- MSCI is still reporting high growth in the second quarter of fiscal 2022, but had to lower guidance for fiscal 2022.
- The company has a great business model with recurring revenue, but is probably not very resilient to a recession and bear market.
- Despite declining 25% from previous all-time highs, the stock is still trading for an extremely high valuation multiple and not a good investment.
I published my last article about MSCI Inc. ( MSCI ) when the stock was trading for $660 back in November 2021 and I was quite bearish about MSCI. And not to be too proud of myself, but not only was the article published rather close to the all-time high of $679 – the “Sell” rating was also a good call. I don’t short stocks, but if one would have followed the advice it would have been a good trade as the stock declined about 45% from the all-time high (and about 40% from the time I published my article).
Looking at the past is certainly important, as past performance can give us hints and we can learn from mistakes, but right now we should rather look forward and ask the question if MSCI is cheap enough to be a good investment – after all, it is still trading 25% below its previous all-time high.
Business Description
MSCI was originally founded in 1969 as Capital International and the business became part of Morgan Stanley ( MS ) in 1986 and was spun off again in 2007. Today, the company is a global provider of equity, fixed income, hedge fund stock market indexes and multi-asset portfolio analysis tools with clients being pension funds, asset managers or family offices as well as hedge funds.
The company is reporting in three main segments – Index, Analytics and ESG & Climate:
- Index : this segment provides over 200,000 indexes including equity indexes, custom indexes, factor indexes, real asset indexes or thematic indexes. It is also including ETFs, mutual funds, annuities, futures, options, or structured products.
- Analytics : This segment is offering risk management, performance attribution as well as portfolio management content.
- ESG & Climate : This segment provides products and services that help institutional investors to understand how the environmental, social and governance criteria will impact long-term risks and investment decisions.
Q2 2022 Quarterly Results
Investment decisions certainly won’t be based on quarterly results, as long-term investors never should base investment decisions on just one bit of information (like quarterly earnings). Nevertheless, MSCI is still reporting great quarterly results with high growth rates. Operating revenue increased from $498 million in the same quarter last year to $552 million this quarter – resulting in 10.8% year-over-year growth with organic revenue growth being 8.4%. Operating income increased even 16.6% year-over-year from $258 million in Q2/21 to $300 million in Q2/22. And diluted earnings per share (on a GAAP basis) increased 30.2% from $1.99 in the same quarter last year to $2.59 this quarter.
When looking at the different segments, all contributed to revenue growth but especially “ESG & Climate” (40% YoY growth) and “All Other-Private Assets” (100% YoY growth) contributed the most to revenue growth in relative and absolute numbers.
And while recurring subscription revenues were up 16.9% YoY, asset-based fees were down 2.9% - this is not surprising considering the bear market that led to lower asset prices since the beginning of 2022 and as consequence also to lower asset-based fees for MSCI.
Although quarterly results were still solid, MSCI lowered its guidance a bit for the full year of 2022. Free cash flow is now expected to be between $1,005 million and $1,055 million (instead of $1,050 million to $1,100 million in the previous guidance).
Recession
I claimed above that we should not focus on the results from a single quarter as the validity of results from just a single quarter for long-term investors might be limited. Instead, we have to look at larger timeframes and, in this case, MSCI is reporting high growth rates. Since 2017, MSCI could grow revenue with a CAGR of 11%, adjusted EPS with a CAGR of 22% and free cash flow with a CAGR of 20%.
MSCI August 2022 Investor Presentation
But at this point we should be rather cautious and take into account the negative impact of a potential global (and probably severe) recession in the coming quarters. In case of MSCI we have data from the past two recessions – the Great Financial Crisis and the COVID-19 recession – and when looking at the numbers we hardly saw revenue reacting to those two recessions. Revenue declined in 2012/2013, but the reason was not a recession. When looking at earnings per share the picture is different: EPS (TTM numbers) declined about 10% during 2020 and recovered rather quickly. But following the Great Financial Crisis, earnings per share declined almost 60% and it took until 2013 before EPS reached pre-crisis levels again.
We should be a little cautious about drawing conclusions from the data of only two recessions – especially as the 2020 recession was a rather untypical recession. Nevertheless, I would assume MSCI being hit rather hard by the next potential recession. In my opinion, earnings per share declined only 10% in 2020 as this recession was not going hand-in-hand with a real, long-lasting bear market. MSCI as a financial services company is also reacting to recessions, but it is especially reacting to bear markets. As long as the bull market is alive, MSCI will probably profit.
