In this write-up of S&P Global, I will start with a description of the company’s operations, followed by an in-depth description of the competitive advantages and growth avenues of each segment of the business. Risks will also be discussed in this section to offer a nuanced perspective of several of the company’s moats. I will conclude with a discussion on valuation for the company, which will include comparison to competitors’ segments which are like S&P Global’s as well as an analysis of how the current economic situation could impact S&P’s top-line numbers.
Description of the company
S&P Global is a provider of independent ratings, benchmarks, analytics and data to the capital and commodity markets worldwide and has four reportable segments:
S&P Global Ratings (46% of revenues): this segment is a provider of credit ratings and analytics to investors, issuers and other market participants. The segment has been compounding revenues at a 6% CAGR for the past 4 years and operates at 57.2% operating profit margins. Credit ratings are one of several tools investors can use when making decisions about purchasing bonds and other fixed income investments. On top of opinions about corporations, states or cities, they also relate to the credit quality of individual debt issues, and the relative likelihood that the debt may default. Ratings is divided between transaction and non-transaction revenues.
Transaction revenues include fees associated with ratings related to new issuance of corporate and government debt, as well as structured finance debt instruments. It also includes corporate credit estimates, which provide an indication of S&P’s opinion regarding creditworthiness of a company which does not current have a credit rating.
Non-transaction revenue includes fees for surveillance of a credit rating, annual fees for customer relationship-based pricing programs and fees for entity credit ratings.
-Market Intelligence (29% of revenues): This segment’s portfolio of data and analytics capabilities helps investment professionals, governments and corporations track performance, identify investment ideas, understand industry dynamics, perform valuations and assess credit risk. The segment’s 4-year CAGR is 9% and its operating profit margin is 34.2%. The suite of products includes Desktop, Data Management Solutions and Credit Risk Solutions.
-S&P Dow Jones Indices (13% of revenues): The segment is a global index provider maintaining a wide variety of indices which aims to provide benchmarks to help with decision making. S&P collaborates with the financial community to create innovative products and provides investors and provide tools to monitor world markets. Indices derives revenue from asset-linked fees based on the S&P and Dow Jones Indices. They also generate revenue from exchange-traded derivatives, which generate sales usage-based royalties based on trading volumes of derivatives contracts listed on various exchanges.
-Platts (12% of revenues): Platts is a provider of information and benchmark prices for the commodity and energy markets. The segment provides essential price data, analytics and industry insights enabling the commodity and energy markets to perform with greater transparency and efficiency. Customers for this segment include producers, traders and intermediaries within the energy, petrochemicals, metals and agriculture markets. The segment’s revenues are separated within subscription revenue, sales usage-based royalties and non-subscription revenue.
Now we can move on the juiciest part of the analysis, a deep-dive of the numerous competitive advantages of each of S&P’s segments.
S&P’s biggest segment is their Ratings business. Ratings has been an important constituent of the world’s financial infrastructure for over 150 years by providing investors with information and independent benchmarks for their investment decisions as well as access to capital markets. When they issue letter grades, credit rating agencies provide objective analyses and independent assessments of companies and countries that issue such securities. The global credit rating industry is highly concentrated with three main agencies: Standard & Poor’s, Moody’s and Fitch. The Big 3 Credit Rating Agencies control 95% of the global ratings business. Moody’s and S&P have 80% of the global market share and Fitch has 15%.
Credit, debt and bond ratings are issued to individual companies, specific classes of individual companies, countries and government bonds. Ratings analyzes and assesses a company’s ability to meet its responsibilities with respect to all its securities issued. Institutional and individual investors rely on bond ratings agencies and their in-depth research to make investment decisions. Ratings agencies thus play an integral role in both primary and secondary bond markets. Sovereign ratings are often prerequisite information institutional investors use to determine if they will further consider specific companies, industries and classes of securities issued in a specific country.
