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Executives

Cheryl Gustitus – Head of Marketing and Communications

Ethan Berman – Chairman and CEO

David Obstler – CFO

Analysts

Stephanie Withers – Goldman Sachs

David Scharf – JMP

Pat Burton – Citigroup

Michel Morin – Merrill Lynch

Michael Weisberg – ING

Giri Krishnan – Credit Suisse

RiskMetrics Group, Inc. (RMG) Q3 2008 Earnings Call Transcript October 30, 2008 10:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q3 2008 RiskMetrics Group Inc., earnings conference call. My name is Latrice and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this call.

(Operator instructions) At this time, I would like to turn the presentation over to your host for today’s call Cheryl Gustitus of RiskMetrics Group. Please proceed.

Cheryl Gustitus

Good morning and thank you for joining us to discuss RiskMetrics Group’s Third Quarter 2008 Financial Results. With us today are Ethan Berman, CEO of RiskMetrics, and David Obstler, CFO. This conference call is being recorded on behalf of RiskMetrics Group and consists of copyrighted material that may not be recorded, reproduced, retransmitted, rebroadcast or downloaded or otherwise used without RiskMetrics’ express written permission. Your participation in the question-and-answer session constitutes your consent to having any comments or statements you make appear in any transcript or broadcast of this call.

Information provided during this call will include certain forward-looking statements. These statements relate to future events or to future financial performance and involve known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from those expressed or implied by the forward-looking statements we make. You should not place undue reliance on forward-looking statements.

Conference call remarks also will refer to certain pro forma results, which assume that the January 11, 2007 acquisition of Institutional Shareholder Services closed on January 1, 2007 and the August 1st acquisition of CFRA also occurred on January 1, 2007. This is a non-GAAP financial measurement that management believes facilitates a comparative analysis of developments in the Company’s business. Reconciliation of non-GAAP financial measures to the nearest GAAP equivalents are included in Tables D and E of RiskMetrics’ earnings release, which was issued earlier today and is accessible on our website at www.riskmetrics.com.

It is now my pleasure to introduce our CEO, Ethan Berman.

Ethan Berman

Thank you, Cheryl, and thank you everyone for joining us this morning. We are pleased to again be reporting solid financial results for another quarter. On a consolidated pro forma basis, RiskMetrics achieved 18.8% pro forma revenue growth in the third quarter and 19.1% for the nine months ending September 30, 2008, with revenue continuing to accelerate in our Risk business.

Third quarter adjusted EBITDA increased 32.7% to $25 million on a pro forma basis, with an adjusted EBITDA margin of 33.1%. Adjusted EBITDA for the nine-month period increased 31% on a pro forma basis to $72 million with an adjusted EBITDA margin of 32.6%, 300 basis points over the same period last year.

Cash flow was very strong with cash increasing $43.5 million from the end of the second quarter to $152 million. For the third quarter, our GAAP EPS was $0.09, up from $0.01 from the third quarter last year.

Let me expand on some of the revenues, sales, and business trends driving our results and then have David take you through our financials in more detail.

First, revenue growth was strong across the board in the Risk business as we continued to experience healthy demand for our Risk products and services. Revenue grew across both geographies and end-market sectors. Our third quarter and nine-month Risk revenues were $40.8 million and $114.1 million respectively, representing a 31.9% and 30.1% increase over the same periods last year.

Despite the market turmoil and the usual summer slowdown across Europe, third quarter risk revenues grew 5.2% sequentially over the second quarter of 2008, again driven largely by a 36.3% growth in RiskManager revenues.

On the Governance side, ISS revenues were $34.7 million in the third quarter and $106.8 million for the nine months, increases on a pro forma basis of 6.3% and 9.3%. ISS third quarter recurring revenues increased 7.9% from the year ago and were up 2.3% over the last quarter. For the nine-month period ending September 30, 2008, ISS recurring revenues increased 9.8%.

Through the first three quarters of 2008, our financial results have not been significantly impacted by the disruptions in the global financial markets. That said our clients have been negatively impacted by the market downturn (inaudible) redemptions, while the benefits we have seen so far this year from the increased focus on risk management have outweighed the negative impact of a consolidating end market.

We have started to see a slowing down of business activity on the part of our clients and therefore the potential for declining sales and renewal rates going forward.

I would like to turn now to discussion about ACV or Annualized Contract Value, which is a key metric for us. We are particularly encouraged by our nine-month ACV growth of 19.6% compared to 2007.

Risk ACV grew 29.3% to just under $160 million from $123.5 million, while ISS ACV grew 9.4% to $128.5 million from $117.5 million a year ago. Risk ACV grew by 24% in the hedge fund sector and 39% in the asset management sector in the Americas and the EMEA region. I will let David speak later about the hedge fund sector in particular, as it seems to be on many people’s minds these days.

