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MOODYS CORP /DE/ - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This discussion and analysis of financial condition and results of operations should be read in conjunction with the Moody's Corporation condensed consolidated financial statements and notes thereto included elsewhere in this quarterly report on Form 10-Q. This Management's Discussion and Analysis of Financial Condition and Results of Operations contains Forward-Looking Statements. See "Forward-Looking Statements" commencing on page 67 for a discussion of uncertainties, risks and other factors associated with these statements. The Company Moody's is a provider of (i) credit ratings, (ii) credit and economic related research, data and analytical tools, (iii) software solutions and related risk management services, (iv) quantitative credit risk measures, financial services training and certification services and (v) outsourced research and analytical services to institutional customers. Moody's has two reportable segments: MIS and MA. MIS, the credit rating agency, publishes credit ratings on a wide range of debt obligations and the entities that issue such obligations in markets worldwide. Revenue is derived from the originators and issuers of such transactions who use MIS ratings in the distribution of their debt issues to investors. The MA segment, which includes all of the Company's non-rating commercial activities, develops a wide range of products and services that primarily support financial analysis and risk management activities of institutional participants in global financial markets. Within its RD&A business, MA distributes research and data developed by MIS as part of its ratings process, including in-depth research on major debt issuers, industry studies and commentary on topical credit-related events. It also provides fixed income pricing services in the Asia-Pacific region. The RD&A business also produces economic research as well as data and analytical tools such as quantitative credit risk scores. Within its ERS business, MA provides software solutions as well as related risk management services. The PS business provides outsourced research and analytical services and financial training and certification programs. Critical Accounting Estimates Moody's discussion and analysis of its financial condition and results of operations are based on the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires Moody's to make estimates and judgments that affect reported amounts of assets and liabilities and related disclosures of contingent assets and liabilities at the dates of the financial statements and revenue and expenses during the reporting periods. These estimates are based on historical experience and on other assumptions that are believed to be reasonable under the circumstances. On an ongoing basis, Moody's evaluates its estimates, including those related to revenue recognition, accounts receivable allowances, contingencies, restructuring, goodwill and acquired intangible assets, pension and other retirement benefits, stock-based compensation, and income taxes. Actual results may differ from these estimates under different assumptions or conditions. Item 7, MD&A, in the Company's annual report on Form 10-K for the year ended December 31, 2013, includes descriptions of some of the judgments that Moody's makes in applying its accounting estimates in these areas. Since the date of the annual report on Form 10-K, there have been no material changes to the Company's critical accounting estimates, except for updates to estimates utilized in the Company's annual goodwill impairment assessment which is performed as of July 31 of each year. 40 -------------------------------------------------------------------------------- Table of Contents Goodwill and Other Acquired Intangible Assets On July 31 of each year, Moody's evaluates its goodwill for impairment at the reporting unit level, defined as an operating segment or one level below an operating segment. At July 31, 2014, the Company had six primary reporting units: two within the Company's ratings business (one for the newly acquired ICRA business and one that encompasses all of Moody's other ratings operations) and four reporting units within MA: RD&A, ERS, FSTC and Copal Amba. The RD&A reporting unit encompasses the distribution of investor-oriented research and data developed by MIS as part of its ratings process, in-depth research on major debt issuers, industry studies, economic research and commentary on topical events and credit analytic tools. The ERS reporting unit consists of credit risk management and compliance software licenses and subscriptions as well as related maintenance and implementation services. The FSTC reporting unit consists of the portion of the MA business that offers both credit training as well as other professional development training and certification services. The Copal Amba reporting unit provides outsourced research and analytical services. On July 17, 2014, a subsidiary of the Company acquired WebEquity Solutions, LLC, a leading provider of cloud-based loan origination solutions for financial institutions. WebEquity Solutions is part of the ERS reporting unit. The Company evaluates the recoverability of goodwill using a three-step impairment test approach at the reporting unit level. In the first step, the Company assesses various qualitative factors to determine whether the fair value of a reporting unit may be less than its carrying amount. If a determination is made that, based on the qualitative factors, an impairment does not exist, the Company is not required to perform further testing. If the aforementioned qualitative assessment results in the Company concluding that it is more likely than not that the fair value of a reporting unit may be less than its carrying amount, the fair value of the reporting unit will be determined and compared to its carrying value including goodwill. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired and the Company is not required to perform further testing. If the fair value of the reporting unit is less than the carrying value, the Company must perform a third step of the impairment test to determine the implied fair value of the reporting unit's goodwill. The implied fair value of the goodwill is determined based on the difference between the fair value of the reporting unit and the net fair value of the identifiable assets and liabilities of the reporting unit. If the implied fair value of the goodwill is less than its carrying value, the difference is recognized as an impairment charge. For the reporting units where the Company is consistently able to conclude on impairment using only a qualitative approach, the Company's accounting policy is to perform the second step of the aforementioned goodwill impairment assessment at least once every three years. At July 31, 2013, the Company performed the second step of the goodwill impairment test on all reporting units, which resulted in no impairment of goodwill. At July 31, 2014 the Company performed quantitative assessments of the FSTC and Copal Amba reporting units and qualitative assessments for all remaining reporting units. The qualitative analyses resulted in the Company determining that it was not more likely than not that the fair value of these reporting units was less than their carrying amounts. The most significant factors in these qualitative assessments were an assessment of actual to projected results and a comparison of projected results in the prior year compared to current year projection for each reporting unit. Additionally, the weighted average cost of capital (WACC) is assessed as well as the impact of various macroeconomic conditions and factors specific to the reporting unit that could impact future cash flows. No assessment was performed on the ICRA reporting unit due to the proximity of the acquisition date to the goodwill impairment assessment date. Accordingly, the carrying value of ICRA's net assets acquired approximates fair value at July 31, 2014. At July 31, 2014, the Company performed a quantitative analysis on the FSTC reporting unit due to the small amount of excess of fair value over net assets in the prior year and slower than anticipated growth in projected cash flows than was utilized in the quantitative assessment performed at July 31, 2013. This slower than anticipated growth in cash flows reflects various investment initiatives in the medium term for this business. The Company also performed a quantitative assessment on the Copal Amba reporting unit due to the acquisition of the Amba business subsequent to the July 31 impairment test dates so as to establish a base-line fair value. Both of these quantitative assessments resulted in no impairment to goodwill at July 31, 2014. 41-------------------------------------------------------------------------------- Table of Contents Determining the fair value of a reporting unit or an indefinite-lived acquired intangible asset involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions, and appropriate comparable market metrics. The Company bases its fair value estimates on reasonable assumptions. However, as these estimates and assumptions are unpredictable and inherently uncertain, actual future results may differ from these estimates. In addition, the Company also makes certain judgments and assumptions in allocating shared assets and liabilities to determine the carrying values for each of its reporting units. Other assets and liabilities, including applicable corporate assets, are allocated to the extent they are related to the operation of respective reporting units. Sensitivity Analyses and Key Assumptions for Deriving the Fair Value of a Reporting Unit The following table identifies the amount of goodwill allocated to each reporting unit as of September 30, 2014 as well as the amount by which the net assets of each reporting unit would exceed the fair value under Step 2 of the goodwill impairment test as prescribed in ASC Topic 350, assuming hypothetical reductions in their fair values as of the date of the last quantitative goodwill impairment assessment for all reporting units. For the FSTC and Copal Amba reporting units, the fair value was calculated as of July 31, 2014. For all remaining reporting units excluding ERS, the fair value was calculated as of July 31, 2013, as there have been no qualitative factors that have resulted in the Company deeming it necessary to perform a quantitative assessment subsequent to this date. For ERS, the WebEquity price was added to the prior year fair value as the WebEquity purchase price approximated its fair value as of July 31, 2014 due to the proximity of the acquisition to the goodwill assessment date. Sensitivity Analysis Deficit Caused by aHypothetical Reduction to Fair Value Goodwill 10% 20% 30% 40% MIS $ 48.5 $ - $ - $ - $ - RD&A 159.2 - - - - ERS 289.2 - (21.9 ) (83.7 ) (145.4 ) FSTC 99.8 (8.6 ) (26.2 ) (43.9 ) (61.5 ) Copal Amba 157.0 - - - - ICRA 246.6 * * * * Totals $ 1,000.3 $ (8.6 ) $ (48.1 ) $ (127.6 ) $ (206.9 ) * ICRA was excluded from the sensitivity analysis in the table above as it was acquired in June 2014. Due to the proximity of the acquisition date to the annual goodwill assessment date, the purchase price of the net assets acquired approximates their fair value at July 31, 2014. As can be seen from the table above, the reporting unit most at risk for potential impairment is the FSTC reporting unit and failure to meet its financial projections could result in further goodwill impairment (there was a goodwill impairment charge of $12.2 million for this reporting unit in the fourth quarter of 2012). This business is, in part, sensitive to the staffing levels and profitability of the global financial services industry, particularly in Canada and EMEA. Based on the July 31, 2013 valuation, the ERS reporting unit also carried some risk of potential impairment. Management of the ERS reporting unit continues to focus on expanding market penetration as well as enhancing the scalability of its products and services. This will reduce margins in the near term but is anticipated that it will enhance margins in the medium to long-term. Furthermore, the ERS sensitivity is impacted due to the WebEquity purchase price being equal to its net assets. 