The very fact that terms like “junk bonds”, “investment-grade”, “non-investment grade” exist show how impermeable CRAs are. The way bonds are perceived by institutional investors and bond funds as investable or not is determined by the universally recognized ratings systems of the three major CRA’s. However, as critical as it is for investors to review credit ratings, it is even more critical to the companies. The rating affects a company by changing the cost of borrowing money. A lower credit rating means a higher cost of capital due to higher interest expense. One Managing Director of Debt Capital Markets at a large Investment Bank has been quoted as saying that: ‘’If I don’t have two ratings on a bond, I simply can’t sell it.’’
Credit ratings also have further effects on companies. They impact the marketability of their bonds in the secondary market. The ability of a firm to issue stock, the way analysts evaluate debt on their balance sheet, and the public image of the company are also influenced by credit ratings. Because the credit rating agencies directly affect the cost of capital and the profitability of issuers, the company has significant pricing power. The company can thus easily afford to match inflation for its ratings fees. Indeed, both S&P and competitor Moody’s have estimated that they can raise prices on bond ratings by 3 to 5% a year. This pricing power is explained by the fact that pricing has no bearing on whether a party is going to issue debt or not. The extra interest a borrower would have to pay on an unrated bond is a lot more than the cost of a rating.
Credit Rating Agencies are regulated at different levels. The Credit Rating Agency Reform Act of 2006 regulates their internal processes, record-keeping and business practices. The agencies came under heavy scrutiny and regulatory pressure because of the role they played in the Great Recession. CRA’s were accused of inflating ratings for structured products such as asset-backed securities in the chase for higher fees and increased market share. The regulatory culmination of the Great Recession was the Dodd-Frank Act, which imposed further regulations on the CRA’s.
The ratings industry also benefits from ratings that result from other government regulations, which often prohibit financial institutions from purchasing securities rated below a certain level. For example, in the US, in accordance with two 1989 regulations, pension funds are prohibited from investing in asset-backed securities below A, and savings and loan associations from investing in securities below BBB. Regulation is thus the source of a moat for S&P Global, and I do not view it as a risk. Very often, regulation-backed companies are the least likely to be disrupted by a vigorous start-up.
I also believe the risk of CRA’s acting improperly has improved. While their downgrades of European and US sovereign debt were criticized, they show S&P is less influenced by poor incentives. For example, in 2011, S&P downgraded the long-held triple A rating of US securities and in 2012, S&P downgraded 9 eurozone countries. Also, the Great Financial Crisis was not the first time S&P made mistakes with their ratings systems. There have been several defaults and financial disasters not detected by the ratings agencies, such as the 1970 Penn Central bankruptcy, the Asian and Russian financial crises, the 1998 collapse of Long-Term Capital Management and the Enron and WorldCom collapses. Thus, I would not be terribly surprised if during the next downturn, the major rating agencies are found to have falsely given out high ratings to troubled companies, but they will likely escape unharmed. If they could thrive after the 2008 crisis, which should have been devastating in terms of survival, they can get through almost any future disaster as well.
Furthermore, under Dodd-Frank rules, agencies must publicly disclose how their ratings have performed over time and must provide additional information in their analyses, so investors can make better decisions. Their existence is as essential as auditors, which is why I compare the big 3 CRA’s to the big 4 auditors in accounting (KPMG, EY, PwC and Deloitte). The Big 4 in accounting have all been through their fair share of controversies but the brand associated with a big 4 has not diminished. In fact, once a firm scales up in size, it is common for them to ditch their small auditor and sign on a big 4 accounting firm, which puts a seal of legitimacy on the company’s financials. Just like the Big 4 will continue thriving after the next crisis, so will the big 3 Credit Rating Agencies. Thus, the big 3 credit rating agencies benefit from a brand moat since the more issuers rely on them for accurate credit ratings, the broader acceptance the Big 3 achieve from investors. And vice versa. Challengers to the Big 3 would have to suffer for years before developing the brand recognition investors and issuers require for ratings.
Another factor that causes barriers to entry in the ratings business to be high is that the ratings industry is reputation-based, and the finance industry pays little attention to a rating that is not widely recognized.
