Nasdaq and Moody's Are a Buy for the Next Five Years

Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The financial markets require a lot of services in order to remain functional. A good financial portfolio should include an exchange, ratings agency, and investment banking firm.

The stock exchange

Personally, I have always been fascinated by stock exchanges. More specifically, the Nasdaq OMX Group (NASDAQ: NDAQ). The company recently acquired Swedish OMX AB, hence the name NASDAQ OMX Group. The NASDAQ stock exchange is the second-largest exchange in the United States.

The company’s market-making activities seem to have soured over the past quarter. This is because in a bull-market, volumes tend to dry up. The economic argument is that sellers of a good or service tend to hold back the good or service in anticipation of rising prices. Hence, we see a drop in volume in its core business of market making. But, on the upside, the company is pursuing new business opportunities and has been very aggressive about returning cash to shareholders with share buybacks and dividends.

Nasdaq OMX earnings

The company reported market services of $553 million for the second quarter, which was down from the $587 million that was reported from the year-ago-period. The decline in revenue from market services is likely to be temporary as underwriting activity is projected to pick up; and if that’s the case, the fees earned from being an exchange operator are also like to go up.

The company reported year-over-year gains in revenue from its listing services, information services, and technology solutions. The revenue from these business units is small when compared to its listing services. The business reported year-over-year revenue gains of 7%, whereas the operating expenses increased by 16%. On a consolidated basis, the company reported that net income declined by 4.3% year-over-year. The decline in net income resulted because revenue growth could not offset the increase in expenses.

The company reported $25 million in merger-and-acquisition related expenses for the quarter, which is why net income fell on a year-over-year basis. The decline in net income is going to be temporary (the company may not necessarily acquire another company next quarter.) It reported $0.62 in diluted earnings per share (non-generally accepted accounting principles). Results fell below the expectation of analysts for the quarter as analysts were anticipating $0.64 in earnings per share.

 The weakness in earnings should be temporary. Analysts currently anticipate the company to grow earnings by 12.3% per year over the next five years. The company also compensates investors with a 1.6% dividend yield.

The rating agency

Moody’s (NYSE: MCO) is another class favorite of mine. I think the stock is likely to outperform going forward just because there will always be a government (federal, state, local) entity in need of money. Governments also need a credit rating. Likewise, a rating agency is given the responsibility of grading a government or company’s ability to borrow and repay money.

Moody’s reported a fairly strong quarter, with revenue up by 18% year-over-year. The company was able to grow its revenue by 18% from its Moody’s investor- services segment, and 9% in the Moody’s analytics segment. The growth in the investor-services segment isn’t that surprising because the company’s rating activities are in high-demand. The company reported that its non-U.S. rating activities were up by 22%, and U.S. activities were up by 21%. The growth in non-U.S. activities is coming from projects and infrastructure activity (foreign governments).

Earnings bottom line

The company reported that expenses increased by 12%. The difference in revenue and expenses resulted in a 26% year-over-year improvement in operating income. Moody's reported earnings per share of $1.00, which beat the consensus estimate set at $0.91 for the quarter.

The company was really optimistic in its outlook. It believes that earnings will grow in high single digits for 2013. The ratings agency could beat its own guidance, especially if demand for debt underwriting picks up in the second half of 2013.

Governments (local, state, federal) may demand even more ratings on bond offerings in order to better balance their budgets. After all, it’s always smart to borrow when interest rates are historically cheap. The Federal Reserve recently had a bit of a hawkish stance on its open market policy by mentioning that both rate increases and tapering of quantitative easing are likely by 2015.

Over the long term, I believe countries in emerging market economies will expand their borrowing as public projects are very important. In the end, roads needs to be built, floodgates need funding, and schools have to be in session.

How this impacts other companies

Goldman Sachs (NYSE: GS) doesn’t really provide guidance. Later into the quarter, you’ll see analysts gradually release earnings figures for the next quarter. Based on Moody’s guidance, we can assume that investment banking should be able to sustain upper single-digit growth. I also think asset-management performance fees should be up significantly as stocks are trading at even higher levels. Performance fees, paired with increases in the mark-to-market value of paper assets on Goldman Sachs' books, should make for a solid year.

I don’t think the company will be able to attract quarter-over-quarter gains in the total assets under management. Seasonally, fund inflows are up the most in the first quarter of the year. Analysts currently anticipate that Goldman Sachs will grow earnings by 5.5% per year over the next five years. I think that growth rates will be closer to 9% over the next five-years based on historical performance, and the sector average.

Conclusion

I really like NASDAQ OMX because the company seems to have a high quality business and has been introducing other businesses to sustain growth. Moody’s seems well-positioned especially because its debt ratings are taken seriously even outside of the United States. Goldman Sachs should be able to sustain reasonable rates of growth as long as the stock market continues to trend higher. I think that all three companies will be able to outperform the S&P 500.

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Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs and Moody's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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