AGB 2022.16 - MSCI (MSCI)
AGB 2022.16 - MSCI (MSCI)
Strong Tailwinds in Index + ESG
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MSCI
MSCI is a leading provider of index data and analytics tools for the asset management industry. Customers use the company’s indexes to define the investment universe for their products, benchmark their performance and construct exchange-traded fund (ETF) products. Customers also leverage MSCI’s analytics software and tools to gain insights into their asset allocation, portfolio construction decisions and measure risk. As of 2021, the company calculates over 15k real time and 267k end-of-day indexes in more than 80 equity markets for its customers.
MSCI started in the 1980s when Morgan Stanley licensed indexes for non-US markets from Capital International. MSCI is still the market leader for international indexes today. The company acquired Barra in 2004 to complement the equity index business with risk measurement tools for customers. MSCI was spun out of Morgan Stanley via an IPO in 2007.
MSCI’s core business is the Index segment, which contributes 61% of revenues and 80% of EBITDA. Within the Index segment, over half of the revenues are recurring subscriptions from asset managers, asset owners and financial intermediaries that license the right to use the company’s indexes. The subscription business is very steady, growing +9% to +12% annually over the past 8 years. This segment also has very high margins with adjusted EBITDA consistently coming in over 70%. This is because the incremental cost of servicing a new customer that subscribes to an MSCI index is almost zero.
The remaining half of revenues are asset-based fees, mainly from asset managers that use the company’s indexes to construct ETF products. Asset-based revenues are more volatile compared to subscription revenues, but the overall long-term trend has been up. The assets under management (AUM) of ETFs linked to MSCI indexes has increased from $192B in 2007 to $1.45T in 2021. And 30% of the AUM is linked to U.S. based ETFs, 43% to international developed markets and 27% to emerging markets.
Historically, even when the market experiences down years like we’ve seen so far in 2022, cash inflows/outflows had been positive in most years with the exception of 2013. MSCI (15% market share in 2021) competes against other index providers like S&P Global (28%), FTSE/Russell (11%) and CRSP (7%). BlackRock is the company’s largest partner, accounting for 44% of all asset-based revenues in 2021. Over the past decade, this percentage has come down as different ETF providers have also used MSCI’s index data for ETF product construction.
Complementary to the index business is MSCI’s Analytics segment, which contributes 27% of revenues and 17% of EBITDA. A majority of this segment is the company’s risk management tools including Value-at-Risk simulation and stress testing. The company has been growing the equity and fixed income portfolio management software side in recent years with some success. The analytics software helps with portfolio construction as well as performance attribution. The growth rate for this segment has been lower than the Index segment, ranging from +2% to +6% and margins for this segment are lower at 36.5%. Margins have improved from 24% in 2013, indicating that the segment does scale.
The company believes that customers choose MSCI because the company’s index products and analytical tools help raise and retain AUM. Here is Chief Financial Officer, Linda Huber at the Raymond James Conference in March 2020.
“I think MSCI is very much already viewed as a revenue generating partner. So we are the embedded benchmark in many asset management firms against which portfolio managers performance and compensation is measured. So that's a very important thing. We think that the clarity and accuracy of our indexes make them a critical part of the investment process. But we do feel that our products allow investors to perform very well for the clients to help them in asset generation, which is really what they're all about. And we think that there is a strong value proposition. There was one investment firm that changed indexes quite a number of years ago. That caused an outflow of AUM. So we believe that there is strong value in what MSCI has to offer.”
MSCI has been good about reinvesting into new growth areas. For the Index segment, the company has recently benefited from the growth in factor and custom indexes. As of 2018, 10% of the total AUM in ETFs linked to MSCI’s indexes were factors based. Most of the growth in index subscriptions has been volume based, with 2/3 of revenue growth coming from new clients and up-sells, and 1/3 of revenue growth coming from pricing. The company talks about having pricing power (as customers will find it detrimental to switch index providers), but tries to be fair to clients and mindful of their cost structures when raising prices.
The other main growth area has been in environmental, social and governance (ESG). The company’s ESG and Climate segment contributes 8% of revenues and 2.5% of EBITDA. MSCI started in ESG with a screening tool for customers that wanted to avoid certain companies and industries in their investment process. That offering evolved into a research team and ratings framework. The company employs over 800 research people dedicated to ESG and has ratings on over 14k corporate issuers that covers over 90% of the market value in equities and fixed income. The company’s ESG research and ratings are incorporated into customers’ investment processes as well as in the reporting of performance and research to their clients.
MSCI is also the market leader in ESG ETFs, with 56% market share in 2022. Similar to the Index segment, MSCI competes against other index providers like S&P Global and FTSE/Russell, which have 12% and 9% market shares, respectfully. In 2022, over $200B of AUM is linked to MSCI’s ESG indexes, which represents roughly 18%-19% of the total AUM linked to all of MSCI’s indexes. MSCI’s dominant market share remains consistent quarter to quarter with the company getting 50%-70% of the quarterly inflows into ESG ETFs.
