Good day, and welcome, ladies and gentlemen, to the Moody's Corporation fourth quarter and fiscal year end 2016 earnings call. At this time, I'd like to inform you that this conference is being recorded and that all participants are in listen-only mode. At the request of the company, we will open up the conference for questions and answers following the presentation. I would now like to turn the conference over to Ms. Salli Schwartz, Global Head of Investor Relations and Communications. Please go ahead.
Thank you. Good morning, everyone, and thanks for joining us on this teleconference to discuss Moody's fourth quarter and full year 2016 results, as well as our outlook for full year 2017. I am Salli Schwartz, Global Head of Investor Relations and Communications. This morning, Moody's released its results for the fourth quarter and full year 2016, as well as our outlook for full year 2017. The earnings press release and a presentation to accompany this teleconference are both available on our website at ir.moodys.com. Ray McDaniel, Moody's President and Chief Executive Officer, will lead this morning's conference call. Also making prepared remarks on the call this morning is Linda Huber, Moody's Executive Vice President and Chief Financial Officer. During this call, we will be presenting non-GAAP or adjusted figures.
To view the nearest equivalent GAAP figures and a GAAP reconciliation, please refer to our earnings release that was filed this morning. Before we begin, I call your attention to the safe harbor language, which can be found toward the end of our earnings release. Today's remarks may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In accordance with the act, I also direct your attention to the Management's Discussion and Analysis section and the risk factors discussed in our annual report on Form 10-K for the year ended December 31st, 2015, and in other SEC filings made by the company, which are available on our website and on the Securities and Exchange Commission's website. These, together with the safe harbor statement, set forth important factors that could cause actual results to differ materially from those contained in any such forward-looking statements.
I would also like to point out that members of the media may be on the call this morning in a listen-only mode. I'll now turn the call over to Ray McDaniel.
Thank you, Salli. Good morning, and thank you to everyone for joining today's call. I'll begin by summarizing Moody's fourth quarter and full year 2016 financial results. Linda will follow with additional financial detail and operating highlights, and I will then conclude with comments on our outlook for 2017. After our prepared remarks, we will be happy to respond to your questions. In the fourth quarter, Moody's revenue of $942 million increased 9%, primarily as a result of higher issuance in global leverage finance, U.S. CLOs, and U.S. public and project finance, as well as continued strength from Moody's Analytics.
Many of Moody's other fourth quarter and full year 2016 financial measures were impacted by the company's January 2017 agreement reached with the U.S. Department of Justice, 21 U.S. states, and the District of Columbia to resolve pending and potential civil claims related to credit ratings assigned during the financial crisis era. The agreement, while costly at $864 million, removed legacy legal risk as well as future costs and uncertainty. As such, we felt that putting these claims behind the company was in the best interest of Moody's, our employees, and our shareholders. Fourth quarter adjusted operating expense, which excludes the $864 million settlement charge, was $551 million, up 3% from the fourth quarter of 2015. Fourth quarter adjusted operating income, which excludes the settlement charge as well as depreciation and amortization, was $424 million, up 17% from the same period last year.
The adjusted operating margin for the fourth quarter of 2016 was 45%, up 320 basis points from 41.8% in the fourth quarter of 2015. Adjusted EPS for the quarter was $1.23, up 13% from $1.09 in the fourth quarter of 2015. Fourth quarter 2016 adjusted EPS excludes a $3.63 loss from the settlement charge and a $0.18 gain from a non-cash foreign exchange benefit related to a subsidiary liquidation. Turning to full-year performance. Against volatile market conditions, Moody's achieved 2016 revenue of $3.6 billion, up 3% from 2015. Foreign currency translation unfavorably impacted Moody's revenue by 1%. Moody's Investors Service record second half revenue overcame a very challenging first quarter, allowing MIS to record a 2% revenue increase to $2.4 billion. The impact of foreign currency on MIS revenue was negligible. Moody's Analytics revenue surpassed $1.2 billion in 2016, a 7% increase over the prior year.
Foreign currency translation unfavorably impacted MA revenue by 3%. Adjusted operating expense, which excludes the settlement charge and a $12 million restructuring charge, was $2.1 billion, up 4% from the prior year. Foreign currency translation favorably impacted expense by 2%. Adjusted operating income, which excludes the settlement and restructuring charges as well as depreciation and amortization, was $1.6 billion, up 3% from 2015. Moody's adjusted operating margin for 2016 was 45.5%, consistent with the prior year. Recognizing ongoing uncertain macroeconomic and geopolitical conditions, our 2017 outlook is for mid-single-digit percent revenue growth and EPS of $5.15-$5.30, which includes an estimated $0.15 benefit from an accounting change related to equity compensation. I'll now turn the call over to Linda to provide further commentary on our financial results and other updates.
Thanks, Ray. I'll begin with revenue at the company level. As Ray mentioned, Moody's total revenue for the fourth quarter was $942 million, up 9% from the prior year period. U.S. revenue of $534 million was up 11%. Non-U.S. revenue of $408 million was up 6% and represented 43% of Moody's total revenue. Foreign currency translation unfavorably impacted Moody's revenue by 2%. Recurring revenue of $472 million was approximately flat to the prior year and represented 50% of total revenue. Looking now at each of our businesses, starting with Moody's Investors Service, total MIS revenue for the quarter was $608 million, up 12% from the prior year period. U.S. revenue increased 11% to $376 million. Non-U.S. revenue of $232 million was up 13% and represented 38% of total ratings revenue. The impact of foreign currency translation on MIS revenue was negligible.
