MSCI (MSCI) Q2 2016 Results - Earnings Call Transcript

| About: MSCI, Inc. (MSCI)

MSCI, Inc. (NYSE:MSCI)

Q2 2016 Earnings Call

July 28, 2016 11:00 am ET

Executives

Stephen C. Davidson - Head of Investor Relations

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Kathleen A. Winters - Chief Financial Officer

Analysts

Alex Kramm - UBS Securities LLC

Ashley Neil Serrao - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Toni M. Kaplan - Morgan Stanley & Co. LLC

Joseph Foresi - Cantor Fitzgerald Securities

Chris C. Shutler - William Blair & Co. LLC

Keith Housum - Northcoast Research Partners LLC

Operator

Good day, ladies and gentlemen, and welcome to the MSCI Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded.

I'd now like to turn the call over to Mr. Stephen Davidson, Head of Investor Relations. You may begin.

Stephen C. Davidson - Head of Investor Relations

Thank you, Chanel. Good day and welcome to the MSCI second quarter 2016 earnings conference call. Earlier this morning, we issued a press release announcing our results for the quarter. A copy of the release and the slide presentation that we have prepared for this call may be viewed at msci.com under the Investor Relations tab.

Let me remind you that this call may contain forward-looking statements. You are cautioned not to place undue reliance on forward-looking statements which speak only as of the date on which they were made and are governed by the language on the second slide of today's presentation. For a discussion of additional risks and uncertainties, please see the risk factors and forward-looking statements in our most-recent Form 10-K and our other SEC filings.

During today's call, in addition to GAAP results, we also refer to non-GAAP measures, including adjusted EBITDA, adjusted EBITDA expenses, adjusted EPS, and free cash flow. We believe our non-GAAP measures facilitate meaningful period-to-period comparisons and provide a baseline for the evolution of results. You'll find a reconciliation of the equivalent GAAP measure in the earnings materials and an explanation of why we deem this information to be meaningful, as well as how management uses these measures on pages 22 to 26 of the earnings presentation.

On the call today are Henry Fernandez, Chief Executive Officer, and Kathleen Winters, Chief Financial Officer.

With that, let me now turn the call over to Mr. Henry Fernandez. Henry?

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Thanks, Steve, and good day, everyone. And please join me in welcoming Kathleen to her first quarterly earnings call at MSCI.

Please turn to slide four for a review of our financial results. The strength of our franchise, our unique position in the investment process and disciplined execution of our growth strategy translated into strong financial results in the second quarter. First, in terms of revenue growth, we recorded a 7.4% increase in revenues, driven by double-digit growth in Index recurring subscription revenue, a 5% increase in Analytics, and a 14% increase in All Other revenue, the latter benefiting from a 20% increase in ESG revenues.

Our top-line growth was dampened by the market volatility in the quarter, which led to a decline in equity values, as we all know, and this impacted our asset-based fees. Since the end of the quarter, though, AUM linked to MSCI indexes has rebounded and have set new all-time records.

Turning now to operational efficiency, the strong top-line numbers were complemented by a 5% decline in adjusted EBITDA expenses. We continue to be focused and disciplined on ensuring that our cost base is right-sized and aligned with our most attractive investment opportunities. As we've discussed on this call in first quarter, we expected that first half of 2016 was going to have lower levels of investment and therefore, EBITDA expenses. We also indicated at that time that we are increasing the pace of investment in the second half of the year as we focus on capturing new opportunities in fixed income and multi-asset class analytics and building our new Analytics interface and completing various IT projects.

And additionally and most importantly, we're also investing in our Index franchise to preserve and grow our leadership in market cap indexes and position us to be the leader in indexes in the fast growing areas of factors or smart beta, ESG, custom, and thematic indexes. All of these investments that I'm referring to are duly reflected in our EBITDA expense guidance. Our tax planning work continues, and we remain confident that we'll be able to reduce our operating tax rate to the low-30%s over the next few years.

Finally, in terms of capital optimization, we continued to repurchase shares in the quarter, and the board has authorized the increase of our regular quarterly dividend by 27% to $0.28 per share. Our financial model is very powerful, high-single-digit revenue growth combined with the strong expense management results in a significant expansion in operating leverage and, therefore, our earnings.

The compounding effect of this financial model makes MSCI highly cash-generative, which provides us with the flexibility to deploy this capital for organic opportunities, both on acquisitions, share repurchases, or dividend payments. We're also committed to maintaining our gross financial leverage in the range of 3 times to 3.5 times. Given that we are currently at the low-end of our range, we are assessing financing options to increase our leverage.

So in summary, a strong revenue growth and disciplined expense management drove a 24% increase in adjusted EBITDA, which combined with a 250-basis point decrease in our effective tax rate and a 14% decrease in our share count drove a very impressive 38% increase in adjusted EPS.

Let's now turn to slide five, in which we have a refresh of our business strategy. Our mission is to be a leading provider of mission-critical investment decision tools. To achieve this objective, we must have superior content and state-of-the-art software applications. By content, we mean the research models with the right data and the analytics that then are enabled by a smart state-of-the-art applications. We believe that companies that are best-in-class at combining content and applications will grow faster and gain market share over time.

