Few companies worldwide can boast a market position so strong that they can raise prices year after year without problems. This is the case for S&P Global, and it is a quality which we value dearly as co-owners.
Although we are sceptical of investing in companies with levered balance sheets we can rejoice in the fact that many companies have a different view on the matter. Many companies carry debt, and when that debt is to be raised or refinanced, they must go through S&P Global or Moody’s for a credit rating – benefitting us as co-owners.
S&P Global (and Moody’s) come very close to being benchmarks for a “BLS-company”. We look for companies which can (at a minimum) increase prices in step with inflation, have protected and scalable business models in which margins increase when business activity does, offer high returns on invested capital, and generate significant free cash-flows.
For S&P Global, the target is to be an industry standard within all the company’s divisions, and this is already the case for three out of four divisions. These quality characteristics contribute to S&P Global’s expectation of growing earnings per share by more than ten percent a year.
Credit ratings at S&P Global are provided through the S&P Global Ratings division, which represents around half of the company’s total revenue of more than six billion US dollars, and more than half of earnings. S&P Global Ratings is a highly profitable business with operating margins of 56 percent. One of the reasons for the high margin relates to the interest saving that the debt issuer gets as a result of obtaining a credit rating from S&P Global – as is also the case with Moody’s. S&P Global, like Moody’s, act like credit rating industry standards, which customers find hard to bypass, resulting in the company being able to increase prices by three to four percent every year.
Old habits die hard – but the tide will turn
Over the past five years, S&P Global Ratings has grown annual revenue by just under eight percent. This primarily relates to debt issuance in connection with refinancing of existing debt and increased debt for the financing of corporate transactions. The amount of outstanding debt generally grows in line with the nominal economic growth. A supporting long-term development is the disintermediation of debt, where there is a growing preference for corporate bonds in contrast to Europe’s and Asia’s more traditional use of bank loans.
In Europe, corporate debt is heavily dominated by bank loans, accounting for almost three-quarters of the debt in non-financial companies. In the USA, the picture is reverse, with bank loans covering only 20 to 30 percent of the total corporate debt market. This provides good opportunity for an increased demand for credit ratings in Europa, as well as Asia. China is a large focus area since foreign ownership of financial companies was made possible in the country in 2017.
As mentioned, it is a lengthy process, as companies have to change their usual approach to debt financing and there must also be a demand from debt investors. The inertia among European and Asian companies has been stronger than expected, but we have no doubt that corporate bonds will be more common in time.
Growth in structured products, where banks, for example, sell their customers’ debt to credit investors as packaged loans, has a positive effect on the number of credit ratings. Packaged loans can be a portfolio of either mortgage loans, credit card debt, or standard bank loans. By selling the debt as packaged loans, the banks avoid the related loss risks. This makes it easier for the banks to comply with the capital requirements made by authorities related to capital reserves.
Structured products are more complex to rate, thus carries a higher fee compared to less complicated issuance. In the years leading up to the financial crisis, structured products represented just under half of revenue in Ratings, compared to merely ten percent today. However, despite the lower share of the higher margin, structured products, margins in Ratings have increased.
Investments in new systems, products, and data are aimed at customer retention and maintaining pricing power in S&P Global Ratings and S&P Global’s other business divisions, Market & Commodities Intelligence and Indices, which – like Ratings – are industry standards within their respective business areas. Investments in technology to optimize efficiency have led to acquisitions of several smaller companies capable of automating data collection, consolidation, and validation, which was previously performed by employees, much faster and cheaper than before. This means that S&P Global can expand the business and do more with the same number of employees. The potential for increased use of artificial intelligence and increased automation of the business is present in all divisions. We therefore expect to see continued increases in margins – from already high levels.
Smaller earnings motor gains market share
Market & Commodities Intelligence consists of Market Intelligence and Commodities Intelligence and represents around 40 percent of revenue and just under 20 percent of operating income respectively. Market Intelligence consists of platforms which collect information about companies and industries, which gives customers access to better information to improve their decision making related to investments, while Commodities Intelligence consists of the S&P Global Platts platform. Platts is the leading provider of information and pricing on energy and other commodity markets. The division has more or less achieved the same status as an industry standard, as Ratings has within credit ratings. Platts’ prices are often used as reference prices and included as benchmarks in contracts when deals in various commodity markets are made. This status enables S&P Global Platts to increase their prices by three to four percent a year.
Market & Commodities Intelligence grows revenues by just shy of ten percent per year, which is impressive given that the market for financial information and market data is growing by about three percent per year. Growth is expected to continue due to a continuously higher demand for information. Platts should grow by a high single-digit growth rate under normal financial circumstances, and Market Intelligence is seeing growth in platform-users of 10-15 percent, well assisted by the merger of the Capital IQ and SNL Financial platforms.
Market and Commodities Intelligence has a market share of around ten percent but is gaining market share from the larger providers such as Bloomberg and Thomson Reuters. The division is a long-term, attractive division with high stability, as over 95 percent of its revenue comes from subscription payments with a similar high renewal rate. We value this kind of stability and predictability, greatly.
The index business started as far back as 1884, when Charles Dow invented the first index. This has grown throughout the years, and today S&P Global Indices manages more than one million indices. In context, there are just under 40,000 listed equities world-wide. In other words, S&P Global offers more than 25 times as many indices as there are listed equities. Further to this, more and more indices are created as demand for passive investments increases. Revenues in S&P Global Indices are expected to grow by around ten percent per year.
S&P Global Indices constructs and offers indices for which asset managers pay a fee to either measure their own returns against or to base their investment holdings on – so-called passive index funds. Today, more than 13.7 trillion US dollars are benchmarked or indexed to an S&P Global index. S&P Global Indices has just under one billion dollars in revenue, of which almost 60 percent are asset-linked fees.
The remaining payments are subscription or transaction payments. Contract structures ensure that a large proportion of payments are recurring payments – more than 80 percent – at the same time ensuring that S&P Global’s fee income increases when assets under management increases, as the result of market price increases or new funds, and in certain instances when index funds or financial instruments are traded more frequently.
World-class operating margin
Despite being the smallest business division, S&P Global Indices boasts the best operating margin of the company, at more than 65 percent. The impressive margin is a result of the index business being highly scalable. When an index has been constructed, there are very few costs related to the addition of new customers or larger asset levels, why the incremental operating margin of an added customer is very attractive and close to 100 percent.
S&P Globals annual free cash-flows amount to just over six percent of the market value. In combination with limited debt of less than one times operating income before depreciation and amortisations, this provides ample opportunities for investing in the existing business and distributing capital to shareholders in the form of dividends and share buybacks. The company aims to distribute a minimum of 75 percent of free cash-flows to shareholders, distributing around 1.5 percent of the market value as dividends and three-four percent through share buybacks.
We consider it prudent that the remaining funds are reinvested in a company with a 40 percent return on invested capital. We trust that management, under the leadership of CEO Douglas L. Peterson, will stay focused on the most value-creating investments and initiatives, which has been the case since he took over the reins in 2013.
It is rare that business divisions of a company act as industry standards, but this is the case for S&P Global, giving the company a unique market position. A market position involving excellent possibilities for further growth and value creation in the future. Something which the company and we, as co-owners, can benefit from.