Moving to the lines of business for MIS, first, global corporate finance revenue for the fourth quarter was $278 million, up 13% from the prior period. This result reflected increased levels of U.S. and European-rated bank loan issuance, as well as higher global speculative grade bond rating revenue. U.S. and non-U.S. corporate finance revenues were up 6% and 28%, respectively. Second, global structured finance revenue for the fourth quarter was $131 million, up 14% from the prior year period. This result reflected increased deal activity in U.S. CLOs and CMBS and in European RMBS and CLOs. U.S. and non-U.S. structured finance revenues were up 18% and 7%, respectively. Third, global financial institutions revenue of $89 million was down 4% from the prior year period, primarily as a result of reduced European banking issuance. U.S. financial institutions revenue was up 4%, while non-U.S. revenue was down 8%.
Fourth, global public project and infrastructure finance revenue of $103 million was up 21% versus the prior year period, primarily driven by strong non-U.S. infrastructure and U.S. public finance issuance. U.S. and non-U.S. public project and infrastructure finance revenues were each up 21%. MIS other, which consists of non-rating revenue from ICRA in India and Korea Investors Service, contributed $8 million to MIS revenue for the fourth quarter, up 10% from the prior year period. Turning now to Moody's Analytics, global revenue for MA of $334 million was up 4% from the fourth quarter of 2015. U.S. revenue of $158 million was up 11%. Non-U.S. revenue of $176 million was down 1% and represented 53% of total MA revenue. Foreign currency translation unfavorably impacted MA revenue by 4%. On a constant currency organic basis, MA revenue grew 5% in the fourth quarter.
Moving now to the lines of business for MA, first, global Research, D ata and Analytics or RD&A revenue of $167 million was up 3% from the prior year period and represented 50% of total MA revenue. Growth was mainly driven by new sales and contract upgrades for credit research and ratings data feeds. U.S. RD&A revenue was up 7%, while non-U.S. revenue was down 1%. Foreign currency translation unfavorably impacted RD&A revenue by 4%. Second, global enterprise risk solutions or ERS revenue of $130 million was up 7% from last year. The growth was driven primarily by the March 2016 acquisition of GGY, as well as an increase in software license revenue. U.S. ERS revenue was up 24%, while non-U.S. revenue was down 1%. Foreign currency translation unfavorably impacted ERS revenue by 3%. Trailing 12 months revenue and sales for ERS increased 12% and 4%, respectively.
Product sales were up 13%, while services declined 16%, reflecting our progress on shifting the mix of the ERS business to emphasize higher margin products. Third, global professional services revenue of $37 million was down 3% from the prior year period. U.S. professional services revenue was flat, while non-U.S. revenue was down 4%. Foreign currency translation unfavorably impacted professional services revenue by 3%. Turning now to operating expense, Moody's fourth quarter adjusted operating expense, which excludes the settlement charge Ray mentioned earlier, was $551 million, up 3% from 2015. The increase was primarily attributable to increased incentive compensation, the March 2016 acquisition of GGY, and annual merit increases, largely offset by management savings initiatives implemented in early 2016. Foreign currency translation favorably impacted adjusted operating expense by 3%. As Ray mentioned, Moody's adjusted operating margin increased 320 basis points to 45% in the fourth quarter.
I'll provide an update on capital allocation. During the fourth quarter of 2016, Moody's repurchased 558,000 shares at a total cost of $60 million, or an average cost of $107.48 per share, and issued 86,000 shares as part of its employee stock-based compensation plan. Moody's returned $71 million to its shareholders via dividend payments during the fourth quarter of 2016. For full year 2016, Moody's repurchased 7.7 million shares at a total cost of $739 million, or an average cost of $96.38 per share, and issued 2.8 million shares as part of its employee stock-based compensation plan. Moody's returned $285 million to its shareholders via dividend payments during 2016. The total capital returned to shareholders in 2016 was $1 billion.
Additionally, on December 21st, 2016, Moody's increased its quarterly dividend by 3%, from $0.37 to $0.38 per common share of stock. Outstanding shares as of December 31st, 2016 totaled 190.7 million, down 3% from December 31st, 2015. As of December 31st, 2016, Moody's had approximately $700 million of share repurchase authority remaining. At year-end, Moody's had $3.4 billion of outstanding debt and $1 billion of additional borrowing capacity under its commercial paper program, which is backstopped by an undrawn $1 billion revolving credit facility. Total cash equivalents, and short-term investments at year-end were $2.2 billion, with approximately 78% held outside the U.S. Free cash flow in 2016 was $1.1 billion, up 4% from 2015, primarily due to changes in working capital. With that, I'll turn the call back over to Ray.
Thanks, Linda. I'll conclude this morning's prepared comments by discussing our full-year guidance for 2017. A complete list of Moody's guidance is included in our fourth quarter and full year 2016 earnings press release, which can be found on the Moody's Investor Relations website at ir.moodys.com. Moody's outlook for 2017 is based on assumptions about many geopolitical conditions and macroeconomic and capital market factors, including interest rates, foreign currency exchange rates, corporate profitability and business investment spending, mergers and acquisitions, consumer borrowing and securitization, and the amount of debt issued. These assumptions are subject to uncertainty, and results for the year could differ materially from our current outlook. Our outlook does not include any estimated impact for potential changes in U.S. tax laws or other possible policy or regulatory changes. Our guidance assumes foreign currency translation at end-of-year exchange rates.
Specifically, our forecast reflects exchange rates for the British pound of $1.24 to GBP 1 and for the euro of $1.05 to EUR 1. As I noted earlier, Moody's expects full-year 2017 revenue to increase in the mid-single digit % range. Adjusted operating expense is expected to increase in the low single-digit % range from the 2016 adjusted operating expense of $2.1 billion. On a constant dollar basis, the revenue growth rate would be approximately 120 basis points higher, and the adjusted operating expense growth rate would be approximately 170 basis points higher. The company is projecting an operating margin of approximately 43%, up approximately 100 basis points compared to 2016's operating margin, excluding the settlement and restructuring charges of 42%. Adjusted operating margin is expected to be approximately 46%.