Overall though, ratings provided by the rating agencies are accurate. For example, in the international bond markets, a 2010 IMF study concluded that ratings were a reasonably good indicator of sovereign-default risk. The below graph also shows that in aggregate, S&P’s ratings are accurate at predicting default risk.
The source of S&P’s regulatory moat goes even deeper, though. Indeed, governing bodies at both the national and international level have woven credit ratings into minimum capital requirements for banks, allowable investment alternatives for many institutional investors and similar restrictive regulations for insurance companies and other market participants.
Another example of the deep regulatory moat backing S&P’ ratings business is that financial market regulations in many countries contain extensive references to ratings. The Basel III accord, a global bank capital standardization effort, relies on credit ratings to calculate minimum capital standards and minimum liquidity ratios. This example shows that the original market information function of providing credit opinions has morphed completely into a regulatory function for credit rating agencies.
To be precise, prior to 2008, S&P spent about 35M$ on compliance costs each year. Today, that number has skyrocketed up to 100M$ a year. The cost is not material for S&P but represents a huge fixed investment new entrants must overcome.
Not only are the Big 3 Credit Rating Agencies’ supported by regulation, S&P collaborates with the regulators! According S&P’s latest earnings call, they are part of the Office of Credits, the Fintech Group of Financial Fixed Income Market Advisory Group for Structured Finance Ratings. It’s an advisory group to the SEC. This means S&P is an advisor to the very group that’s overseeing them to make sure that fixed income markets are transparent and liquid. I think this only consolidates S&P competitive positioning in the Ratings business.
An important risk for the credit-rating segment is the cyclicality of it, since it is dependent on the number and dollar volume of debt securities issued in capital markets and unfavorable economic conditions can reduce investor demand for debt securities.
An avenue for growth for the ratings industry, apart from normal debt issuance growth in North America and Europe, are the Chinese capital markets. As part of the recent Phase 1 trade deal, the Chinese government is opening its capital markets, so more foreign capital coming into China can purchase bonds. Right now, only 1.5% of Chinese bonds are owned by foreigners. The current Chinese bond market is bank-centric, but their bond markets are becoming more institutionalized, and pension funds, insurance companies, mutual and savings funds are looking for more research and data about China. For non-Chinese investors, the only three players in the space which have enough legitimacy to provide their stamp of approval and access to Western capital markets are the Big 3 Credit Rating Agencies.
In 2019, Chinese corporate issuance was 1T$. S&P entered in a greenfield operation and they issued the first rating in June 2019. The company provided 6 ratings for the Chinese domestic bond market in fiscal 2019. S&P charges different fees for different products, from roughly 5 basis points for plain vanilla corporate bonds to 12 basis points for more complex structured products. I do not know how the 1T$ in Chinese issuance is separated, nor how much of this 1T$ is destined for Western investors, but this is certainly a massive opportunity for S&P – one that could easily mount in the hundreds of millions of dollars.
Another potential catalyst for growth is the announced 2 trillion $ infrastructure plan proposed by the current US administration. The plan will of course be financed by issuing bonds, which will require bond ratings. The global need for investment in infrastructure is evident. McKinsey was projecting over 50T$ in necessary global infrastructure spending through 2030 to keep pace with GDP growth.
One last point to reinforce the Ratings business’ moat is that institutional investors and bond indexes usually require a rating to be considered for investment or inclusion in a benchmark. Should bond investors migrate toward passive investment vehicles, as they have for the past 10 years, it will widen S&P’ moat. Coincidentally, S&P also owns the world’s most prominent benchmark businesses, as will be explained below.
Market Intelligence (MI) is a global provider of multi-asset class data, research and analytical capabilities, which integrate cross asset analytics and desktop services. The Market Intelligence segment is both a factory and a distributor of data obtained from S&P’s various segments. A massive 97% of Market Intelligence’s revenue is subscription revenue (recurring), as they are long-term contracts, with annual, automatic renewals. This segment does well in uncertain times, since demand for S&P’s data and analytics intensifies. Market Intelligence’s products are integrated and embedded into their customers’ investment and lending decision workflows platforms which makes products very sticky.