42-------------------------------------------------------------------------------- Table of Contents There could be a future goodwill impairment charge if FSTC fails or ERS significantly fails to meet its current financial plans. Methodologies and significant estimates utilized in determining of the fair value of reporting units: The following is a discussion regarding the Company's methodology for determining the fair value of its reporting units as of the date of each reporting unit's last quantitative test (July 31, 2014 for FSTC and Copal Amba; July 31, 2013 for the remaining reporting units excluding ICRA). ICRA has not yet been subject to a full quantitative impairment analysis due to the proximity of the acquisition of this entity to the annual goodwill impairment assessment date. The fair value of each reporting unit was estimated using a discounted cash flow methodology and comparable public company and precedent transaction multiples. The DCF analysis requires significant estimates, including projections of future operating results and cash flows of each reporting unit, which is based on internal budgets and strategic plans, expected long-term growth rates, terminal values, weighted average cost of capital and the effects of external factors and market conditions. Changes in these estimates and assumptions could materially affect the estimated fair value of each reporting unit which could result in an impairment charge to reduce the carrying value of goodwill, which could be material to the Company's financial position and results of operations. Moody's allocates newly acquired goodwill to reporting units based on the reporting unit expected to benefit from the acquisition. The Company evaluates its reporting units on an annual basis, or more frequently if there are changes in the reporting structure of the Company due to acquisitions or realignments. The sensitivity analyses on the future cash flows and WACC assumptions described below are as of the date of last quantitative assessment for each reporting unit. The following discusses the key assumptions utilized in the discounted cash flow valuation methodology which requires significant management judgment: • Future cash flow assumptions -The projections for future cash flows utilized in the models are derived from historical experience and assumptions regarding future growth and profitability of each reporting unit. These projections are consistent with the Company's operating and strategic plan. Cash flows for the five years subsequent to the date of the quantitative goodwill impairment analysis were utilized in the determination of the fair value of each reporting unit. The growth rates assumed a gradual increase in revenue from financial service customers based on a continued improvement in the global economy and capital markets, new customer acquisition and new products. Beyond five years a terminal value was determined using a perpetuity growth rate based on inflation and real GDP growth rates. A sensitivity analysis of the growth rates was performed on all reporting units. For all reporting units, a 10% decrease in the growth rates used would not have resulted in the carrying value of the reporting unit exceeding its respective estimated fair value. • WACC -The WACC is the rate used to discount each reporting unit's estimated future cash flows. The WACC is calculated based on the proportionate weighting of the cost of debt and equity. The cost of equity is based on a risk-free interest rate, an equity risk factor which is derived from public companies similar to the reporting unit and which captures the perceived risks and uncertainties associated with the reporting unit's cash flows. The cost of debt component is calculated as the weighted average cost associated with all of the Company's outstanding borrowings as of the date of the impairment test and was immaterial to the computation of the WACC. The cost of debt and equity is weighted based on the debt to market capitalization ratio of publicly traded companies with similarities to the reporting unit being tested. The WACC for all reporting units ranged from 10% to 11.5% as of the date of the last quantitative assessment for each reporting unit. Differences in the WACC used between reporting units is primarily due to distinct risks and uncertainties regarding the cash flows of the different reporting units. A sensitivity analysis of the WACC was performed on all reporting units as of the date of the last quantitative goodwill assessment for each reporting unit. For the FSTC reporting unit, an increase in the WACC of one percentage point would have resulted in the carrying value of the reporting unit exceeding its estimated fair 43 -------------------------------------------------------------------------------- Table of Contents value by approximately $2 million. For the remaining reporting units, an increase in the WACC of one percentage point would not result in the carrying value of the reporting unit exceeding its fair value Amortizable intangible assets are reviewed for recoverability whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. There were no such events or changes during the first nine months of 2014 that would indicate that the carrying amount of amortizable intangible assets in any of the Company's reporting units may not be recoverable. This determination was made based on continued growth, consistent with operating and strategic plans for the reporting unit where the intangible asset resides. Additionally, there were no events or circumstances during the first nine months of 2014 that would indicate the need for an adjustment of the remaining useful lives of these amortizable intangible assets. Reportable Segments The Company is organized into two reportable segments at September 30, 2014: MIS and MA. The MIS segment is comprised of all of the Company's ratings activities. All of Moody's other non-rating commercial activities are included in the MA segment. The MIS segment consists of four lines of business - CFG, SFG, FIG, and PPIF - that generate revenue principally from fees for the assignment and ongoing monitoring of credit ratings on debt obligations and the entities that issue such obligations in markets worldwide. The MA segment, which includes all of the Company's non-rating commercial activities, develops a wide range of products and services that support financial analysis and risk management activities of institutional participants in global financial markets. The MA segment consists of three lines of business - RD&A, ERS and PS. In December 2013, a subsidiary of the Company acquired Amba, a provider of investment research and quantitative analytics for global financial institutions. Amba is part of the MA reportable segment and its revenue is included in the PS LOB. In July 2014, a subsidiary of the Company acquired WebEquity, a leading provider of cloud-based loan origination solutions for financial institutions. WebEquity is part of the MA reporting segment and its revenue is included in the ERS LOB. The following is a discussion of the results of operations of the Company and its reportable segments. Total MIS revenue and total MA expenses include the intersegment royalty revenue for MIS and expense charged to MA for the rights to use and distribute content, data and products developed by MIS. The royalty rate charged by MIS approximates the fair value of the aforementioned content, data and products developed by MIS. Total MA revenue and total MIS expenses include intersegment fees charged to MIS from MA for the use of certain MA products and services in MIS's ratings process. These fees charged by MA are generally equal to the costs incurred by MA to provide these products and services. Overhead charges and corporate expenses which exclusively benefit one segment are fully charged to that segment. Additionally, overhead costs and corporate expenses of the Company which benefit both segments are generally allocated to each segment based on a revenue-split methodology. Overhead expenses include costs such as rent and occupancy, information technology and support staff such as finance, human resources and information technology. RESULTS OF OPERATIONS Three months ended September 30, 2014 compared with three months ended September 30, 2013 Executive Summary Moody's revenue in the third quarter of 2014 totaled $816.1 million, an increase of $110.6 million compared to 2013 and reflected strong growth in both MIS and MA. Total expenses increased $52.4 million compared to the third quarter of 2013 reflecting higher compensation and non-compensation costs of approximately $43 million and $9 million, 44 -------------------------------------------------------------------------------- Table of Contents respectively. Operating income of $349.7 million in the third quarter of 2014 increased $58.2 million compared to 2013 and resulted in an operating margin of 42.9%, compared to 41.3% in the prior year. Adjusted Operating Income of $372.9 million in the third quarter of 2014 increased $58.0 million compared to 2013, resulting in an Adjusted Operating Margin of 45.7% compared to 44.6% in the prior year period. Diluted EPS of $1.00 in the third quarter of 2014 increased $0.17 over 2013, and included a $0.03 benefit from a Legacy Tax Matter. Excluding the Legacy Tax benefit in the third quarter of 2014, Non-GAAP Diluted EPS in the third quarter of 2014 was $0.14 higher than the third quarter 2013 Diluted EPS of $0.83. Three months ended September 30, % Change Favorable 2014 2013 (Unfavorable) Revenue: United States $ 449.1 $ 391.0 15 % International: EMEA 231.4 207.4 12 % Asia-Pacific 79.3 62.1 28 % Americas 56.3 45.0 25 % Total International 367.0 314.5 17 % Total 816.1 705.5 16 % Expenses: Operating 236.7 203.5 (16 %) SG&A 206.5 187.1 (10 %) Depreciation and amortization 23.2 23.4 1 % Total 466.4 414.0 (13 %) Operating income $ 349.7 $ 291.5 20 % Adjusted Operating Income (1) $ 372.9 $ 314.9 18 % Interest income (expense), net $ (37.7 ) $ (24.4 ) (55 %) Other non-operating income (expense), net $ 16.4 $ (3.6 ) NM Net income attributable to Moody's $ 215.2 $ 183.9 17 % Diluted EPS attributable to Moody's common shareholders $ 1.00 $ 0.83 20 % Non-GAAP EPS attributable to Moody's common shareholders $ 0.97 $ 0.83 17 % Operating margin 42.9 % 41.3 % Adjusted Operating Margin (1) 45.7 % 44.6 % (1) Adjusted Operating Income, Adjusted Operating Margin and Non-GAAP EPS attributable to Moody's common shareholders are non-GAAP financial measures. Refer to the section entitled "Non-GAAP Financial Measures" of this Management Discussion and Analysis for further information regarding these measures. The table below shows Moody's global staffing by geographic area: % September 30, Change 2014 2013 United States 3,033 2,798 8 % International 6,704 * 4,412 52 % Total 9,737 7,210 35 % * Total as of September 30, 2014 includes approximately 2,200 staff from the acquisitions of ICRA and Amba which occurred on June 26, 2014 and December 10, 2013, respectively, and for which a majority are located in low cost jurisdictions. 45 -------------------------------------------------------------------------------- Table of Contents Global revenue of $816.1 million in the third quarter of 2014 increased $110.6 million compared to 2013 reflecting strong growth in both reportable segments. The increase in ratings revenue reflects strong growth in CLO issuance coupled with growth in EMEA bank loans, U.S. investment-grade corporate debt (excluding a large $49 billion issuance in the telecommunications sector in the prior year) and banking-related issuance. The increase also reflects changes in the mix of fee type, new fee initiatives and certain pricing increases, primarily in the U.S., as well as higher monitoring revenue. The growth in MA reflects higher revenue across all LOBs. The growth in RD&A resulted from solid demand for credit research and content licensing while the growth in ERS was driven by higher software subscription and service revenue as well as higher software maintenance fees. The growth in PS primarily reflects the acquisition of Amba in the fourth quarter of 2013. Transaction revenue accounted for 49% of global MCO revenue in the third quarter of 2014 compared to 47% in the third quarter of 2013. U.S. revenue of $449.1 million in the third quarter of 2014 increased $58.1 million over the prior year, reflecting growth across all LOBs in both reportable segments. Non-U.S. revenue increased $52.5 million compared to the third quarter of 2013, reflecting growth in both MIS and MA revenue across all regions. Operating expenses were $236.7 million in the third quarter of 2014 and increased $33.2 million from 2013 primarily due to growth in compensation costs reflecting higher salaries and related employee benefits primarily resulting from increases in headcount as well as the impact of annual compensation increases. Also contributing to the increase in compensation costs are headcount from the acquisitions of Amba and WebEquity in the fourth quarter of 2013 and third quarter of 2014, respectively. SG&A expenses of $206.5 million in the third quarter of 2014 increased $19.4 million from the prior year period primarily due to approximately $15 million in higher