2023-05-07 05:10:59 ET
Summary
- MSCI reported mixed Q1-23 results, as revenues missed slightly and grew by a mere 5.8%, whereas EPS beat expectations and increased by 6.4%.
- Index revenues grew by 2.6%, Analytics revenues grew by 5.2%, ESG & Climate increased by 28.9%, and Private Assets grew by 3.6%.
- Prior to the results, MSCI stock traded at a very rich valuation, which reflected impossible expectations. After a 13.3% selloff, the stock is trading close to my fair value estimation.
- Despite reaching a more reasonable territory, I am worried about increased competition, as the company's major growth engines are businesses with much lower margins.
- I decrease my long-term projections and reiterate a Hold rating with a fair value estimate of $447.4 per share.
MSCI Inc. ( MSCI ) reported mixed Q1-23 results, as revenues missed slightly and grew by a mere 5.8%, whereas EPS beat expectations and increased by 6.4%. On the positive side, the company's subscription run rate grew by 12.0% and amounts to $2.4B as of the end of the quarter. On the negative side, management discussed longer sale cycles and tightened client budgets.
While MSCI should see growth accelerate as the market rebounds, I find the company's non-index businesses to be inferior in terms of a competitive moat. With its peers trading at much lower valuations, I reiterate a Hold rating and decrease my fair value estimate to $447.4 per share.
Background
A little over a month ago, I published an article covering MSCI and rated the stock a Hold, as I estimated it traded 12.0% above its fair value, and expected an inevitable drawdown due to a rich valuation that reflected impossible expectations.
I urge you to read that article, in which I explained my investment thesis in detail, as well as the company's operating segments, revenue streams, risks, and competitors. Moreover, I explained the strength of its index business, which I find to be the most attractive business of the company.
In short, my investment thesis regarding the company is based on it being the second-largest player in the index business behind S&P Global ( SPGI ), a business that I find as having a very wide moat. Additionally, the fact that most of the company's products and services are sold to large enterprises through recurring fee arrangements provides very high certainty regarding MSCI's revenues, and its ability to provide steady revenue growth. Overall, I find MSCI one of the best positions to capitalize on the global long-term wealth accumulation trend.
Regarding valuation, I showed that MSCI traded at a significant premium compared to its competitors and estimated there was no room for reasonable upside at those levels. Additionally, I discussed increased competition as a major risk for MSCI, and warned of possible dilution of the company's quality, as its non-index segments operate in highly competitive landscapes.
After a 13.3% post-earnings selloff, it's time to focus on the company's results and provide an updated analysis. Spoiler alert: As the company still trades at a premium, and the risks I discussed materialize, I reiterate a Hold rating and lower my price target.
Q1-23 Highlights
MSCI reported consolidated revenues of $592M, a 5.8% increase from the prior year period. Based on its historical seasonality, the group is on pace to deliver 9.0% revenue growth for the entire year. I'm disappointed to see the company is on pace to miss my initial $2,535M sales estimate (12.7% growth) expectation, which means it's on pace to miss the initial consensus expectations as well.
As we can see, growth was low across all segments except ESG & Climate. Index revenues grew by 2.6%, Analytics grew by 5.2%, ESG & Climate grew by 28.9%, and All Other - Private Assets grew by 3.6%. Every segment experienced headwinds. Index saw linked AUM decrease by 6%, and all the other segments experienced longer sale cycles and pushback from tightened customer budgets. If the markets continue to trend upward, we might see growth acceleration in the company's index business, however, there's some lagging effect there, and clearly, we can't foresee how the markets will perform in the near term.
Looking at Adj. EBITDA per segment, we see a more positive picture, as margins increased all across the board. Index Adj. EBITDA increased by 3.2%, reflecting a 40-bps expansion. Analytics Adj. EBITDA grew by 19.4%, with a 4.9 percentage point margin increase. ESG & Climate Adj. EBITDA grew by 47.8%, reflecting a 3.5 percentage point expansion, and All Other - Private Assets Adj. EBITDA grew by 27.9%, with a 6.1 percentage point expansion. On a consolidated basis, Adj. EBITDA grew by 8.2%, and Adj. EBITDA margin increased by 1.3 percentage points.
Despite the aforementioned headwinds, the company's run rate continues to expand, with 7% growth on a consolidated level. As we can see, ESG & Climate is clearly the fastest-growing segment and is projected to become a significant portion of the group in the mid-term. That said, ESG & Climate growth is slowing down, as we'll discuss in the next section.
Looking at the balance sheet, MSCI is very reasonably leveraged, with a BBB- rating from S&P Global, and most of its debt maturing not before 2029.
Important Notes From The Call
The first point I will address is the slowdown in ESG & Climate, which grew by 37.7% in 2022, and slowed to 27.9% in the first quarter. In my previous article, I wrote the following about the segment:
All over the world regulators and journalists are putting pressure on asset managers to include ESG and Climate considerations in their decision-making process. Whether you think it's right or not, MSCI's ESG and Climate segment's EBITDA doubled in 2022, and it's projected to grow at a mid-to-high-20s pace for the foreseeable future.
Well, the problem with demand that is induced by regulation, is that a change in the regulatory environment could cause a sudden change in demand. Without getting into politics, MSCI is seeing a slowdown in institutional demand in the U.S., due to political and geopolitical changes, as Congress is putting less focus on ESG at the moment, during the ongoing discussions on the debt ceiling. Speaking honestly, a lot of institutional clients wouldn't be clients of the ESG segment without the regulatory pressure, and when this pressure eases for a period, a drop in demand follows.
