Description

Introduction

In late February of this year, S&P Global (ticker: SPGI) closed on its acquisition of IHS Markit (ticker: INFO). This deal continues a long corporate evolution for the company which can trace its origins to a provider of information for railroad investors all the way back to 1860. In 2011, the company was spun out of the McGraw Hill publishing conglomerate. In 2016, it divested the J.D. Power division and renamed itself S&P Global. IHS Markit was brought together in 2016 when IHS, a data and analytics provider for businesses and governments, acquired Markit, which provided pricing data on derivatives and other financial assets. Markit was founded in 2003 in London by a former TD Bank executive and was initially backed by a group of large banks seeking transparent pricing data on credit derivatives. SPGI’s deal to acquire INFO, which was valued around $44 billion excluding required divestitures, has created one of the largest global providers of data to the financial community. The current market capitalization of the combined company is around $131 billion. The company now comprises six operating divisions. Collectively these businesses have high margins and recurring revenues with relatively low capital intensity and pricing power. On a proforma basis, the combined company generated revenue of approximately $12.4 billion in 2021. The following chart reflects the combined company’s operating divisions and their contribution to total revenue.

Divisional Overview

S&P Global Ratings (Ratings), which is 100% legacy S&P, will comprise the largest division in terms of both revenue (33%) and operating profit (44%) based on proforma 2021. Given tightening in the credit markets, these numbers will decline in 2022. When investors think of SPGI, Ratings is likely the first thing that comes to mind. SPGI is the largest credit rating firm in the world, slightly larger than Moody’s. Combined, they account for about 80% to 85% of the credit rating industry. Fitch is the next largest competitor accounting for over 10% market share. Credit rating has historically been a very good business due to network effects. The entire fixed income investment ecosystem has been built around credit ratings from the way funds are constructed and marketed to the types of bonds that regulated entities (from banks to insurers) and large institutional investors may hold. Ratings from SPGI and Moody’s are the global benchmark by which participants in global credit markets judge the creditworthiness of one credit against another. Bond issuers need credit ratings from SPGI and Moody’s because global markets are familiar with and accept those ratings.

In addition to network effects, SPGI also benefits from decades of history demonstrating the performance of its ratings. This allows the company to provide reliable default probabilities as well as relative probabilities and comparability between different types of bonds with different ratings. Given decades of experience, SPGI and Moody’s have established relationships with debt issuers and regulators across the globe. In addition, the cost of a rating is less than the savings it provides to the issuer in the form of a lower cost of capital. For example, a rating might cost 7 basis points but will result in a 40 basis point reduction in the interest rate as compared to a similar unrated bond. Historically, as ratings are necessary and relatively low cost compared to the overall cost of debt issuance, S&P has been able to raise price by 3% or 4% annually. Given their prominent role in the world’s financial infrastructure and the relatively low cost of the service, SPGI and Moody’s have formed a natural oligopoly that has lasted for decades, survived the financial crisis, and will likely flourish for many more years.

Obviously, with rates and credit spreads rising this year, the debt issuance environment has been unfavorable to say the least. When SGPI provided initial guidance after the completion of the acquisition, it projected low-single digit revenue growth for Ratings in 2022, which was downgraded to a low to mid-single digit decrease after Q1, and a low to mid-twenties decrease after Q2. The outlook for operating margin has declined from mid-sixties to mid to high fifties. This has been one of the sharpest pullbacks in debt issuance in recent memory. In Q2, Ratings revenue declined 26% from the prior year due to issuance weakness largely in corporates and structured finance. This comes on the heels of a very strong period of growth. Over the past five years, revenue has grown at an average rate of over 10% annually and operating profits have grown even faster given the low-rate environment of recent years. This has led to tremendous growth in total global debt outstanding which will be monitored and eventually need to be refinanced. The following charts shows total global corporate debt rated by SPGI.