compensation costs. This increase primarily reflects higher salaries and related employee benefits resulting from annual compensation increases, headcount growth in MIS and MA as well as in overhead support areas coupled with higher headcount from the Amba and WebEquity acquisitions. Additionally, there were higher rent and occupancy costs of approximately $3 million reflecting additional floors leased at the Company's 7WTC headquarters coupled with various other real estate expansion projects worldwide. Also, there were incremental non-compensation expenses from the Amba and WebEquity businesses acquired in the fourth quarter of 2013 and the third quarter of 2014, respectively. Operating income of $349.7 million increased $58.2 million from the third quarter of 2013. Adjusted Operating Income was $372.9 million in the third quarter of 2014 and increased $58.0 million compared to 2013. Operating margin increased 160bps compared to the third quarter of 2013. Adjusted Operating Margin in the third quarter of 2014 of 45.7% increased 110bps compared to the prior year. Interest income (expense), net in the third quarter of 2014 was ($37.7) million, a $13.3 million increase in expense compared to 2013. This increase is due to $14.9 million of higher interest on borrowings primarily reflecting approximately $11 million in net costs (net of a gain on the termination of an interest rate swap) related to the early repayment of the Series 2005-1 Notes. Also contributing to the increase was interest relating to the issuance of the 2013 Senior Notes in August 2013 as well as the issuance of the 2014 Senior Notes (5-Year) and 2014 Senior Notes (30-Year) in July 2014. These increases were partially offset by lower interest on the Series 2005-1 Notes which were repaid in August 2014. Other non-operating income (expense), net was $16.4 million in the third quarter of 2014, a $20.0 million increase in income compared to 2013. The increase in income is primarily due to approximately $8 million in FX gains in the third quarter of 2014 compared to FX losses of approximately $6 million in the prior year. The FX gains in the third quarter of 2014 were mainly due to the strengthening of the U.S. dollar to the euro and British pound for cash held in international jurisdictions. Also contributing to the increase in income was a $6.4 million benefit from a statute of limitations lapse relating to a Legacy Tax Matter in the third quarter of 2014. 46-------------------------------------------------------------------------------- Table of Contents The Company's ETR was 33.5% in the third quarter of 2014, compared with 29.1% in 2013 with the increase primarily due to higher U.S. and non-U.S. taxes on foreign income in 2014 and certain discrete items that reduced the ETR in 2013. Net Income in the third quarter of 2014, which included the aforementioned Legacy Tax benefit, was $215.2 million, or $1.00 per diluted share. This is an increase of $31.3 million, or $0.17 per diluted share, compared to 2013. Excluding the benefit relating to a Legacy Tax Matter in the third quarter of 2014, Non-GAAP Diluted EPS of $0.97 in the third quarter of 2014 was $0.14 higher than Diluted EPS of $0.83 in the same period of the prior year. Segment Results Moody's Investors Service The table below provides a summary of revenue and operating results, followed by further insight and commentary: Three months ended September 30, % Change Favorable 2014 2013 (Unfavorable) Revenue: Corporate finance (CFG) $ 260.7 $ 233.0 12 % Structured finance (SFG) 102.1 83.5 22 % Financial institutions (FIG) 91.8 78.9 16 % Public, project and infrastructure finance (PPIF) 88.5 82.7 7 % Total external revenue 543.1 478.1 14 % Intersegment royalty 22.3 19.6 14 % Total MIS Revenue 565.4 497.7 14 % Expenses: Operating and SG&A (external) 257.4 232.6 (11 %) Operating and SG&A (intersegment) 3.4 3.0 (13 %) Adjusted Operating Income 304.6 262.1 16 % Depreciation and amortization 11.5 12.1 5 % Operating income $ 293.1 $ 250.0 17 % Adjusted Operating Margin 53.9 % 52.7 % Operating margin 51.8 % 50.2 % The following is a discussion of external MIS revenue and operating expenses: Global MIS revenue of $543.1 million in the third quarter of 2014 increased $65.0 million compared to 2013 reflecting growth across all LOBs. The growth reflects higher rated issuance volumes for CLOs in the U.S. and EMEA and bank loans in EMEA as well as higher banking-related issuance. Also contributing to the growth were higher U.S. investment-grade rated issuance volumes (excluding a large $49 billion issuance in the telecommunications sector in 2013). Additionally, the growth reflects benefits from the mix of fee type, new fee initiatives and certain pricing increases, primarily in the U.S., and higher monitoring fee revenue. Transaction revenue for MIS was 60% and 59% in the third quarter of 2014 and 2013, respectively. 47-------------------------------------------------------------------------------- Table of Contents In the U.S., revenue was $329.1 million in the third quarter of 2014, an increase of $39.1 million compared to 2013 and reflected growth in rated issuance volumes for CLOs as well as growth in public finance issuance volumes. Also contributing to the increase were changes in the mix of fee type, new fee initiatives and certain pricing increases coupled with higher monitoring fees in CFG. Non-U.S. revenue was $214.0 million in the third quarter of 2014, an increase of $25.9 million compared to 2013 reflecting growth in high-yield corporate debt and bank loan revenue coupled with increases in banking revenue across all regions. Also contributing to the growth were changes in the mix of fee type, new fee initiatives and certain pricing increases as well as higher monitoring fees in CFG. These increases were partially offset by declines in infrastructure finance rated issuance volumes in EMEA. Global CFG revenue of $260.7 million in the third quarter of 2014 increased $27.7 million from 2013 and reflects changes in the mix of fee type, new fee initiatives and certain pricing increases coupled with higher monitoring fee revenue across all regions due to growth in the number of outstanding rated entities. Additionally, the growth reflects higher U.S. investment-grade rated issuance volumes (excluding a large $49 billion issuance in the telecommunications sector in 2013) as well as growth in bank loan volumes in EMEA as issuers continue to take advantage of favorable market conditions. Transaction revenue represented 69% and 70% of total CFG revenue in the third quarter of 2014 and 2013, respectively. In the U.S., revenue was $163.9 million, or $12.1 million higher than the prior year. Internationally, revenue of $96.8 million increased $15.6 million compared to the prior year. Global SFG revenue of $102.1 million in the third quarter of 2014 increased $18.6 million compared to 2013 primarily reflecting higher rated issuance volumes for CLOs in the U.S. and EMEA. This growth reflects growing liquidity needs from issuers as well as increased investor demand for this asset class. The growth over 2013 also reflects changes in the mix of fee type, new fee initiatives and certain pricing increases. Transaction revenue was 59% of total SFG revenue in the third quarter of 2014 compared to 54% in the prior year. In the U.S., revenue of $70.0 million increased $16.4 million compared to the third quarter of 2013. Non-U.S. revenue in the third quarter of 2014 of $32.1 million increased $2.2 million compared to the prior year. Global FIG revenue of $91.8 million in the third quarter of 2014 was $12.9 million higher compared to 2013 reflecting robust cross-border issuance from the financial sector in China as well as changes in the mix of fee type, new fee initiatives and pricing increases. Also contributing to the growth was higher insurance revenue in the U.S. reflecting insurers issuing debt to fund M&A activity, recapitalizations and share repurchases. Transaction revenue was 38% of total FIG revenue in the third quarter of 2014 compared to 30% in the same period in 2013. In the U.S. revenue was $37.7 million, or 9% higher than the prior year. Internationally, revenue was $54.1 million in the third quarter of 2014, or $9.9 million higher compared to 2013. Global PPIF revenue was $88.5 million in the third quarter of 2014 and increased $5.8 million compared to 2013 reflecting changes in the mix of fee type, new fee initiatives and pricing increases. The growth also reflects higher U.S. public finance rated issuance volumes compared to the prior year when U.S. municipal bond refunding volumes were suppressed as benchmark interest rates began to rise. These increases were partially offset by decreases in infrastructure finance revenue in EMEA reflecting declines in M&A activity as well as issuers in this region being currently well funded. Transaction revenue was 58% of total PPIF revenue in both the third quarter of 2014 and 2013. In the U.S., revenue in the third quarter of 2014 was $57.5 million, an increase of $7.6 million compared to 2013. Outside the U.S., PPIF revenue decreased $1.8 million compared to 2013. Operating and SG&A expenses in the third quarter of 2014 increased $24.8 million compared to 2013 primarily reflecting higher compensation costs of approximately $20 million resulting from annual compensation increases, headcount growth 48-------------------------------------------------------------------------------- Table of Contents in the ratings LOBs as well as in support areas such as IT, finance and human resources for which the costs are allocated to each segment based on a revenue-split methodology. Additionally, the growth in compensation costs reflects higher incentive compensation due to higher projected achievement against full-year targeted results compared to the prior year coupled with headcount growth. Furthermore, there were higher rent and occupancy costs of approximately $3 million for additional leased floors at 7WTC coupled with various other global real estate expansion projects. Adjusted Operating Income in the third quarter of 2014, which includes intersegment royalty revenue and intersegment expenses, was $304.6 million and increased $42.5 million compared to 2013. Operating income in the third quarter of 2014 was $293.1 million and increased $43.1 million compared to the prior year. Adjusted Operating Margin and operating margin were 53.9% and 51.8%, respectively, or 120bps and 160bps higher compared to the third quarter of 2013. The increase in both margins compared to the prior year reflects strong revenue growth outpacing growth in total operating expenses. Moody's Analytics The table below provides a summary of revenue and operating results, followed by further insight and commentary: Three months ended September 30, % Change Favorable 2014 2013 (Unfavorable) Revenue: Research, data and analytics (RD&A) $ 146.8 133.7 10 % Enterprise risk solutions (ERS) 81.1 64.4 26 % Professional services (PS) 45.1 29.3 54 % Total external revenue 273.0 227.4 20 % Intersegment revenue 3.4 3.0 13 % Total MA Revenue 276.4 230.4 20 % Expenses: Operating and SG&A (external) 185.8 158.0 (18 %) Operating and SG&A (intersegment) 22.3 19.6 (14 %) Adjusted Operating Income 68.3 52.8 29 % Depreciation and amortization 11.7 11.3 (4 %) Operating income $ 56.6 $ 41.5 36 % Adjusted Operating Margin 24.7 % 22.9 % Operating margin 20.5 % 18.0 % The following is a discussion of external MA revenue and operating expenses: Global MA revenue increased $45.6 million compared to the third quarter of 2013, with growth across all LOBs. Recurring revenue comprised 73% and 78% of total MA revenue in the third quarter of 2014 and 2013, respectively. In the U.S., revenue of $120.0 million in the third quarter of 2014 increased $19.0 million, and reflected growth across all LOBs. International revenue of $153.0 million in the third quarter of 2014 was $26.6 million higher than in 2013 also with growth across all LOBs. Global RD&A revenue, which comprised 54% and 59% of total external MA revenue in the third quarter of 2014 and 2013, respectively, increased $13.1 million over the prior year period. The growth, which was most notable in the U.S. and EMEA, was primarily due to strength in credit research and content licensing, general market price increases and the favorable impact of changes in FX translation rates. 