Additionally, in another important ESG market for the company, which is Europe, regulators are putting increased scrutiny on what would be considered an ESG fund and what wouldn't, and as those definitions remain uncertain, it's retail demand that is experiencing a downtrend.
The second point I want to address is the tougher economic environment, especially due to the regional banking crisis, which also provided downward pressure on growth.
The banking crisis per se, it doesn’t have a huge direct effect on us because it has been concentrated in some of the smaller banks, obviously, with the exception of Credit Suisse, which was already in difficulties. The bigger banks, which are our clients are extremely well capitalized, they are extremely regulated, so we’re not as concerned about them. But I think the overall banking crisis does add to the stress in the overall financial system. It adds to uncertainty. It will add to cautiousness and a little bit of risk aversion. So that’s likely to add one more variable to the environment that we have depicted here. We remain pretty – with respect to our pipeline and sales, it remains pretty solid. It remains pretty healthy with a caveat that the larger deals have slowed down what we call the big-ticket items have slowed down. Secondly, the sales cycles are longer and maybe there is a little bit of pickup in cancellations . But we’re not looking into the near future and thinking that we have a big problem coming our way.
--- Henry Fernandez - Chairman and Chief Executive Officer, Q1-23 Call
Is MSCI Diluting Its Competitive Moat?
Overall, it seems the first quarter combined many headwinds on a wide range of fronts for MSCI, which was expected. Thus, the price the company was trading at had to be cut off by the market eventually. The question now is, should we exploit this selloff, and while in my previous article I estimated the company's fair value marginally above where it is right now, I have some new concerns.
In my previous article, I described why I found interest in MSCI. The reason wasn't its ESG & Climate businesses, and it wasn't its Analytics or Private Assets businesses either. Actually, I found all of those dilutive to the company's main attraction point, which is its Index business. In the past, I found those too dilutive to consider investing in MSCI. However, I began to understand the need for additional, recurring revenue streams, with less sensitivity to market fluctuations. Moreover, I am able to see the competitive advantage MSCI has with those businesses and do believe they are accretive to its overall value.
In simple words, I believe that without the non-index businesses, MSCI would be trading at higher multiples, but would worth less. As I found that only 42% of MSCI's revenues, and only 26% of its Adj. EBITDA come from what I find as less attractive businesses, I considered the company as a potential investment.
However, looking at the Q1-23 results, I realized two major concerns. One, is that over time, the Index business is going to lose share to the faster-growing non-index segments and at a sharper rate than what I initially thought. Two, and more importantly, is that while the non-index businesses are only 42% of total revenues, they make 67% of the company's recurring run rate, and that's a much more significant part.
My problem with the non-index businesses, in short, is that they are highly competitive and with much lower switching costs. This is best reflected by the significantly lower margins of those segments. In my previous article, I shared my personal experience as a financial analyst in a large financial institution in Israel, which became a customer of MSCI's ESG data platform. Well, the way it works is that at the end of every year, our company takes offers from many companies which provide essentially the same solution. We have Moody's ( MCO ), FactSet ( FDS ), S&P Global, and many more.
While large enterprises do prefer stability and don't seek to transition from platform to platform every year, I don't find enough differentiation with MSCI's non-index segments to provide sufficient pricing power. Thus, I estimate the non-index segments lack a competitive advantage.
Updated Financial Model
I used a discounted cash flow methodology to evaluate MSCI's fair value. I assume the company will grow revenues at a CAGR of 9.3% between 2023-2030, which is according to the company's long-term growth targets. I believe revenues will grow at that pace due to high growth in AUM linked to existing indexes, as well as the continued introduction of new offerings. Additionally, I expect exponential growth in ESG and Climate, as regulatory pressures recover. Lastly, I project Analytics and All Other to continue to grow according to the management's guidance.
I project MSCI's EBITDA margins to increase incrementally up to 60.1%, slightly above the management's long-term target of the high 50s. I find management's guidance to be overly conservative, as most of its products leverage economies of scale and the company is already maintaining a 58.9% EBITDA margin.
The management is guiding for operational leverage, as it projects double-digit consolidated revenue growth and lower EBITDA expense growth. Thus, I see no reason why the company's EBITDA margin, which stood at 58.9% in 2022, won't increase at least by 1.2 percentage points in the mid-term. It's true that in the short term, the lower-margin ESG & Climate segment should outpace the growth of the higher-margin Index segment, but in the long term, I believe the Index segment will remain a significant source of the company's revenues.
Overall, I slightly lowered my long-term growth assumption and the terminal EBITDA margin, due to the reasons explained in the previous section.
Taking a WACC of 7.6%, I estimate MSCI's fair value at $35.8B or $447.4 per share, which represents an additional 5.5% downside compared to its market value at the time of writing. My valuation represents a 37.5 P/E multiple on 2023 earnings, which is 17.4% below the company's 5-year average forward P/E of 45.3. However, I estimate the company's multiple will contract over time.
Despite being a very high-quality company, MSCI is still too expensive for me at current levels. MSCI will remain on my watchlist until I find it to be at least fairly valued.
Conclusion
More often than not, we see high-quality companies like MSCI trading for rich valuations, with immense optimism baked in the price. For me, I don't mind buying at what is an objectively high multiple, as exceptional quality doesn't come cheap, and I seek to invest in companies for the very long term. However, even after the recent selloff, MSCI is still too rich even for my taste. I am concerned about higher competition, and lower margins, which will lead to a multiple contraction, a trend that has already begun. While there are some potential triggers for growth reacceleration, I think that at current prices, there's very limited upside (if any), and very low margin of safety. Therefore, I reiterate MSCI a Hold.
For further details see:
MSCI: Not Enough Upside Even After The Post-Earnings Selloff