Friday, December 4, 2015

Analysis: McGraw-Hill Financial (MHFI)

Basic info.
Stock Price: $97.00 (12/4/2015)
Market Cap: $26.2 billion
Net Debt: $2.75 billion
EV: $29 billion
TTM Revenue: $5.229 billion
TTM EBIT (adj.): $1.9 billion (including 27% interest payment to CME Group in DJ Indices)
Capital needs: very low, ~ $100m (<2% of sales)

About McGraw-Hill Financial (MHFI)
MHFI was created in May 2013 after the sale of McGraw-Hill Education to Apollo Global Management, LLC for $2.4 billion (after-tax gain of $589m). The origins of the company date back to 1888 when James McGraw purchased American Journal of Railway Appliances and other publications.

The current company has multiple segments, all being "benchmark businesses" in the financial services sector. The businesses include:

S&P Ratings: Considered one the big "two" credit rating agency's (CRA) along with Moody's Corp. (MCO), S&P has about 40% market share in the U.S. (MCO has ~40%, Fitch as ~10%). Currently, S&P Ratings makes up ~44% of total MHFI revenues, but due to the high margins of 47-50%, is about 50% of total MHFI operating income.

S&P Capital IQ/ SNL Kagan: Capital IQ was founded in 1999 and sold to McGraw-Hill in 2004. Through organic growth and acquisitions, became "S&P Capital IQ" in 2010. A data, analytics, research business with market segments including investment management, financial institutions, banking, PE, corporations, and wealth management. Currently is 27% of total sales but is the lowest margin segment of MHFI with ~24%.

S&P DJ Indices: Over 115 years of experience, most known for the "S&P" business, whereby the benchmark S&P 500 is the world's most followed stock market index with > $5.7 trillion in benchmark assets. Formed a JV with the CME Group in 2012, with MHFI owning 73% and CME owning 27%. Currently 11.8% of total sales and growing due to strong inflows to passive investing and indexing, and has exhibited continued margin improvement to a current 67.9% margin.

Platts: A leadng provider of benchmark price assessments, news, analysis with over 12,000 daily price assessments. Platts' Brent price assessment is the benchmark for >60% of the world's crude oil. Platts is bundled into the C&C segment, which will likely change soon with the potential sale of JD Power. C&C has exhibited strong margin growth.

Investment story for MHFI:
The thesis for MHFI has multiple different aspects considering the different business lines; however, the overall story boils down to:

  • Margin expansion of total MHFI: Over the last 3 years, MHFI has taken steps to improve its margin. Some of the initiatives include:
    • 8/2013 - Sold Aviation Week (C&C segment; ~ $50m- $60m sales) to focus on faster growth and higher margin segments
    • 6/2014 - sold data center to QTS for net proceeds of $58m
    • 2013 - reduced staff by 520 people in Ratings
    • 7/2014 - sold corporate airplane to Terry McGraw III for $20m
    • 11/2014 - sold McGraw-Hill Construction for $320m (had ~ $170m revenue)
    • 2014  - reduced staff by 590 people
    • 7/2015 - moved from high-rent 1221 Avenue of the Americas (midtown, NYC) to 55 Waters Street (lower Manhattan)

  • Margin gap catch-up to Moody's CRA: the Ratings business historically lagged its primary competitor, Moody's (MCO). However, since Doug Peterson became CEO in late-2013, he has focused heavily on narrowing the margin gap, despite about 11% of the ratings business revenue is from CRISIL (Indian CRA), which has lower margins than "core" ratings businesses. The most recent quarter (Q3/2015) is the first time MHFI has had similar/better margins than MCO, both being 46-47%. Some of the predominant reasons for margin expansion include: lower legal expenses, which were heightened post-financial crisis, the adjustment of the compensation incentives to employees, restructuring in 2013/2014 where there was a reduction of 590 people in 2014 and 520 in 2013. 

  • Margin expansion of Capital IQ/SNL Kagan: Capital IQ was already in the process of expanding its margins, going from an investment phase in Q4/13 to Q2/2014. Capital IQ was on track for managements long-term goal of mid-20% margins. SNL Kagan is currently temporarily underperforming from a margin standpoint due to investments made recently, which have created a 5-6% headwind, compared to the "core/existing businesses", which have margins in the low 30%. In aggregate, SNL Kagan's margin is in the mid-20%. Through to 2019, MHFI expects $70m EBITDA benefit from the acquisition, which is split 50/50 between cost/revenue synergies. 

