MSCI
Guest write-up by Jayden Preston.
Overview
Spun off from Morgan Stanley in 2007, MSCI is a leading provider of investment decision support tools to investment institutions worldwide. They produce indexes and risk and return portfolio analytics for use in managing investment portfolios.
Their flagship products are their international equity indexes marketed under the MSCI brand. They also offer other products that assist investors making investment decisions. These include portfolio analysis by their Barra platform; risk management by their RiskMetrics product; provision of ratings and analysis that institutional investors to integrate environmental, social and governance (“ESG”) factors into their investment strategies; and analysis of real estate in both privately and publicly owned portfolios.
Their clients include both asset owners and financial intermediaries.
Their principal business model is to license annual, recurring subscriptions to their products and services for a fee, which is, in a majority of cases, paid in advance.
They also charge clients to use their indexes as the basis for index-linked investment products such as ETFs or as the basis for passively managed funds and separate accounts. These clients commonly pay MSCI a license fee, primarily in arrears, for the use of the brand name mainly based on the assets under management (“AUM”) in their investment product. Certain exchanges use their indexes as the basis for futures and options contracts and pay them a license fee, primarily paid in arrears, for the use of their intellectual property mainly based on the volume of trades.
Clients also subscribe to periodic benchmark reports, digests and other publications associated with their Real Estate products. Fees are primarily paid in arrears after the product is delivered.
As a very small part of their business, they also realize one-time fees related to customized reports, historical data sets and certain implementation and consulting services, as well as from certain products and services that are purchased on a non-renewal basis.
Business Segment
MSCI categories its business segments into the following: 1) Index, 2) Analytics, and 3) All Other.
Index Segment
This is their key segment. As I will explain below, this is where I believe the lion’s share of value of MSCI lies.
MSCI indexes are used in many areas of the investment process, including index-linked product creation and performance benchmarking, as well as portfolio construction and rebalancing. Index-linked product creation generates asset-based fees and the latter is the source of their subscription revenue within the Index segment.
MSCI currently calculates over 190,000 global equity indexes, including approximately 7,300 custom indexes.
For 2016, Index generated $613.5 million in revenue, or 53% of their total revenue. Adjusted EBITDA from this segment was $431.5 million, or 76% of total EBITDA. You can see that the EBITDA margin from this segment was 70%.
Analytics Segmen
This segment uses analytical content to create products and services which offer institutional investors an integrated view of risk and return. A few examples of major offerings under this segment include:
- RiskMetrics RiskManager: Clients use RiskManager for daily analysis, measuring and monitoring of market and liquidity risk at fund and firm levels, sensitivity and stress testing, interactive what-if analysis, counterparty credit exposure and regulatory risk reporting.
- Barra Portfolio Manager: An integrated risk and performance platform designed to help fund managers and their analyst teams gain additional portfolio insight, manage their investment process more systematically and make faster, more informed investment decisions.
- HedgePlatform: A reporting service that allows clients that invest in hedge funds, including funds of funds, pension funds and endowments, to measure, evaluate and monitor the risk of their hedge fund investments across multiple hedge fund strategies.
- InvestorForce: This offers performance reporting solutions to the institutional investment community in the United States by providing investment consultants with an integrated solution for daily monitoring of, analysis of and reporting on institutional assets.
In 2016, this segment was responsible for 39% of the total revenue and 22.6% of Adjusted EBITDA. Adjusted EBITDA margin was at a respectable level of 29%.
All Other
This includes their two smaller segments of ESG and Real Estate.
MSCI ESG Research analyses thousands of companies worldwide to help institutional investors understand how environmental, social and governance (ESG) factors can impact the long-term risk of their investments. As of December 31, 2016, subscribers to MSCI ESG Research included 82 of the top 100 global asset managers (as ranked by P&I in its report dated May 2016), as well as leading asset owners, consultants, advisers and academics. Data from MSCI ESG Research is also used in their main Index segment for index construction.