Roughly 56% of MSCI’s ESG revenues are from research and 44% are from ESG indexes. As ESG ETFs have seen significant inflows in recent years, the company’s ESG index revenues have outgrown research revenues. MSCI’s research ratings are different from its competitors and the company anticipates that this to remain this way. There is some controversy around the industry’s ESG ratings (we’ll cover some of that in the last section). It’s MSCI’s view that the company is providing a tool for customers to use to make better investment decisions if their customers’ investment mandate calls for an ESG input.
The remaining segment is Private Assets, which contributes 4% of revenues and 1.5% of EBITDA. This segment is primarily focused on real estate. Customers subscribe to data related to transactions, pricing, capital flows and trends in the private capital space. MSCI has invested capital in this space in recent years with the minority stake in Burgiss in 2020 and the acquisition of Real Capital Analytics in 2021.
In down markets like 2022, MSCI implements its downturn playbook to cut costs through a reduction in headcount and expenses. Variable compensation in the form of cash bonuses that are tied to financial performance are reduced when asset-based fees are down. The company also slows down the pace of hiring and reduces professional fees if necessary. This also depends on cancelation rates from customers.
Looking forward, the company targets low double digit % growth in Index, high single digit % growth in Analytics, mid to high 20s% growth in ESG and high teens % growth in Private Assets. This implies a low double digit % growth for MSCI. While there has been significant margin expansion in the ESG segment at 18% EBITDA, it’s still below the Index segment’s high margins of 76%. The company is targeting high 50%s adjusted EBITDA margins.
Why is it a good business?
As one of the leading index data providers, MSCI benefits from intangible assets and its customers’ increasing switching costs. On the active management side, leading indexes tend to stay in their leadership positions. Asset managers need the index data to benchmark their performance and define their investment universe. Once an equity or fixed income product is established, changing a benchmark can be detrimental to retaining AUM (and therefore may result in a reduction in fees). And because the cost of the data subscription is very small relative to the fees generated, it doesn’t make sense to make changes in most cases.
For passive ETFs, benchmark indexes define the underlying exposures to specific securities and the ETF managers need to license the data. MSCI gets paid a percentage of AUM in the ETFs, which trends near 2.5 basis points. This has moved lower over the years by about ~1 basis point. This is due to the effects of fee pressure across asset management and Blackrock’s increasing share in the ETF market. In 2021, BlackRock contributed to 12.7% of MSCI’s revenues vs. 8.5% in 2012.
MSCI’s Analytics segment also benefits from switching costs, like other enterprise software providers. Customers of the company’s analytics tools and software build knowledge and expertise over time. Furthermore, as customers embed the analytics tools more into their workflows, it becomes more difficult to switch to another vendor. Admittedly, customers are more likely to switch providers of analytics software vs. index subscriptions, given that there are more competitors with substitute offerings, but it’s still sticky.
Evidence of these advantages are seen in MSCI’s high retention rates, which have improved from 90% in 2012 to almost 95% in 2021. This implies a gross churn rate of 5%, which is on par with best-in-class enterprise software providers. Some of the increase can be attributed to the company coming out of the great recession of ‘08/’09 when some customers either went out of business and/or had to save on costs. And part of it is due to MSCI’s increasing number of offerings both in the Index and Analytics segments. Over 60% of the company’s clients purchase all of MSCI’s product lines and this percentage has increased from 55% in 2015. The company’s dominant position in ESG has also contributed to the increasing retention rate.
MSCI has mentioned that ESG has driven a lot of new customers (so not prior Index or Analytics customers) to the company. New client relationships represent 50% of ESG wins. Many of these new customers are less represented in MSCI’s client list like hedge funds, wealth managers, corporations, and insurance companies. Asset managers represent 55% of MSCI’s subscription revenue, followed by financial intermediaries at 14%, asset owners/consultants at 10%, hedge funds at 9%, and wealth management at 5%.
And this is likely because customers get unique insight from MSCI’s ESG ratings. The company states that 45% of the inputs that go into an ESG rating are from alternative data sources, so not directly from the company. The company has been citing this number since 2019, so it’s uncertain if they’ve increased the number of alternative data sources materially since then.
Returns on incremental capital?
Over the past ten years, MSCI has spent 20% of its capital on capex, 28% on R&D, and 52% on M&A. Capex is mostly related to the company’s technology stack and software investments. Just over 1/3 of capex is capitalized software investments. MSCI hosts most of its services on its own servers at its data centers but has recently partnered with Microsoft to provide public cloud based services to its customers and to future proof the company’s own compute and storage requirements. R&D is related to product development. Over the past couple of years, the majority of R&D increases were in the Index, ESG and Private Asset segments.
