Spruce Point Capital Management Announces Investment Opinion: Releases Report and Strong Sell Research Opinion on MSCI Inc. (NYSE: MSCI)
NOTE TO EDITORS: The Following is an Investment Opinion Issued by Spruce Point Capital Management
Provides Evidence That Each of MSCI’s Four Business Segments is Under Pressure, Resulting in Client Retention Challenges
Expresses Concern That MSCI Uses Aggressive Accounting and Financial Reporting to Place Greater Emphasis on Adjusted EPS While Cash Flow Stagnates and the Dividend Growth Rate Plunges
Believes MSCI’s $949 Million Acquisition of Real Capital Analytics Should be Evaluated for Impairment After Client Losses and Rising Competition
Observes That MSCI Exhibits a Pattern of Opaque Deal-Making with People and Entities Related to Morgan Stanley and Questions if They are in the Best Interest of Shareholders
Believes That MSCI – Known for its Environmental, Social and Governance Ratings – Has its Own Social and Governance Deficiencies That Must be Improved
Sees 55% to 65% Long-Term Downside Risk to MSCI’s Share Price and Believes MSCI’s Stock Should Be Underweighted Relative to the S&P 500
January 17, 2024 09:00 AM Eastern Standard Time
NEW YORK--(BUSINESS WIRE)--Spruce Point Capital Management, LLC (“Spruce Point” or “we” or “us”), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled “Indexing The Short Case Against MSCI” that outlines why we believe shares of MSCI Inc. (NYSE: MSCI) ("MSCI" or the "Company") face up to 55% to 65% long-term downside risk, or $190.00 – $244.00 per share. Download or view the report by visiting www.SprucePointCap.com for additional information and exclusive updates.
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Spruce Point Report Overview
MSCI, founded as Morgan Stanley Capital International, is a provider of decision support tools and solutions for the global investment community. The Company has four reporting segments: Index, Analytics, ESG and Climate, and All-Other Private Assets, which includes real estate analytics and the recently acquired Burgiss Group. MSCI’s clients include asset owners (pensions, endowments, etc.), asset managers, financial intermediaries, wealth managers, real estate professionals and corporations. MSCI services 6,500 clients in over 95 countries. We believe each of MSCI’s four segments is under pressure and that the Company is using a variety of aggressive financial reporting and accounting methods, along with expensive acquisitions, in an attempt to position itself for a changing investment landscape.
The concerns we outline in our report include:
- MSCI’s core index business is under pressure, client Retention Rates are declining, executive leadership is being replaced, and reputational risks are rising. MSCI’s core index business (58% of revenue) is no longer the driving force of innovation it once was. Through our research, we found that the Company understates the growing competition it faces from exchanges like Qontigo (owned by Deutsche Börse) and Nasdaq, which are increasing pressure on MSCI as they expand with new software and data solutions. We find that MSCI’s Index segment Retention Rate, a measure of future revenue, has declined year-over-year in the past four consecutive quarters.
In addition, MSCI also faces additional strain from its clients – such as BlackRock – that are under pressures of their own. For instance, approximately 10% and 17% of MSCI’s total and Index segment revenue currently comes from BlackRock, which is embracing self-indexing, which reduces its need for MSCI’s services. On top of that, BlackRock’s U.S. market share of iShares ETFs is in perpetual decline, with analysts expecting Vanguard to soon become the new leader. As a result, it is no surprise that MSCI’s fees linked to ETFs have also been in perpetual decline. In November, MSCI replaced its Head of Index, while BlackRock’s Head of iShares departed last week. The combination of these events cast greater uncertainty over the relationship. On top of that, we believe MSCI’s recent purchase of The Burgiss Group (“Burgiss”) now puts it in greater competition with BlackRock, which could further pressure the relationship and fees.
