Anybody involved in financial markets should be familiar with the name MSCI (NYSE:MSCI). MSCI stands for Morgan Stanley Capital International and was spun off from Morgan Stanley in a 2007 IPO. MSCI is known for its indexes but many people don't realize there is a company behind it - and a really profitable one. If you've invested in MSCI since the IPO in 2007, the total return would have been 851% -that's a compounded annual growth rate of approximately 20%. MSCI is still an $18 billion market cap company, and this article explains why this above average growth can continue.
MSCI has 2 main operating segments, Index and Analytics. Index is the part where MSCI constructs global (equity) indices that are well known globally. The company constructs indexes geographically (MSCI World, MSCI Europe, MSCI Emerging markets) as well as size and sector orientated ( MSCI small cap, MSCI utilities, etc.). The company earns money in 2 ways: asset based fees and recurring subscription revenue. Asset based fees consist of assets that are linked to or track the MSCI benchmark. Based on the recent Q1 2019 report, the company earns 2.88 bps from ETF issuers that link their ETF to an MSCI index.
As per Q1 2019, the company had 7,000 clients spanning over 90 countries. The most important client is BlackRock, (known for its iShares ETF brand) which accounted for 11.9% of total revenues. 96% of the fees that BlackRock paid to MSCI were asset based fees. Not all revenues within the Index segment are based on AUM (assets under management). Actually 60% consists of recurring subscriptions and 40% is based on AUM fees. Clients subscribe to MSCI and use their indexes for many areas of the investment process, including index-linked product creation and performance benchmarking, as well as portfolio construction and rebalancing, and asset allocation.
Although analytics and Index overlap in their offerings, the Analytics segment provides analytics such as risk management, performance attribution, risk and returns insights and various regulatory reporting data. This segment is comparable to companies like Bloomberg and FactSet Research Systems. Another growing revenue stream that is classified under “All other” is ESG and real estate. There is a growing demand among investors to invest ESG responsibly and MSCI's ESG indexes leverage this need.
The analytics segment has less of a moat then the index segment because more companies provide the same analytics. The analytics operating segment is solely based on the subscription model.
Opportunities and Threats
The main catalysts for MSCI are most probably growth of AUM in China and other emerging markets, and the continued shift to index-based investing versus active investing. For China and India, the mutual fund to GDP ratio is approximately 11-12%, whereas in the US this is 101%. These countries have ample room for growth and even a 5% increase in the ratio of China translates to $600 billion in extra AUM. Based on MSCI's most recent take rate of 2.88 bps this represents $170 million in additional revenue. MSCI's total FY 2018 revenue is now $1.4 billion. Of course this is conditional on the fact that the AUM is linked to MSCI's indexes. But it does outline the breadth of the total addressable market.
Apart from geographical expansion, there is the continued shift from active to passive investing. Research from the Federal Reserve Bank of Boston shows that per December 2017, the passive share of global investing stood at 37% in the US, and this number is steadily increasing as shown below. The trajectory is clearly upwards and as the research explains, especially universities and endowments have been switching more to passive solutions.
Furthermore, the shift is also happening in other countries where the passive share is still lower, so there should be ample growth left.
The index business is a much better business than the asset management business. The main players in the index business are FTSE Russel, MSCI, Standard & Poor's and to a lesser extent Bloomberg. Compare this with the countless amount of ETF issuers and you can see that the indexing business is a better business than the asset management business.
There are some threats. The Investors Chronicle reports that some ETF providers have begun to bypass the big indexing companies such as MSCI and have started to self-index. For example, WisdomTree and Goldman Sachs Asset Management manage funds, including ETFs, based on their own proprietary indexes.
Also new index providers have emerged. For example, in the UK, BATS Europe launched 18 UK stock indices in June 2016 to compete with FTSE. However, evidence of ETF providers using smaller index providers remains limited. The MSCI brand does create trust and major wealth managers are noticing that clients are demanding the MSCI brand.
These risks should be taken seriously, but for the moment, MSCI's index revenue that is based on AUM is growing fiercely as we will see below.
MSCI Inc. is highly profitable. Revenue growth was 12.5% in FY 2018, but used to be in the high teens if you go back a couple of years. The index segment (58% of revenue), which earns money through asset based fees and subscriptions, grew 16.2% in FY 2018. Asset based fees specifically have grown the most with 21.9% while subscriptions grew 11.8%.
Even in an environment where self-indexing has emerged and some ETF issuers have grown wary of index fees, MSCI has still managed to grow exceptionally. The analytics segment grew only 4.7%, but is only responsible for 33% of revenue. MSCI also creates ESG (Environment, Social and Governance) and Real Estate indexes and this is grouped under All-other. The segment is still only +/-10% of revenue but grew 22% in 2018. ESG is a major growth area because there is a growing need to inform investors as to what is ESG – responsible investing and what is not.
Due to the nature of the revenue streams (subscription and asset based fees), margins are expanding as operating leverage kicks in. As you can see below, profit margins since the IPO have steadily increased upwards. EPS growth has been expanding very rapidly as well. EPS growth in FY 2018 was around 70%. This is also due to the continued repurchasing of shares. Total diluted weighted average share count at the end of 2018 stood at 89.7 million, while the number was 96.5 million in 2016.
Furthermore, free cash flow grows consistently higher and is now at $560 million, approximately 50% of total revenue. The company is financially very stable. With regard to valuation, the current TTM PE ratio is 35, and as shown below, this is around its historical average. Considering the EPS growth, a PE ratio of 35 is quite reasonable, especially compared with some cloud stocks that are growing EPS with a slower pace or aren't generating any EPS in general.
In my view, this company with an $18 billion market cap is still in its early innings of growth. Geographical expansion, ESG investing, and the continued shift to passive will support the growth. Revenue growth has actually been increasing to 12.5% in comparison to earlier years. Due to operating leverage (and share buybacks), profit margins are increasing and EPS growth is strong. The major threats are that ETF issuers are trying to find ways to bypass indexing fees by using smaller index providers and/or construct their own indexes. This trend has been going on for years but has not affected growth rates. At a PE ratio of 35, this stock is a buy and should be tucked away in your investment account. Take a look again in 5 years.
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.