With content and applications combined, the opportunity to create new products and services and new offerings is immense, and that is exactly what we're doing at MSCI in the investment process for our clients. We are evolving from a product-centric focus to a business model where our tools can help our clients provide answers to their most pressing investment problems and opportunities. We can leverage the four powerful attributes listed on this slide to create new offerings and strengthen the current ones.

Leveraging our unique position in the investment process, informed by a deep understanding of our client needs, we will use a research-driven approach to innovate and develop new content in the form of models, data, and analytics, and we will deliver that content to our clients through smart and state-of-the-art applications.

If you turn to slide six, this highlights our global market leadership as a licensor of indexes at the basis of equity ETFs as of June 30. The AUM linked to MSCI indexes represented 19% of all equity ETF industry AUM globally, and $10 billion of net cash inflows that were recorded in this ETFs year-to-date represented 52% of all net cash inflows for the entire equity ETF industry, making MSCI number one, one more time in net cash inflows gathered.

For market data investing, non-U.S. equity exposure ETFs that were linked to MSCI indexes were number one in assets and in net cash inflows year-to-date. For the smart beta investing or factor investing as we call it, MSCI index linked Minimum Volatility ETFs were number one in assets and in net cash inflows year-to-date, including the number one ETF globally in all categories for net cash inflows year-to-date.

For ESG investing, MSCI index linked ETFs were number one in the number of equity ETFs linked to ESG-themed indexes. So, we are and remain relatively optimistic and proud of the achievement in this area of our business, as exemplified by not only our market leading position and the market based indexes were also in the fast growing areas of smart beta and ESG investing.

On slide seven, we highlight a key trend that we are seeing in the market for our Analytics services, and that is the increase of use of factors by hedge funds of all types, quantitative and fundamental hedge funds. Our hedge fund clients are increasingly coming to us with the same problem, how can we help them better explain their performance to their asset owner clients in volatile markets.

So, by leveraging our factor model data and our software applications, BarraOne and Barra Portfolio Manager, we are helping hedge fund – our hedge fund clients and our asset owner clients speak the common language of factor performance and factor risk. We're also working with a prime brokerage community to help their hedge fund clients do the same. This is a concrete example where we are able to respond to our client problem and provide the tools necessary to achieve their goals.

Lastly, on slide eight, I would like to highlight the work that we're going in environmental, social and governance area or ESG area. ESG is increasingly becoming a very important component of the investment process. Because how companies deal with the environment with their human capital, with their supply chain, and how these companies and their management teams are aligned with the interests of their shareholders, i.e., the governance, is becoming very important for institutional investors all over the world.

As a result, ESG represents a very large opportunity for MSCI and it's one of our fastest growing areas in the company, and we have the leading competitive position due to the quality of our research, our data, our ratings, and our software applications. Each of the participants on this slide is driving the integration of ESG into the mainstream of their investment processes. Asset owners are raising the importance of ESG when selecting and monitoring asset managers that they employ. Investment consultants are increasingly using ESG criteria in their manager selection process.

Regulators around the world are influencing institutional investors about these non-financial metrics. And given that both asset owners and consultants are placing more emphasis on understanding the ESG risks and opportunities in their portfolios, consequently, asset managers do not want to be left behind on those market share. As a result, asset managers are bringing more ESG products to market to meet the growing demand from investors. So, MSCI is playing a central role support this strength. For example, as 31 of the 88 ESG-themed ETFs globally are based on MSCI indexes and that is up from 12 out of 63 ETFs in 2014.

For example, in April, iShares launched an ETF, the iShares Sustainable MSCI Global Impact ETF, that is based on the MSCI ACWI Sustainable Impact Index. The industry's first equity benchmark designed to apply the principle of impact investing by targeting public companies whose products and services aim to address major, social and environmental challenges.

As we know, well, one of the fastest growing areas within ESG is the whole topic of low carbon investing. And we are seeing a significant uptick in direct allocations to low carbon strategies by asset owners. So in Europe, one of Sweden's largest pension funds AP4 announced their intention to allocate $3.2 billion to passive funds benchmarked to the MSCI Low Carbon Index family in July.

Next in the U.S., one of the largest pension funds just committed to allocate up to $2.5 billion in passive funds benchmarked to the MSCI ACWI Low Carbon Target Index. So, on this topic, in summation, our market leading franchise in ESG is helping the investment community face this exciting change and challenge in the investment process.

With that summary, let me now pass it on to Kathleen. Kathleen?

Kathleen A. Winters - Chief Financial Officer

Thanks, Henry. Let's turn onto slide nine, where I'll take you through an overview of our second quarter results. We delivered a very strong Q2 across all these measures as you can see. So, let me walk you through each measure. We delivered a 7.4% increase in revenue, driven primarily by an 8% increase in recurring subscription revenue, and a strong overall revenue growth is despite the market headwind, which caused asset-based fee revenue to decline.

There was a negligible impact from foreign currency exchange rate fluctuations on our subscription revenues. Subscription revenues exposed to foreign currency exchange rate fluctuations represented only 21% of our base year-to-date, principally euro, pound and Japanese yen, with pound exposure representing 8% or $36 million of our subscription revenues year-to-date.

