Analysis: Investors fret over MSCI outlook as ETF price war bites

Just four weeks ago, an MSCI executive was crowing about his company's near-monopoly on providing critical benchmark stock market indexes which are licensed by fund companies around the world.

"It's the only part of our business in which we have a committed strategy of trying to utilize a little bit of pricing power and raise prices a little bit every year," Edings Thibault, MSCI's head of investor relations, told investors at UBS's Best of Americas conference in London on September 7.

How fast times have changed for MSCI, a leading provider of indexes, risk management advice and other investment analysis services.

On Tuesday, the largest U.S. fund manager Vanguard Group, MSCI's second largest index licensing customer, said it was defecting to cheaper rivals. MSCI's stock went into free fall, dropping 27 percent and cutting $1 billion off the company's market value.

Until Vanguard's move, investors seemed to think MSCI, known for its all-world and emerging market stock indices, would be immune from the price war being fought in the $1.5 trillion global exchange-traded fund market. Now it has become clear that the drive for lower ETF fees will hit index providers as well.

With the loss of a big customer to MSCI's still-lucrative index business, analysts and investors are taking a hard look at the rest of the company's operations. Some are coming away unimpressed.

"Their bread and butter business is the indexing," said Steven Roge, a portfolio manager at R.W. Roge & Co in Beverly, Massachusetts. "All the acquisitions they've made to diversify have been a very poor move."

None of the recently acquired companies, such as RiskMetrics, boast the sky-high profit margins of the indexing business, Roge said. Many of the new units often require substantial additional investments to service new clients.

In contrast, revenue from new index-licensing customers is nearly all profit, and revenue from asset percentages increases naturally as markets rise.

Still, Roge said the sell-off in MSCI shares was "overdone" after they hit the lowest price in more than three years at under $25. He was a buyer on Tuesday and the position likely already shows a profit as MSCI shares had recovered some of the losses, quoted at $27.03 early afternoon on Thursday.

Investors fear BlackRock , the top ETF manager and MSCI's single biggest licensing customer, will use the Vanguard defection as leverage to demand lower fees. On Tuesday, BlackRock called MSCI the "gold standard" of indexing and said it planned to "deepen our partnership." But the New York-based firm has since declined to comment on pricing issues.

Last month, BlackRock CEO Laurence Fink said his firm planned to cut some ETF fees to better compete with Vanguard, possibly increasing pressure for concessions from MSCI. While BlackRock's plan is still forthcoming, Charles Schwab on September 21 slashed its ETF fees to as little as four hundredths of a percentage point.

Analysts who follow MSCI at Credit Suisse, Raymond James and other firms sliced earnings estimates and price targets soon after the Vanguard news. Most said they expected BlackRock would get fee concessions but would not switch index providers.

MSCI CEO Henry Fernandez did little to staunch the wound in a 45-minute conference call with analysts on Tuesday morning. Asked repeatedly about the company's prior assertions of strength, Fernandez repeatedly backed down.

For example, MSCI had previously touted the long-term contracts signed by ETF customers like Vanguard.

But Fernandez conceded that the length of the contracts was almost meaningless since an ETF manager could switch to a new index provider without technically cancelling. ETF managers could switch indexes in "relatively short periods of time," he told the analysts, adding assets "may not be as sticky as we all thought."

The fee in MSCI's contracts is calculated as a small percentage of the amount of assets tracking a particular index, so while a contract stays in force, no more fees are due when an ETF manager switches to a new benchmark, he explained.

The risk was disclosed in MSCI's lengthy, annual 10-K filings with the Securities and Exchange Commission. "Clients that have licensed our indices to serve as the basis of index-linked investment products are generally not required to continue to use our indices," the 2011 filing warned. If a client changed, "our asset-based fees could dramatically decrease."

More questions arose after analysts noted that the head of MSCI's indexing business, C.D. Baer Pettit, sold $2.4 million worth of MSCI shares on September 7. Before that, Pettit had not sold shares since 2010, according to securities filings. MSCI declined to comment on the sale or when it first learned Vanguard might defect. Attempts to reach Pettit were unsuccessful.

MSCI's share price may not recover much more in the short term. It has probably lost allure for managers who pick growth stocks without yet falling enough to attract value investors, said Christopher Shutler, an analyst at William Blair & Co.

"Trading at nine times its EBITDA (earnings before interest, tax, depreciation and amortization), it's not exactly a value stock," Shutler said. Shutler trimmed his 2013 earnings per share estimate 6 percent to $2.05.

None of MSCI's five largest shareholders has been willing to talk about the situation.

T. Rowe Price Group , whose funds owned 13.6 percent of MSCI shares at the end of June, and Morgan Stanley Investment Management, with a 12.2 percent stake, both declined to comment as did hedge fund manager Eric Mindich's Eton Park Capital Management, which owned 5.8 percent. Ron Baron, whose firm BAMCO Inc held 7.6 percent, did not return a call. Janus Capital Group , whose funds owned 5.1 percent, declined to comment.

MSCI's crown jewel has always been indexing, its core business when brokerage firm Morgan Stanley and Capital Group International, an affiliate of the firm that manages American Funds, came together to create the MSCI brand in 1986.

An aggressive acquisition spree over the past decade, fueled in part by going public in 2007, has added several other lines of business including Barra, an investment analytics firm, and RiskMetrics, a risk management and proxy research specialist. But the additions, which analysts say are significantly less profitable than indexing, face their own issues.

Even at Tuesday's low closing price, MSCI was not a "buy," analyst William Warmington at Raymond James said. "We continue to remain on the sidelines given the challenges MSCI is facing across business lines," Warmington wrote in a report on Tuesday night.

The portfolio management analytics division saw revenue drop over the past three years. Despite several acquisitions, analysts said, MSCI has not spent enough to improve its software offerings. This has created opportunities for rivals to pick off large clients. In the second quarter, the unit reported an annualized customer retention rate of only 84 percent, down from 91 percent a year earlier.

Revenue at MSCI's ISS proxy research unit, acquired in 2010, has not grown much in 2012, even as big shareholders have grown assertive at underperforming companies.

ISS's reputation with clients could also be at risk from an investigation by the Securities and Exchange Commission into a former employee who was found to have leaked confidential voting data in return for meals and tickets to various events.

MSCI said on Tuesday that the U.S. Securities and Exchange Commission had sent a so-called Wells notice, indicating the SEC may recommend a public administrative proceeding against ISS for violations under the Investment Advisers Act. MSCI said it was cooperating and did not expect the outcome of the matter to have an adverse affect on its business.

(Reporting by Aaron Pressman; Editing by Martin Howell and David Gregorio)