On a consolidated basis, the company had $55.6 million of new ACV sales in the nine months ending September 30, 2008, up 26.7% over the comparable period in 2007. The strong new sales performance was driven by a significant increase in the demand for Risk products as Risk’s new ACV sales were $38.6 million for the nine months ending September 30, 2008, representing an increase of 40.9% over 2007.

Consolidated Q3 2008 new ACV sales were $13.7 million, representing a $2 million decline compared to Q3 2007 as a result of a $1.2 million decline in Risk sales and $800,000 decline in ISS sales due to the slowing market conditions I referred to earlier primarily in Europe. Again, I will have David speak in more detail on this later in the call.

Finally, we continue to have success in growing our relationships with existing clients as approximately 54% of new ACV sales are coming from existing clients. Overall, our renewal rate for the nine months ending September 30, 2008, was 88.5% as compared with a rate of 90.5% a year ago. Risk achieved a renewal rate of 88.9%, a slight decrease from 90.1% a year ago, which we consider a very strong result given the market environment.

ISS renewal rate also decreased slightly to 88% from 91.1% a year ago, largely due to lower renewal rates in the corporate business and the inclusion of CFRA in 2008, which typically has lowered renewal rates in other ISS products. The Governance services’ core Proxy Research and Voting products achieved a renewal rate of 91.5% for the nine months ending September 30, 2008, holding steady from a year ago.

To conclude, we are delivering solid results to the third quarter of this year with 18.8% of revenue growth, 32.7% adjusted EBITDA growth, broadly diversified new sales growth across geographies and market sectors, and average ACV per client growing steadily. Renewal rates are only slightly below its historical trends at 88.5% and we expanded our margin by 300 basis points over the last year to more than 33%.

Even with a downward pressure on renewal rates and possible new sales, we have found that the investments we have made in the infrastructure of both businesses are allowing us to increase margin well above our previous guidance.

To that end, we continue to make investments in both of our business lines as we see the current market dislocation is providing significant opportunities for our firm going forward. On the Risk side, last month, we entered into Performance and Attribution space, the acquisition of Applied4 Technology.

We expect no material revenue benefit from this acquisition in 2009, though the strategic value is significant as it paves RiskMetrics’ way into the multi-asset class Performance and Attribution space at a time when understanding the Risk and Performance and Attribution attributes of an investment portfolio have never been greater.

Our decision to acquire Applied4 was guided by our clients who had strongly indicated the need for advanced Performance and Attribution Analytics built on the same platform and with the same transparency as our current Risk offerings, and it also adds a terrific team of individuals to RiskMetrics going forward.

We are also exploring numerous other risk opportunities around the view that in the aftermath of the financial crisis, we are going to see more Risk regulation in the financial industry going forward. In general, regulation has been an important driver to our business growth and we are optimistic that this will remain the case for the next few years.

On the Governance side, while revenue growth is slower, progress in our new Voting technology is ahead of schedule allowing us to take our costs faster than we have planned. Margins are starting to grow already and we expect them to continue to grow for the rest of this year and in 2009.

In addition, we have seen increased interest in the number of specific Governance offerings around executive compensation, socially responsible investing in climate change, and securities class action services.

With that, I will now turn the call over to David to provide additional detail on our financial results. David?

David Obstler

Thank you, Ethan. As Ethan mentioned, we continue to build upon our strong 2008 results with solid third quarter results in terms of revenue and ACV growth, EBITDA growth, margin expansion, and especially cash flow generation.

I will discuss our third quarter and year-to-date financial performance as well as our sales and renewal results, and give a flavor for what we expect in Q4. I will then provide updated guidance for 2008 and 2009.

First on revenues, total consolidated revenues for the third quarter were $75.6 million, up 21.5% on a GAAP basis and 19.1% on a pro forma basis, pro forma for the CFRA acquisition. For the nine months, revenues were $220.9 million, up 27.9% on a GAAP basis, and 18.8% on a pro forma basis.

The revenue growth was driven by Risk. Third quarter Risk revenues increased 31.9% to $40.8 million from $31 million last year. For the nine months, Risk revenues were $114.1 million, up 30.1% over last year.

On a regional basis, both the Americas and EMEA continued to accelerate a revenue growth in Q3 with the Americas revenues growing 26.8% in Q3, up from 24% year-to-date and EMEA growing 43.1% up from 40.8%.

ISS revenues were $34.7 million for the third quarter, up 11.3% on a GAAP basis and 6.3% on a pro forma basis. ISS revenues declined by $0.6 million from Q2 of 2008 to Q3 due to decline in Compensation Advisory non-recurring revenues due to the normal seasonality of those products.

On a pro forma basis for the nine months ended September 30, 2008, ISS revenues grew 9.3% with recurring revenues growing 9.8%. The reduced growth of ISS in Q3 was due to a lower growth rate of the FR&A revenues in Q3 versus the year-to-date.