The next largest division (based on 2021 proforma revenue) is Market Intelligence (MI). MI is comprised of around 50/50 legacy S&P and IHS and includes desktop, data and advisory, enterprise, and credit and risk. Given the pullback in Ratings, MI will be the largest division in 2022. A vast majority of MI revenue is recurring as many of these products are sold on a subscription basis and have been incorporated into customers’ workflows. This is also high-margin revenue. The legacy IHS financial service segment, which is largely contained in MI, had adjusted EBITDA margins in 2021 of 50% and organic revenue growth from 2016 through 2021 averaged 7%. Legacy SPGI’s MI adjusted operating margins have averaged 32.4% over the previous five years and revenue growth has averaged 6.3% over that period.

·       Desktop includes the legacy S&P data and analytics products such as Capital IQ and SNL which are used by investment managers, investment banks, PE firms, etc. to inform the investment decision making process.

·       The data and advisory business is 75% legacy IHS and includes its Economic and Country Risk research, pricing and reference data spanning major asset classes including fixed income, equity, credit, and foreign exchange, proprietary indices including the PMI series, and valuation services for a broad set of derivatives and cash products used by a wide range of financial institutions.

·       The enterprise segment is legacy IHS and provides standardized and configurable enterprise software platforms to “automate our customers’ in-house processing and connectivity for trading and post-trade processing, as well as enterprise data and risk management solutions.” This includes products like Ipreo, WSO, ClearPar and various “know your customer” solutions.  

·       The credit solutions segment packages and sells credit ratings and related research produced by the Ratings division.

The S&P Global Commodity Insights (CI) division includes the legacy S&P Platts which is the leading independent provider of information and benchmark prices for commodity and energy markets. Platts provides daily price assessments and comprehensive coverage of a wide range of commodities including petroleum, iron ore, power and gas, petrochemicals, metals, and various agricultural products among many others. It generates revenue from subscriptions, conferences, and sales-based usage royalties from the licensing of its proprietary market price data and price assessments. Despite high levels of volatility in commodity prices, Platts has generally been a very stable business. Revenue growth has averaged just over 5% over the past four years. Like some of the businesses in MI, given the nature of Platts’ pricing data, it gets embedded in customers’ processes and can be difficult to switch. For example, Platts’ pricing data is used in long term agreements thus making it difficult to change to another data provider for the duration of the agreement. CI also includes the legacy IHS upstream business which provides technical information and expertise on over 6.5 million oil and gas wells, over 5,000 basins, and 3,400 land rigs. This data is typically used by geoscientists and engineers working in energy exploration. SPGI divested the IHS downstream business to gain regulatory approval for the IHS acquisition. Platts’ adjusted operating margins have averaged over 50% the past five years and the adjusted EBITDA margin for the legacy IHS resources segment averaged over 40% in the three years prior to the deal.

S&P Global Mobility (Mobility) is comprised of the legacy automotive offerings of the IHS transportation segment. Mobility is the leading global provider of data for the automobile industry including tracking OEM production and sales rates across the globe. It also publishes the industry’s most widely used forecasts for future production rates for more than 50,000 different unique vehicle model variants which cover 99% of light global vehicle sales and production. Mobility owns CarFax which is the leading provider of vehicle history reports and provides loyalty and marketing programs to auto dealerships. In the US, sales and marketing offerings draw on a database of nearly 12 billion ownership records covering 790 million vehicles and more than 250 million US households over a period of more than 25 years. In addition to dealership marketing and loyalty programs, Mobility also provide services around vehicle recalls to carmakers by identifying households to be contacted and providing accurate measures of recall completeness. Mobility also owns automotiveMastermind which provides predictive analytics and marketing automation software to auto dealerships. Like the other divisions, historical margins have been high, with adjusted EBITDA margins averaging 45% over the past three years and organic revenue growing an average of 9% annually over the past five years.