49 -------------------------------------------------------------------------------- Table of Contents Global ERS revenue in the third quarter of 2014 increased $16.7 million over 2013, primarily due to growth in software subscriptions and services as well as higher software maintenance fees resulting from growing demand for ERS products and services in the banking and insurance industries. The growth over the prior year also reflects revenue from the acquisition of WebEquity in the third quarter of 2014. Revenue in ERS is subject to quarterly volatility resulting from the variable nature of project timing and the concentration of software implementation and license revenue in a relatively small number of engagements. Revenue from PS increased $15.8 million compared to the third quarter of 2013 with a substantial portion of the growth relating to the acquisition of Amba in the fourth quarter of 2013 coupled with higher revenue from the FSTC business. Operating and SG&A expenses in the third quarter of 2014 increased $27.8 million compared to 2013. The expense growth reflects an approximate $23 million increase in compensation costs primarily due to higher headcount to support business growth and from the acquisition of Amba and WebEquity as well as higher headcount in support areas for which the costs are allocated to each segment based on a revenue-split methodology. Additionally, annual merit increases and higher incentive compensation reflecting greater projected achievement against full-year targeted results compared to the prior year contributed to the growth in compensation costs. The increase also reflects an approximate $5 million increase in non-compensation expenses reflecting higher consulting costs for continued investment in IT infrastructure as well as costs for product development and project delivery in ERS. The increase in non-compensation costs also reflects higher variable costs to support business growth. Furthermore, the growth in non-compensation expenses is due to higher rent and occupancy costs reflecting additional floors at 7WTC as well as various other real estate expansion projects worldwide. These increases in non-compensation expenses were partially offset by lower contingent consideration costs related to the acquisition of Copal. Adjusted Operating Income was $68.3 million in the third quarter of 2014 and increased $15.5 million compared to the same period in 2013. Operating income of $56.6 million in the third quarter of 2014 increased $15.1 million compared to the same period in 2013. Adjusted Operating Margin for the third quarter of 2014 was 24.7%, compared to 22.9% in 2013. Operating margin was 20.5% compared to 18.0% in the prior year. Adjusted operating income and operating income both include intersegment revenue and expense. Nine months ended September 30, 2014 compared with nine months ended September 30, 2013 Executive Summary Moody's revenue in the first nine months of 2014 totaled $2,456.8 million, an increase of $263.5 million compared to 2013 and reflected growth in both MIS and MA. Total expenses increased $91.8 million compared to the prior year reflecting higher compensation costs of approximately $120 million primarily relating to headcount growth and annual compensation increases coupled with higher incentive compensation reflecting higher projected achievement against full-year targeted results through the first nine months of 2014 compared to the same period in 2013. The expense growth also reflects a $12 million increase in rent and occupancy costs reflecting additional floors at 7WTC and other global real estate expansion initiatives. These increases in expenses were partially offset by a litigation settlement charge in the prior year for the settlement of two matters related to structured finance transactions rated by MIS, as more fully discussed in Moody's Form 10-K for the year ended December 31, 2013. Operating income of $1,094.4 million increased $171.7 million compared to 2013 and resulted in an operating margin of 44.5%, compared to 42.1% in the prior year. Adjusted Operating Income of $1,163.0 million in the first nine months increased $170.2 million compared to 2013, resulting in an Adjusted Operating Margin of 47.3% compared to 45.3% in the prior year period. Both the operating margin and Adjusted Operating Margin in 2013 included the aforementioned litigation settlement charge. Diluted EPS of 50-------------------------------------------------------------------------------- Table of Contents $3.48 in the first nine months of 2014, which included $0.36 for the ICRA Gain as well as a $0.03 benefit from a Legacy Tax Matter, increased $0.82 over 2013, which included a $0.14 charge related to the aforementioned litigation settlement. Excluding both the ICRA Gain and the benefit from the Legacy Tax Matter in 2014 as well as the litigation settlement charge in 2013, Non-GAAP Diluted EPS in the first nine months of 2014 of $3.09 was $0.29 higher than first nine months of 2013 Non-GAAP Diluted EPS of $2.80. Nine months ended September 30, % Change Favorable 2014 2013 (Unfavorable) Revenue: United States $ 1,335.8 $ 1,209.3 10 % International: EMEA 715.3 637.0 12 % Asia-Pacific 237.8 205.8 16 % Americas 167.9 141.2 19 % Total International 1,121.0 984.0 14 % Total 2,456.8 2,193.3 12 % Expenses: Operating 674.8 601.4 (12 %) SG&A 619.0 599.1 (3 %) Depreciation and amortization 68.6 70.1 2 % Total 1,362.4 1,270.6 (7 %) Operating income $ 1,094.4 $ 922.7 19 % Adjusted Operating Income (1) $ 1,163.0 $ 992.8 17 % Interest income (expense), net $ (87.5 ) $ (68.1 ) (28 %) Other non-operating income (expense), net $ 15.5 $ 12.9 20 % ICRA Gain $ 102.8 $ - NM Net income attributable to Moody's $ 752.4 $ 597.8 26 % Diluted EPS attributable to Moody's common shareholders $ 3.48 $ 2.66 31 % Non-GAAP EPS attributable to Moody's common shareholders $ 3.09 $ 2.80 10 % Operating margin 44.5 % 42.1 % Adjusted Operating Margin (1) 47.3 % 45.3 % (1) Adjusted Operating Income, Adjusted Operating Margin and Non-GAAP EPS attributable to Moody's common shareholders are non-GAAP financial measures. Refer to the section entitled "Non-GAAP Financial Measures" of this Management Discussion and Analysis for further information regarding these measures. Global revenue of $2,456.8 million in 2014 increased $263.5 million compared to 2013 reflecting growth in both MIS and MA. The increase in ratings revenue reflects growth in rated issuance volumes for CLOs and bank loans as well as higher banking-related issuance. Also contributing to the growth were changes in the mix of fee type, new fee initiatives and certain pricing increases, primarily in the U.S. as well as growth in monitoring fees. The growth in MA reflects higher revenue across all LOBs. The growth in PS reflected revenue from the fourth quarter 2013 acquisition of Amba as well as growth from the Copal business. The growth in RD&A resulted from solid demand for credit research and content licensing. The growth in ERS was driven by higher revenue from software subscriptions and services as well as software maintenance fees coupled with revenue from the acquisition of WebEquity in the third quarter of 2014. Transaction revenue accounted for 50% of global MCO revenue in both the first nine months of 2014 and 2013. These increases were partially offset by declines in rated issuance volumes for public finance in the U.S. 51-------------------------------------------------------------------------------- Table of Contents U.S. revenue of $1,335.8 million in the first nine months of 2014 increased $126.5 million over the prior year, reflecting growth in rated issuance volumes for bank loans and CLOs as well as changes in the mix of fee type, new fee initiatives and certain pricing increases. Also contributing to the growth were higher monitoring fees as well as higher rated issuance volumes for investment grade-corporate debt (excluding a large $49 billion issuance in the telecommunications sector in 2013). Furthermore, the increase reflects growth across all LOBs within MA. These increases were partially offset by declines in public finance reflecting a decrease in refunding volumes compared to the prior year as well as declines in banking-related revenue which is primarily due to an unfavorable shift in issuance mix. Non-U.S. revenue increased $137.0 million compared to the first nine months of 2013, reflecting growth across all regions in both reportable segments. The most notable growth in the MIS segment reflected higher speculative-grade corporate debt and bank loan rated issuance volumes in EMEA coupled with benefits from changes in the mix of fee type, new fee initiatives and certain pricing increases. Additionally, the non-U.S. growth within MA reflected increases in RD&A revenue in EMEA as well as higher ERS revenue in the EMEA and the Americas regions. Non-U.S. PS revenue in MA increased primarily due to the acquisition of Amba in the fourth quarter of 2013. Operating expenses were $674.8 million in the first nine months of 2014 and increased $73.4 million from 2013 primarily due to an approximate $70 million increase in compensation costs reflecting higher salaries and related employee benefits resulting from growth in headcount as well as the impact of annual compensation increases. Also contributing to the increase in compensation expenses were higher incentive compensation costs reflecting greater projected achievement against full-year targeted results compared to the prior year as well as higher headcount related to the acquisitions of Amba and WebEquity in the fourth quarter of 2013 and third quarter of 2014, respectively. SG&A expenses of $619.0 million in the first nine months of 2014 increased modestly compared to the prior year period reflecting higher compensation and non-compensation expenses partially offset by the first quarter 2013 litigation settlement charge relating to two matters regarding structured finance transactions rated by MIS, as more fully discussed in Moody's Form 10-K for the year ended December 31, 2013. The growth in compensation costs of approximately $50 million was primarily due to higher salaries and related employee benefits resulting from annual compensation increases, headcount growth in MIS and MA as well as in overhead support areas coupled with higher headcount from acquisitions. Also contributing to the increase in compensation expenses were higher incentive compensation costs reflecting greater projected achievement against full-year targeted results compared to the prior year coupled with headcount growth. Additionally, there were higher rent and occupancy costs reflecting additional floors leased at the Company's 7WTC headquarters coupled with various other real estate expansion projects worldwide as well as incremental non-compensation expenses from the Amba and WebEquity businesses acquired in the fourth quarter of 2013 and third quarter of 2014, respectively. Operating income of $1,094.4 million increased $171.7 million from the first nine months of 2013. Adjusted Operating Income was $1,163.0 million in the first nine months of 2014 and increased $170.2 million compared to 2013. Operating margin increased 240bps compared to the first nine months of 2013. Adjusted Operating Margin in the first nine months of 2014 of 47.3% increased 200bps compared to the prior year. The increase in operating margin and Adjusted Operating Margin is primarily due to the aforementioned litigation settlement charge in 2013 which negatively impacted the prior year margins. Interest income (expense), net in the first nine months of 2014 was ($87.5) million, a $19.4 million increase in net expense compared to 2013. This increase is primarily due to approximately $25 million in higher interest on borrowings which includes approximately $11 million in net costs (net of a gain on the settlement of an interest rate swap) relating to the early repayment of the Series 2005-1 Notes. Also contributing to the increase was interest relating to the issuance of the 2013 Senior Notes in August 2013 as well as the issuance of the 2014 Senior Notes (5-Year) and 2014 Senior Notes (30-Year) in July 2014. Partially offsetting the increase in expense was an approximate $2 million reversal of interest on UTPs in the first quarter of 2014 relating to the favorable resolution of certain international tax matters. 