MSCI: it's the valuation, stupid

Most people can name a great business. Coke is one. Disney is awesome too. Defining exactly what makes it great, in business terms, is more difficult. Often this involves ugly buzzwords. Intuitively, however, most people can name some traits of greatness. This may include: a product or service that is highly desired or needed (diamonds, gasoline); one with an advantage due to scale, patents, or brand (Wal-mart, Pfizer, Coke); a business that makes a lot of money while investing little back into it (MSCI. NOT Delta Airlines). We keep things simple.

Not all fabulous businesses are good stocks. Why not? Price.

The high free cash flow generated by MSCI (MXB) through its international investment indices is what makes this business great. If you buy an emerging market index, a bit of the fees you pay goes to MSCI. MXB produces indices and risk and return portfolio analytics for ~3,000 clients with "over 100,000 indices calculated daily and over 3 trillion USD of assets globally benchmarked(1)" to the company's indices. The firm's clients are geographically diverse: 53% of clients in the Americas; 33% Europe, the Middle East and Africa (EMEA); 8% Japan, 6% Asia-Pacific.

It derives just over half of sales through fees tied to investment indices; the other half comes from portfolio analytics--this includes portfolio modeling tools used mostly by institutions. Growth has two stories: the passive index side is growing at 20% plus year-over-year (yoy) while the analytics side is at ~9% yoy.

The business model is compelling given its 90%+ retention rate and a sales model based largely on recurring annual subscriptions. But, what is is worth?

Valuation: what's it worth?

At it's current valuation of $3.3B, MXB is trading at close to 9x sales, 25x forward earnings and 16x book value. Is it worth it? Let us turn to a simply 10-year discounted cash flow (DCF) model.

Let's optimistically include management's mid-teens revenue growth goal coupled with recent FCF yield of 29%. A multiple of 15x cash flow at the end of the forecast period plus the cash flows of years 1-10 discounted at 10% per year, reveal a per share value of $24--a 27% discount to the current price. This of course is an estimate.

Key concerns

• share dilution: 6% increase in share count in 2007

• margin expansion: current free cash flow yield (FCFY) of 29% is almost unheard of; mean reversion would have significant impact on valuation: FCFY of 20% would reduce the per share value by over 30%

• portfolio analytics business (50% of sales) is less protected from competition
  

Some thoughts on management
The use of EBITDA (earnings before interest, taxes, depreciation and amortization) multiples is classic managementspeak (2). Charlie Munger refers to EBITDA as "bullshit earnings". Interest and taxes are a reality. They should not be excluded. Nor should depreciation and amortization (where appropriate). An emphasis on real cash flow, both for reporting and compensation purposes, would be more useful. Avoid bullshit.

Last July MXB paid a special dividend of $973M with $325M of cash, and the rest, you guessed it, was borrowed. With no significant capital expenditures and the operating leverage (ex: sales rise 10%, costs rise by less than 10%) of the business, a dividend is understandable but only if the company can't put that cash to work for a higher return elsewhere. The flexibility of a cleaner balance sheet would be welcomed. Borrowing money in this case was a mistake.

Gold star: the company does not provide quarterly guidance. It's refreshing to see people avoid this bad habit.

So what?
At the current price, MSCI is a great business whose valuation more than fully reflects the quality of the business. It's the valuation, stupid.


Quick Overview
Pricing power: average
Oligopoly: yes
Recurring revenue: yes
Brand strength: strong
ROIC > Cost of capital: yes
Balance sheet: average
Valuation: not attractive, yet.



Notes: (1) MSCI Q4 2007 Earnings Conference Call; (2) MD&A section of 2007 10K
Dislosure: No position in MSCI. If you believe markets are efficient, please disregard this post and invest passively, and in regular increments, into index funds.
Image: http://www.midwestcheerexpo.com/images/clipart/money%20machine.bmp