  • Revenue growth leads to strong operating leverage. One of the primary reasons MHFI justified the SNL Kagan acquisition price was the fact that 91% of SNL's sales are domestic. From 2010 to the end of 2014, revenues increase by 47.7%, yet adjusted operating profit grew 63.3%. Furthermore, MHFI is targeting $70m EBITDA synergies by 2019 for the SNL Financial acquisition. 
  • Ability to boost FCF per share by increasing the share buyback due to minimal reinvestment and working capital requirements, low asset intensity, and solid free cash flow generation. Looking at the table below, look at the "capital expenditures" line item and how little it has changed since 2010. Futhermore, MHFI is expecting a total of $100m in capital expenditures in 2015. In reality, most of the reinvestment comes in (a) hiring people and paying them adequately, (b) acquiring tuck-in businesses to compliment S&P Ratings, CapIQ, or Platts, or (c) reinvesting by expanding offices in international markets. Thus, there is little actual tangible capital needed. As the capital markets grow globally, most of the reinvestment will be in hiring more people who understand these international markets and the businesses/products looking for a credit rating, or in the boosting up of technology to continue to provide better information - ratings, data, research, capabilities - for the customers. With about $1 billion in FCF in 2014 and an estimated $1.1 billion (after adjusting for the hopeful one-time legal settlement), after paying shareholders a dividend of ~$350 million in 2015, MHFI could potentially repurchase about $700-$900 million worth of stock in the next 12 months, roughly 3%, without any additional leverage. Current gross leverage is ~ 2.2x, or net debt leverage about 1.40x. This is actually much higher because it only includes a month of SNL Kagan. 

Overview of the Businesses: S&P Ratings
(44% of sales, high-40% margin)

What they provide:
S&P Ratings plays a vital role in the financing markets by bringing transparency and comparability of businesses and products through the use of a ratings process. As companies, municipalities, governments, banks look to raise money, they often look to investors as a means of raising the capital needed. Due to the vast amount of debt needed and issued - across issuance types, asset classes, and geographies - it is substantially easier to compare the credit risk of issuers with the help of a ratings system. In many ways, the ratings provided by S&P (and Moody's) is akin to a currency, whereby without a credit rating by MHFI and MCO, investors would likely avoid participating in the debt or they would have difficulty comparing the riskiness to other issues. As of the end of 2014, S&P Ratings rates more than $47 trillion of global debt and has approximately 1.2 million ratings outstanding.

How they make money:
Although it can ebb and flow, most of the revenue S&P Ratings generates is through annual "credit evaluating and monitoring" programs, which ranges from 50-60% of revenue. The variability of recurring revenue depends on the strength of new issuance in the credit markets, which S&P Ratings earns revenue for providing a credit rating to a 'new bond issuance'. As the recurring revenue largely depends on the total amount of bonds/debt outstanding, which would increase each year as long as the amount of maturities/refinancing/bonds called without additional re-issuance and the amount of newly issued debt. It is almost certain that corporate bond debt in the U.S. will increase each year due to (a) revenues in aggregate growing, thus increase operating income, which enhances the ability to service debt through interest payments, (b) ratings are based on an issuers ability to service the debt, and if the aggregate corporate revenues increase without commensurately increasing debt outstanding, the issuers are not optimizing their cost of capital as they become under-leveraged eventually. (c) even in 2008/2009 there was net new issuance in corporate bonds.

What makes it an attractive business
  • The competitive position they have as ~ 40% of total ratings are done by MHFI (~40% share for MCO)
  • Product necessity: the necessity for issuers of bonds to have an "S&P Rating" assigned to their debt in order to investors to consider it
  • The network effects - commonplace for investors to cross-check the rating of one issuer with the rating of another to compare credit risk ("comparability")
  • Cost vs. Benefit of product: The revenue earned for a new issue is often a small fraction of the benefits from having an S&P Rating. Although I have yet to confirm this, MCO charges 6 bps for an investment grade bond new issue (high yield is higher but undisclosed for competitive reasons) but the benefits often could save the issuer 30-60 bps on the interest rate of new debt. 
  • Pricing power: the duopolistic landscape + low cost for their product compared to the benefit + need to have the product = pricing power of 3-4% per year
  • Low capital needs: physical capital expenditures are roughly $30- $40m per year, showing very little signs of any increases over the last 5+ years. Compare this to $2.5 billion in revenue over the last 12 months, the capital needs are currently 1.2% of sales and will likely decline as a percentage of sales over time.
  • High ROIC: As of the end of 2014, a total of $624 million of tangible assets had been invested in S&P Ratings. This generated about $1.08 billion of pre-tax FCFF, a staggering 173% return on average tangible assets. As S&P Ratings requires very little tangible assets, and as they focus intensely on the margins of the segment, ROIC should only improve in the future, as long as they maintain their competitive position (which they should). 
  • High recurring revenue: 50-60% of the quarterly revenue is subscription based, as issuers continue to utilize MHFI's monitoring services to keep their credit rating up-to-date.
  • High margins: high-40% operating margins with the potential for improvement if new issuance improves