Other macro factors working against MSCI are higher interest rates and a strong dollar. Higher rates have caused total assets of AUM benchmarked to MSCI indices to decline almost double digits since 2021. In Q3’23, MSCI reported a decline in total clients and it has recently expanded risk factors that explain why client activity decreases. Absent punitive price increases, we estimate new recurring sales are down 40% in YTD’23. To win in “growth areas” such as thematic ETFs, MSCI’s CEO recently referenced itself as having to turn into “a giant equity research shop.” We believe the cost and complexity of transforming a large company such as MSCI with pronounced innovation challenges will be too difficult to surmount.
Beyond competition and macro factors, MSCI’s index franchise has also exposed itself to reputational risk in pursuit of fees by promoting Chinese indexed ETFs. As an example, Congress recently questioned MSCI’s role in diverting capital towards Chinese companies included within the index that are possibly engaging in human rights violations.
- MSCI’s Analytics segment is also under pressure, anchored by increasingly commoditized solutions. The Analytics segment is ~26% of MSCI’s revenue and ~18% of Adjusted EBITDA. As one former MSCI employee with 18 years of experience developing models said, “It’s less about brain power – lots of physics PhDs in quant land – and more about the difficult and unglamorous job of sourcing, curating, managing and QA’ing data and the 24/7 operations to ensure updates are there every day, on time, for every asset class, for every model, for every client.” Spruce Point believes artificial intelligence will automate and improve data management to further reduce competitive barriers and fees.
In 2016, MSCI stated its intention to accelerate Analytics revenue growth rate from low to mid-single digits to the upper single digits over the long term. Seven years later, the growth rate has increased modestly to the 6% range (aided recently by punitive fee increases) but has averaged just 4.5% over the time period. Most of the segment was built with acquisitions dating 15-20 years ago and are still anchored by RiskMetrics and Barra Solutions. Not surprisingly, in a recent interview, an industry expert opined that MSCI’s models are becoming commoditized. MSCI’s results reinforce the reality that its Analytics segment is under increased pressures. For example, Spruce Point observes that MSCI recently experienced year-over-year declines in its organic sales growth, Adjusted EBITDA margin and client Retention Rate metrics. Client Retention Rate has fallen in three of the last four quarters while Adjusted EBITDA margin growth is declining after a period of strong expansion. Now, MSCI is referencing higher compensation costs across cost of revenue, selling and marketing and G&A, offset by lower R&D compensation expense after a period of cost capitalization. Our interpretation is that MSCI is likely experiencing wage pressures by retaining employees who may be looking to depart while customers churn.
- Despite having been MSCI’s recent growth driver, the Company’s ESG and Climate segment is now beginning to struggle. Since 2020, MSCI’s ESG and Climate Solutions business has been a growth engine with run rate revenue increasing from $138 million to $297 million and margins expanding from 20.5% to 34.8%. However, we believe the growth spurt is ending not only because of ESG pushback, regulatory uncertainty, and ESG’s market underperformance but also because of MSCI-specific issues that have resulted in notable client retention challenges.
In 2023, MSCI changed the way in which it describes the competitive advantages of its ESG and Climate business from having a “Unique Track Record” to simply having a “Long Track Record.” To say that something is unique means that it is one of a kind or unlike anything else – but to say something has a long track record does not have the same notability. We view this modification in choice of words, along with MSCI’s expanding disclosure of competitors such as Bloomberg and Moody’s in its recent 10-K, as an indicator that its ESG and Climate business is coming under increased pressure. In addition, MSCI also added a pop-up box on its rating page to be used in sales lead generation before providing its public ratings. When we interviewed a former MSCI executive, we were told, “ESG competition is definitely increasing, especially Bloomberg. MSCI was one of the first, but that doesn’t mean competitors aren’t going to eat away at it. As early as 2023, people were leaving the ESG team. To grow, you have to have consistent sales. They were under target and didn’t hit their goals. That business line was struggling.” Lastly, we observe that MSCI is increasing its cost capitalization of development expense, which has the obvious effect of flattering margins.
