Morningstar has announced the launch of its corporate credit ratings initiative which will initially cover 100 companies with plans for expansion to 1,000 companies as additional credit analysts are hired in the coming months. As we have discussed in recent months, the economic moats of the established credit rating firms such as Moody’s and Standard & Poor’s has continued to shrink in light of multiple high profile ratings failures during the financial crisis.
According to a Wall Street Journal article, Morningstar is leveraging its equity research analysts to conduct the credit research work. The company has hired two credit analysts and plans to hire ten more in the coming months which will expand coverage to the 1,000 company target. Morningstar plans to stick with corporate credit ratings and will not rate individual bond issues or complex structured products.
Extension of Equity Analysis
The fact that Morningstar is initially leveraging equity analysts to generate credit ratings makes a great deal of sense when one considers that the factors involved in producing a thorough analysis of a company’s equity in many ways overlaps with credit analysis. Morningstar is one of the few publications that explicitly considers the presence of an economic moat when evaluating a company. The presence or absence of a moat has major implications for credit quality, as stated in Morningstar’s introduction to their ratings methodology:
If you’re at all familiar with the way Morningstar analyzes companies, you’ll recognize the key components to our credit rating methodology: the emphasis on economic moats and competitive analysis, the focus on the size and sustainability of free cash flows, and the assessment of the uncertainty surrounding a firm’s operations and future profitability. In launching credit ratings, we’re codifying work that we’ve been doing for years.
Indeed, many of the most sophisticated value investors regard common stock as the most junior “bond” in a company’s capital structure. Bruce Berkowitz had the following comments regarding this subject at a conference call on September 30 (click here for a summary of the call):
At Fairholme, we treat common stock as the most junior bond in a company’s capital structure, where the true earnings, the free cash flow of a company, are akin to a coupon without a maturity date. We get really excited when we can find more senior and secure bonds that yield better than average equity-like returns. We then compare market prices to our estimates of free cash flows, to determine an expected return on investment.
“Cash Flow Cushion” Concept
Morningstar’s concept of a “cash flow cushion” represents one of the principles of their ratings methodology. This measure is designed to estimate how many times a company’s internal cash generation plus excess cash will cover debt and debt-like contractual commitments over the next five years. Morningstar includes contractual commitments such as lease obligations and retirement plan contributions as “debt-like” commitments.
One potential weakness is obviously related to the analyst’s ability to evaluate a company’s future cash flow generation capabilities. This is clearly more easy to accomplish when evaluating larger established businesses with a significant economic moat.
One interest aspect of Morningstar’s methodology is that analysts appear to take into account both maintenance and expansion capital expenditures when calculating free cash flow available to service contractual obligations. In the example provided for 3M, Morningstar considers the fact that the company has been acquisitive in the past and may continue to pursue such a strategy in the future. While this may be true, expansion capital expenditures are typically discretionary and presumably would not be pursued if doing so would put a company at risk of default. The inclusion of forecasted expansion cap-ex in the “Cash Flow Cushion” measure indicates a bias toward conservatism on the part of the analysts – perhaps not a bad thing in light of recent events.
Step in the Right Direction
While credit ratings are never a substitute for investor due diligence, having a more competitive marketplace for ratings is potentially a positive development for investors. Morningstar appears to be committed to examining a reasonable number of companies based on the number of analysts dedicated to the task. Additionally, the fact that Morningstar is avoiding ratings of individual structured securities and not accepting payments for ratings from issuers is a positive step. While it is too early to know whether Morningstar’s efforts might displace incumbent firms, the methodology seems to be solid and unlikely to result in massive failures like those we have seen over the past two years where impaired securities retained AAA status up to the point of default.