What makes it an unattractive business
  • Reputation-sensitive: While I believe the financial crisis and issues with the inaccuracies and lack of forward-thinking by the CRA's did impact their reputation, it has yet to truly impact their financial performance. Issuer's currently still need a credit rating, and there really are only two dominant global CRAs - S&P and Moody's. However, the crisis did increase the opportunity for government regulation to promote competitiveness in the ratings business. 
  • Government regulation: there is constant monitoring by the SEC in the U.S. as well as in Europe with the CRA III. Over the last 10 years, and specifically since the financial crisis in 2008/9, government regulation has intensified for the CRAs. In the U.S. there is a heightened focus on "conflicts of interest" and in Europe there is strong desire to promote competition among the CRAs to limit dominant players.
    • U.S.: In 1975 the SEC adopted the term NRSRO (Nationally Recognized Statistical Rating Organization) Link. Currently, there are 10 of these in the U.S., The term is important because they are monitored by the SEC, which in turn can actually be a barrier-to-entry for potential new CRAs. In 2006 Congress passed the Credit Rating Agency Reform Act to determine which CRAs qualify as NRSRO's, and the ability to regulate them. Dodd-Frank and the Consumer Protection Act enhanced the SEC's enforcement mechanisms Link. One of the primary focuses was on potential conflicts, such that a credit rating may be more lenient for repeat issuers/large issuers or may promise a good credit rating if an issuer was "shopping around". What ensued was a study into the methodologies for how the CRAs get paid - a % of the bond when newly issued, and a much smaller percentage annually for monitoring, all to be paid by the issuer (not investors). They have yet to come up with a better method for paying the CRAs to this day.
    • Europe: Europe is more focused on increasing competition among the CRA's. For example, they strongly encourage new issuers to consider smaller CRA's to get a credit rating. They don't need to use them, per say, but just there was at least an inquiry and attempt to use the smaller players. By looking at an updated list of the registered CRAs in Europe, you'll notice there are at least 2-3x more CRA's than in the U.S. Link
  • Dependency + Higher Margins on New Issues (Cyclical): Still, about 40-50% of S&P Ratings revenue is transaction based. Looking at recurring vs. transaction revenue, the growth year-over-year, and the margins, S&P Ratings is still quite dependent on the strength of new bond issuance. For example, despite 8-9% recurring revenue growth in Q4/2013 and Q1/2014, a 12% decline in Q4/2013 and 7.2% decline in Q1/2014 in transaction revenue caused the segment to have declines in operating income. In Q4/2013 it was more pronounced as EBIT declined 13.4%. In more recent quarters, despite the slowing down of transaction revenue, it is still apparent that the ability to sustain operating leverage and margin expansion is during strong new issuance periods. Furthermore, the dependency is mostly on corporate bond new issuance, with 51% of 2014 revenues coming from corporations. 
    Recent slowdown in transaction revenue having less impact on EBIT growth & margins. I believe this disconnect is somewhat misleading due to MHFI's large restructuring initiatives in the segment helping prop up margins. Keep in mind pricing is higher for new issues versus "annual credit monitoring" fees.
Appears that when new issuance declines (recurring revenue as % of total increases) then margins are lower.

Industry overview
The CRA industry is largely dominated by Moody's and S&P - which both have about equal market share - and rate ~80% of the market. Currently, there are 10 NSRSO's in the U.S. (see picture).  According to the SEC, only Moody's, S&P, and Fitch are considered the large NSRSO's.Link Pg. 7 In 2013, according to the SEC, there were 2.437 million outstanding ratings in the U.S.. Of these, S&P rated 46%, Moody's rated 37%, and Fitch rated 13.4%. The remaining CRA's had a total 3.6% of the ratings outstanding. The U.S. market is a duopoly for all types of issuers except the ratings of insurance company's, in which A.M. Best issued about 24.2% of the ratings outstanding, exceeding both MCO and MHFI.

The sustained market share leadership by MCO, MHFI and Fitch has seen very little change, even since the financial crisis, in total ratings in the U.S. However, the structured market has shown some market share leakage in recent years as other players - DBRS, Kroll, and Morningstar - fight to gain positioning in the issuance of financial institutions and ABS. (see 'competitive advantages' for a deeper discussion)

