Description

Investment Summary:

BARRA is the leading provider of portfolio analytics and risk management software for institutional investment management firms. Founded 27 years ago, BARRA’s proprietary models are the gold standard for portfolio optimization, performance attribution, and risk management in the asset management industry.

BARRA’s shares have declined from a 52-week high of $61 in March ’02 to the current price on concerns of slowing revenue growth and resulting margin pressure. A closer look at the financial statements and a better understanding of BARRA’s exposure to an equity bear market reveal a compelling investment opportunity. The company has a strong franchise, generates high returns on capital, produces significant free cash flow, and has $243 million of cash on its balance sheet ($12/share) with no long-term debt.


History:

The company was originally formed in 1975 by finance professors at Berkeley. Ziff Communications owned it from 1981-1986 until management bought back the company in a leveraged buyout. The public IPO was in 1991.

From the beginning, BARRA’s equity portfolio analytics were the standard for risk and performance measurement. In 1987, the company partnered with Investment Technology Group (ITG) to develop POSIT, a low-cost matching system that uses algorithms created by BARRA. POSIT reduces transaction costs and minimizes market impact for institutional traders seeking liquidity in a confidential environment. Today, BARRA receives royalty streams from a 50-50 joint venture operated by ITG that licenses the POSIT technology.

In late 1999, BARRA promoted Kamal Duggirala to his current role as CEO. Kamal set about simplifying BARRA’s diverse business mix (consulting, asset management, data products, etc.) and focusing on its core analytics business. Non-core businesses were closed or divested, a process completed in FY02. Kamal intends to build around the remaining core by leveraging the sizable competitive advantages the company already enjoys to increase recurring revenues and reach new clients.


Business Description:

BARRA has two business units. The core business (85% revenues, 50% profits) provides portfolio risk management and enterprise risk management systems to investment professionals at medium and large asset managers. The other business (15% of revenues, 50% of profits) is a revenue royalty interest in POSIT, a computerized trading system for US equities that matches buy and sell orders to trade single stocks and portfolios of securities.

BARRA is the clear market leader in its core analytics business and its competitive advantages of size and scope are likely sustainable. Ten of the ten largest investment management firms and 70 of the top 100 are BARRA clients. Revenue retention runs approximately 90% and a significant portion of its annual growth comes from existing clients signing up for new features or services. As the availability and amount of statistical information increases, BARRA’s ability to incorporate and analyze those inputs becomes increasingly difficult and expensive to replicate. Moreover, the penetration rate among asset managers, pension funds and consultants pose a high barrier to entry for new entrants.

Summary Financials for BARRA’s Analytics business:
(FY ends March)

Revs Op Inc %Margin
2001 112 25.6 22.8%
2002 122 28.5 23.5%
2003(e) 122 28.2 23.1%
2004(e) 126 29.3 23.1%

BARRA receives 13% of commission revenues generated by POSIT, the matching system jointly operated by ITG. Since ITG operates POSIT, there are virtually no costs associated with this revenue. While trading volumes can vary, revenues from POSIT carry little if any associated cost and thus account for a disproportionate share of profit. While many new forms of competition are emerging, POSIT remains the largest and most cost effective trading platform for institutional traders seeking liquidity and confidentiality. Several well-financed competitors have emerged in recent years to challenge POSIT’s position but the impact was minimal.

Royalties for BARRA’s POSIT business:

FY 2002 24.0
FY 2003(e) 20.3
FY 2004(e) 20.6



Capitalization:

Share price: $25.00
TSO: 20.40
Market Cap $510
Cash & ST investments $243
TEV $268


Valuation Metrics:

FY03 EPS $1.72 14.5x (includes cash)
FY03 EBIT $45.7 6.0x (excludes cash)
FY03 EBITDA $50.7 5.4x (excludes cash)

The company has $243 million cash and equivalents on its balance sheet ($12 per share) and no long-term liabilities. The cash has accumulated through a combination of free cash flow (~$35 million this year but recently higher) and sales of non-core businesses. Management intends to reinvest in its core business, make selective (probably small) acquisitions, and repurchase shares. In the first quarter of this year, BARRA spent $42 million to buy ~950K of its current 1.5 million share authorization. Recent conversations with management suggest that the company continues to buy back its shares in the open market.


Investment Thesis:

Investors worry that clients will look to cut discretionary expenses as assets under management fall and that new account growth will all but stop. Analysts suggest that contracts will be renegotiated at lower prices or cancelled altogether at renewal (contracts are for one year). While market declines cause existing clients to examine spending on products like BARRA’s analytics and certainly limit new account growth, i) BARRA’s subscriptions represent a small fraction of the typical clients research budget (average is $110,000 and top out at $2 million for the largest accounts); ii) market volatility increases demand for BARRA’s risk analytics; iii) revenue retention last quarter was 85% (near the 90% target); and iv) current price discussions involve holding the line versus historical increases of 4-5%. The other worry is POSIT: trading volume is down from recent highs, but remains healthy, its market share unchanged, and unlikely to fall permanently from last year’s 20 million shares (down from 24 million in FY02) (volume numbers represent BARRA’s share). CY02 first quarter volume was 8% higher, the second 16% lower, and in the just ended Oct quarter, down 25%.

The market is overestimating BARRA’s market exposure and overlooking its financial strength, durable franchise, and significant cash flow. Revenues are largely recurring, pricing and margins are relatively stable, and a difficult market further limits the threat of new competition.

With $12 per share in net cash on its balance sheet, approximately $1.60 per share in free cash flow in FY ending March, investors have little risk of permanent capital loss. If BARRA is able to achieve anywhere near its historical growth in its core business and POSIT in future years maintains something close to 20MM shares annually (again, BARRA's share), the stock is very cheap and offers an exceptional buying opportunity.


Other:

Management owns 4.27 million shares as of the most recent quarter (20% TSO) and including options, insiders as a group control 24%.

Catalyst

Potential Catalysts:

1) significant share repurchase
2) acquisition by Moody’s, Standard & Poor’s, Investment Technology Group, etc.