk associated with the financial reform legislation.
Rating Action

On Aug. 3, 2010, Standard & Poor's Ratings Services assigned its 'BBB+' corporate credit rating to Moody's Corp. We also affirmed the existing 'A-2' short-term rating. The outlook is stable.

At the same time, we assigned a preliminary 'BBB+' senior unsecured rating to Moody's shelf registration. According to the company, it will use the proceeds for general corporate purposes, which may include debt repayment, acquisitions, and share repurchases.

Rationale

The 'BBB+' corporate credit rating primarily incorporates our view of Moody's business risk following the passage of financial reform legislation by the U.S. Congress. While we believe potential business risks have increased, we continue to view Moody's business risk profile as "Satisfactory" (see "Criteria Methodology: Business Risk/Financial Risk Matrix Expanded," published May 27, 2009, on RatingsDirect), reflecting Moody's scale as a provider of credit ratings globally and the company's well-known brand. We believe that these factors will likely support Moody's ability to maintain its solid market position. In addition, we expect Moody's to maintain a relatively conservative financial policy with regard to share repurchases, dividends, and acquisitions. As a result, we believe Moody's financial risk profile is likely to remain "Modest," as demonstrated by good levels of profitability, a high level of conversion of its EBITDA to discretionary cash flow, low leverage, and high cash balances.

In our opinion, the legislation will likely result in more instances of defending against litigation and other changes in operating practices that will likely increase operating costs and thereby reduce profitability and margins. The legislation, among other things, addresses the applicable pleading standards for certain litigation brought against rating agencies. This is contained in a provision whereby investors may be able to sue a rating agency if they can show that the agency knowingly or recklessly failed to (1) conduct a reasonable investigation of the factual elements relied upon by a credit rating agency's rating methodology, or (2) obtain a reasonable verification of those factual elements from independent third-party sources. While we believe it is likely that the new pleading standard will lead to an increase in litigation-related costs at Moody's and therefore poses an element of risk, whether the new pleading standard may increase the likelihood of successful litigation against Moody's will be determined in the future by the courts.

Moody's management has stated that it plans to adapt its business practices in an effort to offset any potential new litigation-related costs associated with the legislation. Nevertheless, we believe that Moody's will likely face higher operating costs, lower margins, and increases in litigation-related event risk that we believe may present risks to the company's reputation. (See discussion under "Litigation" in our "Encyclopedia Of Analytical Adjustments For Corporate Entities," published July 9, 2007, on RatingsDirect as part of our Corporate Ratings Criteria.) While we believe the additional costs that Moody's may incur related to the legislation and to additional regulation around the globe may lead the company to experience margin compression, we believe Moody's is likely to maintain a good EBITDA margin at least in the 40% area on average, which is reflected in our investment-grade rating on the company. Per our criteria, potentially increasing business risk and lower profitability are key factors in our evaluation of Moody's business risk profile.

In addition, the final legislation removes many references to nationally recognized statistical rating organizations (NRSROs) from federal regulations, which may reduce investor demand for ratings. However, we believe this change is unlikely to impair Moody's business position over the intermediate term, as the company is likely to successfully defend its market position given its long track record and reputation as a rating agency of choice for investors.

Over the long term, we believe Moody's franchise likely will either be sustained or diminished based on the rigor, timeliness, and transparency of its analytics. In addition, Moody's business processes will likely undergo noticeable changes due to new global regulations and the U.S. legislation's impact on industry risk, which are business risk considerations under our
criteria.