The S&P Dow Jones Indices (Indices) division includes primarily the legacy S&P Index business with a small amount of revenue coming from asset-linked fees pertaining to the IHS indices. This has been SPGI’s highest margin business as it licenses the S&P name to asset managers. The largest ETF in the world, the SPY, pays royalties to SPGI for use of their intellectual property. SPGI believes that future growth in the index business will come from ESG in addition to the continued growth of passive investing in general. Indices also generates transaction royalties on exchange traded derivatives, notably S&P 500 index futures on CME and S&P 500 index options and VIX options on CBOE. Indices has seen impressive growth in recent years as capital has flowed into equity index funds. It is likely that future growth will slow as passive comprises a larger share of the investment landscape and passive funds push for lower fees as they grow larger. However, any growth that occurs has very high incremental margins.

Finally, the smallest division is S&P Global Engineering Solutions which is all legacy IHS and publishes standards, codes, and specifications collected from standard setting organizations that are used by product designers and engineers. This includes things like codes, specifications, technical references, best practices, patents, etc. An example of this is the publication every other year of the “Boiler and Pressure Vessel Code” in association with the American Society of Mechanical Engineers. Another example is a product called BOM Intelligence which has a database of over 1 billion electronic components and parts which allows customers to integrate their bills of materials with obsolescence management, product change notifications, end-of-life alerts, and research and analysis. For all the legacy IHS and S&P businesses, Engineering Solutions has been the slowest growing and lowest margin business.

Collectively, over 75% of company revenues are recurring and many products are sold on a subscription basis. As evidenced by historical rates of growth, the products and services sold by both legacy S&P and IHS have high rates of renewal and the ability to raise prices over time. Whether automotiveMastermind in Mobility, portfolio management platforms in MI, investment funds offering S&P index products in Indices, daily price assessments in Platts, many of these products are embedded within their customers’ businesses, thus making it difficult to switch providers and providing some measure of protection from competition.

Financial Overview

As previously mentioned, the combined company generated $12.4 billion in sales in 2021. At the time of the acquisition, the company projected mid-to high single digit sales growth through 2023. That seemed reasonable considering average five-year revenue growth for SPGI of 8% (which is largely organic) and organic growth in IHS’ transportation and financial services segments averaging 9% and 7%, respectively, over the same period. After a reset this year due to turbulence in the debt markets, I think it’s highly likely that revenue growth will return to the mid-to high single digit range moving forward due to both pricing and volume growth. A strong auto market in the US due to supply improvements as well as relatively strong commodity prices could lead to upside for Mobility and CI moving forward. For Ratings, the business likely won’t return to the very strong growth of the past two years as a lot of debt issuance was pulled forward by incredibly low interest rates. However, given the growth in the overall quantity of global debt, upcoming refinancing needs, and pricing power, the business should return to growth sooner rather than later.

From a margin standpoint, SPGI has projected a 200 basis point improvement in margins in both 2022 and 2023 based on continued growth in the businesses as well as the opportunity for cost synergies totaling $600 million. Frankly this seems quite conservative given the natural margin leverage that has occurred historically in both legacy SPGI and IHS. For example, IHS’s EBITDA margin increased from 36.1% in 2016 to 43.6% in 2021 as legacy transportation and financial services have increased margins and grown as a percentage of the total. SPGI has shown very strong incremental margins as the adjusted operating margin has increased from 45.6% in 2017 to 55.1% in 2021. All of SPGI’s legacy businesses have demonstrated margin leverage in recent years, especially Ratings and Platts. After a reset for Ratings this year, I see no reason why margins can’t continue to expand, especially as cost synergies start to flow through and the various legacy businesses are integrated into the new divisions. Given the strong distribution platforms in MI and CI, the integration of financial data from IHS will increase the utility of these platforms and allow for value-based incremental pricing.

