MSCI: Emerging Market Opportunity?
Recently, shares of MSCI dropped 30 percent on news that Vanguard, one of its largest clients, would be switching benchmark providers to FTSE to cut costs. By our estimation, this $24 million loss in revenue and operating income translates into a 10% haircut to MSCI’s trailing earnings. However, the reason the stock is down much more is due to the fear that this change will force MSCI to cut its prices in order to retain the remaining customers in its asset-based fee business. We believe these concerns are overblown.
MSCI is an extremely profitable, scalable, recurring revenue business with very few capital needs. Its flagship product, which makes up about 32% of revenue, is a subscription-based indices business. A very strong brand name, MSCI has long been viewed as the gold standard for international indices. In part, this is because MSCI smartly chose to essentially give away its services to pensions and endowments, which in turn mandate their managers to use MSCI, creating a network effect that has led to nearly 90% market share. This strength has led to an attractive asset-based fee business (14% of revenue before the Vanguard defection) in which MSCI usually collects 3 basis points or more for firms such as Blackrock to simply have the MSCI label on their index funds and ETFs – more on this in a moment. MSCI’s other crown jewel (39% of revenue) is its risk management and portfolio analytics software business (RiskMetrics and Barra) where customers experience high switching costs the more ingrained they become in the software. Finally, MSCI has an attractive corporate governance business (ISS) that contributes 13% of revenues. Nearly half of its total revenue stream comes from overseas and, until the recent Vanguard news, appeared very sticky with all of its lines of businesses at approximately 90% retention rates.
Before investors decide to write-off the value of these businesses, we believe it’s important to recognize that MSCI benchmarks are written into contracts across many pensions and endowments, making it difficult for these institutions and their money managers to switch to a different benchmark. Additionally, institutions generally care more about trading liquidity and tracking error than expenses, meaning that the sheer volume of assets managed in MSCI-branded index funds and ETFs adds to their desirability versus competing products. These deep customer relationships and valuable product advantages are likely why CEO Henry Fernandez stated in the conference call discussing the Vanguard developments that MSCI management is confident in the strength of their brand and refused to negotiate lower on pricing. So, while there will probably be some pricing pressure on MSCI, we think the odds are good that this pressure will be less than expected given Vanguard’s more retail focus and MSCI’s entrenchment in the institutional world. Fortunately, Blackrock, MSCI’s biggest customer, has already indicated it’s sticking with MSCI for its iShares ETFs. Additionally, our sensitivity analysis indicates that even if we’re wrong about the extent of the fee pressure that MSCI will experience, the forward expected returns from the current stock price would still look fairly attractive – particularly when one considers the tailwinds towards index funds and ETFs in general, as well as fund flows into international assets as we become a more global world.
We believe the market has overreacted on the news and created an opportunity to become an owner of a fabulous business at a good price.
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.