Their ESG portfolio includes:
- MSCI ESG Ratings: These ratings identify ESG risks or opportunities that may not be captured through conventional means. As of the end of 2016, they have ratings for more than 6,500 companies worldwide, including more than 6,000 equity issuers and 4400 issuers of fixed income securities.
- MSCI ESG Business Involvement Screening Research: This is a screening service that is designed to enable institutional investors to manage ESG standards and restrictions reliably and efficiently through their online platform.
- MSCI ESG Governance Metrics: This provides institutional investors with corporate governance research and data on more than 7,000 public companies worldwide. The assessment model is based on 96 unique metrics organized into four individual scoring pillars, designed to provide consistency, transparency and structural integrity.
Real Estate is their smallest segment. Their Real Estate products provide real estate performance analysis, reporting and benchmarking for funds, investors, managers and lenders. Their Real Estate performance and risk analytics range from multi-asset class to property-specific analysis. Business intelligence to real estate owners, managers, developers and brokers worldwide are also provided.
For 2016, this segment contributed 7.7% of revenue and 1.7% of Adjusted EBITDA. Adjusted EBITDA was only 10.6%.
Durability, Moat and Quality
Index
Let’s focus on Index first.
The purpose of having an index is twofold. First, for active investors, it’s used as a benchmark to compare one’s performance to the market. Second, for passive investors, it showcases the performance that should have been captured. Unless people stop engaging in the stock markets, both of the above functions will always be needed. The durability of the concept of index is undoubtedly enduring.
However, there is still the difference between using a third-party index versus using an index you created. There is a recent and growing trend of asset managers and investment banks creating their own indexes. This is referred to as self-indexing.
10, 15 or 20 years ago, the threat of self-indexing was minimal. In a world where active management was clearly the preferred strategy and a world where the asset management industry was more fragmented, no single active manager would bother setting up a department to calculate indexes themselves.
Fast forward to 2017, the landscape of investment management has changed significantly. Not only is passive investing all the rage, the ETF market, the gold standard for passive investing, has also become fairly concentrated among the top 3 players. (BlackRock, Vanguard and State Street owns more than 70% of the ETF market) The major competition ground for passive investing lies in price competition. As the rivalry among the top players heats up, there exists pressures to lower cost. One means to do so is switching from paying a fee to a third-party index provider to relying on indexes created in-house.
This is more pronounced for “factor” or “smart-beta” investing. Asset managers, such as WisdomTree and Goldman Sachs Asset Management, manage funds or ETF indexes based on their own proprietary indexes. This market is still relatively niche though. WisdomTree, with $44 billion in AUM is the biggest smart-beta ETF manager.
Could major ETF providers switch to self-indexing? In other words, would self-indexing go mainstream? Personally, I think there will be more self-indexing. But the overall impact on “branded” index providers should not be terminal.
The ETF market is a highly lopsided market. Here are some figures from April 2017*. There were close to 2,000 ETFs listed in the US. Combined, they had nearly $3 trillion in assets. The industry asset has been growing at around 20% annually. This is a huge amount of assets growing at a rapid rate. But the 3 biggest ETFs, SPY, IVV and VTI account for nearly 25% of the total. We immediately see the extreme concentration of assets in the ETF market. These 3 biggest ETFs all track the most widely known index in the world, S&P 500. For such flagship products, what are the chances that these ETF providers will switch to a self-developed index? The S&P 500, through decades of existence, has been ingrained in all investors’ mind as the benchmark for US large cap. It has the most mind share and is the industry standard. Switching away from S&P 500 may save you a couple of basis points, but this risks losing assets to your two main competitors.
The risk lies not just in losing existing assets, the problem would also be unnecessarily increasing the difficulty of attracting new assets. As such, your marketing expense would probably increase. The major reasons why these 3 ETFs are the biggest are: 1) They were introduced a long time ago and 2) They track the most famous index. When you sell an ETF that tracks the S&P 500, you really do not need to do much explanation. The client would know this is the cheapest way to track the return of the US large caps. Yet, when you sell a “smart-beta” ETF, more effort is needed in explaining what exactly your ETF is tracking. The same problem occurs when you try to sell an ETF similar to one that utilizes the industry standard benchmark.