It is almost impossible to replicate MI’s scale of information and data across economies, entities, securities and properties. I find, with my own usage of some of MI’s products such as CapIQ, that their MI platform is the ultimate bundling play. There is enough specificity to each asset class and industry covered that it would require a start-up to build a substantially different product for each, which requires deep expertise as well as a lot of time and money. Data is also used to make huge bets in the financial world, so complete accuracy and reliability are needed, which makes institutional investors, large corporations and governments cautious when experimenting with new products, particularly those built by start-ups.
S&P has not shied away from making strategic, tuck-in acquisitions to complement its data processing capabilities and adding to its already rich collection of data sets. S&P can then integrate their acquisitions into their own distribution offering by inserting the acquired products into their offerings, supported by their international salesforce. An example of a recent acquisition was Kensho, in 2018, for 550M$. Kensho uses machine learning to make complex financial analysis as easy as a search on Google. Users can pour millions of market data points to find correlations by scanning more than 90 000 actions like drug approvals, economic reports, monetary policy changes and their impact on nearly every financial asset on the planet. Pretty nifty, eh? Another recent acquisition, Trucost, launched climate change physical risk data set to help companies’ investors understand their exposure to physical risks. Trucost’s data sets cover six climate change risk indicators, such as heat wave and costal flooding data.
Another example to demonstrate just how crucial S&P’s Market Intelligence segment is to various industries is that MI is offering free access to their supply chain intelligence platform to hospitals and relevant government agencies, helping them keep track of supply chains of ventilators and personal protective equipment during this coronavirus pandemic. The platform is also providing free research reports, analytics & data about the COVID-19 outbreak to the public.
S&P Dow Jones Indices: S&P is one three major index providers, with the others being MSCI and FTSE Russell. This lucrative segment has 4-year revenue CAGR of 11% and operating margins of 69.2%. The business’ revenue mix is from asset-linked fees, exchange-traded derivatives and data & custom subscriptions. The segment primarily makes money from asset-linked fees based on the S&P and the Dow Jones indices (more than 70% of the segment). The asset-linked fees are from exchange-traded funds and mutual funds based on the S&P Dow Jones Indices benchmarks. S&P generates revenues through fees based on a percentage of assets and underlying funds. For example, the world’s largest ETF on Earth is the SPDR S&P 500 Index, managed by State Street, and has roughly 250 B$ in assets. Nearly one-third of all of State Street’s fund expenses for the ETF flow to S&P Global. The ETF pays S&P a global licensing fee of 0.03% of assets under management (75M$ in licensing fees) and an annual fee of 600 000$ for the right to use the S&P 500 name and duplicate the index with its ETF. However, all the heavy lifting is done by State Street. Finding managers, attracting investors, marketing activities all come out of State Street’s annual take, after S&P Global’s licensing fees have paid out of course.
S&P Global has benefited greatly from the asset flows from active management into passive management because all mutual funds and ETF’s with S&P’s name in it must pay licensing fees to S&P Global. In aggregate, 1.6T$ has gone into passive strategies in the past decade, with an outflow of 1.4T$ in cumulative outflows from active strategies such as active mutual funds. Indeed, ETF AUM associated with S&P’ Indices increased with market gains and inflows, by a factor of 17% a year since 2013. This also represents a risk for S&P, since the growth of assets under management for passive strategies might not be nearly as great as for the past.
Thankfully, S&P also licenses its illustrious name to ESG funds. CEO Doug Peterson projects growth for ESG products to be at 40% a year. This is because ESG investors want a deeper and broader understanding of the entities they’re investing in or lending to. The concept goes beyond just finance, since investors want to understand the corporate social responsibility profile, the reputational risk and the security of their data. One ETF S&P lent its name to in 2019 was the S&P 500 ESG Index, which has 450M$ in AUM. MSCI, a competitor to S&P Global, and the leader in ESG offerings, sees the current penetration of ESG offerings at less than 30% and projects the next two years to increase to over 50% for institutional investors. S&P has invested early to create relevant data sets and so has taken advantage of this impactful market opportunity, and it will likely be too late for competitors to launch competing products.