Turning to ACV, our ACV at September 30, 2008, was approximately $288 million or growth of 19.6% over last year. Risk ACV grew 29.3% while ISS ACV grew 9.4%. As Ethan mention, the Risk ACV growth was driven by strong growth in hedge fund traditional asset managements sectors in Europe.

Consistent with previous quarters, Risk average ACV per client continued to grow to more than $260,000 from $190,000 in the same period last year. On new sales, consolidated new ACV sales for the nine months were $55.6 million, up 26.7% over the prior year percent. Risk sales were 69% of the new sales or $38.6 million, up over 40% over last year.

What has been driving Risk sales growth all year has been the strong growth in the US and EMEA which grew 40% and 57% over the last year and growth in the hedge fund and asset management sectors, which grew 44% and 53%.

In addition, we began to get increased contribution from cross selling, which increased to $3 million in Q3 and $6.2 million for the year. After very strong new ACV sales growth in Q1 and Q2, we had $30.7 million in new sales in Q3, a $2 million decline over the third quarter of last year.

The new ACV sales do not include $2.9 million of contracts, which were signed in the quarter and were more backward weighted, and including those sales, the new sales would have increased by $5.7 million versus the third quarter of last year.

The new sales performance in Q3 is equivalent to the types of levels that we experienced in each quarter of 2007 and what we had expected this year before the acceleration of Risk demand in Q1 and Q2.

Of the new sales, $8.6 million were Risk and $.5.2 million were at ISS. The delayed sales that will be recognized in the fourth quarter were concentrated at Risk. In Q3, we continued to experience new sales growth in the US in the hedge fund segment, but experienced weakening demand in Europe partly related to seasonal factors.

In Q4, based on our current sales level and pipeline, we expect similar new ACV sales to the last quarter with more of a waiting towards Risk sales. Our renewal rate year-to-date was 88.5%, down from 90.5% in the previous year and slightly below the bottom of our previous range of guidance.

Despite the challenging market environment, we feel that our renewal rate showed substantial stability in our business. The major reason for non-renewal continued to be consolidation.

On the Risk side, our renewal rate was just under 89%. Weakness in our hedge fund renewal rate versus last year due to difficulty to some new launches and smaller hedge funds was offset by a very solid low 90s renewal rate in the asset management segment where many of the requirements are regulatory.

On the ISS side, the story is similar. The renewal rate was weaker in some of the more discretionary product lines in the corporate and research areas that remained solidly above 90% in the Proxy Research and Voting business for asset managers, where again regulation comes into play. The overall ISS renewal rate was 88% versus 91% last year.

I would like to stand a moment looking at our customer segmentation and our exposure to the hedge fund market in particular. Asset managers are a larger segment, our traditional asset managers. They count for 56% of our ACV. The next largest, our hedge funds at 18%, banks at 14%, funds of funds in prime brokers at 5%, and incorporations at 5%.

We have discussed previously that our asset management segment has been experiencing renewal rates over 91% due to amongst other things, regulatory requirements faced by that customer base. We have $51 million of ACV from hedge funds, of which most of it is from sales of RiskManager.

Our hedge fund RiskManager customers tend to be larger, multi-strat hedge funds. The average AUM of our RiskManager hedge funds clients is $5.5 billion and 50% comes from hedge funds over $5 billion.

While there is certainly increased volatility in that end market, we believe there is substantially more stability in those larger, more diversified hedge funds and the smaller hedge funds are new launches.

The ACV of our hedge fund customers grew 25% in the last year. That has been produced by accelerated new sales, partially offset by higher non-renewals. Our Risk new hedge fund sales this year have increased 40% over last year, including a very strong third quarter.

We had seven sales or up sales over $500,000 to larger hedge funds in 2008. We have also experienced, as I mentioned, more volatility with lower renewal rates in that segment. We expect these trends to continue in the fourth quarter and 2009 with larger new sales and continued volatility with potential upside if there is increased regulation of hedge funds.

Moving on to our profitability. Consolidated adjusted EBITDA on a pro forma basis increased 32.7% in Q3 to $25 million and by 31% for the nine months to $72 million showing continued EBITDA acceleration and margin expansion.

Our consolidated adjusted EBITDA margin for the nine months increased to 32.6% versus 29.6% for the last year or 300 basis points, significantly above our 150 to 200 basis point target. Our business model is proving to be more scalable than we had originally thought even while continuing to spend for future growth.

Our Q3 margin was 33.1% versus 32% in Q2 2008 as adjusted EBITDA expenses remained flat and revenue increased 2%. The significant year-over-year margin increase was due to a 19.1% pro forma revenue growth and 14.1% adjusted EBITDA expense growth.

On a pro forma basis in the first nine months, compensation expense, the majority our expense, 68% of total EBITDA expenses increased 11%, as head count growth was significantly less than revenue growth.