As a reminder, we do not provide the impact of foreign currency fluctuations on our asset-based fees tied to average AUM, of which approximately two-thirds are invested in securities denominated currency other than the U.S. dollar.

Operating expenses and adjusted EBITDA expenses were down 4% and 5%, respectively on a reported basis. Excluding the impact of foreign currency exchange fluctuations, operating expenses and adjusted EBITDA expenses both (19:11), reflecting a $2.7 million FX benefit to operating expenses and a $2.5 million benefit to adjusted EBITDA expenses.

Expenses that are exposed to foreign currency exchange rate fluctuations represented 42% of adjusted EBITDA expenses year-to-date. The primary currency moves that drove the benefit was the British pound with smaller benefits from the Mexican peso and Indian rupee as well as other currencies.

The pound represented 12% of adjusted EBITDA expenses or $35 million. So our expenses saw a net benefit from the recent weakening of the pound. We delivered a 28% increase in operating income and a 24% increase in adjusted EBITDA, resulting in 690 basis point increase in our operating margin and a 660 basis point increase in our adjusted EBITDA margin to 50.3%. Our effective tax rate was 33.4%, down from 35.9% in the prior year and in line with our guidance as we continue to align our tax structure with our operating footprint.

Diluted EPS and adjusted EPS, both increased to 38%. Cash flows were up significantly year-over-year with free cash flow at $104 million versus $12 million last year. This was primarily driven by the timing of cash collections, stronger operating results and lower cash expenses. In summary, this is a very strong quarter despite the market volatility from Brexit.

Turning to slide 10, you can see our refinement of full year adjusted EBITDA expense guidance. As you see on the left hand side of the page, you can see the refinement to full year adjusted EBITDA expense guidance reflecting our continuing strong expense management.

We now expect to come in at or slightly below the low end of the previously announced range of $600 million to $615 million. On the right hand side of the slide, we're bridging from the annualized first half adjusted EBITDA expenses, so $580.5 million, to the low end of the full-year guidance range, $600 million.

The $20 million in incremental expenses that we expect to flow through in the second half will be more weighted to the latter part of the second half as we increase investment. This will consist of new hires and technology, research and sales, investments and initiatives, initiatives like fixed income analytics and technology, mainly higher professional fees and IT expenses.

On slide 11, you can see a detailed walk showing its different drivers of EPS growth in Q2. Adjusted EPS increased $0.21 from $0.56 per share to $0.77 per share or 38% in comparison to second quarter 2015. Strong revenue growth contributed $0.11 per share. Operational efficiency both strong expense management and the lower effective tax rate contributed $0.06 per share, and share buybacks benefited EPS as well.

We've reduced our average weighed diluted share count by 14% with a partial offset from higher net interest expense resulting in accretion of $0.05 per share. And lastly, FX and other items had a net $0.01 per share negative impact which includes the impact of a $3.7 million charge for estimated losses associated with miscellaneous transactions included in the other expense line partially offset by FX benefit as mentioned earlier.

On slide 12 through 13, I'll walk you through our segment results. So let's begin with the Index segment on slides 12 and 13. Revenues for Index increased 9% on a reported basis, driven primarily by an 11% increase in recurring subscription revenue with growth in core products, usage fees and custom, factor and thematic products.

We also had a higher non-recurring revenue, primarily due to a payment for the use of our indexes in connection with derivative products. Higher recurring subscription revenue and higher non-recurring revenues were partially offset by lower asset-based fee revenue, which I'll address in a moment.

Recurring subscription sales increased 6% year-over-year, driven by higher core module sales. Very strong retention continued in the second quarter at 96%, up slightly from the prior year and in line with first quarter 2016 levels. Index run rate grew by $29 million or 5%. This is the net of an increase in subscription run rate of $35 million or 10% and a $6 million or 3% decrease in asset-based fee run rate due primarily to change in product mix. The adjusted EBITDA margin for Index was 70%, up slightly from the prior year and up from 69.2% in the first quarter. Index delivered high margins while continuing to invest for future growth.

Turning to slide 13 now. You have detail on our asset-based fees. Starting with the upper left-hand chart, overall, asset-based fee revenue decreased $2 million or 3% over Q2 2015, driven by a $3 million or 8% decrease in revenue from ETFs linked to MSCI indexes, partially offset by some favorability in institutional passive revenue and revenue from exchange traded futures and options contracts.

Regarding the biggest component of the change is decrease in revenue from ETFs linked to MSCI indexes. This was primarily driven by a decline in the average basis point fee primarily due to, one, market decline in non-US exposures in ETFs linked to MSCI indexes and, two, increased asset flows into lower cost ETFs linked to MSCI indexes.

Subsequent to quarter end and as of July 27, AUM and ETFs linked to MSCI indexes have increased to a record $462 billion on quarter-to-date inflows of $6 billion and market appreciation of $16 billion, bringing our third quarter to date average AUM to $451 billion. We've continued to see strong inflows into the iShares, MSCI USA Minimum Volatility ETF in second quarter 2016, with $2.8 billion in inflows in the quarter and $6.3 billion inflows year-to-date.