NSRSO market share in U.S. as of the end of 2013, according to the SEC

Competitive Advantages
  • Current dominant position: By already have rated a substantial amount of the debt outstanding, they have the data, research, and capabilities of providing a comprehensive credit rating, which is sufficient/supplementary to investors when purchasing bonds.
  • NSRSO requirements to qualify: new entrants must show a history of providing credit ratings and have some of their clients write a letter stating they've used the company in the last 3 years. Link
  • New CRA skepticism: if a new CRA enters the market and issues a rating alongside one of the "big 2", there are three outcomes: the rating is worse, the same, or better. Unfortunately, as Moody's and S&P have the scale, breadth, data, and resources, it would be difficult to respect a much smaller CRA as having a more superior rating. If the new CRA rates the issue: (a) worse - the issuer may be disastified and not use them in the future, may scare off potential clients, and/or issuers may think their methodology is flawed, (b) the same - then what value is it to have another CRA write a rating, just to confirm that the larger CRA's methods are adequate?, or (c) better/higher - it looks as if the smaller CRA is trying to "buy its way into the market", which would likely bring skepticism and criticism. A good read on this is how Kroll took over S&P in the CMBS market, is now #2 and Moody's is #1, as well as how they won the state of Connecticut's business in 2012 by charging 91% less than Moody's. The difficult of Kroll can be seen in their decision to hold the city of Chicago at a higher rating than Fitch, Moody's and S&P. Link
  • Comparability: investors appreciate the ability to compare - globally - the credit risk of one issue versus another, as done by through the credit rating scale. A majority of the smaller CRA's are either specialized in a certain type of issuance or are only familiar with a certain region/location. As the credit markets become more intertwined globally, and emerging markets improve their financial systems, the ability for a U.S. investor to compare a new issue from, say China, is valuable to both the Chinese issuer and the U.S. investor. 
  • Entrenchment/familiarity with the issuers: When a corporation is looking to issue bonds for the first time, the CRA's become heavily entrenched with the company. It is not an overnight process by the CRA's of understanding the ins-and-outs of the business, the capital allocation policies, management, etc. It is time consuming. Once the corporation has a credit rating and uses the CRA annual monitoring service, if they need to issue more debt the time needed is much less than the original process, primarily to the amount of work that was done upfront.
  • Investor Restrictions to "Big 3" issuers: many investors are restricted to buying securities that have been evaluated by one or more of the big three CRA's. Link
  • Costs and time to the issuer: Having a CRA become fully knowledgeable of the ins-and-outs of your corporation is time consuming; having a couple of them, which is often the case  - Moody's and S&P - is even more time consuming, and increases the cost. Having, say, 5 credit rating agencies monitor a corporation and write a rating is extremely time consuming and potentially expensive to the point it may not be economically beneficial enough by having the interest cost improvement be offset by the multiple CRA fees. If a CRA charges 6 bps to write a new rating, and it improves the debt interest rate by 30 bps, having 5 credit rating agencies eats up all of the financial benefit from having them in the first place. This is one of the reasons  it is beneficial to have 2 CRA's issue a rating versus a multitude. 
  • On-going regulatory and legal costs: post-financial crisis, the costs to be a NSRSO have increased, as they are more monitored and watched than ever before. For a smaller NSRSO this regulatory expense can be quite burdensome on their overall business, where as the largest CRA's can absorb these costs better.

Reinvestment Opportunities
Based on S&P Rating's current positioning in the U.S. and international, most of the future reinvestment opportunities will likely be guided by secular growth in the global credit markets, disintermediation of banks in Europe, and re-attempting to gain market share in the CMBS market in the U.S.. My belief is that these will be the reinvestment opportunity for the ratings business:
  • Continued expansion/building out of market position internationally (open offices, expand offices, hiring people, purchasing computers/IT)
  • China: Link As corporations still rely heavily on equity issuance and bank loans 
  • India: through CRISIL
  • Other tuck-in acquisitions in current markets, similar to the October 2014 acquisition of BRC Investor Services S.A. ("BRC"), a Colombia-based ratings firm. 

Geographical Presence:
54% of S&P Rating's revenue is domestic, 46% is international (similar 2012 - current)
  • United States: S&P Ratings is already very dominant in the U.S., which has about $40 trillion of debt outstanding Link, and although their closest competitor is Moody's, almost all issuers will get credit ratings from more than one agency, so both end up writing a rating on the same issuer/bond. In 2014, S&P rated approximately 84% of the $1.8 trillion of debt issued in the U.S. versus 88% in 2013. About 50-58% of the quarterly revenue comes from the U.S. (avg. 54%)
  • China: there are currently 5 credit rating agencies in China: Link S&P has offices in Beijing, Shanghai, and Hong Kong. 
    • China Chengxin International ("CCXI", a joint venture with MCO)
    • China Liange Credit Rating (a joint venture with Fitch Ratings)
    • Dagong Global Credit Rating 
    • Shanghai Far East Credit Rating
    • Shanghai Brilliance Credit Rating (partnership with MHFI)
  • India: MHFI has a current presence with CRISIL (see more on CRISIL below), of which they own a majority 68%.
  • Malaysia: RAM Holdings is partially owned by MHFI, Fitch, and other financial institutions. Link
  • Other locations: Japan, Korea (Seoul), Singapore, Australia (Sydney and Melbourne), Argentina. Brazil, Mexico. (total of 26 countries)
CRISIL: India's leading credit rating agency
CRISIL is a global analytical company that provides ratings, research, and risk and policy advisory services to a globally diversified client base. Only about 35% of CRISIL's revenues are from the ratings business, with 59% from "research services" and the remaining 6% from "advisory services" Link. About 10-11% of S&P Ratings consolidated revenues come from CRISIL, but the margins are lower at about 33-37% operating margins. A testament to the limited need for capital for credit rating agencies, CRISIL actually has negative invested capital for the ratings business.