Non-compensation expenses increased 22% on a pro forma basis, due mainly to increased occupancy, data, travel and the legal and accounting and insurance costs related to being a public company.

The adjusted EBITDA growth and margin expansion was largely driven by the Risk business. Risk EBITDA grew 39.1% in Q3 2008 over Q3 2007 to 14.4% and 47.5% to 40.5% in the year-to-date comparison. The Risk adjusted EBITDA margin increased to 35.4% for the nine months and increased 410 basis points and was 35.2% in Q3 and increased to 280 basis points over the previous year period.

While we expect strong margin expansion in the Risk business to continue, we do not expect margin expansion to be as high as the year-to-date levels due to investment in the business.

For ISS, Q3 and year-to-date adjusted EBITDA were $10.7 million and $31.5 million respectively, increases of 31.5% and 31.9% on a GAAP basis. On a pro forma basis, the increases were 24.9% for the quarter and 14.5% for the nine months.

The ISS EBITDA margin increased 29.5% for the nine months versus 28.2% – was 29.5% versus 28.2% last year, an increase of 130 basis points. We began to realize efficiencies at ISS as EBITDA margins expanded to 30.7% in Q3 from 29% in the first six months. EBITDA expenses were flat in Q3 versus the prior year.

Turning to net income, we are reporting net income on both a GAAP and adjusted basis. GAAP net income increased from $0.5 million in Q3 2007 to $6.3 million in Q3 2008 and EPS increased from $0.01 a share to $0.09 a share. For the nine months, the increase was to $0.18 a share from $0.02 a share.

On an adjusted basis, EPS increased to $0.16 per share in Q3 2008 from $0.09 per share last year and to $0.44 per share for the nine months from $0.20 per share. The tax rate for the nine months was 39.1%, right in the middle of our previous guidance.

We will spend a minute on foreign currency exposure. Given the current volatility in foreign exchange rates, I would like to summarize our exposure on the revenue in cost side.

Even though approximately 39% of our consolidated revenue comes from outside the United States, we only invoice just over 20% of our revenues in non-dollar currencies. Most of this non-dollar invoicing is in euros followed by pounds.

This foreign currency exposure is mostly hedged to our foreign currency operating expenses, which are about the mid-teens as a percentage of revenue, mainly in pounds followed by euros. As a result, approximately 5% to 7% as a percentage of revenues are unhedged across the basket of our currency exposures.

While this exposure may create fluctuations in our revenues and earnings, we have not hedged thus far as we do not view this exposure to be significant.

Turning to cash flow, we had a very strong cash flow generation quarter in 3Q significantly above our expectations. The company had $151.7 million of cash and cash equivalents at the end of Q3, up $43.4 million over end of Q2. The increase was driven by a $40.3 million of increase of cash flow from operations, brining the year-to-date total to $58.8 million versus $17.3 million last year.

As we said earlier, our cash flow from operations becomes increasingly positive as the year progresses. We had $40.3 million of cash flow from operations in Q3 versus $31.4 million in Q2 of 2008, and we had a cash use of $12.9 million in Q1. Q3 was particularly strong because of increased profitability, accelerated contribution from working capital, although over $27 million versus Q2 due to accelerated collections, increased expense accruals due to bonuses and other comp, and a tax refund.

We have a very strong liquidity position with net debt of $139 million and a net debt to LTM EBITDA ratio of 1.5 times. All of our cash is invested conservatively in short-term treasury and US Government guaranteed instruments.

In closing, RiskMetrics Group produced strong financial results for the third quarter. As Ethan mentioned, we delivered strong top line, profitability, and cash flow growth in a challenging market environment.

While we see more volatility in our top line, given the consolidations in our end market, we believe that our business model and scalable and controllable cost structure will continue to allow us to increase margins above current levels consistent with what has occurred in the last couple of years. We believe that we can accomplish this even while investing in new product lines such as Performance and Attribution.

With that, I will now turn to our updated guidance for 2008 and 2009. With respect to the company’s financial outlook for the remainder of 2008, the company continues to anticipate revenue and Adjusted EBITDA to be above the high end of our previous ranges, which were $295 million and $95 million, respectively.

Given the current market conditions and where we see Q4 renewals, renewal rates are expected to be slightly below previous guidance of 89% to 91% and are expected to be in the 88% to 89% range. The company now expects adjusted EBITDA margin expansion in 2008 to be significantly above the previous guidance of 150 basis points to 200 basis points as evidenced by the year-to-date results.

I would like to conclude with our guidance for 2009. Given the current market conditions, the company anticipates revenue for the fiscal year ending December 31, 2009, to be in the range of $325 million to $340 million and adjusted EBITDA to be in the range of $112 million to $120 million.