In the upper right hand chart, we can see that we ended the second quarter with $439.7 billion in period-end ETF AUM linked to MSCI indexes, up slightly from the prior year and also versus Q1. Despite the volatility in early 2016 and Brexit in June, our franchise has performed very well. The year-over-year market value decline of $38 billion was more than offset by cash inflows of $42 billion, reflecting the resiliency of our franchise.

On slide 14, we have the financials for the Analytics segment. Revenues for Analytics increased 4.5% to $112 million on a reported basis with negligible impact from FX. The increase in revenue was primarily driven by higher revenues from risk manager, as our clients manage risk across their enterprises and leverage our managed services to obtain operational efficiency.

We also had higher equity model revenue driven by our clients' increasing focus on factors resulting in demand for our products that helped them understand and explain performance. Recurring sales were lower compared to the prior year second quarter, due to lower risk manager sales, which offset strong growth in equity models, as we see a challenging environment and seeing some deals taking longer to close.

Cancels increased versus the prior year primarily due to market conditions, specifically the continuing cost and budget pressures that our bank clients are experiencing. Retention, however, remained high at 92%. Analytics run rate at June 30 grew by $24 million or 6% to $449 million compared to June 30, 2015, and the impact of FX was not significant.

Adjusted EBITDA margin was 29.6%, up from 19.8% in the prior year and up from 27.5% in the first quarter 2016. The increase in margin was driven primarily by a $7 million or 8% decrease in adjusted EBITDA expenses due to lower compensation and benefits within the technology group, the ongoing improved cost structure of the product area, and higher software capitalization in the quarter compared to the prior year. As we continue to invest in Analytics, we expect the adjusted EBITDA margin to decline from these levels in the second half of the year.

And on slide 15, we discuss the All Other segment. Revenues for All Other increased 14% to $26.1 million on a reported basis and grew 15.4% on an FX adjusted basis. First, in terms of ESG, a $2 million or 20% increase in ESG revenue to $11 million was due to strong ESG ratings driven by the increasing integration of ESG into the investment process, as Henry referenced earlier.

Real estate revenues increased 10% to $15 million on a reported basis. It would have been up 13%, excluding the impact of foreign currency exchange rate fluctuations. The year-over-year increase primarily reflects the timing of our report deliveries and higher market information product revenue in second quarter 2016.

The All Other adjusted EBITDA margin was 23.8%, up from a negative 4.4% in the prior year and 11.4% in first quarter 2016. The increase in the adjusted EBITDA margin was driven by continued strong growth in ESG revenue as well as lower real estate cost primarily due to a reduction in head count and strong cost management. As a result of the seasonality of real estate revenues, which are more weighted to the first half of the year, All Other adjusted EBITDA margin is expected to decline from second quarter 2016 levels.

On slide 16 now, you have an update of our capital return activity. As you know, we've returned substantial amounts of capital to investors in recent years. More specifically, since 2012, we've returned almost $2 billion through share repurchases and dividends. In Q2, we repurchased 1.6 million shares at an average price of $75.13 for a total value of $122 million. Approximately $424 million remains on the outstanding repurchase authorization as of June 30, 2016.

On slide 17, we provide our key balance sheet indicators. We ended the quarter with cash and cash equivalents of $405 million, which includes $156 million of cash held outside the United States and a domestic cash cushion of approximately $125 million to $150 million, which as a general policy, we maintain for operational purposes.

On July 27, the board authorized the company to explore financing alternatives that could increase interest expense and the gross leverage ratio of the company above current levels. We're exploring financing options. However, the occurrence and timing of any such potential financing will be subject to, among other things, market conditions and the company's ability to obtain the terms and conditions authorized by the board.

In the event that the company does increase leverage above the stated range, given the strength of our financial model, we expect to quickly delever and return to levels within our stated range. As we begin to explore the possibility of adding incremental leverage, our priority will continue to be maximizing every dollar deployed to ensure we get appropriate return for our shareholders.

Our dividend payout ratio dropped slightly below our 30% to 40% payout range based on second quarter results. The board has authorized a 27% increase in the regular quarterly cash dividend to $0.28 per share or $1.12 per share on an annualized basis.

Lastly, on slide 18, we are refining our full year guidance. The only refinement to our guidance as discussed earlier is that for adjusted EBITDA expenses, we now expect to be at or slightly below the low end of the previously announced range of $600 million to $615 million. This guidance assumes among other things that MSCI maintains its current debt levels. Lastly, we continue to work hard toward our long-term targets.

So, in summary, we're very pleased with our results for Q2. We executed well throughout the quarter as reflected in the Q2 results.

And with that, we'll open the line to take your questions.

Question-and-Answer Session

Operator

Our first question comes from the line of Alex Kramm of UBS. Your line is now open.

Alex Kramm - UBS Securities LLC

Hey. Good morning, everyone.

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Good morning.