From Sept. 2015 Quarter for CRISIL; negative capital employed for the ratings service.

Revenue Drivers:
Recurring Revenue: (~54% of revenue)
  • total debt outstanding rated by MHFI that is currently under the annual credit monitoring and surveillance service
  • the net increase of debt rated by MHFI in each period, which hopefully evolves to a annual monitoring relationship with the issuer
  • pricing power of 3-4% per year
Transaction Revenue: (~46% of revenue)
  • Mostly driven by corporate new issuance - predominantly "investment grade" versus "high yield". The more IG new issuance, the lower the revenues and margins, all things considering, as HY new issuance commands higher pricing by MHFI, leading to higher operating margins.
  • Levels of structured financing issuance
  • interest rates in each respective market
  • appetite for yield driven by comparisons to other asset classes and perceived future returns
  • structured product new issuance, driven by bank regulation and investor appetite
  • Mergers and acquisition activity and the need for financing the deals
  • Economic growth drives the need for debt issuance to fund capital expenditures and projects
  • Volatility in the markets lowers the appetite for new issuance
  • Pricing power
  • Return to CMBS market January 21, 2016
Total global corporate IG maturing $6.9 trillion (77%) and HY maturing $2.0 trillion (23%)

Global Corporate Debt Maturing by Region (2015-2019)

Revenue Sources:
Of the $2.455 billion in S&P Ratings revenue in 2014, if you exclude the 11% from CRISIL, other, there is a remaining $2.185 billion in revenue from corporations, financial institutions, governments, and structured finance. By excluding CRISIL, we can compare S&P Ratings business to Moody's Ratings business.

Corporations: 51% of total S&P Ratings revenue, or 57% excluding CRISIL. This compares to 48-50% of Moody's Rating revenue being from corporates. 

Financial Institutions: 17% of total S&P Ratings revenue, or 19% excluding CRISIL, which is higher than Moody's 14-17% of revenues.

Governments: 9-10% of S&P Rating revenue, lower than Moody's position of 16-17% of revenues from government related entities. 

Structured Finance: 12% of total S&P Ratings revenue, or 13-14% ex. CRISIL, which is lower than Moody's 19-21%, which makes sense since Moody's has a stronger position in structured products and MHFI was put on a "time out" from rating new CMBS until January 2016. From conference calls, CEO Doug Peterson has explicitly stated one of the reasons margins have been lower from S&P Ratings versus Moody's was due to MCO's strength in the CMBS market. 

From a geographical standpoint, Moody's earns more in their ratings business domestically, with about 58-60% of their revenue in the U.S., compared with 53% for S&P Ratings. Considering the U.S. market being the largest, most active, and least competitive, Moody's being slightly more U.S.-centric bodes will as the revenue recognition is based on the issuers domicile, and most of the activity will likely be in the U.S., at least until things improve/expand in Europe or China.

MCO vs. MHFI revenue growth in ratings businesses; both include FX impact.

Margin Drivers:
Operating Expenses: recent years growth in OpEx has been mid-single digits.
  • incentive costs (moves with performance of the businesses)
  • advertising (minimal for entire company, ~$30m - $40m per year, on average)
  • legal expenses
  • settlement/lawsuits
  • stock-based compensation expense
Based on past historical information and more recent restructuring by MHFI, I would expect that margins will expand when: (a) revenue growth is at least in the mid-single digits, which can leverage the highest cost of the business: employee compensation, (b) transaction growth (new issuance) is strong, as the new issuance fees are the higher margin payment type compared to recurring revenue, (c) MHFI can offshore some projects to lower cost businesses, such as CRISIL. (d) high-yield new issuance is strong, which largely depends on the appetite for the credit markets, interest rate spreads, and default rates, and (e) the level of structured finance new ratings. 

In my valuation, I would expect a low case of 43-44% EBIT margins, which would be caused by a much lower high-yield new issuance market, much lower overall new issuance in corporate bonds, and a softening of the revenue stream from recurring revenue due to either defaults, pay down of debt, or excess cash build up by corporations. Best case, I expect S&P Ratings margins to be in the 52% - 54% range. The best quarterly margin for S&P Ratings was Q2/2015 at 50.0%, but there was softening in recurring revenue, transaction revenue, and currency headwinds. This compares to 54.3% for Moody's for the same quarter. Moody's, with more revenue domestically than S&P Ratings, as well as more more transaction revenue (as a percentage of segment sales: S&P Rating at 50-58% recurring revenue, Moody's is 36-42% recurring revenue), should have higher revenue during strong new issuance periods.