The effective tax rate is expected to be approximately 31%-32% and reflects the U.S. accounting change related to equity compensation as well as changes to U.K. tax laws, as noted in our earnings press release. Full-year 2017 EPS is expected to be $5.15-$5.30, including the estimated $0.15 per share benefit resulting from the accounting change previously mentioned. Free cash flow is expected to be approximately $500 million, which includes the payment of the settlement charge recorded in the company's fourth quarter 2016 financial results. Moody's expects share repurchases to be approximately $500 million, subject to available cash, market conditions, and other capital allocation decisions. Capital expenditures are expected to be approximately $100 million. Depreciation and amortization expense is expected to be approximately $135 million. For MIS, the company expects full-year 2017 revenue to increase in the mid-single digit % range.
Both U.S. and non-U.S. revenues are expected to increase in the mid-single digit % range. On a constant dollar basis, the revenue growth rate for MIS would be approximately 100 basis points higher. Corporate finance revenue, structured finance revenue, and financial institutions revenues are each expected to increase in the mid-single digit % range. Public project and infrastructure finance revenue is expected to increase in the low single-digit % range. For Moody's Analytics, the company expects 2017 revenue to increase in the mid-single digit % range. U.S. revenue is expected to increase in the low single-digit % range, and non-U.S. revenue is expected to increase in the high single-digit % range. On a constant dollar basis, the revenue growth rate for MA would be approximately 180 basis points higher. Research, D ata and Analytics revenue is projected to increase in the high single-digit % range.
Enterprise risk solutions revenue is expected to increase in the mid-single digit % range, and professional services revenue is expected to increase in the low single-digit % range. This concludes our prepared remarks, joining Linda and me for the question and answer session are Mark Almeida, President of Moody's Analytics, and Rob Fauber, President of Moody's Investors Service. We'll be pleased to take any questions you might have.
Thank you. If you'd like to signal for a question, please press star one. Once again, that's star one to be placed in the queue, we'll pause for a moment to allow everyone an opportunity to signal. Again, as a reminder, that's star one to signal. We'll go first to Alex Kramm with UBS.
Yeah. Hey. Hello, everyone. I think my questions are mainly for Linda today. Starting with the expenses, I think the margin guidance was a nice surprise relative to what you've said before. Could you walk through the puts and takes a little bit more? How should we think about what's driving the upside? Is it the way you've ended in terms of being soft on hiring this year? What about legal expenses that might be coming down post the settlement? Maybe any color on variable compensation, what we should be expecting there for the year? Thank you.
Hey, Alex. Glad you're happy, have a couple of points to make about that. We did do better in 2016 due to some pretty rigorous expense control measures that we took back in February of last year. We did better at the conclusion of '16, even than we had expected. Those controls will continue going into '17. We feel pretty good about guiding to approximately 100 basis points of margin expansion. Some of that does come from savings in legal costs, the majority is what we're doing in terms of hiring. We have slowed the pace of hiring for the corporation. MA continues to move a little bit faster than the rating agency and shared services. Looking at '16 over '15, MIS is actually down in head count shared services is approximately flat.
All those things have helped us just with good general housekeeping and some discipline. In terms of incentive compensation, let me find the right page here and we'll talk about that. As what sometimes happens, we notice that in the fourth quarter, because our performance was a good deal stronger in '16, Alex, the quarters had gone in '16 for incentive compensation, about $32 million, $35 million, $42 million. As sometimes happens, the fourth quarter was $59.6 million in incentive compensation. For 2017, probably the right thing to model there is somewhere between $40 million and $45 million per quarter of incentive compensation. Does that hit most of what you wanted?
I think that got everything here. Secondly, similar on cash flow, I guess. How should we be thinking about the settlement and how you will actually end up paying for that and the timing of all of that? If you can run through the buybacks. Are those going to be more third quarter or fourth quarter? How about, are you going to draw on the revolver or the commercial paper program? What's the interest rate we should be thinking about? I don't think you've guided on interest expense. Just think about, you have a lot of cash overseas. You generate decent cash here, but maybe not enough. How should we be thinking about that? Maybe lastly, related to that, how do you think about leverage in general?
If you need to raise a little bit more debt for this, I think you're hitting some of your initial targets. Are those targets changing? How do you think about it from being a rated company yourself? Anything we should be thinking about here? Thank you.
Okay, Alex, that's about all the questions.
Sorry about that.
Let me try to start with the DOJ settlement. The happy news is we're done, or we're just about done. The payments have been made. Those were largely completed. The way we did that was cash on hand, U.S. cash on hand. You'll recall back in 2016, we reduced share repurchase guidance from $1 billion to $750 million. Also for those who've been paying close attention, we've reentered the commercial paper market. We have about $600 million of commercial paper outstanding right now, about an average maturity of 60 days, and we're paying about 1.2% on that commercial paper. We're very happy with the receptivity of the commercial paper markets, and that's how we have financed the payment of the settlement. Again, that's done. Going forward, we've guided to about $500 million of share repurchase for the rest of the year.
That's subject to many things as we've discussed already, but some of it is how cash flow comes in for the year for the company. We'll see. As we announced the settlement, one of the other rating agencies that looked at us did provide a little bit more leverage room for us under its measure, which is now 1.52 times rather than the 1.5 times that you had seen before. We very much like our rating category that we have right now, and we don't like to run right up to the edge of our leverage level. We feel that we have some dry powder. We're happy about that. We have at least $500 million of dry powder, something like that, as we look at what we might want to do for 2017. We like the leverage levels. We have a bit of room.
Share repurchase about $500 million, again, we just want to be thoughtful given everything that we've just had to deal with, and we don't like to be too close to the edge in terms of the leverage levels. I don't know if Ray had anything else you wanted to add. I think that's most of it.
No, I just want to underscore both, this is implied both in the question and then addressed directly by Linda's answer. Between our cash on hand and our various borrowing options, we feel we have quite a bit of flexibility. We are going to be making decisions according to market conditions as we go through the year. As I imagine you would expect, we're going to pay close attention to what we think are the best opportunities.