Alex Kramm - UBS Securities LLC

Hi. Just coming back, I guess, to some of the comments on the selling environment and in particular, as it relates to Analytics and the retention coming down there a little bit, the sales being a little bit lower. So can you maybe parse out what you're seeing, is this environmental factors, is this also maybe – over the last couple of years, you've been investing a little bit less. But also you've been talking about maybe raising prices in some areas. So those are couple of things that you've been working on. So, just where is the maybe little bit of the pressure this quarter coming from, if you think about some of those dimension?

Kathleen A. Winters - Chief Financial Officer

Hi, Alex. Thanks for the question. Yeah. So, overall, if you look at the total sales numbers, really nice performance I think for the quarter, but when you look at Analytics, yeah, I would say that's where we're seeing some challenges is the quarter. It is a challenging environment right now. And as you probably know in Analytics, sales can be a little lumpy in that segment. But what we're seeing is that we're seeing banks continuing to be under cost pressure, hedge funds underperforming. So it's a little bit of a challenging environment right now.

But that said, we look at the pipeline, and the pipeline is very solid. Deals are taking a little bit longer to close, but we do feel like that pipeline continues to remain solid. And we'll be working to execute on that.

Alex Kramm - UBS Securities LLC

Okay. And so some of the moves that you've been making in terms of maybe investing less or asking for more pricing, you don't think that's a driver at all?

Kathleen A. Winters - Chief Financial Officer

No. We're not seeing anything with regard to any of the pricing that we've done, causing any cancels or anything like that.

Alex Kramm - UBS Securities LLC

Okay. And then maybe to my second topic, just real quick on the buyback commentary, maybe you can just flush it out a little bit more just so I understand it right. So you're basically saying you're at 3 times and 3 times to 3.5 times is kind of your range. But did I hear you right that you could explore going a little bit above the range, maybe to 4 times or so to maybe have a little bit more firepower in the near term and then delever from there? And then just generally speaking, how would you all else equal think about the pace of buybacks from here?

Kathleen A. Winters - Chief Financial Officer

Yeah. We are looking at potential additional financing. And we might lever up a little bit higher than the stated range. I wouldn't expect that it would be significantly higher. And I expect that you'd see a pretty quick delevering if you just consider our strong business model and our cash flows. I think we'd delever pretty quickly from there. But again, it would be a pretty slight increase above the stated range.

Alex Kramm - UBS Securities LLC

All right. Fair enough. Thank you.

Operator

Thank you. And our next question comes from the line of Ashley Serrao of Credit Suisse. Your line is now open. Please go ahead.

Ashley Neil Serrao - Credit Suisse Securities (USA) LLC (Broker)

Good morning. Henry, I know you've looked at the fixed income arena from time to time. I was hoping to just get an update here on your plans. And just a general comment on whether the M&A market seems attractive at this point in time.

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Yeah. So, as all of you know, when you look at the entire franchise of MSCI, we're extremely happy and pleased of where we are in all the components of that franchise – the major components of that franchise. And the exception is in fixed income analytics, on both counts, on our desire to continue to be a leader on the strength of fixed income commonalities in the context of multi-asset class analytics, i.e., the component of fixed income in multi-asset class analytics, and then secondly to be a much bigger participant in providing fixed income analytics for fixed income portfolio managers around the world. So with that, we are doing a few things. We are meaningfully investing organically in fixed income analytics, particularly as it relates to some of the changes that are going on in that sector of the industry that provide cash and provide great opportunities for us to do things organically.

And then secondly, we are always evaluating the M&A market for these kinds of assets and evaluating them on the basis of what they can do for us. Can they really fit into what we do or not and then decide if it's a good deployment of capital. Regardless of what we do or don't do in any M&A environment, we are extremely focused on – if we deploy capital, getting the rates of return on the capital that we are – that we put to ourselves and with our board. So this is a focus – very much of a focus area clearly for the company as we mentioned in the prepared remarks, and our team to continue to develop it.

Ashley Neil Serrao - Credit Suisse Securities (USA) LLC (Broker)

Great. Thank you for the color there. And we have a question for Kathleen. I believe you're spearheading the creation or optimization of several franchise metrics to better manage the business. Can you just give us an early update on how things are going there so far?

Kathleen A. Winters - Chief Financial Officer

Sure, I can do that. So maybe I'll step back a little bit and just give you my perspective after being here, not quite three months now. I think it would help to kind of catch my response in that way. So as I said, I've been here almost three months now and as you would expect I've spent most of that time, right, just learning the MSCI model and the organization. And I've been very impressed with the people in the organization, the assets and the really very attractive business model that we have.

So I look at this opportunity and say, well, how can I help to take this franchise to the next level. And one of the ways that I can do that is to look at the metrics that we use to run the business and the financial management to run the business. So I'm really looking at reinforcing the rigor with which we make capital decisions and building out the analytics. In particular I think we can do a lot of good work around analytics, around our clients and in the product areas. And there's is a lot of system work that we are in the process of doing, so continuing to implement that system work to enable us to do those analytics to really make the best decisions.

Ashley Neil Serrao - Credit Suisse Securities (USA) LLC (Broker)

All right. Thank you for the color and thanks for taking my questions.