Both MHFI and MCO have improved their ratings business margins, through efficiencies, scale, improvements in new issuance since 2009 and a leveraging of a cost base that is largely tied to employee compensation. (see charts below for both MCO and MHFI as a basis for margin used in valuation)

Capital Needs & ROIC
S&P Ratings is a very capital-light business, whereby about $30-$40m per year is invested in physical capital expenditures, a number similar to the depreciation amount. In 2009 the cap-ex was $30m and in 2014 the cap-ex was $33m. In my valuation, I would cancel out the add-back of non-cash charges of D&A with the capital expenditures, assuming they are essentially all maintenance related. This is consistent with how S&P conducts business, which is where their largest assets are not factories, machinery, or equipment, but rather their reputation, dominant position, and the people they employ. Pre-tax FCFF return on average assets invested will continue to increase over time as very little tangible capital is invested in the business, and the growth comes from (a) hiring more people, (b) pricing power, (c) leveraging existing technology assets/updating when needed.

Summary of S&P Ratings:
  • Very dominant position as a CRA globally
  • Duopoly market structure with Moody's and distant third, Fitch Ratings
  • Solid revenue growth historically due to (a) the need for new debt, thus new ratings, (b) low interest rates helped fuel issuance to lock-in lower rates, (c) increase of new issuance builds up recurring revenue stream, (d) pricing power of 3-4%
  • Seemingly sustainable competitive positions due to (a) need by investors to have an independent third party provide analysis on the credit risk of a bond issue, (b) network effects, (c) low price compared to benefit received from rating, (d) customer stickiness/reluctance to try new CRA because current value proposition difficult to beat, (c) closest competitor - Moody's - also benefits as well, thus little/none retaliatory concerns, (d) increased regulation in U.S. and Europe makes it harder for new CRAs to gain traction
  • Pricing power of 3-4%
  • Asset-light, with little increase in capital needed each year to grow the business
  • Heavily dependent on talented and capable personnel, which, along with their reputation, is S&P's largest asset 
  • Potential for margin expansion when new issuance recovers, as well as regain business in the CMBS market in 2016
  • 54% of revenue is subscription-based, leading to more consistency and less cyclical earnings
  • 53% of revenues are domestic, the remaining 47% internationally
  • High margins in the high-40% range

Overview of the business: S&P Capital IQ / SNL Financial 
(27% of sales, 23.9% margin)

What they provide:
S&P Capital IQ's products are organized by Desktop & Enterprise Solutions, Credit Solutions, and Markets Intelligence.

Desktop & Enterprise Solutions: integrated data sets, research, and analytical insights in an integrated desktop solution. Enterprise assists clients in the front, middle, and back office with pre-trade (idea generation) and post-trade activities, including risk and compliance, performance monitoring, etc.

Credit Solutions: Uses the information obtained by S&P Ratings. The subscritpion-based offerings - RatingsDirect and RatingsXpress - give clients direct access to S&P Ratings content.

Markets Intelligence: analysis, research, and non-discretionary advisory services.

SNL Financial: quite a bit of overlap with Capital IQ. Subscription-based model that provides corporate, financial, operating, and market data, analytics, and news.

How they make money:
Prior to the SNL Financial acquisition (Q2/2015 for $2.225 billion) , legacy Capital IQ earned 90% of its business from a subscription based model. The business grew off the back of strong retention rates - mid-90% + pricing power of 3-6% + upgrades + new products/volume. Historically, the legacy business grew mid-single digits and had mid-to-high teens operating margin, the lowest segment margin of total McGraw-Hill Financial (MHFI)

About the business:
Despite decent mid-single digit revenue growth, Capital IQ had ample room for operating improvement based on the high percentage of recurring revenue (90%+). Once Doug Peterson took over in Q4/2013 as CEO, he began implementing change through all the operating segments, noticing there was ample room for more efficiencies. He reinvested in people (sales force, customer service) and technology over a 2-3 quarter period which temporarily lowered operating margins but was meant to improve the product and retention rates. Since then, the margin improvement has been a success story, as margins hit an all-time-high in the most recent quarter to 23.9%.

SNL Financial

  • reasoning for the acquisition was a combination of cost synergies and revenue opportunities
    • Cost: eliminating overlapping management levels, integrating similar software, technology
    • Revenue: S&P Capital IQ had 34% of revenue internationally but SNL Financial had only 9% of revenues internationally. The revenue capabilities lie in using the CapIQ sales force internationally to cross-sell the SNL products, driving international growth.
  • Sales by geography: 91% of sales from Americas, 7% from Europe, 2% from Asia
  • Sales by product focus: 52% of revenue from banking, 15% energy, 10% insurance, 9% real estate, 8% media, 6% metals & mining
  • 3,300 employees
    • sales force and customer service mostly in North America
    • Research analytics in India, Pakistan, Philippines and U.S. 
  • Over 5,000 customers and 75,000 users 
  • HQ - Charlottesville, VA
  • 19 offices gloablly
  • Similar to Capital IQ and Platts, grew mostly through M&A
SNL Financial: Timeline from 2004-2014 growth through M&A

