MSCI Barra Spinoff Provides Look At Indexers' Inner Workings

After decades of secrecy, we're about to get a much closer look at the inner workings of the index industry.

News that Morgan Stanley would spin off its MSCI Barra (MXB) data unit elicited little notice on Wall Street, where MSCI is a bit player in the massive Morgan Stanley (MS) machinery. But for our little corner of world, indexing, it was big news: it meant an index company was going public for the first time, and we were getting our first look inside the box.

Sure, most index providers are part of publicly traded operations—S&P is part of McGraw-Hill (MHS), Dow Jones (DJ) Indexes is part of, well, News Corp (NWS)—but they have always been small pieces of a bigger publishing puzzle. As a result, they're usually glossed over in the financial statements and quarterly filings; their returns get lumped together with larger operations. MSCI, moreover, has been one of the more mysterious and secretive of the big index providers, as well as one of the most successful.

As a stand-alone, however, MSCI will be forced to disclose a lot of very interesting information about its index operations, and answer some long-standing questions like:

• Is it profitable?

• How profitable is it?

• Where does the money come from, and who are the biggest clients?

• What risks does the business face?

• Where are new growth opportunities coming from?

Now, rather than trying to suss this information out of the tea leaves of various conference presentations, we'll have it all packaged up in nice, neat quarterly statements and other regulatory disclosures.

We got our first peek when the first prospectus hit the SEC. You can find it here.

An “Interesting” Deal

Renaissance Capital, an independent research and investment services firm focused on newly public companies, is evaluating MSCI as information becomes available. Although she says the valuation, terms and roadshow would give her even better insight, Vice President Melanie Hase is impressed with what she’s seen so far.

“Based on the initial document, I’d say this is a very interesting deal,” Hase commented. “Just from looking at it, it’s a very impressive business that they have established. They have a long operating history. They have a global, large presence and strong brand recognition that I think will really help them. And of course, they’re run by this really experienced management team that’s done this for many years.”

Hase added that other strengths included MSCI’s comprehensive product line and its customer retention, which she said was an impressive 93% for the first half of the year.

MSCI’s size is also a major advantage, in addition to its strong customer base and strong brand name, Hase says. And its acquisition of Barra in 2004 boosted the index provider’s cash flow margins.

“Over the last two years, they’ve had cash flow margins north of 38%, which is really strong,” she says. Perhaps most importantly, Hase says MSCI is a quite profitable business: It had profit margins in 2005 and 2006 of 17% and 22%, respectively.

Who said indexing wasn’t sexy?

Operating revenues for the unit have grown steadily, from $83.8 million in 2002 to $91.2 million in 2003, $178 million in 2004, $278.5 million in 2005 and $310.7 million in 2006. For the first six months of 2007 (ended May 31 because of MSCI’s November 30 fiscal year), revenues were up nearly 18% versus the prior-year period. The Barra acquisition has made a major contribution to revenues and been one of the driving forces that has allowed MSCI’s annual revenues to triple in just a few years.

Segment By Segment

MSCI has broken its revenues into four segments: equity indices, equity portfolio analytics, multi-asset class portfolio analytics, and other products. All four saw a big bump from 2004 after the Barra acquisition. Last year, although total operating revenues were up, multi-asset class portfolio analytics and other products actually declined from 2005, by 2.3% and 3.9%, respectively. One thought is that MSCI simply decided to focus its efforts on its core operations rather than on two areas that, combined, constitute less than 20% of total revenues.

MSCI is, of course, an index provider, and the Equity Indices segment is the source of roughly 50% of the company’s revenues. The firm calculates more than 90,000 indexes daily and the segment has 2,100 subscription clients. Meanwhile, the Barra-branded Equity Portfolio Analyatics segment includes 750 subscription clients among its revenue sources. The segment represented about 35% of total operating revenues in 2006.

“My initial take was that Morgan Stanley probably is thinking that they want to unlock the value of this MSCI business and [an IPO is] one way of doing that. I think because of the fact that the top executives have come from Morgan Stanley, it will be a rather smooth transition,” Hase says. Although she believes Morgan Stanley will retain a majority interest in MSCI based on currently available information, she is optimistic about MSCI’s odds for survival on its own.

“Granted, currently Morgan Stanley provides a lot of services to them, but I think eventually they’ll become a standalone entity, and I don’t see that to be a big problem,” she adds.

Currently, MSCI has more than 2,800 clients, including 24 of the top 25 asset management firms in the world, as determined by Nelson MarketPlace. Its ten largest clients account for slightly less than one-third of its total revenues. Subscriptions and their renewal are a primary source of revenue, but the firm has seen revenue from licensing its indexes for investment products increase steadily over the years. For ETFs alone, it has seen the number of funds based on its products increase from 67 in 2004 to 152 at June 30 of this year, with 89 of those funds in the U.S. Assets linked to MSCI-based ETFs stood at more than $156 billion recently, and MSCI earns basis points on those amounts.

Growth Prospects

In the prospectus, MSCI identifies hedge funds as a key area of growth, particularly those with managers using long/short strategies. MSCI says that it counts roughly one-third of U.S. and European hedge fund managers with more than $500 billion in assets under management as clients.

Interestingly, MSCI said it would also actively seek out acquisitions, including products, technologies and companies. This raises some intriguing possibilities in light of the Barra acquisition, which was a major growth driver for MSCI. Would these sought-after acquisitions include another index provider? A research house? A technology firm?

Risks

There is a large section in the filing addressing risk. Many are fairly standard, such as changes in client behaviors, swings in financial markets, technological issues, interruptions of support services, increased competition and consolidation in the indexing industry, catastrophic events, and consequences associated with changes in its relationship with Morgan Stanley. Two stated risk factors, however, were somewhat interesting. One was that clients might independently develop their own tools, particularly in the area of risk-related data. Another was that the increasing availability of information could cause reduced demand for MSCI products.

Another item of note in the prospectus was payment of a $973 million special dividend to Morgan Stanley and Capital International in July of this year. Renaissance Capital’s Hase believes that some of the proceeds from the IPO will be used to pay off the debt that was raised to fund the dividend, and she questions why this was necessary, when MSCI could have simply used the IPO to issue the dividend rather than raising debt.

In any case, with a long path to its IPO still ahead of it, and then lots of quarterly conference calls in our future, the indexing world can expect to learn a lot more about the inner workings of MSCI. With the valuation still unknown, a crucial question is going unanswered: How much is a successful indexing business worth? Once that is answered, another key piece of the puzzle will fall into place.

Written by Heather Bell