Furthermore, we expect adjusted EBITDA margin expansion in 2009 to be 150 basis points to 200 basis points range over 2008 annual levels with the continuation of unlevered free cash flow in excess of adjusted EBITDA.

And with that, Ethan and I will now open the call to your questions.

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from the line of Stephanie Withers with Goldman Sachs. Please proceed.

Stephanie Withers – Goldman Sachs

Good morning guys and thanks for all that color on the call. A couple of questions, first on your 2009 guidance, could you give us an idea of what kind of renewal rates you are baking into that guidance?

Ethan Berman

We are baking in mid-to-high 80% renewal rates at this point.

Stephanie Withers – Goldman Sachs

Okay, and on the margin, we have heard from a lot of management teams that in this toughening macro environment, they have been a little more conservative on spending, is there any deferred kind of – spending that you have deferred that has contributed to this impressive margin expansion?

David Obstler

Our expenses for this year are very close to our budget that we created at end of last year, so the out performance in the margin is largely being created by the revenue out performance, be that as it may, as we said all long, our costs are very visible and controllable and we believe we have flexibility to change that in different market environments.

Stephanie Withers – Goldman Sachs

Great, and again thanks for all this – all the detail.

David Obstler

Thank you.

Ethan Berman

Thank you.

Operator

And our next question comes from the line of David Scharf with JMP, please proceed.

David Scharf – JMP

Hi, good morning. Ethan, I just had a question on the renewal side, thanks for all the color sort of helping us quantify that. Can you talk a little bit about the process, in particular, I am kind of curious given things are moving so quickly in your end markets, things have changed so rapidly in the last couple of months, how much of lead time do you generally get when it looks like there is going to be a cancellation, and I am just sort of curious as we think about, you know, the visibility into that mid-to-high 80% renewal, you know, estimate across the year?

Ethan Berman

Every year, because we are a subscription-based business, we have, as I think we have talked before, a very significant account management function which is servicing clients every day, and while I do not want to say every client is spoken to every day, there is a regular dialog with our clients as they get – they research and updates are much constantly throughout the year. Every client, the account management – the account managers are paid based on renewal rates and they assign a sort of rating to every client as far as green, yellow, red, in terms of likelihood of renewal and clearly to the extent that we get any client that we put in the yellow or red category, we do our best to determine is this a service issue, is this a consolidation issue, or whatever. So, in terms of clients that exist, it is very rare for us to have a client that we are working with, those months before they are not going to renew, we don’t know, they are not going to renew months before. The exception to that of course is consolidation, where, you know, we do not know what these days is going to happen on Sunday night before the market opens, and as we see that consolidation happen, those obviously are not foreseen. You also get, you know, clients who are in trouble, you will see a significant slowdown in their activity with us, and again, we view that as a sort of red flag. We should stress though, and I think as David pointed out, the volatile part of our market place tends to be the, I guess, these days very large banks, investment banks, and hedge funds, and we as we play through our client base, that is a minority of our clients, and then if you go into the hedge fund sector in particular, I think you find that it stays within the very large. So, if we read that a very large hedge fund goes under tomorrow, yet that will not be foreseen, but if we don’t read that, we have a very good insight into which hedge funds are going to renew and which are not well before their contracts end comes up.

David Scharf – JMP

Got it.

David Obstler

The planning for next year has incorporated the consolidations that we know of today and what we think is going to happen, that obviously could change, but we do have significant lead time in those bank consolidations as departments are integrated and we have dialogs with the owner and the department is being integrated.

Ethan Berman

And lastly just to mention, even when we were running sort of the 90% renewal rates that we had in the past, that assumed a reasonable amount of consolidation because that is the number one reason for non renewals and has always been the case at both ISS and RiskMetrics.

David Scharf – JMP

Okay, that – it is very helpful. There is obviously an awful lot of visibility here. Two other quick questions, one, on the sales and marketing side, I think that the actual dollar amount was sequentially down from the second quarter, although I made – I have not done the calculation pulling out stock comp, any change we should be aware of either in staffing, accruals, or commission levels?

David Obstler

No. That would be the play out of the commission relative to sales, sales were higher in the second quarter as we talked about than the third quarter, and there is variability within the marketing as we spend – as we had a weak spend out over the year.

Ethan Berman

Again very specifically, the number of sales people actually went up in the third quarter, not down, obviously salaries did not change, benefits did not change, so I think it is reflected directly of very strong second quarter new sales which led to an increase in commissions and the fact that our marketing dollars don’t tend to be spent over the summer.

David Scharf – JMP

Got it, and actually you answered my next question which was on the sales person count, any numbers you can provide us with in terms of sales person count in what we might look for at the end of 2009?

Ethan Berman

I think we will continue to be slightly above where we are now. I think we added (inaudible) September 30, 2008, but in my instinct is we probably added 2 to 3 sales people in the third quarter. I would expect to see 2009 to be slightly above that by the end of 2009, assuming business is in line with what we expect.