Not only do asset managers use the indices S&P provides to display their results, measure performance and run portfolio analysis on portfolios and to structure index-based products like index funds and ETFs, there are also significant switching costs attached to the benchmarks S&P provides, especially on the institutional side of the business because funds need to seek approval from fund boards and customers to change a benchmark.
Like for S&P’s Ratings business, the Indices segment benefits from regulation. For example, European Mifid II regulations includes provisions that mandate conditions and requirements on the licensing of benchmarks, for which S&P must pay compliance fees.
Other catalysts for growth include continued index innovation, such as ESG indices as mentioned above, smart beta and factors indices. S&P also aims to expand local presence in emerging markets and increasing global indices awareness.
A note relating to the Ratings segment is that S&P has begun giving ESG ratings evaluations and has completed 6 such evaluations as of year end 2019. S&P also acquired the ESG Ratings Business of RobecoSAM, which includes SAM* Corporate Sustainability Assessment (CSA), an annual evaluation of companies' sustainability practices. This acquisition shows that S&P Global has readily identified a market growth opportunity and is pouncing on it.
Platts is a provider of information and benchmark prices for the commodity and energy markets (ex: oil rigs data, trend analysis, etc.). The segment generates revenue from subscriptions and licensing for derivatives trading, thousands of daily price assessments and comprehensive coverage across commodity markets. The 4-year CAGR for Platts is 7% and the operating profit margins are of 50.2%.
Despite the drastic drop in oil prices, I believe Platts, like Market Intelligence, is an all-weather franchise. 91.7% of their revenue is recurring, which confirms that similarly to Market Intelligence, Platts’ products are deeply embedded into customers’ investment decision making frameworks. These contracts are fixed-price, annual, auto-renewal contracts with a high 90s customer retention rate. This creates revenue stability in an industry with little incentive for changing data providers.
Regulatory surveillance, much like it is for the Ratings and Indices’ businesses, is the source of a competitive advantage for Platts. For example, the European Securities and Markets Authority has published guidance dictating that benchmark administrators such as Indices and Platts need to implement and seek authorization by an EU National Competent Authority with their respective benchmark activities in Europe. This legislation causes greater operating costs and compliance costs for Indices and Platts. But a company with deep pockets like S&P can easily foot these compliance costs and it just creates an additional financial barrier to entry for new firms.
Platts also benefits from switching costs and intangible assets. Indeed, like MI, the company provides proprietary data sets that inform investors and decision makers. Given the embedded nature of many of these products, it is highly challenging for end users to substitute data vendors. For example, Platts pricing is used on long-term futures contracts, which means that S&P can not be removed as a data provider until the contract expires, and contracts are usually multi-year.
A risk for Platts is lower volatility in the markets. In Q4 2019, Platts reported lower revenue because decreased volatility reduced exchange-traded derivative volume for products such as index options, VIX activity and CME equities.
Catalysts for growth for the segment include expanded capabilities in Asia and launch of new products. For example, in 2019, Platts launched micro e-mini futures -44 million contracts were traded at the Chicago Mercantile Exchange (CME) as well as low sulfur marine fuel contracts -for which 667 000 contracts were traded at the CME.
The Platts business is impacted by volatility in the commodities market though, so a continued drawdown in oil prices could affect top-line figure, even though S&P has done a good job at diversifying across different commodity markets, such as metals and agriculture, recycled plastics and hydrogen data and analytics.
Valuation
For the valuation section, I will discuss how I expect each of S&P Global’s segments to be impacted and effects on 2020 earnings. I do not want to look beyond 2020 for precise numerical forecasts because of the current economic uncertainty, even though I am quite confident that S&P Global will continue thriving for many years to come.