It’s more likely that a competitor will try to create an entirely new ETF that tracks the same underlying shares but utilize a self-created index than an existing ETF changing its underlying index. For them to compete effectively, they would need to offer a much more attractive price. Yet, all new ETFs are at a size disadvantage when compared to established ones. And size matters a lot in ETFs in terms of how low your cost can get. More importantly, size also dictates to a very large extent the liquidity of your fund. All things being equal, the more liquid an ETF is, the more attractive it is.
There is another aspect of brand power I want to talk about.
Brand is usually strongest when the criteria for selection is not obvious or when it is the most difficult to evaluate cost-effectively. MSCI’s brand value lies more in the former. While almost all investors know of the MSCI brand, almost none know exactly how they do their index calculation or how they select what companies can be included. When investors pick a benchmark, they never pick one that they think have the best methodology. They just choose whatever is the most well-known.
Back in the tech bubble, some smart investors believed the flawed methodology from the major index creators had contributed to the stock bubble. Indexes were mostly market cap weighted. The problem here is, there can be a company that receives a significant weighting due to its large market valuation, yet having relatively little float. This means as passive funds tried to replicate the indexes, they must chase for disproportionately less shares than suggested in the weightings, driving up share prices. Despite such flaws, no new index provider was started. I also do not believe any of those investors who share this concern switched their benchmark. It’s only since 2004 that float-adjusted weighting became the industry standard. And all the major index providers had a smooth transition.
Currently, there is still a lot of confusion about how different metrics, such as overall P/E, P/B, forward P/E and whatnot of the indexes are calculated and what are the differences, if any, among different index providers. Investors are unlikely to spend time to understand such issues fully. They will just opt for the best-known brand.
Altogether, when it comes to ETFs that track industry standard indexes, such as the MSCI ACWI index or MSCI EAFE index, I am not worried about assets being moved away to self-produced indexes in any meaningful way**.
In case an ETF provider insists switching the underlying index, it would likely be easier if it’s a switch to another famous index provider. As such, the rivalry among existing players perhaps carries more weight.
The existing global index market is more or less an oligopoly. While S&P is dominant in the US market space, and FTSE Russell in the smaller cap space. MSCI is the dominant player in the international market. Their indexes are widely used as benchmarks for international, non-US investors. As a brand, its durability comes right from the meaningful head start it enjoyed within non-US markets.
In 1968, Capital International pioneered the development of global equity indexes, i.e. non-US markets, and began licensing its equity indexes the following year. In 1986, Morgan Stanley licensed the rights to the indexes from Capital International and branded the indexes as Morgan Stanley Capital International, and hence the MSCI name. With a clear first mover advantage, MSCI indexes gradually became the primary benchmark indexes outside of the US. This doesn’t make MSCI immune from a losing business to a rival provider though.
In the past 5 years, there was an incidence where a big asset manager/ETF provider switches indexes. In 2012, Vanguard announced it was switching 22 of its biggest index funds away from MSCI indexes to cut cost***. 6 of the index funds were international stock funds with $170 billion of assets, which included the Vanguard Emerging Markets Index ETF. These 6 funds have since tracked indexes from the FTSE Group. This piece of news caused MSCI’s share price to drop 27% that day. This wasn’t the first time for Vanguard as they had switched from S&P to MSCI back in 2003.