Operator

Thank you. And our next question comes from the line of Toni Kaplan of Morgan Stanley. Your line is now open.

Toni M. Kaplan - Morgan Stanley & Co. LLC

Hi. Good morning. Can you give us a sense of how your customers are reacting to purchases of your Analytics products since Brexit? Have you seen any lengthening of the sales cycle, or conversely have you seen an increase in demand in some of the risk products?

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Yeah. So, first of all, interestingly enough, one of our strongest regions of the world in Analytics sales and retention rates has been EMEA in the last couple of quarters. So that would be contrary to what a lot of people would have expected. And we've done that on the strength of the management team, the sales team in EMEA and very deep engagement with our clients. The softness that we have seen recently was more in Asia-Pacific on the heels of the uncertainties around the Chinese market and the like and a bit of softness recently in the U.S.

So what happened also in the quarter was that Analytics sales tend to be very lumpy in the quarter and the second attribute of Analytics sales is that they tend to be very back-ended in the quarter, meaning, the last two weeks of the quarter, typically represent a meaningful percentage of sales. So therefore, given the way Brexit happened which was a week or so before the end of the quarter, quite a lot of our European clients were distracted understanding Brexit and what it meant for them and all of that and therefore the signature that we needed in their contracts did not happen and it was pushed off by a week or so.

So therefore, that's a little bit of what you see in the impact on sales. But the pipeline has remained the same. There is not any meaningful items that have been taken out of the pipeline because of Brexit. We're almost like a business as usual after Brexit with respect to the Analytics clients in EMEA and around the world. And we haven't yet seen any meaningful uptick in interest or desire because of Brexit. So it's almost like business as usual, with the only caveat that – in EMEA, right, with the only caveat that distraction that took place one week before the end of the quarter moved the line of certain contracts that we were expecting to close.

Toni M. Kaplan - Morgan Stanley & Co. LLC

Okay. Great. And would you expect that the contracts might close in third quarter, or is it still early to tell?

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

I think we would expect those to close in the third quarter and the like, now, that's all we are. That's also all sort of encompassed or encapsulated in the also overall context of EMEA, and what the impact that Brexit is having on the banks as an example and obviously some of our sales to banks as you all know well, there is quite a lot of turmoil with some of the German banks, the Italian banks and the like. And therefore, that is yet to be determined what impact if any it has on our sales in that segment in this current quarter.

Now, we don't only sell to banks, we sell to asset managers and hedge funds and asset owners, et cetera in EMEA, but obviously, we're closely monitoring what ultimate impact on purchase invitations by banks, how will they be affected by the consequences of Brexit and the volatility that we have seen in the banks.

Toni M. Kaplan - Morgan Stanley & Co. LLC

Okay. Great. And then my second question really quickly is just on all other margins, really high this quarter, because of the ESG revenue and lower real estate head count. You mentioned it'd be lower in the second half, but there's really a big delta between this quarter and history. So just wondering how we should think about a normal level of margins in all other going forward?

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Yeah, look, I think, we've tried not – it's very hard to manage through margins, right? We manage through revenues and through EBITDA expenses and capital expenditures. And obviously, with respect to the capital optimization, we do everything we can to reduce the tax rate and the share count, if appropriate, right? So therefore, now, we clearly overshot a little bit with respect to all the margins, right, in the company, and everything went well.

But it was understandable because given the volatility – and the huge volatility that you remember took place in the first quarter, we slowed down the pace of hiring and investing in the first quarter, given that we didn't know whether it was going to – we were entering a bear market or whether it was just a nasty correction, which is – it ended up being a nasty correction. And therefore, that hiring machine takes a little bit of time to reenergize.

So that affected the second quarter. We are looking to increase the pace of hiring and investing gradually in the second half of the year, not dramatically. Now, with respect to margins, we continue to be very, very comfortable on the longer-term margin targets that we have outlined in the past as a company as a whole, 50% or so. And with respect to the Index business, that's 68% to 72%.

The Analytics business in the low to mid-30%s, and the All Other category, which is pretty high now relative to what our targets are, which is 15% to 20%. The issue with the Other segment is we have an expanding margin business in ESG, but it does require investment in order to make it grow at these levels. And then we have the restructuring that is going on in real estate. So we clearly already got to very, very close if not surpassed the levels of margins that we had projected for the longer term, but then you will see a moderation of that, but we are very comfortable in the longer term targets.

Kathleen A. Winters - Chief Financial Officer

Yeah. And I would just – maybe to add to that and concur that we feel comfortable on those long-term margin targets, but a little more color just specifically to your question on All Other and to remind you that we've got a real seasonality impact going on when you look at first half versus second half with regard to real estate within our All Other segment. So, that seasonality impact influences it, as well.

Toni M. Kaplan - Morgan Stanley & Co. LLC

Thanks a lot, guys.

Operator

Thank you. And our next question comes from the line of Joseph Foresi of Cantor Fitzgerald. Your line is now open.

Joseph Foresi - Cantor Fitzgerald Securities

Hi. I know you talked about this in your initial remarks, but maybe you could just frame for us the one or two top areas of savings versus the one or two top areas of investment, first half of the year versus second half of the year, so we get a good understanding of exactly where you're focusing your efforts?