52-------------------------------------------------------------------------------- Table of Contents Other non-operating income (expense), net was $15.5 million in the first nine months of 2014, a $2.6 million increase in income compared to 2013 and reflected $6.4 million in benefits related to a statute of limitations lapse for a Legacy Tax Matter. Partially offsetting this increase in income were lower FX gains in 2014 of approximately $5 million compared to 2013. The FX gains in 2014 were primarily due to the strengthening of the U.S. dollar to the euro, British pound and Russian ruble relating to U.S. denominated assets held in international jurisdictions. The FX gains in 2013 primarily related to the strengthening of the euro to the British pound in the first nine months of the prior year. The Company's ETR was 32.0% in the first nine months of 2014, up from 30.1% in 2013 with the increase primarily due to higher U.S. and non-U.S. taxes on foreign income. The 2014 ETR included a benefit related to the reversal of UTPs resulting from the favorable resolution of certain international tax matters. The prior year ETR included a benefit related to U.S. tax legislation enacted in early 2013 which retroactively extended certain tax benefits to the 2012 tax year and prospectively extended these benefits to the 2013 tax year as well as tax benefits on the aforementioned litigation settlement. Net Income in the first nine months of 2014, which included $78.5 million for the ICRA Gain as well as a $6.4 million benefit related to the aforementioned Legacy Tax Matter, was $752.4 million, or $3.48 per diluted share. This is an increase of $154.6 million, or $0.82 per diluted share, compared to 2013, which included a $0.14 charge related to the settlement of certain legal matters. Excluding the ICRA Gain and benefit from the Legacy Tax Matter in 2014 as well as the charge for the litigation settlement in the prior year, Non-GAAP Diluted EPS of $3.09 in the first nine months of 2014 was $0.29 higher than Non-GAAP Diluted EPS of $2.80 in the same period of the prior year. Segment Results Moody's Investors Service The table below provides a summary of revenue and operating results, followed by further insight and commentary: Nine months ended September 30, % Change Favorable 2014 2013 (Unfavorable) Revenue: Corporate finance (CFG) $ 846.0 $ 754.2 12 % Structured finance (SFG) 308.0 273.7 13 % Financial institutions (FIG) 269.4 249.9 8 % Public, project and infrastructure finance (PPIF) 267.2 258.8 3 % Total external revenue 1,690.6 1,536.6 10 % Intersegment royalty 65.7 57.5 14 % Total MIS Revenue 1,756.3 1,594.1 10 % Expenses: Operating and SG&A (external) 765.4 747.6 (2 %) Operating and SG&A (intersegment) 10.0 8.5 (18 %) Adjusted Operating Income 980.9 838.0 17 % Depreciation and amortization 34.3 34.9 2 % Operating income $ 946.6 $ 803.1 18 % Adjusted Operating Margin 55.9 % 52.6 % Operating margin 53.9 % 50.4 % 53 -------------------------------------------------------------------------------- Table of Contents The following is a discussion of external MIS revenue and operating expenses: Global MIS revenue of $1,690.6 million in the first nine months of 2014 increased $154.0 million compared to 2013 reflecting changes in the mix of fee type, new fee initiatives and certain pricing increases coupled with higher rated issuance volumes for bank loans and CLOs as well as higher banking-related issuance. The growth over 2013 also reflects higher monitoring fees across all regions. These increases were partially offset by declines in rated issuance volumes in U.S. public finance. Transaction revenue for MIS was 62% in both the first nine months of 2014 and 2013. In the U.S., revenue was $997.3 million in the first nine months of 2014, an increase of $81.0 million compared to 2013 reflecting changes in the mix of fee type, new fee initiatives and certain pricing increases coupled with growth in rated issuance volumes for CLOs. Additionally, a favorable shift in issuance mix in infrastructure finance, higher rated issuance volumes for investment-grade corporate debt (excluding a large $49 billion issuance in the telecommunications sector in 2013) and higher monitoring fees contributed to the revenue growth. These increases were partially offset by lower refunding volumes in the public finance sector as well as declines in rated issuance volumes from high-yield corporate debt. Also, the increases were partially offset by unfavorable issuance mix in the banking sector. Non-U.S. revenue was $693.3 million in the first nine months of 2014, an increase of $73.0 million compared to 2013. The growth reflects higher speculative-grade corporate debt, bank loan and CLO rated issuance volumes in EMEA as well as higher banking-related issuance volumes in EMEA and Asia Pacific. The growth over 2013 also reflects changes in the mix of fee type, new fee initiatives and certain pricing increases. Additionally, the growth reflects higher monitoring fees resulting from an expanding base of monitored instruments. Partially offsetting these increases were declines in investment-grade corporate debt revenue in the EMEA region as well as declines in SFG revenue in the Asia-Pacific region across most asset classes. Global CFG revenue of $846.0 million in the first nine months of 2014 increased $91.8 million from 2013 reflecting changes in the mix of fee type, new fee initiatives and certain pricing increases, primarily in the U.S. The growth also reflects higher rated issuance volumes for bank loans resulting from increased M&A activity combined with increased investor appetite for higher-yielding variable rate fixed income securities. Additionally, the increase over 2013 is due to higher rated issuance volumes in the U.S. for investment-grade corporate debt (excluding a large $49 billion issuance in the telecommunications sector in 2013) reflecting continued favorable market conditions. Monitoring and program fee revenue also contributed to the revenue growth in all regions due to a higher number of outstanding rated entities. Partially offsetting these increases was a decline in high-yield corporate debt issuance in the U.S. and investment-grade revenue in EMEA in the first nine months of 2014 compared to robust refinancing issuance volumes in the prior year. Transaction revenue represented 72% of total CFG revenue in the first nine months of 2014, compared to 74% in the prior year period. In the U.S., revenue in the first nine months of 2014 was $517.8 million, or $51.7 million higher than the prior year. Internationally, revenue of $328.2 million in the first nine months of 2014 increased $40.1 million compared to the prior year. Global SFG revenue of $308.0 million in the first nine months of 2014 increased $34.3 million compared to 2013 primarily due to higher rated issuance volumes for CLOs in the U.S. and EMEA. The growth reflects growing liquidity needs from issuers as well as increased investor demand for this asset class. Also contributing to the growth was an increase in the number of rated U.S. CMBS and REIT deals as well as the favorable impact of changes in the mix of fee type, new fee initiatives and certain pricing increases. 54-------------------------------------------------------------------------------- Table of Contents Transaction revenue was 60% of total SFG revenue in the first nine months of 2014 compared to 58% in the prior year. In the U.S., revenue of $205.5 million increased $30.3 million compared to the first nine months of 2013. Non-U.S. revenue in the first nine months of 2014 of $102.5 million increased $4.0 million compared to the prior year. Global FIG revenue of $269.4 million in the first nine months of 2014 was $19.5 million higher compared to 2013 due to changes in the mix of fee type, new fee initiatives and pricing increases as well as higher banking-related issuance in the Asia-Pacific and EMEA regions. Also contributing to the increase was higher issuance activity in the managed investments sector in the U.S. Partially offsetting these increases was a decline in U.S. banking revenue which reflected an unfavorable shift in issuance mix. Transaction revenue was 36% of total FIG revenue in the first nine months of 2014 compared to 35% in the same period in 2013. In the U.S., revenue was $107.2 million, or flat compared to the prior year. Internationally, revenue was $162.2 million in the first nine months of 2014, or $18.9 million higher compared to 2013. Global PPIF revenue was $267.2 million in the first nine months of 2014 and increased $8.4 million compared to 2013. The growth reflects changes in the mix of fee type, new fee initiatives and pricing increases partially offset by lower U.S. public finance refunding volumes due to higher benchmark interest rates. Transaction revenue was 58% of total PPIF revenue for the first nine months of 2014 compared to 61% in the prior year. In the U.S., revenue in the first nine months of 2014 was $166.8 million and decreased $1.6 million compared to 2013. Outside the U.S., PPIF revenue increased $10.0 million compared to 2013. Operating and SG&A expenses in the first nine months of 2014 increased $17.8 million compared to 2013 primarily reflecting higher compensation costs of approximately $60 million resulting from annual compensation increases, headcount growth in the ratings LOBs as well as in support areas such as IT, finance and human resources for which the costs are allocated to each segment based on a revenue-split methodology. Additionally, the increase in compensation costs reflects higher incentive compensation resulting from greater projected achievement against full-year targeted results compared to the prior year as well as headcount increases. Also, there were higher non-compensation costs in the first nine months of 2014 to support the Company's IT systems and infrastructure as well as higher rent and occupancy costs for additional leased floors at 7WTC coupled with various other global real estate expansion projects. These increases were partially offset by a litigation settlement charge in 2013 regarding two structured finance transactions rated by MIS as more fully discussed in Moody's Form 10-K for the year ended December 31, 2013. Adjusted Operating Income and operating income in the first nine months of 2014, which includes intersegment royalty revenue and intersegment expenses, were $980.9 million and $946.6 million, respectively, and increased $142.9 million and $143.5 million, respectively, compared to 2013. Adjusted Operating Margin and operating margin were 55.9% and 53.9%, respectively, or 330bps and 350bps higher than the prior year respectively. The increase in both margins compared to the prior year is primarily due to the aforementioned litigation settlement charge in the first nine months of 2013. 55-------------------------------------------------------------------------------- Table of Contents Moody's Analytics The table below provides a summary of revenue and operating results, followed by further insight and commentary: Nine months ended September 30, % Change Favorable 2014 2013 (Unfavorable) Revenue: Research, data and analytics (RD&A) $ 432.4 $ 393.6 10 % Enterprise risk solutions (ERS) 208.1 177.6 17 % Professional services (PS) 125.7 85.5 47 % Total external revenue 766.2 656.7 17 % Intersegment revenue 10.0 8.5 18 % Total MA Revenue 776.2 665.2 17 % Expenses: Operating and SG&A (external) 528.4 452.9 (17 %) Operating and SG&A (intersegment) 65.7 57.5 (14 %) Adjusted Operating Income 182.1 154.8 18 % Depreciation and amortization 34.3 35.2 3 % Operating income $ 147.8 $ 119.6 24 % Adjusted Operating Margin 23.5 % 23.3 % Operating margin 19.0 % 18.0 % The following is a discussion of external MA revenue and operating expenses: Global MA revenue increased $109.5 million compared to the first nine months of 2013, with growth across all LOBs. Recurring revenue comprised 76% and 80% of total MA revenue in the first nine months of 2014 and 2013, respectively. In the U.S., revenue of $338.5 million in the first nine months of 2014 increased $45.5 million, and reflected growth across all LOBs. International revenue of $427.7 million in the first nine months of 2014 was $64.0 million higher than in 2013. Global RD&A revenue, which comprised 56% and 60% of total external MA revenue in the first nine months of 2014 and 2013, respectively, increased $38.8 million over the prior year period. The growth, which was most notable in the U.S. and EMEA, was primarily due to increases in credit research and content licensing as well as general market price increases and the favorable impact of changes in FX translation rates. Global ERS revenue in the first nine months of 2014 increased $30.5 million over 2013, primarily due to growth in software subscriptions and services as well as higher software maintenance fees resulting from growing demand for ERS products and services in the banking and insurance industries. The revenue growth also reflects the acquisition of WebEquity in the third quarter of 2014. Revenue in ERS is subject to quarterly volatility resulting from the variable nature of project timing and the concentration of software implementation and license revenue in a relatively small number of engagements. Revenue from PS increased $40.2 million compared to the first nine months of 2013 with approximately 80% of the growth reflecting revenue from the acquisition of Amba in the fourth quarter of 2013. In addition to the acquisition of Amba, the growth reflects higher revenue from Copal reflecting further penetration into the market for outsourced research and analytical services as well as growth in the FSTC business. 