In response to this news, BlackRock responded by saying they would be sticking with MSCI as it is “the gold standard of global and international equity indexes – the near universal choice of professional investors”. It’s interesting to compare these two providers’ Emerging Market ETFs now. As of the end of August 2017, Vanguard FTSE Emerging Markets ETF has $85 billion in AUM and an expense ratio of 0.14%. On the other hand, iShares MSCI Emerging Markets ETF has around $35 billion. However, its expense ratio is much higher at 0.68%. This means despite having 2.4x the assets, due a much lower expense ratio, Vanguard is earning less revenue from their Emerging Markets ETF than iShares. How could one explain the level of assets iShares have despite a much higher expense ratio? One could be that MSCI is still the better brand name. Second, it would be the better historical investment returns achieved by the MSCI index.
Nevertheless, we should expect the pricing pressure to continue.
The above discussion circles around the asset-based fees ETF providers pay the index brand owners. In 2016, they constitute 34% of index revenue and 18% of overall revenue for MSCI. The remaining revenue source in the Index segment includes subscriptions services for clients to gain access to MSCI index data, such as composition of MSCI indexes, historical data, different metrics and etc. As long as MSCI indexes remain one of the gold standards, the demand for MSCI index data will remain strong. For the past 5 years, their Index Subscriptions business has been growing at a nice clip, likely at more than 10% p.a.
Analytics
MSCI’s positioning in Analytics is not as strong. Not only are there more players in the analytics industry, MSCI also doesn’t occupy the strongest foothold. The range of competitors include Axioma, Inc., BlackRock Solutions, Bloomberg Finance L.P., and FactSet Research Systems Inc.
Additionally, many of the larger broker-dealers have developed proprietary analytics tools for their clients. Similarly, many investment institutions, particularly the larger global organizations, have developed their own internal risk management analytics tools. As risk management is seen as a value adding element, this gives an incentive for big players with scale to develop their own proprietary system in hopes of gaining an edge.
However, their Analytics is still a very good business. The following are the major advantages listed in their 10-K:
- Extensive historical databases: They have amassed extensive databases of historical global market data, proprietary equity index data, private real estate benchmark data, risk data and ESG data. Historical data is a critical component of their clients’ investment processes, allowing them to research and back-test investment strategies and analyze portfolios over many investment and business cycles and under a variety of historical situations and market environments. Their databases of research-enhanced data, including more than 45 years of certain index data history, nearly 35 years of certain risk and real estate data history, as well as more than 15 years of certain historical governance data, would be difficult and costly to replicate. The information is not available from any single source and would require intensive data checking and quality assurance testing that they have performed over their many years of accumulating this data.
- Client integration of their products and services: Many of their clients have integrated MSCI’s products or services into their performance measurement and risk management processes, where these products or services become an integral part of their clients’ daily portfolio management functions. In certain cases, their clients are requested by their customers to report using MSCI’s products or data.
- High data quality: They offer proprietary software and databases that house data from more than 200 third-party sources as well as their proprietary data
The nature of the Analytics business is clients pay service providers in advance, usually by 6 months or 1 year. Adding the above advantages the big providers have, the retention rates are usually in the low 90%. The difficulty lies in growing the business through market share gain. This explains why the entire Analytics business of MSCI was not built organically but through acquisitions.
We will ignore the All Other segment as its contribution is not meaningful.
Valuation and Growth
MSCI is a very cash generative business. As the business scales further, operating leverage should continue to work in their favor.
In their Index business, they benefit from the natural asset growth in the ETF market. In other words, without incurring expenses themselves, they can gain more revenue through assets growth in the ETFs. Despite occasional pricing adjustment, the upward trend is unmistakable. For instance, in Q2 2016, the average BPS MSCI was charging on ETFs linked to their indexes was 3.12. This dropped to 3.07 in the last quarter, a 1.6% decline. However, average AUM increased 35.8% from $438 billion to $595 billion. Over a longer period, ETF average BPS has declined 4% annually since Q2 2013, while AUM from ETFs linked to MSCI indexes increased 23% p.a. Combined, this has led to an increase of 18% annually for their asset-based fee run rate.