- The Private Assets segment, formed by the acquisitions of Real Capital Analytics (“RCA”) in 2021 and The Burgiss Group (“Burgiss”) in 2023, is fraught with continued challenges. MSCI’s acquisition of RCA for $949 million was richly valued at approximately 13x and 48x run-rate revenue and EBITDA, respectively. We believe the RCA acquisition was littered with challenges and shows MSCI’s propensity for aggressive revenue accounting. MSCI quickly marked down total clients from 2,000 to 1,600 after the acquisition but continued to claim that it had a high retention rate and that revenue should be considered recurring. MSCI and analysts talked up RCA’s mid-to-high teens revenue growth and high and improving renewal rates. However, within a year after the acquisition, the evidence points to substantially lower revenue growth and MSCI stopped reporting RCA’s Run-Rate revenue – a suspicious coincidence. A former MSCI employee commented, “The RCA deal was not the best or easiest transition. It was pretty disorganized. It was like a dumpster fire. There were a lot of mismanaged accounts. I don’t think they did enough due diligence, like on their run rate, and what they are producing. There were a lot of outdated or accounts that weren’t updated.” Segment organic growth recently went negative while segment retention rate is negative on both a QoQ and YoY basis.
In 2023, MSCI acquired the 66.4% of The Burgiss Group it didn’t own at an implied 10x and 68x revenue and EBITDA, respectively. Spruce Point believes that at best Burgiss was breakeven and at worst it was losing money and it has struggled to grow its client base in the past four years. We have also identified evidence of weak accounting and/or financial controls as suggested by MSCI electing to report Burgiss’ results on a three-month lag. Lastly, Burgiss competes with eFront, a company owned by BlackRock, which raises the risk of greater friction with its largest customer.
- MSCI has exhibited an alarming pattern of nepotism-like acquisitions and alliances with Morgan Stanley and MSCI-related alums. MSCI was formerly Morgan Stanley Capital International, so there is no hiding the fact that its roots originated at Morgan Stanley. MSCI IPO’ed in 2007, and Morgan Stanley was its lead underwriter.
Unsurprisingly, we find that MSCI has recently engaged in a suspicious pattern of acquisitions and alliances that benefit Morgan Stanley and well-known MSCI alums. Overall, we question whether these deals are in the best interest of MSCI shareholders or are being done simply to benefit the former colleagues in the circle of MSCI Chairman and CEO Henry Fernandez. We refer to this as nepotism-like dealing and we find many recent examples.
(1)
In 2021, Mr. Fernandez became Lead Independent Director of Royalty Pharma plc (NYSE: RPRX), which receives fees from MSCI for advice on science-based thematic ETFs. Morgan Stanley is also a top shareholder of RPRX. Mr. Fernandez’s son became employed at RPRX around the time of his father’s appointment.
(2)
In 2022, MSCI struck an alliance with Menai Financial Group, a company in the digital asset space intended to provide MSCI advice, with undisclosed deal terms. Menai was founded by Zoe Cruz, former co-President of Morgan Stanley.
(3)
When it comes to the recent Burgiss transaction in 2023, Jay McNamara was President of Burgiss and was formerly an Executive Committee member at MSCI. MSCI hasn’t disclosed how much Mr. McNamara personally benefited from the transaction, which, as we pointed out, was at a rich valuation.
(4)
Lastly, in December 2023, MSCI acquired Fabric, a wealth technology platform for an undisclosed amount. Our research suggests that Fabric had limited headcount and web traffic growth. Fabric’s co-founder was formerly Morgan Stanley’s first Chief Risk Officer.
- MSCI is shifting attention to Adjusted EPS while cash flow and dividend growth struggles and aggressive accounting decisions flatter revenue and costs. MSCI ceased providing margin guidance and dismissed margins as not meaningful while putting greater emphasis on Adjusted EPS. In 2022, MSCI changed management’s long-term compensation targets to cumulative Adjusted EPS and revenue despite not providing investors with guidance on either metric. We believe MSCI uses a variety of dubious adjustments to bolster its Adjusted EPS.
