RiskMetrics Carries Its Own Risk

Dec. 7.08 | About: RiskMetrics (RMG)

RiskMetrics Group, Inc. (RMG) has rebounded by nearly 50% after hitting a low two weeks ago. As implied in the name, the recently public company provides risk management and other services to institutional investors as well as corporations. RMG priced a successful IPO back in January when the markets were still healthy and institutional investors had capital to spend on such services. But, at a time when risk management is the most important, institutional investors are seeing budgets squeezed, and many are shutting down altogether. This is bad news for RMG which is now serving a customer base experiencing huge challenges.

Looking at the third quarter earnings release, the company was able to grow revenue by 21.5% during the third quarter. This is impressive, but unfortunately includes two acquisitions (Institutional Shareholders Services - ISS, and Center for Financial Research and Analysis - CFRA). These acquisitions helped add to revenue, which means that organic revenue growth was somewhat muted.

Earnings came in at $0.16 per share after blacking out intangible items. The earnings certainly represent strong growth over last year, but the main question is whether that is accounted for by the stock price. Currently, the stock is trading at a PE near 30 when compared to 2009 consensus estimates. The situation leaves room for two deadly forces which could affect the stock price.

The first issue is that of earnings expectations. Since RMG has grown earnings well over the past three quarters, analysts are quick to assume this trend will continue. However, if the fourth quarter turns out to be disappointing (as it very well may given the number of institutional investment companies going out of business), those estimates could be sharply reduced. This would likely take place within the next six weeks as analysts review assumptions for the fourth quarter.

Perhaps more importantly, the earnings multiple on the stock assumes a healthy growth rate. Investors will not pay 30 times next year’s earnings unless they expect 2010 and 2011 earnings to be significantly higher. This type of multiple makes sense in bull markets, but during the current challenging period, a multiple of 30 may very well be a train wreck waiting to happen.

Assume for a minute that these two forces happen together. If analysts were to decrease their estimates by 20%, that would equate to 2009 estimates of roughly $0.39 per share. At the same time, if the multiple were to contract to what may be considered a more reasonable 15 times earnings, that would imply a stock price of $5.85 - about 58% lower than the current stock price. While this example is very crude and unrefined, it does a good job of showing how these two forces work together, and the potential risk in this volatile stock.

The company raised quite a bit of cash when it priced the IPO at $17.50. Much of the capital was used to pay off debt, but there still remains an outstanding balance of $289 million. At the same time, the asset side of the balance sheet has a very large “goodwill” category that makes up 54% of the total assets. While intangible assets certainly have their place, the current market environment requires a rigorous analysis of balance sheet risk and with a substantial amount of debt, RMG could face funding challenges if revenues are compromised.

From a defensive standpoint, it would appear that RMG is a large risk to hold in a portfolio. This is simply a difficult time to justify holding growth stocks with high multiples. And from a more offensive strategy, it may make sense to short this name and profit from another trading leg lower. At any rate, I would submit that RiskMetrics may help customers assess and manage risk, but the company actually carries quite a bit of risk within its own walls.


RMG Notes

Disclosure: Author does not have a position in RMG.