There are numerous statistics to look at how big the ETF market can get. Globally, the ETF market has now around $4 trillion. Despite tremendous growth since 2000, growing from around $79 billion, this still pales in comparison to the global mutual fund industry, at $40 trillion and overall global assets under management that is estimated at more than $70 trillion. ETF still represents only about 1% of total institutional assets.
In the past 12 months alone, ETFs has gathered another $500 billion, good for a 14% of growth. Industry experts have long term projections that point to the ETF industry growing to $15 trillion to $25 trillion by 2024/2025****. That equates an annual growth rate of 20% p.a. to 26% p.a. for the next 7 to 8 years, in line with the rate MSCI observed in the past 4 years. As the international market matures, it’s arguable that non-US market ETFs linked to MSCI indexes could potentially grow faster than the industry. Altogether, this gives me confidence that we can expect at least similar growth rate, of around 18%, in their asset-based fees going forward. Let’s use 15%. By 2025, MSCI could be generating $580 million in revenue from their asset-based fees. For recurring subscriptions under the Index segment, the growth rate has been higher than 10%. Without more insight, let’s assume this segment can grow 7% a year. This brings us $660 million by 2025. Together, the Index segment will then be generating $1.24 billion by 2025. With an EBITDA margin at 70%, this would bring close to $870 million in EBITDA.
For Analytics, I would assume a slower growth rate that tracks nominal GDP growth of around 5%. By 2025, the revenue would then be $650 million. The interesting part for their Analytics is that the margins there have been improving significantly in the recent few years due to constant cost control, especially by moving more staff to overseas emerging market centers with lower labor costs. The adjusted EBITDA margin has thus expanded from 17% to 28% in the last three years. Assuming the current rate as sustainable, we get $182 million in EBITDA.
In the All Other segment, the ESG part of the business is growing and receiving more demand while the Real estate part of the business struggles. Through cost cutting in the Real Estate business, the All Other segment improved from a negative EBITDA in 2015 to $9.5 million in 2016. But again, I am going to put a zero value on this segment. In all likelihood, the ESG segment should grow given the trend in “sustainable” investing.
In total, we are expecting EBITDA to be $1.05 billion by 2025.
MSCI doesn’t specify the operating income per segment. Yet it is relatively reasonable to look at EBITDA, given a big chunk of the amortization are customer relationships and trademark value created from their previous acquisitions. We will estimate the actual free cash flow by deducting capex and capitalized software development costs. In 2016, they spent $33 million. The figures for the previous 3 years were around $40 million to $50 million. The guidance for FY2017 was also between $40 million to $ 50 million. This equates 4% to 5% of revenue. Assuming they will keep the current investment level, by 2025, they would be investing close to $100 million.
For 2017, they are expecting interest expense of $116 million. Currently they have three big unsecured senior notes totaling $2.1 billion, maturing in 2024, 2025 and 2026 respectively. They have a fixed rate of 4.75% to 5.75%. These are good notes to issue for MSCI, since they are long term with fixed low interest rates. Let’s assume no further debt will be raised, but these notes will be rolled over. Then by 2025, MSCI would have a pretax owners’ earning of $830 million, assuming depreciation and amortization tracks capital expenditure. After a 35% tax rate, our final free cash flow estimate of 2025 will be $540 million. That’s a revenue to free cash flow conversion of 28.5%.
The company’s guidance for FY2017 is free cash flow of $310 million to $370 million. We are thus expecting an annual growth rate of only 5% to 7% over the next 8 years. This seems conservative to me. What might a constant stream of cash flow growing at least 5% be worth? 25x to 30x seems reasonable. That’s a dividend yield of 3% to 4%, with the dividend stream growing at 5%. Total return can thus be 8% to 9%.
Putting 25x to 30x on the current FY2017 free cash flow projection gives us an estimation of MSCI’s equity value at $7.75 billion to $11.1 billion.
If the stock price of MSCI falls 50%, it will be a screaming buy.