In an article about Morningstar ( MORN ) published more than a year ago, I describe this in more detail:
In bull markets (especially in the last phase of a bull market, during the euphoria stage), a lot of people are drawn to the stock market that usually don’t care about stocks or investing. And quite naturally, Morningstar is profiting from these trends: higher assets under management, more people needing investment tools, people using Morningstar’s data and/or indexes.
And the same is true for the index and analytics services MSCI is offering. If asset price increase, fees will also increase and as long as the euphoria is ongoing, people will sign up for the services of MSCI. But during a bear market this could change dramatically. In the above-mentioned article, I continued:
But during the following bear markets, many of these new investors are disappointed and stop investing as quickly as they started investing, which is not good for Morningstar.
It is also not good for MSCI, and we can’t really claim the company is resilient to a potential recession. Especially asset prices declining is a huge risk for MSCI as it will lower asset-based fees. Not only will declining stock prices lower fees (as fees are often calculated as a percentage of the value of the assets). A long-lasting bear market will also lead to several investors withdrawing funds lowering assets under management for MSCI and therefore lowering fees as well. In its investor presentation, MSCI is claiming it has resilient AUM growth across market cycles. And it is true that MSCI saw outflows only in one year (in 2013) and no outflows in 2008, 2009 or 2020. Nevertheless, I would be rather cautious if this must be true in coming recessions as well.
MSCI August 2022 Investor Presentation
One might also point out, that only 24% of total revenue are asset-based fees while 74% of total revenue are recurring subscriptions and these subscriptions might be more resilient to a potential recession.
MSCI August 2022 Investor Presentation
However, in a long-lasting bear market I would also assume some investors or institutions to cancel subscriptions. Investment banks might get in trouble and reduce headcount, hedge funds might go out of business, and this will lead to a lower number of people using MSCI’s services.
Intrinsic Value Calculation
MSCI is currently trading for a P/FCF ratio of 47 and a P/E ratio of 52. Even for a company that can continue growing with a high pace, this is a rather high valuation multiple. Extremely high valuation multiples can only be justified by extremely high and long-lasting growth rates. And one might argue that valuation multiples already got lower in the last few quarters as MSCI was trading for 80 times earnings and more than 60 times free cash flow in 2021. But MSCI is still priced for perfection and if growth rates should slow down, valuation multiples will probably decline quickly.
I don’t make final buy or sell decisions based on simple valuation multiples, but when a stock is trading for more than 30 to 40 times earnings or free cash flow, I get rather cautious and above 50, a stock is usually not a buy anymore as the stock is too expensive and the risk of a steep decline as the market is suddenly ascribing a lower valuation multiple to the stock is extremely high. Instead of just looking at simple valuation metrics, we can also calculate an intrinsic value by using a discount cash flow calculation.
When using a DCF calculation it is similar difficult to justify the current stock price. When taking the free cash flow of the last four quarters as basis ($930 million) and assume a 10% discount rate and 6% growth till perpetuity starting in ten years from now, the company must grow its free cash flow 14% annually for the next ten years.
We saw above that MSCI could report higher growth rates than 14% in the last few years – during the last decade, earnings per share increased with a CAGR of 19.96%. MSCI is also optimistic about its long-term growth targets and is expecting adjusted EBITA to grow in the low-to-mid-teens (and this is not including share buybacks, which was also a tool MSCI used in the past.
MSCI August 2022 Investor Presentation
But for the next two or three years we should expect a recession and bear market – especially in the United States – and double-digit growth rates are rather unrealistic. Instead, we should expect a declining free cash flow. There is also a rather high possibility of free cash flow declining much steeper than net income in the coming quarters. In the last few years, we saw free cash flow being higher than net income as subscriptions are usually paid upfront and appear in the cash flow statement right away (but not in the income statement). However, when growth rates should slow down, this trend might reverse. When subscriptions are declining, free cash flow could be lower and taking the current free cash flow as basis might be rather risky.
If we assume for example a 30% decline in free cash flow next year (a realistic scenario), MSCI must grow clearly above 20% for the next decade in order to be fairly valued right now and while I can image MSCI growing with a high pace in the two or three years following a recession, I won’t assume such high growth rates for an entire decade.
Conclusion
In my opinion, MSCI is still overvalued, although the stock is trading about 25% lower than when my last article was published and an investment in MSCI could be rather dangerous in the next few years. It is a realistic scenario that not only earnings per share will decline, but market participants will assign MSCI a much lower valuation multiple (20 to 25 is more than realistic). As a result, the stock could easily be cut in half over the next few quarters. And although the company is clearly a high-quality business that should be able to continue growing with a rather high pace (after a potential recession), it is not an investment I would make right now.
For further details see:
MSCI: No, 50 Times Earnings Is Not A Bargain!