Yeah. Alex, one final point which may not have been taken into account by everyone looking at their models. We did do some financing in 2016, excuse me. You'll see in 2017, the roll-forward effect of that interest expense. Secondly, we do have the $600 million of CP, and we are considering the term market at this time. We'll see what we decide to do about that. Again, if we take that 1.2% expense, I'm sorry, the rate we're paying for the CP and we term that out, I think it'd be fair to say that we would expect that that interest expense would be a little bit heavier. We're considering that right now, and that's one of the reasons why everything doesn't flow fully down to EPS. Very helpful as usual. Thank you.
We'll go next to Joseph Porizi with Cantor Fitzgerald.
Hi. My first question is just, any thoughts on issuance given the new administration? I'm sure you're predicting that one. What could that do to your current projections? Any internal scenarios you're setting up for?
Joe, what we'll do, I'll go through what we usually do regarding our views that we're hearing from the investment banks, and then we have an exciting new feature. Rob Fauber's going to add a little bit of color in terms of what the rating agency is noting in the marketplace. Starting with the U.S. view, and again, this is coming from the investment banks, and it's sort of an averaging of what we're hearing from the different banks. Investment grade right now is running very, very strong. January was $200 billion in issuance. A strong month is $100 billion. And this is record January supply. Financials had dominated, as well as significant issuance from TMT companies. For the year, we're looking at about $1.2 billion of U.S. investment-grade issuance. That's about flat year-over-year.
The pipeline is robust as corporates exit their blackout periods and potentially look to get ahead of Fed rate hikes later in the year, which might be June, could be March, and then potentially again toward the end of the year. We note that many issuers we're hearing from the banks pre-funded in favorable 2016 issuance environment, that might serve as a bit of an offset to 2017. We're thinking about the M&A pipeline, which is bouncing around a bit. For U.S. high yield, $35 billion issued so far, $250 billion expected for the year, which is up 5% year-over-year. 2017 has started on a positive tone. Large cash inflows to high yield, recovering commodity prices, and attractive yields are very constructive. More constructive default scenarios and energy price outlooks are helping with the backdrop, and we think that will support 2017 high yield bond issuance.
Leveraged loans so far, $120 billion. That is a torrid pace, $400 billion expected this year. The year is expected to be down 15% year-over-year. For right now, stability in the macro backdrop is aiding the leveraged loan market. With potential interest rate increases, the floating rate view is preferred for investors. We continue to have CLO formation, and that will support leveraged loan activity. Not enough, though, to surpass the elevated levels of 2016. Now moving to Europe, what we've heard from the banks, investment grade in Europe, volumes were higher than usual in January as issuers took advantage of the good conditions and low rates. The ECB and Bank of England continue to buy bonds and support the market. There's a strong pipeline as issuers look to go to market ahead of key political events in Europe and potential ECB tapering.
We're about two months away from the French election. That's the first major event. High yield in Europe and the leveraged loan market remain in robust shape. ECB bond buying has indirectly supported the high-yield market and should help maintain rates at all-time lows. Macroeconomic and geopolitical risks continue to be key focus, though, in Europe, particularly for the speculative grade market. Now I'll invite Rob to make any further comments that he might want to offer.
Linda, that was pretty thorough. I don't have too much to add to that. I might just talk about a little bit of the upsides and downsides in general and how we're thinking about issuance. Certainly, higher economic growth leading to more capital investment and in turn, debt financing would be a positive. Some sort of infrastructure stimulus, either privately funded or in the municipal market. A more constructive M&A environment, certainly Linda touched on that. I think importantly, a pull forward of these 2019 through 2021 maturity walls. We think we're seeing some pull forward now, but if we see more pull forward, that could provide some upside. Things we're thinking about as potential headwinds, I think you mentioned, potentially unfavorable tax changes. I know there's been a lot of discussion around that, around corporate interest, tax deductibility, repatriation of foreign cash.
Interestingly, we did see in January some very large issuance from some big tech players who have large cash balances offshore. We're looking at trade developments that could disrupt market stall investment. Obviously watching the election calendar in the EU. Strengthening of the US dollar would also be something that would have an impact on us as well.
Not that we're supposed to ask the questions, but Rob, you had mentioned one of the pieces of research we released last week on the refinancing walls.
Yep. I don't want to confuse people because I don't have the global numbers handy. We just put out some research last week. In regards to the U.S. spec grade maturity wall, we're looking at the five-year maturity wall is now over $1 trillion for the first time. That's up about $100 billion from the study this time last year.
Got it. Any color, though, on sort of real time, what the clients are telling you, given the new administration? Are you seeing a wait-and-see approach or any pull forwards? I'm just wondering if there's anything outside of what you've laid out from the issuance side of things.
No, this is Ray. Obviously, conditions were very strong in January, the markets remain active in February. We really don't expect to see the January kind of numbers in the loan and high-yield sectors continue at that pace, but market conditions remain good. All of that indicates that issuers are taking advantage of a tight spread environment. They may be moving ahead of uncertainty later in this year, whether it's policy uncertainty here in the U.S. or the potential implications of unexpected outcomes in the European election. The pull forward is, I think both a recognition of good market conditions and potential uncertainties later in the year.
Okay. The last one from me. On the regulatory side, we've heard about some repeal, maybe at some large institutions. Just wondering if you had any thoughts about any of that impact on your Analytics practice. Thanks.
Yeah. I'll let Mark comment on how they're thinking about that, and I'll add any color if appropriate.
Yeah. I'd say that we're not seeing any meaningful impact to any of the talk about pullback on banking regulation, for example. We're still seeing very good demand for our products, for regulatory requirements, as well as some of the accounting rule changes that are coming through, both the IFRS 9 and the Current Expected Credit Loss, CECL program that's coming in in the U.S. Nothing meaningful from our standpoint.
Thank you.