56-------------------------------------------------------------------------------- Table of Contents Operating and SG&A expenses in the first nine months of 2014 increased $75.4 million compared to 2013. The expense growth reflects an approximate $60 million increase in compensation costs primarily due to higher headcount to support business growth as well as higher headcount in support areas, for which the costs are allocated to each segment based on a revenue- split methodology. Headcount from the fourth quarter 2013 acquisition of Amba and the third quarter 2014 acquisition of WebEquity as well as annual merit increases also contributed to the compensation expense growth. The growth in compensation costs also reflects higher incentive compensation due to higher projected achievement against full-year targeted results compared to the prior year. The increase also reflects an approximate $15 million increase in non-compensation expenses due to higher consulting costs for continued investment in IT infrastructure as well as costs related to ERS product development and project delivery. Furthermore, there was an increase in rent and occupancy costs of approximately $5 million reflecting additional floors at 7WTC as well as various other real estate expansion projects worldwide. Also, the expense growth reflected additional non-compensation costs related to the acquisitions of Amba and WebEquity. These increases were partially offset by approximately $6 million in lower contingent consideration costs relating to the Copal acquisition. Adjusted Operating Income was $182.1 million in the first nine months of 2014 and increased $27.3 million compared to the same period in 2013. Operating income of $147.8 million in the first nine months of 2014 increased $28.2 million compared to the same period in 2013. Adjusted Operating Margin for the first nine months of 2014 was 23.5%, compared to 23.3% in 2013. Operating margin was 19.0% compared to 18.0% in the prior year. Adjusted operating income and operating income both include intersegment revenue and expense. Liquidity and Capital Resources Cash Flow The Company is currently financing its operations, capital expenditures and share repurchases from cash flow from operating and financing activities. The following is a summary of the changes in the Company's cash flows followed by a brief discussion of these changes: $ Change Nine Months Ended Favorable September 30, (Unfavorable) 2014 2013 Net cash provided by operating activities $ 709.8 $ 653.5 $ 56.3 Net cash used in investing activities $ (244.6 ) $ (222.8 ) $ (21.8 ) Net cash used in financing activities $ (393.4 ) $ (343.2 ) $ (50.2 ) Free Cash Flow* $ 653.0 $ 622.5 $ 30.5 * Free Cash Flow is a non-GAAP financial measure. Refer to the section "Non-GAAP Financial Measures" of this MD&A for further information on this financial measure. Net cash provided by operating activities The $56.3 million increase in net cash flows provided by operating activities primarily reflected: • an increase in net income of $158.3 million which was partially offset by the net-of-tax non-cash ICRA Gain of $78.5 million; 57 -------------------------------------------------------------------------------- Table of Contents • an approximate $64 million increase primarily relating to higher incentive compensation payouts in 2013 compared to 2014 which reflected greater achievement against full-year targeted results in 2012 compared to achievement in 2013; Partially offset by: • a $38.7 million decrease in cash flow from changes in accounts receivable balances primarily reflecting an increase in accounts receivable balances in the first nine months of 2014 compared to 2013. The increase in accounts receivable balances primarily reflects growth in MIS rated issuance volumes. Approximately 32% and 29% of the Company's accounts receivable balance at September 30, 2014 and 2013, respectively, represents unbilled receivables which primarily reflect certain annual fees in MIS which are invoiced in arrears; • a $26.3 million decrease relating to changes in UTPs and other non-current tax liabilities which includes a non-cash reduction in UTPs in the first quarter of 2014 resulting from the favorable resolution of international tax matters; • an approximate $26 million decrease due to the timing of income tax payments. The remaining increase in cash flow is due to changes in various other assets and liabilities. Net cash used in investing activities The $21.8 million increase in cash used in investing activities is primarily due to: • an increase in capital additions of $25.8 million which reflects ongoing initiatives to enhance the Company's IT infrastructure as well as costs relating to the build-out of additional leased space at 7WTC; • cash paid, net of cash acquired, of $80.5 million to acquire additional equity shares of ICRA Limited. The acquisition of these additional shares resulted in the Company obtaining a controlling interest in ICRA. The amount in 2014 also includes $130.0 million in net cash paid for the acquisition of WebEquity; Partially offset by: • a decrease of $214.5 million in net sales of short-term investments reflecting higher prior year purchases of short-term investments with excess non-U.S. cash. Net cash used in financing activities The $50.2 million increase in cash used in financing activities was attributed to: • treasury shares repurchased of $780.2 million in the first nine months of 2014 compared to $747.6 million repurchased in the prior year period; • higher dividends paid to MCO shareholders of $34.5 million reflecting $0.84 per share paid in the first nine months of 2014 compared to $0.65 per share paid in the same period of the prior year. Cash and short-term investments held in non-U.S. jurisdictions The Company's aggregate cash and cash equivalents and short-term investments of $2.1 billion at September 30, 2014 consisted of approximately $1.4 billion located outside of the U.S., of which approximately 52% is denominated in euros and British pounds. Approximately 93% of the cash and cash equivalents and short-term investments in the 58 -------------------------------------------------------------------------------- Table of Contents Company's non-U.S. operations are held by entities whose undistributed earnings are indefinitely reinvested in the Company's foreign operations. Accordingly, the Company has not provided deferred income taxes on these indefinitely reinvested earnings. A future distribution or change in assertion regarding reinvestment by the foreign subsidiaries relating to these earnings could result in additional tax liability to the Company. It is not practicable to determine the amount of the potential additional tax liability due to complexities in the tax laws and in the hypothetical calculations that would have to be made. The Company manages both its U.S. and international cash flow to maintain sufficient liquidity in all regions to effectively meet its operating needs. Indebtedness At September 30, 2014, Moody's had $2.5 billion of outstanding debt and $1.0 billion of additional capacity available under the 2012 Facility. At September 30, 2014, the Company was in compliance with all covenants contained within all of the debt agreements. The 2012 Facility, the 2007 Agreement, the 2010 Indenture, the 2012 Indenture, the 2013 Indenture, and the 2014 Indenture contain cross default provisions. These provisions state that default under one of the aforementioned debt instruments could in turn permit lenders under other debt instruments to declare borrowings outstanding under those instruments to be immediately due and payable. As of September 30, 2014, there were no such cross defaults. On July 16, 2014, the Company issued $450 million aggregate principal amount of unsecured notes in a public offering. The notes bear interest at 2.75% and mature on July 15, 2019. Also on July 16, 2014, the Company issued $300 million aggregate principal amount of unsecured notes in a public offering. The $300 million notes bear interest at 5.25% and mature on July 15, 2044. The Company used the proceeds to retire the Series 2005-1 Notes and will use the remaining proceeds for general corporate purposes. The Company entered into interest rate swaps with a total notional amount of $250 million to convert the fixed interest rate on a portion of the $450 million unsecured notes to a floating interest rate based on the 3-month LIBOR. The purpose of this hedge was to mitigate the risk associated with changes in the fair value of a portion of the $450 million unsecured notes. The repayment schedule for the Company's borrowings is as follows: Year Ended Series 2007-1 2010 Senior 2012 Senior 2013 Senior 2014 Senior 2014 Senior December 31, Notes Notes Notes Notes Notes (5-Year) Notes (30-Year) Total 2014 (after September 30,) $ - $ - $ - $ - $ - $ - $ - 2015 - - - - - - - 2016 - - - - - - - 2017 300.0 - - - - - 300.0 2018 - - - - - - - Thereafter - 500.0 500.0 500.0 450.0 300.0 2,250.0 Total $ 300.0 $ 500.0 $ 500.0 $ 500.0 $ 450.0 $ 300.0 $ 2,550.0 Management may consider pursuing additional long-term financing when it is appropriate in light of cash requirements for operations, share repurchases and other strategic opportunities, which would result in higher financing costs. 59 -------------------------------------------------------------------------------- Table of Contents Other Material Future Cash Requirements The Company believes that it has the financial resources needed to meet its cash requirements and expects to have positive operating cash flow for the next twelve months. Cash requirements for periods beyond the next twelve months will depend, among other things, on the Company's profitability and its ability to manage working capital requirements. The Company may also borrow from various sources. The Company remains committed to using its strong cash flow to create value for shareholders by investing in growing areas of the business, reinvesting in ratings quality initiatives, making selective acquisitions, repurchasing stock and paying a dividend, all in manner consistent with maintaining sufficient liquidity after giving effect to any additional indebtedness that may be incurred. In October 2014, the Board of Directors of the Company declared a quarterly dividend of $0.28 per share of Moody's common stock, payable on December 10, 2014 to shareholders of record at the close of business on November 20, 2014. The continued payment of dividends at this rate, or at all, is subject to the discretion of the Board. On February 12, 2013, the Board approved $1.0 billion of share repurchase authority. At September 30, 2014, the Company had approximately $4 million of share repurchase authority remaining under this program, which does not have an established expiration. On February 11, 2014, the Board approved an additional $1.0 billion of share repurchase authority which will be utilized once the February 12, 2013 authorization is exhausted. Full-year 2014 total share repurchases are expected to be up to $1.25 billion, subject to available cash, market conditions and other ongoing capital allocation decisions. As part of the Copal acquisition in November 2011, Moody's and the non-controlling shareholders entered into a put/call arrangement whereby the noncontrolling shareholders have the option to sell the portion of Copal that Moody's does not currently own and Moody's has the option to purchase this portion from the noncontrolling shareholders. The exercise price of this option was valued at $68 million at the time of acquisition and will fluctuate based on the entity's financial results subject to a floor exercise price of approximately $46 million. In connection with the acquisition of Amba in December 2013, the revenue and EBITDA multiples set forth in the original put/call option agreement were modified to include the results of Amba. The redemption value of this redeemable noncontrolling interest was $137.6 million at September 30, 2014. There is no limit as to the amount of the strike price on the put/call option. In the third quarter of 2014, the Company notified the non-controlling shareholders that it plans to exercise its call option to acquire the remaining interest in Copal Amba that it does not currently own which is expected to settle in the fourth quarter of 2014. In accordance with the terms of the put/call agreement, the Company will be required to pay a 25% premium to the formulaic redemption value. The exercise of the call option will also trigger the payment of contingent consideration to the Copal Amba minority shareholders of approximately $11 million which will be paid upon the settlement of the call option. On February 6, 2008, the Company entered into a 17.5 year operating lease agreement to occupy six floors of an office tower located in the Canary Wharf district of London, England. The total base rent of the Canary Wharf Lease over its 17.5-year term is approximately £134 million, and the Company began making base rent payments in 2011. In addition to the base rent payments the Company will be obligated to pay certain customary amounts for its share of operating expenses and tax obligations. The total remaining lease payments as of September 30, 2014 are approximately £102 million, of which approximately £8 million will be paid in the next twelve months. 