Is MSCI Inc a Good Way to Profit From the Rise of Index Investing?

Recently, I found out that MSCI Inc (NYSE: MSCI) is a listed company. That got me really excited.

MSCI is one of the major index providers in the world. It formulates and provides indexes – such as the MSCI World index and the MSCI US equity – to financial institutions. In total there are more than 1,200 ETFs (exchange-traded funds) that track MSCI indexes. As of 31 December 2019, there was a mind-boggling US$934 billion in assets under management that are benchmarked to MSCI indexes.

With the rise of passive investing, I believe that index providers stand to benefit the most. Index providers such as MSCI collect a small cut of every dollar invested in an ETF that tracks its index. That’s a great business model and one that will likely continue to grow as more money flows into index-tracking ETFs. In addition, MSCI also offers other subscription services that recur each year.

Steady track record of growth

Passive investing has been on the rise for years now. So its no surprise to see that MSCI has been growing steadily along with the broader industry.

From 2015 to 2019, operating revenue increased at a decent clip of 7.7% per year. Operating income ticked up by 13% annually, while the company’s dividend increased by 25% a year.

The chart below illustrates the company’s sales growth over the last five years.

Fat margins

But what makes MSCI a truly solid business is its fat profit margin. In 2019, the index provider earned net income after taxes of US$563 million from revenue of US$1.56 billion. That translates to a healthy net profit margin after tax of 36%.

It achieved this partly because of its low cost-of-revenue, as its gross margin was around 81% for the year. This is a margin that investors usually associate with software-as-a-service companies.

MSCI’s high profit margin means that the company can afford to spend more money expanding its business, as more of that top-line growth filters down to the bottom line.

Recurring business

If you’ve read this blog before, you would know that one of the six main factors that Ser Jing and I look out for in companies is recurring revenue. Businesses that have recurring revenue can focus their efforts on winning new clients and developing other areas of the business.

MSCI is an example of a business that ticks this box. The index provider offers recurring subscriptions to clients under renewable contracts. Recurring subscription revenue made up 75% of MSCI’s total revenue in 2019. 

In addition, asset-based fees, which includes the fees it charges ETFs for tracking any of its MSCI indexes, made up 23% of revenue.

Both these sources of revenue will likely recur year after year.

Another important metric to note is the retention rate. The retention rate is the percentage of clients that renew existing contracts with MSCI. MSCI boasted a retention rate of 94.7% as of the end of 2019. Impressively, the company’s retention rate has been above 90% in recent history, highlighting the crucial role that MSCI plays for its clients.

Steady cash flow

MSCI’s cash flow has also grown along with its profits. The company generated US$709.5 million in cash from operations in 2019. Its business requires very little capital expenditures, which was only around US$33 million. 

That means most of the cash generated from the business is in the form of free cash flow that can be returned to shareholders or used to buy back shares.

A black mark?

There are many things I like about MSCI as a business. However, one negative is that the company has been, in my opinion, too aggressive in rewarding shareholders. This is causing its balance sheet to weaken.

MSCI spent US$949.9 million and US$292 million buying back its own shares in 2018 and 2019, respectively. In addition, it paid US$170.9 million and US$222.9 million as dividends in those years. Together, this is more than the cash the company generated from operations.

It’s great that MSCI is returning money to shareholders, but I think it is a little too aggressive.

MSCI took on an additional US$1 billion in debt last year, partly because it spent so much on repurchasing shares. It now has US$1.5 billion in cash and US$3 billion in debt. While its net debt position is still manageable, I prefer management to be more cautious and not take on so much debt.

Closing thoughts

MSCI is a company that has many merits. It boasts recurring revenue and is one of the leaders in a growing market. On top of that, MSCI generates copious amounts of cash flow, has a fat profit margin, and is a very capital-light business, meaning it can grow without burning a hole in its pocket.

However, there are some risks to note such as its heavily leveraged balance sheet. From a potential investor’s standpoint, I can forgive management for taking an aggressive approach to maximising shareholder value, given its recurring revenues. However, if management is not careful and continues to be overly aggressive by taking on too much debt in the future, I may have to change my view on the company.

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