SNL Financial: Financial Overview 
Two types of business:
(1.) Established: 8-10% revenue growth, low-30% margin, track record of low-teens organic growth
(2.) Developing: in the investment phase, still losing money, expected to make money by 2017.
Combined SNL in the 20%+ margin

Low working capital needs as customers actually pay SNL upfront for the years' contract

Estimate $70m of EBITDA synergies by 2019

  • 50%; cost related
  • 50%: revenue synergies as SNL expands internationally
GAAP accretive by 2018

Quality of the business: Strong
  • 90%+ revenues are recurring, are subscription based; SNL retention has been 94% consistently over last 5 years and has 96% recurring revenue
  • SG&A is fairly fixed, providing ample opportunity for operating leverage in the business
  • Margin improvements, from mid-teens to low-20% in a few years (most recent quarter was 23.9% EBIT margin)
  • Software is entrenched with their customers, providing very high retention rates (>90%) and improving trends in retention
  • Pricing power of 3-4%+
  • Can piggyback off the data and research obtained by the strength of S&P Ratings, which is a huge revenue synergy for both businesses, helps cross-selling
  • Target customer is sophisticated in the financial markets; investment banks, trading floors, mid-office, back-office, asset management, insurance companies
  • Lower growth at times versus other segments, but also more consistent
  • Organic growth of legacy Capital IQ business ranged from 4-8%, with some coming from growth in the market + increased market share, and less so from price increases (Q2/2014 earnings call)
  • Long term management hopes to get the margin in the mid-20% for the legacy S&P Capital IQ business (Q1/2015 earnings call)
S&P Capital IQ quarterly revenue. Q3/2015 includes a month of SNL Financial, thus the seemingly abnormal increase sequentially.

  • Bloomberg
  • Thomson Reuters
  • FactSet

Key Metrics to focus on for S&P Capital IQ/ SNL Financial
  • recurring revenue percentage
  • retention rates on existing business
  • Margin expansion for legacy S&P Capital IQ business (target is low-to-mid 20%) and SNL Financial (currently low 20%; I estimate established businesses at 33% and "developing businesses" will become profitable in 2017, per management commentary. Combined SNL Financial would have mid-20% margin in a few years)
  • Updates on cost & revenue synergies, estimated to be $70m EBITDA by 2019
  • Organic growth rates for both businesses
  • Growth rates for "established businesses", which seems to be in decline from low-to-mid teens revenue growth in last 10 years to 8-10% currently

My estimates of future S&P Capital IQ and SNL (2015 to 2019) ("base case")

Overview of the business: S&P DJ Indices
(12% of total revenue, 67.9% margins and improving)
(73% owned by McGraw-Hill Financial, 27% by CME Group)

What they provide:
This segment offers brands that are the leading resource for index-based innovation (indices) and more than $3 trillion in assets are directly linked to these indices. To grow the business, they establish relationship with various exchanges around the world to expand global distribution by using their brands, mostly "S&P". Examples: S&P 500, S&P/NZX50 (New Zealand stock exchange), or S&P/BMV (Mexican stock exchange).

S&P DJ Indices 

How they make money:

ETFs and Mutual Funds: licensing fees on assets invested in products linked to S&P DJ Indices = non-subscription revenue (>50% of revenue)

OTC Derivative & Structured Products: Fixed or variable annual and per-issue fees or blanket fees for OTC derivatives and structured products  = non-subscription revenue (<10% of revenue)

Listed Derivatives: royalties based on trading volume of derivative contracts listed on global exchanged  = non-subscription revenue (>20% of revenue)

Data and Custom Indices: custom index solution and data subscriptions that support index fund management, analytics, and research = subscription revenue (~20% of segment revenue)

  • 20% subscription based, 80% non-subscription based
  • 80% of revenue is domestic, 20% international

Key Metrics for the business:
  • growth in passive, index-based investing (ETFs and index mutual funds), taking share from active mutual funds. As of Dec. 2014, 26% of total funds invested are in indexed ETFs and mutual funds versus 12% a decade ago.
  • Global exchange trade products (ETP) are estimated to double from $2.8 trillion in 2014 to $6.0 trillion in 2019
  • Growth in fixed-income ETPs
  • Net inflows to index-based stock funds
  • growth in new indexed solutions/products (commodities, infrastructure, real estate)
  • margin expansion

The "Bull" Thesis:

Continued Margin Expansion of all segments
Sustained Competitive Advantages of each segment lead to strong revenue growth, participation in growing global credit markets, and pricing power
Global Debt Maturities provide revenue insight
Asset Light/ Low Physical Capital Needs with strong Cash Flow Generation
Catalyst once S&P returns from an agreed "time-out" from rating any new CMBS until January 21, 2016
The current valuation multiple is not excessive but appropriate due to dominant position, low capital needs, and shareholder friendly capital allocation.

