MSCI Inc. quarterly report, Q3 FY2012

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Business context and reporting period

MSCI Inc. provides investment indices, portfolio risk and performance analytics, ESG products, and governance research and services. It reports two segments: Performance and Risk, and Governance. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2012; comparisons are with the corresponding 2011 periods unless stated otherwise. Amounts below are in U.S. dollars.

Financial results and key metrics

  • Third quarter: Revenue was $235.4 million, up 4.6%; operating income was $83.5 million, up 1.6%; operating margin was 35.5%, versus 36.5%. Net income was $48.3 million, down 3.0%; diluted EPS was $0.39, versus $0.40.
  • First nine months: Revenue was $703.1 million, up 4.2%; operating income was $251.6 million, up 4.7%; operating margin was 35.8%, versus 35.6%. Net income was $129.8 million, up 0.6%; diluted EPS was $1.05, unchanged.
  • Segment revenue, third quarter: Performance and Risk generated $205.4 million, up 4.7%; Governance generated $30.1 million, up 4.4%. For the nine months, segment revenue was $611.1 million, up 4.7%, and $92.0 million, up 1.1%, respectively.
  • Revenue drivers: Third-quarter Index and ESG revenue rose 6.5%, risk analytics rose 5.1%, portfolio analytics fell 3.7%, energy and commodity analytics rose 18.6%, and Governance rose 4.4%. Nine-month growth was led by Index and ESG subscriptions (+13.7%) and risk analytics (+6.7%); energy and commodity analytics fell 39.7%, in part due to a revenue-recognition correction.
  • Cash flow: Nine-month operating cash flow was $287.7 million, versus $174.9 million. Investing activities provided $8.6 million, compared with $86.6 million used in 2011; financing activities used $210.9 million, versus $134.4 million. Capital expenditures were $38.1 million. Cash and cash equivalents increased $88.2 million to $340.5 million.
  • Liquidity and debt: Cash plus short-term investments totaled $434.3 million at September 30, 2012. Debt carrying value was approximately $865.5 million, including current maturities. The term loan bore interest at 2.47%; the $100 million revolving facility was available under the credit agreement. Leverage and interest coverage ratios were 1.88x and 11.56x, within covenant limits of 3.25x maximum and 5.00x minimum.
  • Other balance-sheet items: Total assets were $3.05 billion, down from $3.09 billion at year-end 2011; shareholders’ equity was $1.47 billion, up from $1.31 billion. Goodwill was $1.71 billion, with no impairment recorded.

Material changes versus prior periods

  • Quarterly revenue growth did not translate into higher net income: operating expenses rose 6.4%, led by a 17.2% increase in SG&A, including higher staffing and severance costs. The effective tax rate increased to 36.1% from 29.2%.
  • Nine-month operating cash flow increased substantially, primarily reflecting improved billings and collections and the timing of lease payments. The company also received a $6.5 million lease inducement.
  • On May 4, 2012, MSCI refinanced its debt with an $880 million term loan and a $100 million revolver, both maturing in May 2017. Debt was reduced from the year-end 2011 balance, but refinancing-related costs contributed to higher nine-month interest expense.
  • Aggregate retention was 90.0% for the quarter, versus 91.3% a year earlier; nine-month retention was 91.3%, versus 91.6%. Quarterly Run Rate was $915.0 million, up 4.4% year over year but down 0.5% sequentially.

Outlook, commentary, risks and unusual items

  • MSCI provided no specific financial guidance. Management said it expects operating expenses over time to grow more slowly than revenue, while noting it may prioritize investment in growth opportunities. Management believed domestic and foreign liquidity would be adequate for operating needs and commitments for at least the next 12 months.
  • On October 2, 2012, Vanguard announced it would change the benchmarks for 22 ETFs. MSCI excluded the associated $131.1 billion of assets from its September 30 asset-based fee Run Rate, reducing that Run Rate by $24.4 million. This post-quarter development presents a revenue risk.
  • On October 30, MSCI agreed to acquire IPD Group Limited for approximately £77.9 million, expected to close in the quarter ending December 31, 2012 and to be funded with existing cash, subject to customary conditions. MSCI had incurred about $1.3 million in transaction costs. IPD’s reported revenue was approximately $26.4 million for the six months ended June 30, 2012 and $47.7 million for 2011.
  • MSCI recorded a one-time $5.2 million cumulative revenue reduction in the first quarter to correct prior energy and commodity license revenue recognition. The company said the error was not material to previously reported results and did not restate them; going forward, applicable license fees are recognized over the contract term.
  • Occupancy costs increased as MSCI moved into its new 7 World Trade Center headquarters and Rockville offices. It recorded a $3.3 million charge for vacating 88 Pine Street. The 7 World Trade Center lease runs initially to 2033, with approximately $170.1 million aggregate rent over its term.
  • Risk factors include dependence on third-party data and delivery systems, competition, market-sensitive index asset-based fees, foreign exchange exposure, and regulatory uncertainty around indices and proxy advisers. MSCI disclosed that it received a September 14 SEC staff Wells Notice concerning allegations that an ISS employee disclosed confidential proxy-voting information to proxy solicitors in exchange for cash and gifts; the filing does not report a final determination.
  • The company was under tax examinations in multiple jurisdictions and had an $8.4 million reserve related to its potential indemnification of Morgan Stanley for a New York tax settlement. Management said it could not reasonably estimate the potential change in unrecognized tax benefits over the next 12 months. Management did not expect currently pending legal matters to have a material effect, while acknowledging uncertainty.
  • Controls and procedures were assessed as effective, with no material changes to internal control over financial reporting reported during the quarter. The independent accountant performed an interim review, not an audit.

Important facts for investors to verify

  1. Track the realized revenue impact and client transition timing of Vanguard’s benchmark changes, and confirm the continuing effect on asset-based fee Run Rate.
  2. Review retention trends by product, particularly the declines in risk, portfolio, and energy and commodity analytics retention.
  3. Assess the SEC Wells Notice matter, related compliance actions, and any regulatory or client consequences for ISS.
  4. Monitor the IPD acquisition’s closing, cash funding, integration costs, and contribution to revenue and profitability.
  5. Reconcile ongoing cash generation and debt repayment with refinancing costs, floating-rate exposure, lease commitments, and covenant headroom.
  6. Review the $5.2 million revenue correction and its ongoing effect on energy and commodity revenue comparability, as well as open tax examinations and reserves.