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MSCI no bargain even after this week's selloff Add to ...

A company loses a client that provides just $24-million of its $900-million in revenue, and the shares fall 27 per cent. Wild overreaction?

Perhaps, but in the case of investment-services provider MSCI Inc., the loss means more than just a blip on the top line. The client in question is Vanguard, the giant mutual fund provider, which is terminating its contract to use MSCI’s equity indexes as the basis for its ETF products. MSCI’s disclosure of the move Tuesday prompted the freefall in its shares, from $35.82 to $26.21 (U.S.) in a single day.

Problem No. 1? The fees from Vanguard are almost pure profit, meaning it’s a $24-million hit to operating income, which was about $330-million over the last 12 months.

“While it is relatively easy for MSCI to plug the hole at the top line from this client loss, it will be more difficult to fill the gap at the bottom line,” Swami Shanmugasundaram of Morningstar Equity Research said, predicting MSCI’s operating margins would shrink by several percentage points.

Analyst Christopher Shutler of William Blair & Co. cut his 2013 earnings-per-share estimate by 6 per cent as a result.

More concerning is what the Vanguard move means in the broader context of the ETF industry. Mr. Shanmugasundaram says while “the direct fallout from Vanguard's move is significant, it will pale in comparison if other ETF sponsors (BlackRock in particular) decide to follow suit.”

BlackRock, owner of the iShares product line, represents 8 per cent of MSCI’s total revenue, he estimates. “If BlackRock either decides to switch to a different service provider or use its own indices, it will be a devastating blow for MSCI. As with Vanguard, MSCI would be able to absorb any loss in revenue from BlackRock, but the impact on margins will be severe. With BlackRock already talking about developing its own indices, we think MSCI is on shaky ground.”

This may be too much fear. Mr. Shutler, who has a “market perform” rating on the stock, noted BlackRock allowed MSCI to quote it Monday as saying that “MSCI is the gold standard of global and international equity indices” and that it plans “to deepen our relationship and partnership with MSCI.”

Jennifer Huang of UBS Securities, who has a “buy” rating and reduced her target price from $40 to $35 this week, believes the Vanguard loss should only cause a $4 to $5 drop in valuation and the stock reaction is also implying MSCI loses two-thirds of the fees it gets from BlackRock. “While we believe iShares may be in a stronger negotiating position … we are not yet convinced that a dramatic fee reduction is a given, in part because iShares can now differentiate its ETFs based on its partnership with MSCI.”

In Wednesday’s trading, investors bought back in to MSCI, adding $2 to its share price, leaving it 21 per cent below Monday’s close. (Shares are steady so far today). That gives it a forward price-to-earnings ratio of 14, and trailing P/E of nearly 20, not clearly in bargain territory.

Mr. Shutler, of William Blair, notes “MSCI was already trying to navigate its way through the intersection of slowing revenue growth and significant investments into the business,” and says he has a “lack of conviction that the core business will achieve a material acceleration in gross sales in the next couple of quarters.”

It seems MSCI’s comeback from losing 2 per cent of its revenue might be rather slow.




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