By our estimate, Adjusted EPS was -28% and -13% below MSCI’s reported results in 2021 and 2022, respectively. MSCI’s revenue in recent quarters has been flattered with non-recurring revenue, some of which is related to prior periods. On the cost side, MSCI’s segment reporting gives management the potential for wide latitude to manipulate margins to its benefit. We observe that it can allocate costs by segment using different methods without incurring “arm’s length” charges. Lastly, MSCI appears to be making greater use of capitalized development costs that are added to the balance sheet, amortized to the income statement and conveniently ignored as non-cash add-backs. MSCI should disclose how much costs are being capitalized per segment and the exact effect on margins. As of its last financial update, MSCI has not been able to increase cash flow guidance even as operating costs rise and after tapping the revolver for additional liquidity to complete the Burgiss acquisition (despite enough cash on hand and cash flow). Moreover, MSCI’s dividend growth has averaged 27.9% from inception in 2014 through 2023 but its recent increase was 10.4%, the lowest growth rate ever. We believe management may be signaling cash flow growth challenges ahead with these actions.
- In the context of our findings about aggressive accounting decisions and lapses in acquisition due diligence, we have grave concerns about Board, audit, and accounting oversight at MSCI. We are alarmed to see that MSCI’s Chief Accounting Officer (CAO) resigned on August 18, 2023. As of this report, MSCI has not named a successor to the CAO role and it does not have a Global Controller, which should be a significant red flag for investors. In addition, we question the fitness of MSCI’s Director Catherine Kinney who has served on the Board since 2009. Ms. Kinney has not only been involved with SolarWinds (NYSE: SWI) since its IPO, but most concerning, she served as the Chair of the Nominating and Governance Committee which was responsible for firm-wide risk management. She was also a member of the Audit Committee. Spruce Point finds it alarming that the SEC recently charged SolarWinds with fraud for internal control failures during Ms. Kinney’s directorship. Also of concern is the fact that MSCI claims its Audit Committee “Financial Expert” is Robert Ashe. Mr. Ashe has primarily served in operational and business management roles during his career with a brief stint as a public company CFO of Cognos over 20 years ago. While he was CEO of Cognos, the Company delayed its 10-K/Q as the SEC reviewed its revenue recognition policies. He has a CPA in Canada, but MSCI reports in U.S. GAAP. If the weakness with MSCI’s Board and accounting oversight is not evident enough, we also find evidence that MSCI’s PwC Audit Engagement Partner is not a financial services specialist. Her other audit clients are primarily chemical and shipping companies, and her LinkedIn biography references the title “Industrial Products Assurance Partner.”
- The bottom line is that an investment in MSCI presents a poor risk/reward for investors, given the Company’s high expectations, rich valuation and apparent struggles. Analysts are bullish on MSCI, however, the average sell-side consensus price target is $554/share, representing just 2.6% upside potential. Spruce Point believes the current sell-side promoters need to refresh their thinking about MSCI and the sustainability of its growth and margins, especially in “faster growth” segment areas in ESG and Climate and Private Assets. We believe it is easy to dismiss much of the bull case narrative with some simple channel checks, a close forensic review of MSCI’s financials and by speaking with former employees. Specifically, we believe analysts and investors need to rethink the sustainability of MSCI’s high client retention in a changing competitive landscape and its capital allocation policies. We believe management is showing poor discipline with acquisitions, while deploying too much capital to share repurchases with its stock trading at an industry-high multiple of 17x and 29x 2024E revenue and Adjusted EBITDA. Investors would be better served with a higher dividend rather than allowing management to essentially buy its way toward handsome long-term bonuses tied to Adjusted EPS. MSCI’s leverage is now at a decade high at approximately 3x Net Debt / EBITDA which we believe is at the worst time as client Retention Rates decline. By conducting a realistic sum-of-parts valuation of MSCI’s business segments, we estimate 55% - 65% ($190.00 – $244.00 per share) downside risk and expect MSCI to underperform the S&P 500 and its own relevant benchmark indices.
The research note can be found at www.sprucepointcap.com and updates will be posted on twitter @sprucepointcap.