David Scharf – JMP

Right, great job.

David Obstler

And the sales force has been running in the mid-60s and as we said in last call that these are commission sales people, might grow up to 70 by year-end.

David Scharf – JMP

Okay, thank you very much.

Ethan Berman

Welcome.

Operator

And our next question comes from the line of Pat Burton with Citigroup, please proceed.

Pat Burton – Citigroup

Yes, hi, congratulations, and thanks for the additional numbers as well. Going into the hedge fund side in quite a bit of detail, can we talk about may be some other markets, sovereign wealth funds, your entrance into China, or some of the areas that are actually really growing rapidly despite this environment, thanks?

Ethan Berman

Well, I will start backwards if you don’t mind, China is, I don’t know if we have shared, we are in the process of opening an office in Beijing which we expect to have up and running by the end of the first quarter. It will be primarily a research and development office, not a sales office though we will have a presence there and we hope that we can leverage the initial sort of clients that we develop there. I don’t personally see that as a big growth area in 2009 for the company from a sales and revenue point of view. I think that we have a couple of key clients and they are the sort of most sophisticated and most international of the firms in China, and I don’t think that you are going to see the interest in corporate governance and financial risk management as we see it in China in the next – in 2009, so I do not see that as a big growth area from a revenue point of view, though I do see as a big growth area from a talent point of view bringing into RiskMetrics going forward. As far as sovereign wealth funds go, they are and continue to be good client to the firm. They are continuing to look for more transparency in the investments they make and the asset managements they use, and I expect that to continue to be a growth area for the firm in 2009.

Pat Burton – Citigroup

Let me ask it this way, is the – you know, you are seeing accelerating revenue growth, what chunk of client basis is really driving that acceleration on the risk side? I had assumed it is not hedge funds, but may be I am wrong?

Ethan Berman

Wrong.

David Obstler

You are wrong.

Ethan Berman

It is actually hedge funds. It is asset managers first and hedge funds second. Sovereign wealth funds are well below this too. I think that if you think in terms of hedge funds as a business that is – for lacking a better term growing up, from a business that was very focused on individuals and somewhat “secret” I think that as they become more institutionalized, they are being forced sometimes appropriately and they speak after more transparency into what they are doing with institutional money, and so we are seeing hedge funds today that frankly before the crisis would never have been willing to provide investors any transparency into their portfolio, today you are saying, okay, I will provide you an independent view of the risk taking, not getting obviously to the level of the positions, but using RiskMetrics to do that, so we have seen tremendous growth in that segment and again that tends to be from the larger hedge funds. Asset managers again, some combination of regulation, in particular, in Europe and now increasingly in the US, they are under the same scrutiny whether it be from investors giving the money or as asset managers get larger and have a diversified portfolio of equities, fixed income, international emerging markets, commodities, and some sort of 130-30 funds at the management level of those firms, they want to get a better assessment of the risks that are being taken throughout the firm to understand that there really is diversification or whether all the managers are really making the same bet in the marketplace, and then lastly, I would focus on what is increasingly important is counterparty exposure where firms who are doing business with large banks or large banks who are doing business with large hedge funds, or large banks who are doing business with – large banks are seeking more information about the exposure that they have with those firms on their, in particular, over-the-counter derivative transactions.

David Obstler

Yes, I think we said that, Risk ACV growth was 29% of which asset management was 39% and hedge funds about 25% and that has been driven by very strong new sales to asset managers which are over 50%, and then also the hedge funds with the counterbalance of the lower renewal rate in the hedge fund market.

Ethan Berman

Again, I think that, while there is clearly the trend of fewer hedge funds. Remember, we do not tend to sell to sort of hedge funds below the top thousand. The trend toward more redemptions unless that is assets under management hedge fund, we do not work off of an assets under management business model. What is more important is the trend toward transparency among hedge funds and I think many people expect more regulation, and I think that that will clearly play to our strength, so, we are continuing to anticipate growth in that segment around the other way around.

Pat Burton – Citigroup

Thank you.

Operator

And our next question comes from the line of Michel Morin with Merrill Lynch, please proceed.

Michel Morin – Merrill Lynch

Good morning. You just talked about the potential upside from changes in the regulatory landscape for hedge funds, is there anything else on the regulatory front that could change that you think might be a needle mover for you either next year or down the road?

David Obstler

I think there is a number, I think, that in general there will be a push toward transparency of risk taking at different types of institutions, and whether that is at the shareholder level, whether that is at the investor level, whether that is at the portfolio level, to be determined, but I would be very surprised that at the end of this, people do not come to the conclusion that more transparency into what is going on in financial markets in particular and some of the financial markets that are more opaque, you know, lots talking about credit default swaps, so more information around pricing in market like that is, I believe, highly likely to occur and ultimately a firm like us benefits from the idea of giving tools around information around understanding financial portfolios.

