“Free enterprise has undergone tectonic shifts before, especially as large numbers of people moved from farms to factories in the 19th century and from factories to offices in the 20th century. These earlier shifts brought about fundamental changes in the nature of work and economic progress. The same thing is happening today. MSCI’s business strategy can help us navigate and shape this new landscape. Our mission is to power better investment decisions for a better world: a more prosperous, more thriving, more sustainable world. This mission informs and inspires our efforts on climate and ESG. We see the evolution of free enterprise as a huge opportunity for companies and investors. But seizing the opportunity will require innovative tools, models and data. MSCI can provide them.”
-Henry A. Fernandez, MSCI CEO
MSCI is a company with a lot of moving parts. In simple terms, MSCI provides tools and solutions to the investment world through indexes, portfolio construction & assets allocation models, ESG (a segment growing at over 30% per annum over the past two years), analytics and more. MSCI reports revenue in four segments - index (~61% of 2021 revenue), analytics (27% of revenue), ESG & Climate (8% of revenue), and All Other - Private Assets (4% of revenue).
However, this write-up won't focus on explaining the various segments. Because there are so many different parts of the business to consider, let's instead focus on the overall financial performance of MSCI, the numbers and the valuation. This will help us understand why MSCI has compounded at 30.4% annually over the past decade - and why it is valued at a multiple which assumes rapid growth in the coming years as well.
Revenue, Free Cash Flow & FCF per Share
Since 2012, MSCI has compounded revenue and free cash flow at 9.5% and 11.7% annually, respectively. These numbers are good - but maybe not as great as you would expect from a company which has delivered such extraordinary stock price returns over the same time frame. However, there is more to the story.
MSCI has been buying back stock pretty aggressively since the share count peaked in 2012. To illustrate, free cash flow per share has delivered a 16.2% CAGR over the past decade. The numbers are similar between 2008 and today despite the 70% decrease during the global financial crisis. Since 2013, MSCI has decreased the number of shares outstanding by 34%.
I think shareholders can appreciate the opportunistic nature of the buybacks. When MSCI was arguably overvalued in 2021 (along with many others), management slowed the buybacks notably. In the third quarter of 2022, MSCI bought back more shares than it did during all of 2021. Even though you can still argue that the valuation is steep, at least it seems like management likes its stock at these prices.
(FWIW, stock-based compensation is not accounted for in the free cash flow per share numbers. SBC was ~3% of total revenues in both 2012 and 2021).
Another way to look at free cash flow is the cash conversion ratio - how much of the profits that is actually turned into cash. Some investors use EBITDA instead of net income as a way of measuring profits but net income is the more conservative approach.
MSCI’s numbers are pretty impressive and to the benefit of shareholders as MSCI mostly allocates this money to dividends and buybacks. As can be seen below, one of the reasons free cash flows are consistently higher than net income is the deferred revenue. Most of MSCI’s revenues are recurring based on subscriptions and fees from AUM (assets under management) where clients typically pay in advance of the subscription period. Per company numbers, 97% of MSCI’s revenue is recurring, and the retention rate on this subscription based business was ~94% in each of the past three years. In my opinion, the high cash conversion speaks to the quality of MSCI's earnings.
Return on Capital Employed
Prior to about 2018, MSCI’s return on capital averaged between 12-14%. Along with the index revolution (generating asset-based fees and index subscription revenue) and the global ESG push, returns have about doubled in the last few years. In my opinion, management is justified for increasing the amount of debt when it is able to create more value for shareholders by investing in attractive projects.
If you like the financial numbers from MSCI, you probably won’t like this section so much. Investors are pricing in high free cash flow growth in the future as well, and even though it is perfectly reasonable to believe that MSCI can pull it off, there doesn’t seem to be a lot of room for error (“margin of safety”).
Some of the assumptions below could be off (I’m a rookie at DCFs/inverse DCFs), but the main takeaway is that the implied free cash flow growth at the current price is 22-23% CAGR over the next five years (almost 2.8x from $1.3B to $3.6B). If we assume that MSCI will continue to buy back shares at a similar pace, implied FCF growth is closer to 20%. Regardless - MSCI’s execution is expected to be flawless at the current valuation.
I think it is hard not to be impressed by MSCI’s financial performance. Given the industry tailwinds, the diversified products MSCI provides to a growing list of clients with more assets under management and increased need for a variety of investment products, this is only likely to continue. The question investors have to ask themselves is what price they are willing to pay for the quality MSCI offers. I remain on the sidelines for now in hopes of Mr. Market offering a more attractive price at some point.
Thanks for reading!