Kathleen A. Winters - Chief Financial Officer

Yeah. So, from a savings perspective, if you look at expenses year-over-year, that's basically driving a large part of where the savings come from. And when you think about investment, really across all areas, investing in our product segments, in research, in our coverage organization, and in technology, so it's really doing that smart investing looking across each of the areas and saying, what smart investments can we do to drive future growth. So I think, it's pretty much across the board.

Joseph Foresi - Cantor Fitzgerald Securities

Okay.

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

And importantly, we are purely in indexes is about factor investing. There are other areas, but we clearly are putting a lot of effort there in investing. In Analytics, it's about the new fixed income analytics and the new interface. In ESG and in real estate, it's across the board. And in terms of savings, I just want to emphasize, given the last few years of MSCI, that the – whenever we talk about investing, we are really determined to self-fund this investment plan and not take them out of the target margins, profit margins that we have. And, therefore, we will continue to be extremely focused on looking at our entire cost base and creating efficiencies out of that, reassigning resources, or redeploying resources in order to match them with the best opportunities, and so on and so forth.

So, a lot of this talk about investing is – I wanted to be very clear that it's not a philosophy to knock down margins or anything like that at this point. The margin expansion that took place recently was because we had slowed down a bit on that self-funding investment plan, and obviously, we want to correct a bit of that in the second half.

Kathleen A. Winters - Chief Financial Officer

Yeah. So as Henry said, the philosophy is not to take the investment out of margin, but to really drive hard on productivity and to think about that every day and to find the opportunities to drive productivity, so we can fund that investment.

Joseph Foresi - Cantor Fitzgerald Securities

Okay. And then I was wondering, is there any way you can frame for us your thoughts on, I guess, passive investment penetration levels and/or opportunity in new offerings? I mean, I guess, the reason why I'm asking is that the market is obviously performing fairly well in the U.S., so that has a positive impact. But I'm wondering what kind of growth rates you think you can generate from those two aspects of the business, just so we get a sense of what the baseline growth rate could be, should there be volatility in any particular quarter from something like Brexit or something else? Thanks.

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Yeah. If I understand your question correctly, let me try to answer it in the following way. There is no question that the client base of a company like MSCI is going through some significant challenges from banks in their own balance sheets, from asset management units of banks, wealth management units of banks. So as you know, when banks get into difficulty and they start cutting, it goes across the board, regardless of whether they have great divisions or not, right? So hedge funds are underperforming, so they're pulling in a bit. Active managers are getting hit by passive and smart beta and the like, but we are seeing other opportunities.

The non-bank wealth managers around the world are in growth plan. The asset owners are building internal capabilities, in-sourcing asset management. They need a lot of help with our tools. There are geographies around the world that are being very good to us like Canada and parts of the U.S. as well and so on and so forth. So I mean, we have a fairly diversified business. The other thing that is critically important is that we obviously have a bet on bull's-eye, so we have a bet of passive managers and that has done well. And if anything is expanding dramatically from market beta to a smart beta, to ESG beta so to speak and thematic beta, so we're capturing that significant opportunity. And we're also helping in whichever way we can the active managers deal with all these changes and the dialog with them is incredible, because they need us more than ever in that whole process.

So, we got a fairly wide and diversified product line that – and our franchise is increasing dramatically. I mean the dialog we have with the C level of our clients today compared to a year ago or two years ago or three years ago or four years ago is exponentially bigger, and they are looking for answers, they are looking for solutions, they are looking for ways to – for them to launch new products and increase revenues and create their own operational efficiencies and meet regulatory demands and all of that. So our franchise is great and really great in all this, but in the context of clearly a challenging end client – a changing end client environment we're very optimistic that we can continue to grow at this levels. Clearly, we would like to accelerate them if we can, but it's – we were where we want to be in this whole thing.

Joseph Foresi - Cantor Fitzgerald Securities

Thank you.

Operator

Thank you. And our next question comes from the line of Chris Shutler of William Blair. Your line is now open.

Chris C. Shutler - William Blair & Co. LLC

Hi, everyone. Good morning. Given the expense guidance is weighted more towards Q4, can you maybe at a high level help us think through how we should consider constant currency expense growth in 2017? Are we talking more kind of low-single-digits or mid-single-digits?

Kathleen A. Winters - Chief Financial Officer

Yeah. We'll be working through our 2017 expense guidance as we go through our annual budget process. So, at that point in time, I think we'd be prepared to give you better color on that.

Chris C. Shutler - William Blair & Co. LLC

Okay. And then on the increase in the leverage, just curious why you're considering increasing the leverage at this point? Is it that you have desire to buyback stock at a pace faster than your cash flow generation or is it fair to read that maybe you have a greater desire to have more optionality on the acquisition front?

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Well, Chris, it's actually driven by the market conditions in the high yield market. They are exceptionally strong for actuaries (57:50) like ours. As you know, there is always a big flight to quality in that market. Rates have come down and spreads have been – are attractive. There is a significant appetite for high quality paper like ours that gives them higher yields on sovereign bonds around the world.