60-------------------------------------------------------------------------------- Table of Contents On October 20, 2006, the Company entered into an operating lease agreement with 7 World Trade Center, LLC for 589,945 square-feet of an office building located at 7WTC at 250 Greenwich Street, New York, New York, which is serving as Moody's headquarters. The 7WTC Lease has an initial term of 21 years with a total of 20 years of renewal options. The total base rent of 7WTC Lease over its initial 21-year term is approximately $536 million including rent credits from the World Trade Center Rent Reduction Program promulgated by the Empire State Development Corporation. On March 28, 2007, the 7WTC lease agreement was amended for the Company to lease an additional 78,568 square-feet at 7WTC. The additional base rent is approximately $106 million over a 20-year term. The total remaining lease payments as of September 30, 2014, including the aforementioned rent credits, are approximately $455 million, of which approximately $31 million will be paid during the next twelve months. On October 21, 2013, the Company entered into a fourteen-year lease for three additional floors at its 7WTC headquarters. The total remaining net commitment for this lease is approximately $63 million. The lease became effective in January 2014 and the net cash outlay during the next twelve months will be immaterial. Off-Balance Sheet Arrangements At September 30, 2014, Moody's did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose or variable interest entities where Moody's is the primary beneficiary, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, Moody's is not exposed to any financing, liquidity market or credit risk that could arise if it had engaged in such relationships. 61 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following table presents payments due under the Company's contractual obligations as of September 30, 2014: Payments Due by Period (in millions) Total Less Than 1 Year 1 - 3 Years 3 - 5 Years Over 5 Years Indebtedness (1) $ 3,657.4 $ 111.8 $ 523.0 $ 634.7 $ 2,387.9 Operating lease obligations 830.2 82.5 145.4 135.3 467.0 Purchase obligations 103.1 56.3 46.8 - - Contingent consideration related to acquisitions (2) 13.3 11.0 2.3 - - Pension obligations (3) 131.0 27.7 11.1 36.6 55.6 Total(4) $ 4,735.0 $ 289.3 $ 728.6 $ 806.6 $ 2,910.5 (1) Reflects principal payments, related interest and applicable fees due on the Series 2007-1 Notes, the 2010 Senior Notes, the 2012 Senior Notes, the 2013 Senior Notes, the 2014 Senior Notes (5-year), the 2014 Senior Notes (30-year) and the 2012 Facility as described in Note 13 to the condensed consolidated financial statements. (2) The amount in the "less than 1 year" category reflects an $11.0 million contingent consideration obligation related to the Copal acquisition. Additionally, the amount in the "1-3 years" category reflects a $2.3 million contingent cash payment related to the November 18, 2010 acquisition of CSI Global Education, Inc. The cash payment is dependent upon the achievement of a certain contractual milestone by January 2016. (3) Reflects projected benefit contributions to the Company's funded U.S. DBPP and payments relating to the Company's U.S. unfunded DBPPs and Retirement and Other Plans described in Note 12 to the condensed consolidated financial statements (4) The table above does not include the Company's net long-term tax liabilities of $238.5 million relating to UTP and Legacy Tax Matters plus accrued interest, since the expected cash outflow of such amounts by period cannot be reasonably estimated. In addition, the table above does not include the $137.6 million Redeemable Noncontrolling Interest. As discussed, in the "Other Material Future Cash Requirements" section of this MD&A above, the Company notified the non-controlling shareholders that it plans to exercise its call option to acquire the remaining portion of Copal Amba that it does not currently own which is expected to settle in the fourth quarter of 2014. The ultimate payment that will be made to the sellers has not yet been finalized as of the filing of this Form 10Q. Dividends On October 21, 2014, the Board approved the declaration of a quarterly dividend of $0.28 per share of Moody's common stock, payable on December 10, 2014 to shareholders of record at the close of business on November 20, 2014. Non-GAAP Financial Measures: In addition to its reported results, Moody's has included in this MD&A certain adjusted results that the SEC defines as "non-GAAP financial measures." Management believes that such non-GAAP financial measures, when read in conjunction with the Company's reported results, can provide useful supplemental information for investors analyzing period to period comparisons of the Company's performance, facilitate comparisons to competitors' operating results and can provide greater transparency to investors of supplemental information used by management in its financial and operational decision-making. These non-GAAP measures, as defined by the Company, are not necessarily comparable to similarly defined measures of other companies. Furthermore, these non-GAAP measures should not be viewed in isolation or used as a substitute for other GAAP measures in assessing the operating performance or cash flows of the Company. Below are brief descriptions of the Company's non-GAAP financial measures accompanied by a reconciliation of the non-GAAP measure to its most directly comparable GAAP measure: 62-------------------------------------------------------------------------------- Table of Contents Adjusted Operating Income and Adjusted Operating Margin: The Company presents Adjusted Operating Income because management deems this metric to be a useful measure of assessing the operating performance of Moody's, measuring the Company's ability to service debt, fund capital expenditures, and expand its business. Adjusted Operating Income excludes depreciation and amortization because companies utilize productive assets of different ages. Companies also have different methods of depreciating and amortizing productive assets. Management believes that the exclusion of this item allows for a more meaningful comparison of the Company's operating results from period to period and across companies. Below is a reconciliation of the Company's operating income and operating margin to Adjusted Operating Income and Adjusted Operating Margin: Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Operating income $ 349.7 $ 291.5 $ 1,094.4 $ 922.7 Adjustments: Depreciation and amortization 23.2 23.4 68.6 70.1 Adjusted Operating Income $ 372.9 $ 314.9 $ 1,163.0 $ 992.8 Operating Margin 42.9 % 41.3 % 44.5 % 42.1 % Adjusted Operating Margin 45.7 % 44.6 % 47.3 % 45.3 % Full-Year Ended December 31, 2014 Operating margin guidance 42% - 43% Depreciation and amortization 3% Adjusted Operating Margin guidance 45% - 46% Non-GAAP Diluted EPS The Company presents this non-GAAP measure to exclude the impact of a litigation settlement charge in the first quarter of 2013, the ICRA Gain in the second quarter of 2014 and the Legacy Tax benefit in the third quarter of 2014 to allow for a more meaningful comparison of Moody's diluted earnings per share from period to period. Below is a reconciliation of these measures to their most directly comparable U.S. GAAP amount: Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Diluted EPS - GAAP $ 1.00 $ 0.83 $ 3.48 $ 2.66 ICRA Gain - - (0.36 ) - Legacy Tax benefit (0.03 ) - (0.03 ) - Impact of litigation settlement - - - 0.14 Diluted EPS - Non-GAAP $ 0.97 $ 0.83 $ 3.09 $ 2.80 Projected Full Year Ended December 31, 2014 Diluted EPS guidance - GAAP $4.34 - 4.44 ICRA Gain (0.36) Legacy Tax benefit (0.03) Diluted EPS guidance - Non-GAAP $3.95 - 4.05 63 -------------------------------------------------------------------------------- Table of Contents Free Cash Flow: The Company defines free cash flow as net cash provided by operating activities minus payments for capital additions. Management believes that free cash flow is a useful metric in assessing the Company's cash flows to service debt, pay dividends and to fund acquisitions and share repurchases. Management deems capital expenditures essential to the Company's product and service innovations and maintenance of Moody's operational capabilities. Accordingly, capital expenditures are deemed to be a recurring use of Moody's cash flow. Below is a reconciliation of the Company's net cash flows from operating activities to free cash flow: Nine months ended September 30, 2014 2013 Net cash flows provided by operating activities $ 709.8 $ 653.5 Capital additions (56.8 ) (31.0 ) Free cash flow $ 653.0 $ 622.5 Net cash used in investing activities $ (244.6 ) $ (222.8 ) Net cash used in financing activities $ (393.4 ) $ (343.2 ) 2014 Outlook Moody's outlook for 2014 is based on assumptions about many macroeconomic and capital market factors, including interest rates, corporate profitability and business investment spending, merger and acquisition activity, consumer borrowing and securitization, and the amount of debt issued. There is an important degree of uncertainty surrounding these assumptions, and, if actual conditions differ, Moody's results for the year may differ materially from the current outlook. The Company's guidance, which is presented in the table below, assumes foreign currency translation at end-of-quarter exchange rates. Full-year 2014 Moody's Corporation guidance Guidance as of MOODY'S CORPORATION Current guidance as of the filing of this Form 10Q September 30, 2014 Revenue growth in the low-double-digit percent range NC Operating expenses growth in the high-single-digit percent range NC Growth in compliance and regulatory expense Less than $5 million NC Depreciation & amortization Approximately $100 million NC Operating margin 42% to 43% NC Adjusted operating margin 45% to 46% NC Effective tax rate Approximately 33% NC Non-GAAP EPS* $3.95 to $4.05 NC Capital expenditures Approximately $90 million NC Free cash flow Approximately $900 million NC Share repurchases Up to $1.25 billion (subject to available cash, market conditions and other ongoing capital allocation decisions) NC 64 -------------------------------------------------------------------------------- Table of Contents Full-year 2014 revenue guidance Guidance as of September 30, MOODY'S INVESTORS SERVICE Current guidance as of the filing of this Form 10Q 2014 MIS global growth in the high-single-digit percent range NC MIS U.S. growth in the high-single-digit percent range NC MIS Non-U.S. growth in the low-double-digit percent growth of approximately 10% range CFG growth in the low-double-digit percent growth of approximately 10% range SFG growth in the high-single-digit percent range growth of approximately 10% FIG growth in the mid-single-digit percent range NC PPIF growth in the high-single-digit percent growth in the mid-single-digit percent range range MOODY'S ANALYTICS MA global growth in the mid-teens percent range NC MA U.S. growth in the low-double-digit percent range NC MA Non-U.S. growth in the high-teens percent range NC RD&A growth in the high-single-digit percent range NC ERS growth in the mid-teens percent range NC PS growth of approximately 40% NC NC-There is no difference between the Company's current guidance and the last publicly disclosed guidance for this item. * Full-Year 2014 GAAP Diluted EPS guidance is $4.34 to $4.44 and includes the $0.36 ICRA Gain and the $0.03 Legacy Tax benefit Recently Issued Accounting Pronouncements In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers". This ASU outlines a comprehensive new revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. This ASU is effective for annual and interim reporting periods beginning after December 15, 2016 and early adoption is not permitted. The Company is currently evaluating its adoption options and the impact that adoption of this update will have on its consolidated financial statements. In June 2014, the FASB issued ASU No. 2014-12, "Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period." This ASU clarifies the current accounting guidance for entities that issue share-based payment awards that require a specific performance target be achieved for employees to become eligible to vest in the awards, which may occur subsequent to a required service period. The current accounting guidance does not explicitly address how to account for these types of award. The ASU provides explicit guidance and clarifies that these types of performance targets should be treated as performance conditions, and accordingly should not be reflected in the determination of the grant-date fair value of the award. This ASU is effective for all annual periods and interim reporting periods beginning after December 15, 2015, with early adoption permitted. The Company currently accounts for transactions involving stock-based compensation awards with performance conditions in accordance with the provisions set forth in this ASU. Accordingly, the adoption of this update will not have an impact on the Company's consolidated financial statements. Contingencies Legal proceedings in which the company is involved also may impact Moody's liquidity or operating results. No assurance can be provided as to the outcome of such proceedings. In addition, litigation inherently involves significant costs. For information regarding legal proceedings, see Item 1 - "Financial Statements", Note 14 "Contingencies." 