Michel Morin – Merrill Lynch

Great, okay, thank you. And then, just to clarify on the renewal rate assumption that you have baked into your 2009 outlook in the mid-to-high 80’s, it looks like you are kind of there right now in the third quarter if we were to just focus on the third quarter, so I was interested to see if you could give us a little bit more color on how the renewal rate actually trended during the quarter? Did we really see a decline after kind of the Lehman Brothers event in particular? Thank you.

David Obstler

Yes, you are right. Renewal rate for the third quarter was in the 87.5% [ph] range, and we are really seeing the renewal rate to be sort of in this range all year, at the 87% to 89%, it has sort of gone up and down. We really have not seen that much variability in the renewal rate. As I mentioned, we have had some downward pressure on the hedge fund, the bank renewal rate in this consolidation has been actually surprisingly high. Many of the departments that are being consolidated as we think we have mentioned all along, you might have a consolidation or integrated contract, but a retention in – so we found that, so we really – in the third quarter really have not seen that much of a difference, a 1% or a 1.5% difference relatively seen all year, and we did not see that much difference in September than we did in August. We saw the same types of situations happening in both months.

Michel Morin – Merrill Lynch

Okay great.

Ethan Berman

I would actually say that the level of activity that we are having with our clients has gone up again. I think that, sort of September, summer is always slow, but September, I think with some degree, there was shell-shock and so you saw much less activity where people were focusing on the things. We have seen actively that are clients backed to – or slightly higher than normal levels in the recent weeks.

David Obstler

I will also add that, quarter-to-quarter variability in the renewal rate also has to do with the relative percentage of concentrations of products that are up for renewal. For instance, with the Proxy having a higher Proxy Research and Voting having higher renewal rate, the more renewals you might have in that quarter, it might put some upward stimulus on the renewal rate and the more that you might have some of the lower renewal rate products historically, it might have some downward pressure, so you might see that variability in the quarter-to-quarter renewal rate.

Michel Morin – Merrill Lynch

Right, that’s great color. Thanks very much.

Operator

(Operator instructions) And our next question comes from the line of Michael Weisberg from ING, please proceed.

Michael Weisberg – ING

Hi everyone.

David Obstler

Hi Michael.

Michael Weisberg – ING

A couple of things, David, I missed a couple of things on the new sales. The new sales for the quarter were $13.2 million?

David Obstler

It is $13.7 million, with $2.9 million of contracts signed in Q3, but not going into license in Q3.

Michael Weisberg – ING

Okay, and that was – the $13.7 million was down $2 million year to year?

David Obstler

$2 million over the Q3 of last year, yes.

Michael Weisberg – ING

Okay.

David Obstler

When you add back in these signed deals, you would be 5.7% above Q3 of last year.

Michael Weisberg – ING

Right, and you gave a forecast of new sales for the fourth quarter as being flat with the third?

David Obstler

It is at about flat with the third, yes.

Michael Weisberg – ING

And where did that $2.9 million come in? I don’t know if – I am trying to understand, when you said fourth quarter flat with third, was that putting the $2.9 million in the fourth quarter?

David Obstler

That will be putting the $2.9 million, so I made with that, it is slightly higher than – we were dealing more with the generation of new sales, so that may result in slightly higher ACV sales in the fourth quarter than the third quarter.

Michael Weisberg – ING

I am sorry, let me just ask you again, I apologize, does that assume – when you said flat versus the third, was that flat versus $13.7 million or flat versus $16.5 million.

David Obstler

It will be most likely with that, slightly higher than the $13.7 million, but not up to the same amount. There always are some deals that are signed towards the end of the year and that are delayed in license date until January 1st.

Michael Weisberg – ING

So you were saying flattish versus the $13.7 million number?

David Obstler

Right, that is right.

Michael Weisberg – ING

Got it, I just want to understand that. Did you say the renewal rates were softer in Europe, it sounded like on the ISS side, it was softer on the CFRA side, is that right?

David Obstler

That’s right. We had softer renewal rates in the research areas and the corporate areas and stable renewal rates in the proxy business.

Michael Weisberg – ING

Okay, I guess the research and corporate would be a little bit more discretionary?

David Obstler

That’s right. In fact that’s probably the major effect and the slow down of the growth rate of ISS. It would be lower growth rate in the research businesses and a stable growth rate in the proxy business.

Michael Weisberg – ING

Okay. And then, I know that from a margin standpoint, you are pretty well hedged on the currency, but it would have a negative impact to some extent in terms of actual revenues. What assumption are you making in terms of the euro and pound in your 2009 forecast, and what impact on revenues would that –?

David Obstler

I don’t think we – I don’t think we have guidance for that – guidance on that – but in the range of revenues that we have given, we have taken into account a range of possibilities of currency in 2009.