We'll go next to Bill Warmington with Wells Fargo.
Good morning, everyone, and congratulations on the strong quarter.
Thanks.
First question, wanted to ask about new issuer rating mandates for 2016, how that's been trending versus previous years.
The fourth quarter was up year-on-year. We had I think about 175 new rating mandates in Q4. That's good looking forward into the new year. We are not at the peaks we were at back in 2013, 2014, but it has been a stable flow of new mandates at healthy levels, just off peak levels. Rob, I don't know if there's anything else worth adding on that.
No, I think that's right.
Yeah.
How is the breakdown between Europe and U.S.?
I don't have that number in front of me. Rob is telling me it was skewed towards the U.S., at least in the fourth quarter.
Okay. On the Moody's Analytics side, just wanted to ask how things were looking at RD&A in terms of how the retention rates have been holding up, how the pricing realization has been.
It continues to be strong on both fronts. We're running in the mid-90s on customer retention. Pricing is solid. We're seeing good upgrade activity. That's all strong. Any softness we see in the RD&A numbers for the quarter really are down to currency. We really took it on the chin on currency translation in Europe. It hit us pretty hard. The underlying business is as strong as it's been over the last couple of years.
Okay. Last question on ERS. You had mentioned the GGY acquisition, which you're going to be anniversarying, and also some what looked like very strong software license revenue. I was going to ask for some help in terms of modeling that out for the rest of the year, how we should think about that.
Yeah. Well, you're right. We had a good year in 2016 because we had very good performance in the business. We also had help from the GGY acquisition, that was all good. Linda also referred to the fact that we are making good progress on our transition in the mix of the business. As we've been talking about for a while, we are de-emphasizing the services piece of the business and focusing much more heavily on sales of products that are much more scalable and therefore much more profitable. The impact of that will flow through to 2017 revenue in the sense that we had a deliberate revenue decline in the services segment of the business. You're going to see that flowing through to revenue growth in 2017.
We're guiding toward mid-single-digit revenue growth in ERS, and I think the way to think about that is think about 2017 in terms of ERS revenue growth as sort of a transition year as we shift the mix of the business away from services and focus more heavily on products, which we think will drive a much stronger P&L over the coming years.
Got it. Thank you very much.
We'll go next to Manav Patnaik with Barclays.
Hi, good afternoon. Linda, just to follow up on the expense commentary, could you give us the ramp that you usually guide us to from now to the fourth quarter? Also, how much of that 100 basis points is coming from the Moody's Analytics side? Maybe you could just update us on the efforts for the margin improvement there.
Sure. Manav, the first question's a little bit easier, maybe I'll let Mark think a little bit about what he wants to say on your second question.
This year, we're hoping that the ramp will be a little bit flatter than it's been in previous years. To give you somewhere to start, I think I've got this right, we're looking at about $532 million for the first quarter budget for expenses in 2017. We're looking at the ramp going up $20 million-$25 million from the first quarter to the fourth quarter. Now I'll give the same warning that I give every year. That includes the view that incentive compensation lays out pretty evenly for the year. We haven't had that sort of performance recently. In 2016, you'll note, incentive comp went way up in the fourth quarter because of the strong performance. All things being equal, you want to start with $532 or so and take it up $20 million-$25 million.
Now, we've had some pretty significant margin work in MIS and some pretty strong cost controls in shared services in 2016. That reduces the run rate increase for 2017. Mark's continuing to focus on margin by looking at its higher margin businesses as we said in the prepared remarks. I don't know, Mark, if you want to make any other comments on your thoughts.
Yeah, I would only observe, consistent with what we've said before, that I think we are making good progress with the MA margin. The challenge that we have is it's difficult for you to see that because of the way that we allocate overhead expense to the two operating businesses. MA, as it's been growing faster than MIS over the last two years, is attracting more overhead. That's sort of offsetting the work that we're doing in the business itself. It's difficult for you to see it because of that. It's difficult for you to see it because of the impact on the margin, at least in the short run, with some of the acquisitions we've made. We believe we're making good progress. We think that progress is only going to get better over the coming years.
It is going to be difficult to see it on the MA standalone P&L, just given the way we treat overhead expense.
Is the target still mid-20s over several years?
Yes.
Yes.
Just one on the ratings side, maybe Rob can add some color here, but I think you guys have put out some pieces around tax reform and the impact on issuance. It sounds like for Moody's specifically, obviously the lower tax and repatriations are positive. Just on the broader tax reform piece, I guess it sounds like the view is it should be a negative, but how should we think about timing and how that impacts issuance and the company's decision-making? Any help or color there would be helpful.
That's right. When we look at potential changes in taxes, there are a number of puts and takes. Certainly to the extent that there are impacts from changes in interest deductibility, you have to count that as a negative. To the extent that debt financing is still a low-cost form of financing, you would have companies that have more available cash. It would probably be a stimulus for economic growth, I would hope and anticipate we would see more new money borrowing. The quantification of whether it ends up being a net negative or a net positive is difficult to assess without having more detail about what the actual changes in tax law would be. As we see that, we will obviously communicate it.
Got it. All right. Thanks a lot, guys.
We'll go next to Toni Kaplan with Morgan Stanley.
Hi, good morning.
Good morning.
Good morning.
In 2016, your transactional ratings revenue growth was up about a half a percent while your biggest competitor was up about 6% in transactional ratings. What do you think the key drivers are that explain the delta there, just given that historically you've been a little bit more in terms of transactional mix shift, just wanted to figure out what we should be thinking about.
Toni, it's Linda. This is one of the most difficult types of questions for us to answer because we can see what goes into that view for us, of course, we don't know what goes into that calculation for our competitor. Makes it pretty hard for us to judge. I'll ask Rob if he wants to make any other comments on this, we don't have as much clarity on that as you might think, it's a little hard for us to parse. Rob?
Yeah. The only thing I think I could surmise would that it be some sort of shift in the mix.