65-------------------------------------------------------------------------------- Table of Contents Regulation MIS and many of the securities that it rates are subject to extensive regulation in both the U.S. and in other countries (including by state and local authorities). Thus, existing and proposed laws and regulations can impact the Company's operations and the markets for securities that it rates. Additional laws and regulations have been adopted but not yet implemented or have been proposed or are being considered. Each of the existing, adopted, proposed and potential laws and regulations can increase the costs and legal risk associated with the issuance of credit ratings and may negatively impact Moody's operations or profitability, the Company's ability to compete, or result in changes in the demand for credit ratings, in the manner in which ratings are utilized and in the manner in which Moody's operates. In the EU, the CRA industry is registered and supervised through a pan-European regulatory framework which is a compilation of three sets of legislative actions. In 2009, the EU established an oversight regime for the CRA industry commonly referred to as CRA1. CRA1, which required the registration, formal regulation and periodic inspection of CRAs operating in the EU, became fully effective in September 2010. MIS applied for registration in August 2010 and was granted registration in October 2011. In January 2011, CRA2 established the European Securities and Markets Authority. ESMA has had direct supervisory responsibility for the registered CRA industry throughout the EU since July 2011. In the summer of 2013, a new set of rules that augmented the CRAs' supervisory framework went into effect. Commonly referred to as CRA3, these new rules, among other things: • impose various additional procedural requirements with respect to ratings of sovereign issuers; • require member states to adopt laws imposing liability on CRAs for an intentional or grossly negligent failure to abide by the applicable regulations; • impose mandatory rotation requirements on CRAs hired by issuers of securities for ratings of resecuritizations, which may limit the number of years a CRA can issue ratings for such securities of a particular issuer; • impose restrictions on CRAs or their shareholders if certain ownership thresholds are crossed; and • impose additional procedural and substantive requirements on the pricing of services. Certain of the provisions of CRA3 are subject to further rule-making. In September 2014, the Commission endorsed rules covering two areas of direct relevance to the CRA industry: 1) CRAs' reporting requirements to ESMA on their fees; and 2) the types of information that CRAs are to provide about certain ratings (those that were paid for by issuers) for publication on a central website administered by ESMA (the European Ratings Platform). The Commission-endorsed rules have been presented to the EU Parliament and Council for final adoption. It is expected that the full process will conclude by the first quarter of 2015. In August 2014, the SEC voted to adopt its final rules for NRSROs as required by the Financial Reform Act. The final rules track closely to the proposed rules which had been published in 2011. There are, however, some modifications to earlier proposals. These include additional measures regarding: (i) sales and marketing activities; and (ii) the design and enforcement of internal controls for the rating process. In anticipation of the final rules, the Company has made substantial IT and other investments over the past several years. Consequently, the Company will be in a position to 66-------------------------------------------------------------------------------- Table of Contents implement the relevant compliance obligations by the set deadlines, generally ranging from 60 days to 9 months following the September 15, 2014 publication of the final rules in the Federal Register. In December 2012, the Staff of the SEC's Trading and Markets Division published a "Report to Congress on Assigned Credit Ratings." In the report, commonly referred to as the Franken Amendment Study, the SEC Staff identified several potential courses of action without endorsing any of them and noted that any changes through SEC rulemaking would require additional study of relevant information. In light of the regulations that have gone into effect in both the EU and the U.S. (as well as many other countries), from time to time and as a matter of course pursuant to their enabling legislation these regulatory authorities have and will continue to publish reports that describe their oversight activities over the industry. In addition, other legislation and regulation relating to credit rating and research services is being considered by local, national and multinational bodies and this type of activity is likely to continue in the future. Finally, in certain countries, governments may provide financial or other support to locally-based rating agencies. For example, governments may from time to time establish official rating agencies or credit ratings criteria or procedures for evaluating local issuers. If enacted, any such legislation and regulation could change the competitive landscape in which MIS operates. The legal status of rating agencies has been addressed by courts in various decisions and is likely to be considered and addressed in legal proceedings from time to time in the future. Management of the Company cannot predict whether these or any other proposals will be enacted, the outcome of any pending or possible future legal proceedings, or regulatory or legislative actions, or the ultimate impact of any such matters on the competitive position, financial position or results of operations of Moody's. Forward-Looking Statements Certain statements contained in this quarterly report on Form 10-Q are forward-looking statements and are based on future expectations, plans and prospects for the Company's business and operations that involve a number of risks and uncertainties. Such statements involve estimates, projections, goals, forecasts, assumptions and uncertainties that could cause actual results or outcomes to differ materially from those contemplated, expressed, projected, anticipated or implied in the forward-looking statements. Those statements appear at various places throughout this annual report on Form 10-Q, including in the sections entitled "2014 Outlook" and "Contingencies" under Item 2. "MD&A", commencing on page 40 of this quarterly report on Form 10-Q, under "Legal Proceedings" in Part II, Item 1, of this Form 10-Q, and elsewhere in the context of statements containing the words "believe", "expect", "anticipate", "intend", "plan", "will", "predict", "potential", "continue", "strategy", "aspire", "target", "forecast", "project", "estimate", "should", "could", "may" and similar expressions or words and variations thereof relating to the Company's views on future events, trends and contingencies. Stockholders and investors are cautioned not to place undue reliance on these forward-looking statements. The forward-looking statements and other information are made as of the date of this quarterly report on Form 10-Q, and the Company undertakes no obligation (nor does it intend) to publicly supplement, update or revise such statements on a going-forward basis, whether as a result of subsequent developments, changed expectations or otherwise. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company is identifying examples of factors, risks and uncertainties that could cause actual results to differ, perhaps materially, from those indicated by these forward-looking statements. Those factors, risks and uncertainties include, but are not limited to, the current world-wide credit market disruptions and economic slowdown, which is affecting and could continue to affect the volume of debt and other securities issued in domestic and/or global capital markets; other matters that could affect the volume of debt and other securities issued in domestic and/or global capital markets, including credit quality concerns, changes in interest rates and other volatility in the financial markets; the level of merger and acquisition activity in the U.S. and abroad; the uncertain effectiveness and possible collateral consequences of U.S. and foreign government initiatives to respond to the current world-wide credit market disruptions and economic slowdown; concerns in the marketplace affecting our credibility or otherwise affecting market perceptions of the integrity or utility of independent credit agency ratings; the introduction of competing products or technologies by other companies; pricing pressure from competitors and/or customers; the level of success of new 67 -------------------------------------------------------------------------------- Table of Contents product development and global expansion; the impact of regulation as an NRSRO, the potential for new U.S., state and local legislation and regulations, including provisions in the Financial Reform Act and anticipated regulations resulting from that Act; the potential for increased competition and regulation in the EU and other foreign jurisdictions; exposure to litigation related to our rating opinions, as well as any other litigation to which the Company may be subject from time to time; provisions in the Financial Reform Act legislation modifying the pleading standards, and EU regulations modifying the liability standards, applicable to credit rating agencies in a manner adverse to credit rating agencies; provisions of EU regulations imposing additional procedural and substantive requirements on the pricing of services; the possible loss of key employees; failures or malfunctions of our operations and infrastructure; any vulnerabilities to cyber threats or other cybersecurity concerns; the outcome of any review by controlling tax authorities of the Company's global tax planning initiatives; the outcome of those Legacy Tax Matters and legal contingencies that relate to the Company, its predecessors and their affiliated companies for which Moody's has assumed portions of the financial responsibility; the impact of mergers, acquisitions or other business combinations and the ability of the Company to successfully integrate acquired businesses; currency and foreign exchange volatility; the level of future cash flows; the levels of capital investments; and a decline in the demand for credit risk management tools by financial institutions. These factors, risks and uncertainties as well as other risks and uncertainties that could cause Moody's actual results to differ materially from those contemplated, expressed, projected, anticipated or implied in the forward-looking statements are described in greater detail under "Risk Factors" in Part I, Item 1A of the Company's annual report on Form 10-K for the year ended December 31, 2013, and in other filings made by the Company from time to time with the SEC or in materials incorporated herein or therein. Stockholders and investors are cautioned that the occurrence of any of these factors, risks and uncertainties may cause the Company's actual results to differ materially from those contemplated, expressed, projected, anticipated or implied in the forward-looking statements, which could have a material and adverse effect on the Company's business, results of operations and financial condition. New factors may emerge from time to time, and it is not possible for the Company to predict new factors, nor can the Company assess the potential effect of any new factors on it. |