Michael Weisberg – ING

Okay, great. And in that assumption, what level of new sales are you assuming – what level of sales are you assuming relative to the current run rate?

David Obstler

We have not provided specific guidance on that. I think we have – we have said so far that we had higher than normal trend line demand in the first and second quarter and the third and fourth quarters were more online with the normal trend line.

Michael Weisberg – ING

Okay, great. Thanks a lot.

David Obstler

Thanks.

Ethan Berman

Thank you.

Operator

And our final question comes from the line of Giri Krishnan with Credit Suisse, please proceed.

Giri Krishnan – Credit Suisse

Hi, thanks for taking my questions. This is for David. David do you happen to have the average ACV per client for ISS?

David Obstler

Yes, one moment. It is $51,000.

Giri Krishnan – Credit Suisse

Okay, and on the ISS renewal rates, I understand part of the reason it is down was due to inclusion of CFRA, but if you exclude CFRA what would the renewal rates have been?

Ethan Berman

Slightly higher, we have not provided that, but we only provide – we only included CFRA for the period we owned it last year and we included for the full year. The renewal rates of CFRA are around 80% and CFRA’s ACV, I think as we put in previous documentations that we acquired was around $16 million.

Giri Krishnan – Credit Suisse

Okay.

Ethan Berman

Again, we have said the core business Proxy, Voting, and Research is 91.5% year-to-date, so if you take those two out, I think the corporate business is around 80% as well, and I think you should think in terms of it is north of 90% for the rest of the governance business.

David Obstler

Yes, the governance businesses would be running in around 91.5% and the two other businesses around 84% in total.

Giri Krishnan – Credit Suisse

Okay, and a question for Ethan. If I recall directly the last quarter, I think you had talked about the sales force may be selling Risks more aggressively than ISS, and I was wondering if you have any update on that at all?

Ethan Berman

Yes, we have, as previously mentioned, added a number of sales people and have created a governance specialty sales force within the sales force, so that has occurred. So, we are confident that we will not have that problem going forward.

Giri Krishnan – Credit Suisse

Okay, okay. And then, sort of a broader question, are you seeing with what has happened in the markets in the past few months? Are you seeing clients focus more on the processes behind Risk and risk management as opposed to just getting the models right? I am trying to get a sense for what the focus has been today from the point of view of clients both in asset management and hedge funds.

Ethan Berman

I think it is primarily about getting information. I don’t think it is a case that, we have all the information and let’s tweak the model. That does not mean to say we are not spending time with clients and working on models, but I think it is more about are we capturing all the information and are there other ways of looking at that information, so if someone is using B7 statistics, are there two other statistics that I should be looking at, and/or do they actually have all their positions or all their exposures in one place, or have they been sort of capturing one in one place, one in another place, and they will have to combine it, so to your specific point, I think that the process and the output has been much more the focus and the distribution of that information to a broader audience, so new people are asking about things around Risk what were not asking about it sort of 3 or 6 months ago, and in that context are coming up with new ways of showing the exposures. I think, to be much more to that end, we should come up with a new model for a particular market.

Giri Krishnan – Credit Suisse

Okay, and then the last question I had was, for the new ACV, I think it was roughly half between existing and new clients last quarter and are you seeing more contributions from existing clients, is that – is that something that you expect to continue and you talked about sales cycle just slowing, and may be that contributed to the fact, could you just comment on that?

Ethan Berman

I think, you know, this 50/50 split has been very consistent and we continue to see that in a consolidating world of a fewer sort of client end markets, eventually and the focus of that we are on adding services such as Performance and Attribution, I think we continue to see in longer term that existing clients are going to become a greater and greater percentage of our – both our revenue obviously and our new sales, so we are certainly focused on that. I think the comment about sales cycle probably has the most to explain what happened in the second quarter and the third quarter, where in the second quarter you had clients speeding up contracts and in the third quarter, you had people slowing down contracts. If you put the two together, you probably got the right trend rate for, you know, where our new sales are.

Giri Krishnan – Credit Suisse

Okay, and does that impact the way you have – you have historically thought about pricing where you have mentioned that you are not only looking to gain the pricing increases as much, but rather you would like to focus on getting more and more modules or more and more applications sold, does that change at all or are you still having the same mode of thinking?

Ethan Berman

No, I think that is the same – that is the same approach we have for our clients.

Giri Krishnan – Credit Suisse

Okay, okay. Thanks a lot.

Operator

That was our final question, and now I would like to turn the call back over to management for closing remarks.

Ethan Berman

Great. Thank you all very much for joining us this morning and we look forward to talking to you in three more months, bye-bye.

Operator

Thanks for your participation in today’s conference. This concludes the presentation. Have a great day.

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Source: RiskMetrics Group, Inc. Q3 2008 Earnings Call Transcript
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