Before discussing valuation, I want to address S&P Global’s strong financial profile. The company currently has 3.95B$ of total debt and 2.91B$ of cash and cash equivalents. Free cash flow in 2019 was of 2.52B$ and cash returned to shareholders was 1.8B$ in the form of buybacks and dividends. S&P usually returns 70% of free cash flow to shareholders every year.
Now starting with Ratings, I want to establish that despite the coronavirus, corporate refunding needs over the next few years are set to increase. In fact, there are 3 trillion $ in corporate refunding needs over the next 4 years.
In 2020, Moody’s expected issuance to be flat in 2019, while S&P expects issuance excluding international public finance to grow by 5%. These forecasts were made in the beginning of March 2020 however, and I believe the economic situation has deteriorated in the past few weeks. As a comparison point, in 2008, S&P (which was called McGraw Hill Publications at the time) reported a 7% decline in Corporates, Financials and government revenue. I believe S&P has some untapped pricing power as well, so I will assume the top-line decline to be of about 5%, which would reduce operating profit to 1.67B$.
I am using operating profits for the valuation section since it is mostly top-line growth that will be affected by the pandemic, and recent operating leverage efforts have been mostly realized at S&P for the past two years, so I wanted to measure the effects to S&P as high up on the income statement as possible.
Note that corporate issuance tends to bounce back quickly after market drops, as the graph below demonstrates (graph from Moody’s):
I will compare the Market Intelligence segment to Moody’s Analytics, which is not a substitute product, but many of the end users are like S&P’s platforms’ users. Moody’s has said that their insights business held up very well during the last downturn and they expect it to fare even better this time since financial markets, corporations and governments are calling on them to provide information and scenarios to help them manage through these uncertain times. Moody’s Analytics reported that their segment sees intensified demand during market drops, as was the case in between 2008 and 2010.
A data point from S&P is that they reported that their data on the economic and credit impacts of the coronavirus were visited 4x as much as previous important topics such as Brexit. Due to the nature of highly recurring, subscription revenues of the segment, I am assuming that the platform’s sales will be flat in 2020, as new sales might be more challenging since S&P’s salesforce must work from home. This means operating profits should stay roughly constant at 607M$.
As for the Indices segment, top-line will be hurt by lower assets under management but will probably be boosted by the company’s joint venture with the CME Group, which generates revenue from trading volume from its S&P futures contract. Indeed, S&P has a license agreement with the CME Group where S&P Dow Jones receives a share of the profits from the trading and clearing of CME Group’s equity index products. In 2019, this was 114M$. However, asset-linked fees still make up most of the segment’s revenues but will be slightly be offset by the licensing revenues from the CME Group, so I am assuming that operating profits will be down by about 6%, to 592M$.
The Platts segment is dependent on commodity prices and while petroleum prices have plummeted in 2020, S&P has done a good job at diversifying the segment’s revenues, including commodities are peculiar as rice. An interesting comparison point is that despite oil prices performing poorly in 2019, Platts still saw 4% growth. This growth makes sense, as the segment also sees highly recurrent revenue. However, I am assuming some of Platts’ petroleum clients might restructure or go bankrupt, so am assuming a 5% drop in the segment’s operating margins, to 416M$.
In aggregate, with what I believe to be quite conservative figures, operating profits in 2020 should be roughly 3.29B$. Operating profit multiples have hovered around 14.5x on the low end the past 5 years, so applying that multiple on projected 2020 figures gives about 46B$ of market cap, implying that if shares were to drop by a further 22% from current levels, I would be a buyer.
In conclusion, S&P Global is a fantastic business, with significant competitive advantages in each segment it operates in. The company will benefit as total corporate debt outstanding continues to grow over time since S&P is the toll road to the world’s debt capital markets. Other catalysts for growth include increased penetration in Chinese capital markets, investors seeking increasingly unique data, assets shifting to indexed investments, ESG investing gaining momentum and trade flow changes driving additional price assessments usage.
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