The "Bear" Thesis:

New Bond Issuance Slows: New Issuance makes up 25-30% of total MHFI revenue, as well as is a tremendous driver of the high margin and any further margin expansion. A slowdown in new bond issuance would likely have a material impact on revenues and margins, with both seeing declines, despite new issuance on being 1/4 of total MHFI revenues.

25-30% of total McGraw-Hill Financial (MHFI) revenue comes from S&P Ratings transactions (new issuance). 

Global Debt Continues to Rise Link
High Yield Market Softness
Slowdown in Global Growth/ Emerging Market Debt Weakness Link
Record U.S. Corporate New Issuance May Be Near Term "Peak"
New Issuance Softness + Deleveraging = Lower S&P Ratings Revenue and Lower Margins
Energy Sector Defaults Impact HY issuance
New Issuance "pulled forward" over anticipation of Fed rising rates
China debt issues & Contagion Link
The run-up in the stock price ran ahead of the fundamentals, with >20% of the stock price appreciation from 2010 to 2014 coming purely from multiple expansion.

Questions still need to be answered: (will follow up)
1. How MHFI thinks of reinvestment opportunities for S&P Ratings
2. Are there any markets S&P Ratings is not in but would like to be?
3. Any markets S&P Ratings is in and would expect expansion at some point?
4. Pricing power of new issuance - corporates (investment grade & high-yield) and structured products
5. How does the 2015 - 2019 timeframe of global debt maturities compare to previous 5 year timeframes?
6. Was decline in U.S. total rated volume market share solely due to less CMBS and structured product ratings?
7. From investor deck in 2015: $2.218 trillion new rated corporate debt globally by S&P in 2014; 51% of the $2.455 billion S&P Ratings revenue came from corporate bonds. Assuming 46% of that revenue was transaction based, this implies 2.6 bps per S&P global rates corporate volume. Is this logic and math correct?


FCF Yield + Future Growth
DCF (low/base/bull)

(still in process........)

Sources (besides those not linked)
Historical Primer on the Business of Credit Ratings
George Mason -brief history of CRAs
Goldman Sachs on the China bond market (First Half - 2015)
The Economist: Deleveraging Delayed (10/24/2015) on China bond market
China's bond market
The Economist: Big, But not the Biggest (07/17/2014) on China bond market
RAM Ratings in Malaysia
CRISIL financials


  1. Great work, thanks for that!

    I think CRISIL offers a nice upside for the rating business, and I expect the network effect in Capital IQ to be significant in years to come (OPEX should remain relatively flat at this point so EBIT growth should be in the lower teens). From my experience from 4-5 yrs of usage, Capital IQ is a great product. For me it was much more intuitive and easy to use than Bloomberg. I know very little on SNL but it seems to provide the software segment a similar growth catalyst as CRISIL is to the rating biz, no?

    All in all it's a great company, would love it even better if it was a bit cheaper but it will probably do well as a compounder at current prices as well.

    Looking forward for the valuation part and again - thanks for the hard work.

  2. Majority of SNL is growing 8-10%, has low 30% margin. The "recent investments" are growing much more (4 yr CAGR of ~70%) but are not profitable, won't be until 2017, have 5-6% margin headwind on SNL. When the deal was first announced MHFI said low double digits/>10% growing for the "established" businesses. On the Q3 call they said 8-10%. Given that 91% of MHFI revenue is domestic, this lowering of revenue shouldn't be from FX (although it could be, but doubt it). That being said, I expect mid-to-high single digit revenue under normal circumstances, at least in the near future. Once the market gets more saturated, would expect mid-90% retention of clients + 1-3% upgrades + 3-6% pricing initiatives, where you could get flat - mid-single digits over time.

    Margin expansion in all businesses make it attractive, especially in the CRA S&P Ratings business, where the last few years has been burdened by lawsuits, legal expenses, beefing up compliance, etc., which all should start to normalize post CalPERS and US settlements.

    From what I know, MCO (Moody's) is generally more conservative - both from an operating standpoint and from the actual ratings - than McGraw Hill (S&P). That being said, MHFI under Doug Peterson has made leaps and bounds to be more lean - selling the corporate jet, relocating to lower Manhattan, selling some IT infrastructure assets, adjusting the compensation package to more align with business performance.

    From a valuation standpoint, any valuation is a guess. I like the non-ratings business but am somewhat less familiar with the ins-and-outs, except for looking at the financials. At ~5% FCF yield, I personally would prefer a FCF yield + 3-4% pricing initiatives of at least 10%. Any margin expansion + accelerated revenue growth + improved "structured products" performance in S&P ratings + any pricing above 3-4% is "gravy".

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