Just to add onto that, our transaction versus recurring revenue splits remained fairly constant in 2016 versus 2015, so we didn't see any big shifts there.
Okay, great. I guess related, can you just talk about sort of the pricing environment within MIS?
Sure. It's Linda. We had spoken about at Investor Day back in 2016, that we felt pretty good about the pricing environment. I think that continues. I think I had noted then that we expected to be closer to the 4% end of the range we had said of 3%-4%. We are very interested in providing appropriate value for what we do, and we think that we've made some significant investments in what the team has been able to do in terms of ease of use and otherwise a very strong value proposition, which I'll let Rob talk about. We're feeling okay about pricing. Rob, anything else you want to mention?
No, I think that's it.
Okay, great. Your long-term framework calls for EPS growth in the teens. This coming year, you're expecting a mid-single-digit MIS growth environment. Why only 5% on the EPS increase excluding the tax benefit? I think you did mention perhaps the higher interest expense before rolling into 2017 from the actions you took in 2016, are there other pieces that we should be thinking about as well?
Toni, you might want to note the new accounting provision is helpful to us. The U.K. has a couple of laws that's going to limit the interest deductibility piece to 30% of EBITDA, that is costing us about 160 basis points on the tax line. The tax line is, in this climate, one of the more challenging things for us to predict. If we do see a change in tax policy, I would note, which might be helpful to you, that a 1% change in the ETR, that's 100 basis points, gives us $0.07-$0.08 in EPS, which is a lot. We're quite sensitive to what happens to that tax line, you know that we've guided to 31%-32%. We'll see what happens with that, there's obviously some variability around it.
We're taking a prudent view on this given what we know now. If we have adjustments, we'll be happy to discuss those with you on future calls. Ray, I don't know if you want to-
The only other thing I would direct you to is the fact that we do have higher financing costs this year than we did last year. Part of that is the roll forward of financing that we did during the year last year. Part of it is the fact that we've done some financing and we'll continue to do some financing as a result of the settlement with the Department of Justice and the payments that were made there. That's just giving us an increase in that line that we normally wouldn't see.
Thanks a lot.
We'll go next to Warren Gardiner with Evercore.
Great. Thanks. On the margin in analytics in the quarter, it sounds like there were a couple of moving parts there with GGY and some FX. Any sense you could kind of parse that out for us and give us what you think the core margin would be for that business?
I can tell you that if we ignore the additional overhead expense that we absorbed and we ignore the impact of the acquisition, for the quarter, the margin would have been flat to 2015. I should also note that we had a couple of million dollars of non-recurring expense in the fourth quarter of 2016 that we won't have going forward. If you want to look at on a run rate basis, you want to back out a couple million dollars for that as well.
Okay. I guess on expenses overall, for Linda maybe, this has kind of been asked a little bit, in the past you guys have given us a sense what you might have to pull back on if things got choppy. Any sense of what that level of flexibility would be for 2017?
Yeah, I think I'd stick to what we said in 2016. We always tell you guys we can achieve $50 million of expense savings, voila, we achieved $50 million of expense savings. There's probably another $50 million in there across the company. I would note that we are being very thoughtful about expenses. We note that both operating expenses and CapEx. CapEx is looking to be up about $100 million as we go through 2017. We've had a little bit of lightening up in terms of our real estate projects. We had taken two floors in One World Trade Center in 2016. As you know, we're making some investment in our technology, we expect that to lighten up a little bit in 2017, we're guiding to $100 million, as we had said.
Just across the board, we're just being really careful with what we're doing and considering every cost. We do have a procurement group that's done a really nice job on some of our expenses, such as T&E, we're managing very closely. We'll think about maybe flexibility for another $50 million for 2017.
Got it. Okay. Makes sense. Thanks a lot.
Next to Andrew Benjamin with Goldman Sachs.
Thanks. Good afternoon. I guess I wanted to come back to the ERS growth and the assumed deceleration in mid-single digits from double digits the last three years. I know you called out the mix shift of going towards products away from services. One, I just want to confirm, just for similar offering, the implication is that it's lower priced. I just want to confirm that that's right, for one. Then two is how much of it is that versus just you being conservative the last couple of years? I think you've guided the mid-single digits, and put up something much healthier than that.
Yeah. Andrew, a couple of things. First, as Linda said earlier, she noted that trailing 12-month sales in ERS are up 4%, then she decomposed that. She said that product sales, again, trailing 12 months, product sales are up 13% and services are down 16%. If you just start with the trailing 12-month sales for ERS up 4%, that sort of flows through to our mid-single digit revenue guidance for 2017, right? Because we've got sort of the lag on revenue recognition. That's sort of how we get to the guidance. The mix shift, again, is designed to deliver more margin. I think you're right in talking about fees. You're right in the sense that over the last number of years, we've done some very large projects for customers where we charged many millions of dollars for the services work that we did.
In that respect, not doing projects of that scale and charging those kinds of fees for services will put a bit of a drag on top-line growth. We think that because the product is more mature, it is more scalable, it meets more needs for more customers, we think we'll be able to sell more. I guess what I'm saying is we're going to make it up to some degree, we're going to make it up on volume. We'll be able to, as we get through this transition, we'll be able to get to a better growth rate over time. Then the other thing to keep in mind here is that decline, that 16% decline in services sales in 2016, was kind of a one-time phenomenon. Our expectation is that we'll hold that line flat going forward. You won't see a big contraction there.
We'll be holding that flat while the product line continues to grow at a double-digit rate. We think we're going to get to, on balance, we'll get to a much healthier overall growth rate in ERS, which is why I say it's healthy to think of, or helpful to think of 2017 as a transition year for the business.
Okay. That's helpful. I guess just to follow up on the margin question a couple other people asked. Definitely makes sense that you're getting more overhead. You've been talking about that for a while now. It's just explicitly to make sure we modeled it right. Should we assume that margins for that business are up next year as you work through this transition, or is the getting to the mid-20s more back-end loaded?
