Initial public offerings, exchange-traded funds and spin-off spotting – three of my favorite topics to blog about. Today you get a three-for-one deal. Morgan Stanley filed this week to spin-off a portion of its indexing and data crunching arm, MSCI, in an IPO. MSCI, which publishes zillions of widely followed market indexes and provides analytical software, has been growing like a weed on the back of licensing revenue from ETF sponsors creating funds based on its indexes. At the end of May there were over 500 ETFs trading just in the U.S., triple the number from the beginning of 2005. And total ETF assets are nearing $500 billion, double the level from the beginning of 2006, according to the Investment Company Institute. With the ETF market exploding not just in the number of new funds but also measured by assets in the largest funds, MSCI wins twice. Worldwide, 152 ETFs holding $156 billion licensed MSCI indexes as of June 30.
As you might expect, then, operating results have been super duper, especially since the indexing firm snapped up rival Barra Inc. in 2004. The company’s revenue almost doubled from $178 million in 2004 to $311 million in 2006. For the first half of fiscal 2007 (which will end November 30), revenue was up 18%. That’s helped push up the company’s operating profit margin to 30% last year from under 15% in 2004. So far in 2007, it’s running at 32%. And the bottom line jumped to $78 million in 2006 from $18 million in 2004. In the first half of ’07, net income was up 17%.
MSCI also have a long and storied history in the investment world. Its basic indexes were created in 1969 by a unit of the Capital Group Cos., the Los Angeles-based outfit that manages American Funds, the biggest fund family on planet earth (excluding money markets, of course). Morgan Stanley came in as a partner decades ago when Capital realized the indexes were in demand all over. Currently, Morgan Stanley owns over 96% of MSCI and Capital Group a little over 3%.
Although the recent results are great, it does appear that growth has slowed dramatically in 2007 from the past few years when the Barra merger came on. And this is yet another case where the pre-IPO owners loaded on debt so they could receive a one-time dividend. MSCI borrowed $648 million to pay for a portion of a $973 million dividend to Morgan Stanley and Capital Group last month (the rest came out of cash). The IPO is only looking to raise $200 million, so a large portion of the dividend debt will remain and the interest expense will no doubt take a huge bite out of MSCI’s net income going forward. All of the great results noted above came as the company had no debt and built a cash stake of almost $400 million. There might even need to be more borrowing. MSCI says, to fund further growth with the demise of that cash. Pro forma information about just how big a bite the interest expense might be wasn’t included in the initial prospectus for the IPO.
Then there is the question of what will happen to the huge percentage stake in MSCI being held by Morgan Stanley. The filing says Morgan has made no decision about what it might do though options being considered include a complete spin-off to its current shareholders, or a full or partial sale to another party. Does anyone smell private equity? I was talking to Ben Phillips, an investment banker and managing director at Putnam Lovell in Boston, the other day. Phillips said he thought private equity firms would turn increasingly to financial sector acquisitions which wouldn’t need a lot of junk bond financing due to the current problems in the high yield bond market.
Another risk in the MSCI deal is the legal status of requiring fund sponsors to pay licensing fees in the first place. McGraw Hill, which owns Businessweek, and Dow Jones lost the first round of a legal battle over the issue to the International Securities Exchange, which wanted to offer options based on Dow and S&P indexes without paying fees. Since licensing revenues made up 53% of total revenue in the first half of 2007 (and were growing at a rate of 28% versus less than 10% for the software and data side of the business), an adverse decision could crush MSCI’s growth prospects.
So, the bottom line, instead of an exciting and potentially hot IPO, this deal has more of the characteristics of a dud which could then turn into an undervalued gem. Still, we don’t know the per-share price yet, so that conclusion could change. There’s a solid and growing business at MSCI but it’s weighed down by debts to its owners and a bit of uncertainty about its legal rights. Hot or not? Right now — not.
I’ll be on vacation next week, so discuss further amongst yourselves…