So, we are extremely opportunistic. We don't have to do anything. But if the right conditions are there, we will want to do it. And that's why Kathleen commented that, if we get exceptional demand, if we go to the market which is not clear, but if we see exceptional demand at fairly low yields, we may want to do a bit more than we would normally do, and therefore, maybe go a bit higher than 3.5 times leverage. But that's what is driving us in order to relever to the desired levels.

And then the flip side of it is, okay, what are you going to do with the proceeds? And I think it's the same as always, organic growth, which is already funded by the current cash flows, it will be buybacks, and if there are opportunities in the M&A market, we will do that. But we're not doing this, because we are gearing ourselves to do any acquisition, it's just being opportunistic.

Kathleen A. Winters - Chief Financial Officer

Yeah. And this is pretty consistent with what we've done in the past, right. As leverage came down, we then look to lever up again, right? We were at 3.7 times after we did the debt offering in August 2015. And then, as you can see, we brought the leverage ratio right back down again after that.

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

I think, a big part of this thing is we want to deliver on the promise that we have made which is, we said we will be 3 times to 3.5 times gross leverage. If we delever, we want to get back into that range. We clearly want to do it opportunistically, not automatically. If yields were really high, we'd want to wait to do that, but if the yields are attractive, we want to get back to there, and therefore be a consistent communicator of our policies and messages.

Chris C. Shutler - William Blair & Co. LLC

Okay. And I know, I want to sneak one more in here if you don't mind. You talked about the need to continue to invest in Analytics as you've been saying for a while. But at the same time saying comp in the Analytics tech group was down. So, help us reconcile those two items.

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Yeah. I think the comps that we're talking about in the Analytics is just simply we focus intensely on the head count there on the projects and which areas, so we ended up – the team in Analytics ended up reprioritizing projects, reprioritizing head count where the head count should be located and that had a impact in compensation expense, not individual, clearly compensation.

So, it was a big effort in continuing to make sure that all of our expenses in Analytics, including the head count, is completely focused on the right projects that have the highest capital return, the highest impact and the like, and not be involved in a lot of other things that may have much longer payback or lower payback. So, that's a big effort of what we did.

And that has allowed us to increase the margin and at the same time, fund new initiatives, including this fixed income analytics initiative which we're not planning to – when we started with the budget at the beginning of the year, we had not put that into our budget and the opportunity came up given the changes in that space, and we are self-funding that increase in investment in fixed income analytics out of all those efficiencies.

Chris C. Shutler - William Blair & Co. LLC

All right. Thanks a lot.

Operator

Thank you. And our next question comes from the line of Keith Housum of Northcoast Research. Your line is now open.

Keith Housum - Northcoast Research Partners LLC

Good morning. Thanks for taking my question. Two questions for you. I guess the first one, you guys announced the disposition of the Global Occupiers business in June to Jones Lang LaSalle. Can you provide a little more color on the size of that business and what it means perhaps going forward?

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

Yeah. It's a relatively small business within real estate, right, it's in real estate and relatively small. But importantly, it was a business whose client base were corporate in which we were helping them optimize their facilities footprint. And we remain extremely focused on MSCI in which we say, our client base are institutional investors and their advisors, and not sort of the corporate. If it is a corporate, the pension fund of a corporate, for example, the treasury of a corporate. And therefore, we have no business being in that part of the space. So, we therefore decided that that segment of the product line in real state was better off housed in another organization that will buy it that will then make better use of it.

Kathleen A. Winters - Chief Financial Officer

And Keith, that business was a very small business as part of our portfolio, quite immaterial in the scheme of things.

Keith Housum - Northcoast Research Partners LLC

Got you. And then the next question for you is that non-recurring revenue over the past three quarters has been up substantially over, I guess, the prior year, sort of like 30%. How should we think about non-recurring revenue going forward? Is that kind of focus of yours to grew more of that through one-off projects or how should we think about that going forward?

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

I'm sorry, can you repeat what kind of revenues you were referring to?

Keith Housum - Northcoast Research Partners LLC

Your non-recurring revenue.

Henry A. Fernandez - Chairman, Chief Executive Officer, President & Director

The non-recurring revenue. Yeah. So, we have very much focused on every dollar of revenue. There was a little bit of bias in the past of focusing on only recurring revenue and not as much as what we call one-time revenue, which is actually most of the revenue for everyone else in the world. So, we reenergized our goals and objectives with the coverage team to make sure that sure that we were focused on every dollar or every pound, every euro of revenue anywhere else in the world. And therefore, this has resulted on higher, what we call, one-time or non-recurring revenues in the company. They are very lumpy, obviously. So of course, we'll be more – some quarters will be less and the like. But there is a significant effort to ensure that we get everything that is worth for our financial model.

Keith Housum - Northcoast Research Partners LLC

Great. Thank you.

Operator

Thank you. And I'm showing no further questions at this time. I would now like to turn the call over to Mr. Stephen Davidson for closing remarks.

Stephen C. Davidson - Head of Investor Relations

Thank you very much, everyone, for your interest in MSCI and have a great afternoon.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone have a great day.

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