MSCI has invested capital well, whether it’s reinvesting back into the business, returning capital to shareholders or M&A. The company looks for Triple Crown investments when aiming for reinvestment opportunities. These investments have a high return profile, a quick payback period of less than 3 years and are related to investor interest at the time. Recently, most of the reinvestments have gone into the Index and ESG segments.
Most of the recent ESG investments have been organic, which have resulted in high returns as indicated by the revenue growth rates of +23% and +49% in 2020 and 2021. The company has only recently started to break out the ESG segment financials. The base for the ESG business came with the RiskMetrics acquisition in 2010 for $1.55B. At the time RiskMetrics generated $303M in revenue and $101M in EBITDA, implying a valuation of 5x revenues and 15x EBITDA. Prior to this deal, RiskMetrics had acquired Institutional Shareholder Services (ISS) in 2006, which had governance related expertise. After MSCI acquired RiskMetrics, the governance portion was folded into MSCI’s ESG practice from which the company expanded into ratings and research. MSCI also acquired Carbon Delta in 2019, which added a climate element to their ESG segment.
Recent M&A activity has been related to the Private Asset segment and in particular real estate. MSCI acquired a 40% stake in Burgiss for $190M in 2020. Burgiss provides private asset data to its customers that the company sources from the investors of private equity, debt and real asset funds (almost like a consortium model).
MSCI has also acquired Real Capital Analytics (RCA) in 2021 for $950M. RCA generated $70M in revenue and ~$20M in EBITDA, implying a valuation of 13.6x revenues and 47.5x EBITDA. RCA is a data and analytics provider for commercial real estate transactions. The company has a database of over 20T property transactions in over 170 countries. We note that the valuation for RCA is very high, even with an expected revenue growth rate in the high teens % range. MSCI competes against CoStar in this space.
We estimate that MSCI generated returns on incremental capital between 60%-80% over the past 5 years. Due to the company’s high incremental margins for the index segment and improving margins for both the Analytics, and ESG segments, the incremental ROIC is very high. Combine that with a low capital intensity for the business (even including R&D and capitalized software) with the added growth from the ESG segment and you have much better incremental ROICs in the past 5 years than in the beginning of the past decade. The RCA acquisition was quite expensive and a decent size for MSCI, which may suppress incremental returns in 2022 and beyond.
Reinvestment potential?
What makes the MSCI story compelling is that the company still has many opportunities for organic reinvestment. Even within the core Index segment, there are more customers that stand to benefit from subscribing to an Index subscription, in particular hedge fund, wealth management, and insurance customers. The company expects that additional growth within the Index segment will come from newer areas like custom indexes, structured products, factors, futures and fixed income. Even with little reinvestment, the company should still benefit from solid trends in the Index segment due to the stickiness of the client base, increasing % of asset based fees and high incremental margins.
Within analytics, the company has laid out a TAM of $3.5B, compared to 2021 revenues of $544M, which implies a penetration rate of 15%. There is more room to grow with midsized clients, especially in core asset management and asset owners. MSCI believes that the runway for Analytics is long, placing the long-term opportunity at $20B+, and could see the segment become larger than the Index segment at some point.
For ESG, demand continues to grow and MSCI’s leadership position has helped it gain the majority of the market share in ratings and research. At its 2021 Analyst Day, MSCI estimated that the existing ESG solutions had a TAM of $3.2B, compared to 2021 revenues of $166M, which implies a penetration rate of over 5%. ESG ratings have been adopted by ~30% large asset managers and could quickly grow to 50% in the near future. With the addition of new solutions, the company estimates that the near-term TAM is $3.9B.
With the growth in ESG, especially on the asset-based side, there could be some cannibalization that impacts the Index segment. For the subscription side, MSCI has not seen evidence of meaningful cannibalization as asset managers typically keep existing index subscriptions when adding on new ones. And the company has stated that when assets migrate to ESG from non-ESG ETFs, this is actually a net positive for MSCI. Presumably the take rates are higher in ESG indexes. ESG also allowed MSCI to address corporate clients.
And lastly the Private Asset market opportunity continues to grow for MSCI. Asset allocation to alternatives has increased from just 4% in 1997 to over 25% in 2017. The number of publicly listed companies in the U.S. have also shrunk from over 8k in 1997 to over 4.3k in 2017. The AUM for private equity, debt, infrastructure and real estate is expected to grow from $7T in 2017 to $15T by 2025.
With a reinvestment rate between 15%-25% and a return on incremental capital between 60%-80%, we estimate that MSCI has increased its intrinsic value between 12%-15% annually over the past 5 years. Going forward, the incremental returns may get suppressed somewhat due to the RCA acquisition, but the reinvestment rate should temporarily move much higher.
What else is important?