Well, again, we don't give specific margin guidance by line of business. I will tell you again, that if you ignore the GGY acquisition, you ignore the additional overhead that we attracted in 2016, and if you ignore that couple of million dollars that I mentioned, that non-recurring expense that we had in the fourth quarter, we would've seen over 100 basis points of margin expansion in MA from 2015 to 2016. I would expect that trend to continue.
Okay, thanks.
We'll go next to Peter Appert with Piper Jaffray.
Thanks. Ray, what's left on the legal front?
Fortunately, not much. If we step back and look at all of the crisis-era litigation, we've now disposed of better than 90% of what we were facing globally. Very little left in terms of numbers.
Linda, I understand their rationale in terms of a lower pace of share repurchase in 2017. Should we anticipate then that in 2018, maybe you get back to more of the billion-dollar kind of run rate you've been doing in recent years?
Peter, it's hard for us to guide that far ahead in terms of share repurchase. We do look at market conditions. We do want to reinvest in our businesses, and share repurchase oftentimes is sort of the last number that we look at given that we thought it was best to be prudent for this year. Yes, we would like to return to more vigorous share repurchase, we're going to have to see. It's too early to tell where that will go.
I think the fairest thing we could say looking out that far is we believe we would certainly have the capacity to do so.
Yes
Would make those decisions near the date.
Got it. Then lastly, Rob, just on the trends in the structured finance market, which seems like it's basically come back to life. Any commentary in terms of changes you're seeing in the market that might give you more confidence in the sustainability volumes there? Any commentary on competitive dynamics, because it does seem like there's more competitive pressures in that market than you see elsewhere. Thanks.
Yeah. Maybe I'll focus primarily on the U.S. It's obviously the largest market. In the ABS sector, got off to a bit of a subdued start as folks were still adapting to the Reg AB II loan level reporting requirements. The pipeline's certainly heating up and activity is heating up in February on some very strong demand there.
In terms of CMBS, we saw a very weak start that was due to a pull forward of deals from the risk retention deadline at the end of the fourth quarter of 2016. I would say that CMBS hasn't weathered risk retention quite as well as the CLO market. We've only seen two risk retention compliant deals get printed since the deadline at the end of December. That said, there is a pipeline building in CMBS. In CLO, we've seen some very strong issuance continuing into the first quarter of 2017. Obviously you saw in our results there was a very strong issuance in the fourth quarter due to a real pull forward from 2017 into 2016 in advance of that risk retention deadline. I would note that much of the early volume in the first quarter in CLOs is refi.
As spreads have come in, we are starting to see some new CLO formation come into the March pipeline. As the CLO market seems to have found some structures that work within the risk retention framework. Just in terms of from a competitive standpoint, our coverage continues to be strong, we actually have seen some nice gains in our coverage in Europe.
Thank you.
We'll go to Timothy McHugh with William Blair & Company.
Yes, thanks. Just on the margin question, obviously 2017's better, I guess. Are you finding things that you didn't expect, or are we seeing some of the expected margin expansion that you talked about at the Investor Day in terms of the path towards 45%, just come faster than you would have otherwise expected?
Yeah. I think it's a couple of things. We have taken actions in 2016 that were somewhat accelerated against our original expectations, and we're getting the benefits of those. We've also got a little bit, as you might imagine, better position on the legal side now than we had last year. We are still anticipating that we can move to the mid-40s % margin overall, again, subject to the mix of the two different businesses. Yes, you've got an acceleration of what we were identifying earlier in the year last year. Linda, I don't know if there's anything else you wanted to add to that.
Yeah. We're very pleased with the progress we made in 2016. I think we even surprised ourselves, frankly, Tim. We did a $12 million restructuring charge. The genesis of that was split sort of half and half between the rating agency and shared services. We're being very careful with what we're doing in headcount, and in shared services we're very thoughtful about our use of lower cost locations, and those are our own employees that we're using in those lower cost locations. We've gotten the run rate down, and we're very happy about that, and we're being really careful about what we do going forward. I think it's good housekeeping, and Ray and I encouraged our colleagues to think hard about the margin line, and everybody really got the message and did a great job, and we expect that will continue.
We run the business in a very disciplined way. We've been very careful in terms of adding new headcounts and even backfilling. We're pleased with what we're seeing, and we're doing a little bit better than we even thought. We're very happy with all that. There's no magic to it. It's just day-to-day hard work and good discipline.
Okay, great. Thanks. Just a follow-up on the tax benefits from the new stock comp rules, I guess. Is that causing more seasonality in the tax rate than we should expect? Because I know there's timing differences sometimes and when you'll recognize the benefit associated with that part of it. I don't know if the U.K. rule has similar.
Yeah, sure. The U.S. rule probably will see seasonal effects, and we've estimated about $0.15, but there are a number of factors that go into that which could move around. We would urge everybody to think about that as an approximation. A lot of that might come into the first quarter when our restricted stock awards vest, and there are a bunch of factors there. One is, what is the exercise price? Second is, what is the pace of that exercise pricing? The timing, the number, and any number of other factors. We would expect that effect might be heavier in the first quarter, particularly given very happily where the stock price is right now. We'll see how that lays out. This is new to us, and we'll give more information as we see what we get in the first quarter.
Okay, thank you.
We'll go next to Craig Huber with Huber Research Partners.
Great. Thank you. Just a broad question on the tax policy potential changes we hear out of Washington. If they do get rid of interest expense deductibility in the U.S. as part of overall tax reform, is you guys' base case that would hurt potentially high yield issuance much more so than investment grade issuance? That's my first question.
I think it would probably have more of an impact on high yield. Again, though, just trying to weigh the puts and takes on that. It's also high yield companies that are going to
Probably want to take most advantage of having additional cash on hand. That gives them more flexibility. It might cause them to engage in different behaviors, whether it's from an M&A standpoint or business expansion. I do think the premise of your question probably leans against high yield more than it leans against investment grade. There's pluses and minuses in both cases.