Misjudgmen
In addition to waiting for the right price, I see 4 keys to MSCI being a great investment:
- MSCI’s brand value persists, especially within the international equity space
- ETFs continue to increase its share in the global asset management industry
- No Loss of major clients, i.e. BlackRock
- MSCI utilizes its cash flow well.
As point 1 and 2 are discussed above. We will delve a bit deeper into point 3 and 4.
Point
BlackRock has long since been the biggest customer of MSCI. In 2016, BlackRock was 9.4% of MSCI’s revenue. 94% of that are asset-based fees. These two figures have been stable for the past 3 years, but has increased from the 8% to 9% range and 80% to 90% range respectively from the period of 2011 to 2013. As a percentage of MSCI’s Index segment, BlackRock was 17.3% in 2016. So there is a risk that if BlackRock decided to move to another index provider like Vanguard did, MSCI’s value will instantly decrease by least 10%.
The concentration in BlackRock, however, is in line with the industry. In terms of asset-based fees, BlackRock should be accounting for roughly half for what MSCI receives every year. And BlackRock has close to 50% of the ETF market. In addition, the fixed cost to serve BlackRock is likely insignificant.
Point 4
Historically, MSCI has acquired assets to bolster its Analytics business. In the past few years, these have mostly been small deals in the millions. However, MSCI did do some big deals. In March 2010, they purchased RiskMetrics for $1.57 billion*****. They paid a super high EV/EBIT of 22x or 5x EV/Sales. They valued RiskMetrics at $21.75 per share, in which they offered $16.35 in cash and 0.1802 MSCI shares for each RiskMetrics share. This valuation might still be in the realm of reasonableness, albeit undoubtedly closer to the upper limit. In any case, it’s not a price that can generate strong return unless it’s a business that can grow at least 10% without much capital reinvestment. The problem with any potential acquisitions MSCI might do is the fact that the usual targets would usually command a high valuation, due to such companies generally being seen as high quality businesses. Overpaying for acquisitions is a key risk to MSCI’s capital allocation going forward.
For the past three years, MSCI has been leveraging up its balance to buy back shares. As I am not advocating buying MSCI at current level, I am also not too excited about this current capital return program, even though the current valuation is not exactly outrageous.
Conclusio
I believe MSCI is a high-quality business. No doubt, when the next market correction arrives, their business will be impacted as ETFs’ AUM declines. Nevertheless, if we look out 10 to 15 years, it’s difficult to not see ETFs gaining more assets and the international markets growing to become a bigger percentage of the global market. Both of these should benefit MSCI disproportionately. For instance, it’s estimated that approximately 33% of assets invested in ETFs worldwide are based on indexes belonging to S&P Global Inc. MSCI might have between 15% to 20% only as of now.
If we can buy the stock below $60 a share, I believe it will be an excellent investment.
NOTES
* What US ETF Market Looks Like Today
http://www.etf.com/sections/features-and-news/what-us-etf-market-looks-today?nopaging=1
** That being said, I would still advocate monitoring future changes. For instance, Schwab is about to launch an ETF that tracks the largest 1000 US stocks. But they won’t be tracking Russell 1000. Instead it will be their own index. How much asset can it gather in 1 year? The iShares Russell 1000 currently has $19 billion. How much asset would it lose?
***Vanguard dumps MSCI indexes from 22 funds to cut costs: https://www.reuters.com/article/us-vanguard-indexes/vanguard-dumps-msci-indexes-from-22-funds-to-cut-costs-idUSBRE8910PY20121002
**** ETFs see nearly $500B in 12 months; top $3T
https://www.cnbc.com/2017/06/17/etfs-see-nearly-500b-in-12-months-top-3t.html
2017 Investment Company Factbook
https://www.ici.org/pdf/2017_factbook.pdf
2016 Doubling Down on Data by BCG
*****MSCI to buy RiskMetrics for $1.55 billion
https://www.reuters.com/article/us-riskmetrics-msci/msci-to-buy-riskmetrics-for-1-55-billion-idUSTRE62041J20100301