ESG is Controversial
ESG has been a big growth driver for the asset management industry in recent years, with a large portion of assets flowing into ESG labeled products. As a clear leader in this new space, MSCI has benefited from that growth but it’s not without controversy. The company and its competitors have been criticized for their ratings methodologies and it’s still uncertain whether investments or products that are labeled as “ESG” result in any type of outperformance.
A Bloomberg article from December 2021 goes over some of the salient points against the efficacy of MSCI’s ESG ratings. The authors argue that there is little connection between the marketing around ESG (particularly on the environmental side) and the actual ratings that some of the companies are given.
“Yet there’s virtually no connection between MSCI’s “better world” marketing and its methodology. That’s because the ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders. MSCI doesn’t dispute this characterization. It defends its methodology as the most financially relevant for the companies it rates.”
The article also points out that the ratings methodologies are different across the different research firms, which is unlike the credit ratings agencies. Part of that has to do with the disparate data that each firm incorporates into their ratings. Remember that MSCI claims that 45% of the data used for ESG ratings are from alternative sources. And part of it has to do with the fact that each firm has their own proprietary rating system, which is not examined by any regulators. The company’s stance is that ESG ratings should be different across firms and while there may be some form of standardization in the future the ratings won’t converge like with credit ratings.
There is also the issue with investment performance of ESG rated companies. (Admittedly, we are biased against ESG indexes and ESG rated strategies because the extra constraint, especially when its being placed by a third-party research firm, could be a detractor from potential returns.)
MSCI believes that the company only provides clients the tools to reach their investment objectives, whatever they may be. Here is CEO, Harry Fernandez, discussing the different investment objectives of different clients:
“We, at MSCI, serve a large number of different type of investors. In ESG and in climate, we serve investors that are looking to integrate ESG and climate considerations into their investment process and, therefore, they only focus on financial risk associated with ESG controversies and ESG issues or climate issues in security selection or pricing of their portfolios.
The second type of investors are impact investors, and those are very different than the ones that are looking for financial metrics only. These are investors that are looking to, as the name says, make an impact in what they do, and some of them may be willing to give up returns. And the mandate that they've been receiving as fiduciary indicate that they could do that. The third type of investors is values-based investors, religious organizations and the like in which they want to – they only want to be investing what they believe in and are willing to give up substantial returns sometimes for that, or increase risk in their portfolios for that.
So, I think that everyone that we have talked to, as a consequence of this article, has completely recognized the differences between one thing and another. And many of them have indicated that it is very incredible to have people that think that they can take fiduciary's money and go out and fight social causes with the fiduciary's money when that is not part of their mandate. So, a lot of what these articles have been advocating is for people like you and others on this call to go out and invest and get lower returns on the basis of helping different parts of the world. And that's not what is written in your mandate in how people run money. So, there are others that do that and we serve all kinds of investors.”
There also are examples of certain asset owners that are against the move towards ESG products. In December of 2022, the state of Florida pulled $600M from BlackRock’s ESG strategies and is looking to reallocate another $1.4B in 2023. In October 2022, the states of Louisiana and Missouri also reallocated almost $800M and $500M away from BlackRock ESG strategies.
Management May be Too Optimistic about Future Growth
It’s reasonable for the management team at MSCI to be optimistic about the future growth of the company. Given the company’s past performance, it’s likely that optimism created the environment for MSCI’s newer product offerings that are getting good traction with customers. Revenue growth for the company has been very consistent, ranging between +7 and +10% from 2012 to 2020 (net of divestitures) and +20.5% in 2021. New product offerings like ESG and Private Assets have grown much higher than the company average and those segments have experienced significant margin improvements in recent years.
However, the management team may be too optimistic in certain respects for the Index and ESG segments. At the company’s 2021 Analyst Day, the company put out a sensitivity analysis of the number of indexes that MSCI could create by the end of 2030. The historical growth trend had been near +20%, and applying that growth rate going forward would put the number of indexes at 2M by 2030. Even this growth assumption may be too optimistic, given that +20% growth for a long period of time can become astronomical. (Just look at Berkshire Hathaway’s growth in book value over the the past 50+ years.)
But instead of +20% being the bull case or even base case, the company put out assumptions for +30% and +50% growth until 2030, resulting in 3M and 14M indexes by 2030. While this doesn’t actually mean anything in terms of near-term guidance or have a financial impact today, it does show that the management team may be too optimistic for the Index segment.
Optionality
MSCI has done a great job at creating new subscription data offerings for its clients with the investments in ESG and Private Assets. The company was able to do this while maintaining consistent growth in the core Index and Analytics segments as well. Future areas of optionality will likely be new areas that MSCI can become the data partner for its clients. And since being a first mover has many advantages when servicing asset management customers, MSCI’s culture of innovation may allow it to discover these new areas of growth.
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