By The Valuentum Team
Credit rating giant S&P Global's (NYSE:SPGI) business model is fantastic and largely recurring, and its dividend track record is second to none. It has paid a dividend each year since 1937 and has increased its dividend annually for the past 40+ years, but its dividend yield of ~1.2% remains uncompetitive, at least relative to the average of a group of 500 stocks that shares its name (yes, the S&P 500). The company's Economic Castle rating, however, matches up with some of the best in our coverage universe, and its Dividend Cushion ratio of 3.4 is phenomenal. Here's the cash flow bridge that builds into the Dividend Cushion ratio calculation.
Image Source: Valuentum, S&P Global stock landing page
How have things been going at S&P Global of late? Well, in the second quarter of 2016, S&P Global reported double-digit growth on both its top and bottom lines as revenue advanced 10% and diluted earnings per share jumped 12% from the year ago period. Operating margin expansion of 70 basis points helped earnings growth outpace revenue growth. It's hard to find much fault with the many secular trends powering its business, not the least of which are significant refinancing needs by corporates and increased investor sophistication requiring more advanced tools.
The company retains a strong balance sheet following its ~$2.2 billion acquisition of SNL Financial, which will only pave the way for future free cash flow expansion. The pending close of the sale of J.D. Power will help its balance sheet as well. Ongoing margin improvements should be expected in the near term, and the recovery of bond issuance from a weak start in 2016 should help growth in the back end of the year. Mid-single-digit revenue growth is expected in 2016, a reduction from previous guidance due to the aforementioned divestiture, and adjusted diluted earnings per share for the year are expected to be in a range of $5.05-$5.20.
S&P Global's Investment Considerations
• S&P Global is a content and analytics provider serving the capital, commodities and commercial markets. The firm's businesses include S&P Ratings, a provider of credit ratings, and S&P Capital IQ, a provider of digital and traditional financial research. S&P Ratings accounts for just under half of revenue and operating profit.
• McGraw Hill Financial recently changed its name to S&P Global after selling its Securities Evaluations and Credit Market Analysis businesses as well as its consumer data and analytics business J.D. Power. The firm continues to distance itself from publishing.
• Multiple secular trends should continue to provide S&P Global with long-term growth opportunities. The sophistication of investors continues to increase, requiring real-time data and analytics. Capital markets in emerging economies will continue to transform, and significant debt maturities and ongoing bank deleveraging will drive demand in its credit rating business.
• S&P Global can now add SNL Financial to its list of leading rating agency, provider of analytical tools, and leading index provider. The company scooped up the financial gem in 2015, and we're huge fans of its subscription-based business with high recurring revenues and renewal rates.
• An increase in the demand for daily commodity price assessments and additional financial market complexity are requiring new data sets and analytics. S&P Global is at the forefront of developing solutions for these dynamics.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. S&P Global's 3-year historical return on invested capital (without goodwill) is 86%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. S&P Global's free cash flow margin has averaged about 12.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At S&P Global, cash flow from operations decreased about 75% from levels registered two years ago, while capital expenditures expanded about 19% over the same time period.
We think S&P Global is worth $93 per share with a fair value range of $73-$113.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.1%.
Our model reflects a 5-year projected average operating margin of 44.7%, which is above S&P Global's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.5% for the next 15 years and 3% in perpetuity. For S&P Global, we use a 10.1% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $93 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for S&P Global. We think the firm is attractive below $73 per share (the green line), but quite expensive above $113 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate S&P Global's fair value at this point in time to be about $93 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of S&P Global's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $122 per share in Year 3 represents our existing fair value per share of $93 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.