Ray, I assume you'd say that probably even more so if the interest expense deductibility was limited to only up to 30% of EBITDA, similar to what you talked about in the U.K., and I guess Germany has as well, as opposed to getting rid of it 100%.
Yeah. There's what it does in an absolute sense, it's also relatively what is still the more or less attractive ways to raise capital. Even if it's less attractive, if it's still the most attractive, you would expect firms would make rational economic decisions.
Ray, as a follow-on to that, if you just isolate, I know this is hard, if you just isolate if the corporate tax rate, U.S. federal rate, goes from 35% to 15% or 20% or thereabouts, what is your general sense on what that could do to debt issuance in terms of, obviously it should be more pro-growth out there and stuff, what do you think it would do from debt issuance from an M&A perspective and investing back in companies, et cetera?
Yeah.
What do you think it could be to debt issuance?
I don't have a quantification of that for you, Craig, again, the pluses and minuses that we've outlined in a couple of our comments throughout the call indicate that we don't expect dramatic change in what is happening around our business. It's going to have some impact, whether it's at 15% or 20% or 25%, and we're just going to have to see.
Linda, a couple quick housekeeping questions. Maybe I missed this. What percentage of your cash hoard is outside the U.S. right now, if you would, please?
78% is offshore now, Craig. The numbers are U.S. is roughly $500 million. International is roughly $1.7 billion. That totals to $2.2 billion. A little bit more, 78% overseas. That's because we used some of the U.S. cash as we dealt with the DOJ situation. As we noted, the very vast majority of the settlement payments have already been made.
As has been the case in the past, a substantial fraction of our foreign cash is also held in U.S. dollars.
Okay. Lastly, Linda, if I could just ask, just given the ongoing concerns around Brexit, for your ratings business, was your revenues out of the U.K. for full year 2016 roughly 7%-8% of your ratings revenue again? Is that a fair number to think about?
Offhand, excuse me, Craig. I'm not certain. We're puzzling and looking at Rob to see if he has any further information.
Yeah. It's not as straightforward as you might hope, Craig, because we do both U.K. entity-based ratings out of the U.K., but we also do European-based ratings, EU-based ratings out of the U.K. The companies that are issuing into the EU may be followed from any one of a number of offices. Both how the revenue gets apportioned and then how the expense base supporting that revenue gets apportioned are subject to some interpretations of what's in and what's out. The U.K. is not a large part of our overall European business, but I don't have a fraction I can give you.
Okay. Thank you.
We'll go next to Jeff Silber with Bank of Montreal.
Hey, good morning, guys. It's Henry Chen calling for Jeff. I just had a question on MIS. Just curious from a commercial sales perspective now with the business stabilizing, are there any new markets or geographies that you're looking at to potentially expand your coverage in?
Yeah. In terms of markets that we are looking to expand in, we have been active, as you have seen, in emerging markets, including India, increasing our stake in Korea. Growing business coming out of China has been growing very nicely. With the liberalization that is being proposed and discussed in the Chinese market, we would anticipate that that should create some opportunities. We've also been concentrating on building out the business in Latin America and Middle East. Rob, I don't know if there's anything else you wanted to add to that.
Yeah. We opened an office last year in Sweden, so we've been building out a presence as well in the Nordic region.
Got it. Okay. Yeah, that's helpful. Just on MIS, just as a follow-up. In terms of the different products, are there any margin changes when one sort of increases as a percentage of the whole? If, say, structured increases as a percentage, does that sort of impact the margins of the business?
The margins in the MIS business for all of the fundamental areas are roughly the same. The structured finance margin is more variable. It's a more transactionally-oriented business. In periods of high volume, you get higher margins, and low volume, lower margins. It's also susceptible to how intense the monitoring activity has to be. In periods of greater stress, there is greater allocation of resource to having to be on top of the monitoring, simply because in periods of stress there are more assets that have to be scrutinized more closely, and so you get some swings there as well. That's the only line of business that I would say has substantial variability in margin.
Yep. The monitoring for the structured or just overall?
Monitoring for structured in particular, because of the large number of assets that underlie those pools.
Got it. Okay, great. Thanks so much.
I will go next to Patrick O'Shaughnessy with Raymond James.
Hey, good afternoon. Quick CLO question for you. Does a CLO refinancing create the same sort of revenue opportunity for you guys as a CLO issuance?
No. New issuance would be a higher revenue opportunity than refi.
Got it. Then follow-up question. The acquisition that you just announced the other day, this structured finance data and analytics business of SCDM, is that going within Research, Data and Analytics? If so, can you talk about how much of the high single-digit revenue growth target for that segment in 2017 is going to come from the acquisition?
The answer to your first question is yes, it is part of RD&A, it is a very, very small acquisition. I think it's a good acquisition. It makes a ton of sense. We've done this a number of times before where we've acquired businesses, where in this case, we didn't acquire any people. We essentially bought a product that is very similar to an existing product of ours. We're going to transition their customers from the legacy product to our product. Essentially we bought that business without buying any expense, frankly, that would come along with it. I think it's a very good transaction for us, honestly, it's tiny. Strategically it's a nice fit, it's not going to turn the dial on financial performance for RD&A in 2017. Yeah.
Yep. Got you. Smaller than the GGY acquisition of last year?
That's correct.
Significant.
Okay, great. Thank you.
We have no further questions at this time. I'd like to turn the conference back over to Mr. Ray McDaniel for closing comments.
Okay. Thank you all for joining the call today, and we look forward to speaking with you again after the first quarter. Thanks.
This concludes Moody's fourth quarter and fiscal year-end 2016 earnings call. As a reminder, a replay of this call will be available after 3:00 P.M. Eastern Time on Moody's IR website. Thank you.