Given the lack of large-scale M&A at SPGI in recent years (the exception being the $2.2 billion acquisition of SNL Financial in 2015), historical returns on invested capital have been extraordinarily high. For example, over the past five years, SPGI has invested $1.34 billion in capital expenditures and acquisitions and NOPAT has increased by $665 million during the same period for an incremental ROIC of 50%. The company has been able to grow with minimal incremental investments. As a result, it’s typically paid out a quarter of free cash flow as dividends and over 50% as share repurchases. FCF per share has compounded at 22% annually over the past five years. For legacy IHS, returns on capital have not been as strong primarily because the company has been very acquisitive. Returns on invested capital have been in the high single digit range over the past five years. However, if you compare the growth in NOPAT to the incremental capital invested over the past three years, the incremental ROIC is over 16% as proceeds from divestitures exceeded acquisition spending during this time frame.

Gross leverage of the combined company currently stands at 2.5x including $3.3 billion for the Indices put option (based on the JV agreement with CME), small pension liabilities and capitalized leases. In a change to historical practice, the company has said target leverage will be in the 2 to 2.5x range going forward. Given likely HSD/LDD growth in EBITDA over time, maintaining leverage at 2.5x will generate significant excess cash that the company will likely return to shareholders in the form of dividends and share repurchases. For example, consensus EBITDA for 2023 is $6.93 billion, an increase of $740 million from expected 2022. Leveraging this additional EBITDA will result in additional cash of $1.85 billion to be returned to shareholders. Given that the IHS deals brings significant additional recurring revenue, it makes sense to run with a bit more leverage, albeit still at a very manageable level.

Valuation/Returns

At a current stock price of $386 and with 339 million shares outstanding as of June 30, SPGI’s market cap is currently $131 billion. Prior to the melt down in the bond market this year, management projected that the combined company would generate more than $5 billion in free cash flow in 2023. Given the recent rebound in credit markets, I think this is still very achievable. Combined free cash flow for SPGI and IHS in 2021 was over $4.5 billion and this includes expenses associated with the acquisition. Given the realization of synergies and growth in the businesses, ongoing free cash flow a year or two down the road will be in the high $5 billion range which implies a free cash flow yield on the current market capitalization of around 4.5%. Including the “debt boost” from incremental borrowing to keep leverage within the target range, total cash flows to equity will likely be close to $7.5 billion. With management having committed to capital returns of 75% to 85%, the company will repurchase significant amounts of stock going forward which will likely lead to free cash flow per share compounding at mid-teens rates. With a starting yield of 4% to 4.5%, and double-digit rates of growth in free cash flow per share, I think it is very likely the stock compounds at mid-teens rates going forward, even without margin expansion continuing at the pace of recent years.

Risks

SPGI is significantly impacted by global bond issuance with the Ratings segment being the largest in terms of EBITDA contribution (over 40% of the combined company). Given the significant amount of global debt issuance in recent years and the rapid rise in interest rates in the first half of 2022, near term debt issuance has declined. A longer-term sustained increase in interest rates would be detrimental to ongoing debt issuance trends which would mute the growth potential of Ratings moving forward. While the future path of rates is unknown, I believe it is unlikely that rates will rise significantly from here. The addition of IHS has brought more recurring revenue which should provide more balance to volatility in Ratings.

If interest rates did increase and remain at higher levels, as previously mentioned, this would have a negative impact on Ratings. It would likely lead to a derating in the multiple of SPGI. The mid-teens return expectation mentioned previously assumes no contraction in the multiple over time. Given the relatively high multiple of SPGI and the fact that demand for the product of its most profitable division would be adversely impacted by rising rates, multiple contraction is a risk even if the business performs well. However, given the likely growth in cash flow per share over the next few years, I think even with some multiple contraction, the results can still be adequate.

The task of integrating IHS is huge. At $44 billion before divestitures, this is by far the largest acquisition undertaken by SPGI and is not without risks. The company is attempting to merge two global businesses and realize $600 million in cost synergies and $350 million in revenue synergies over the next few years. While I believe the management of SPGI has proven itself very capable and the company has generated significant shareholder value over time, integrating IHS is a major undertaking.

Conclusion

I believe there is a lot of evidence that SPGI is a collection of very high-quality businesses. Common characteristics among Ratings, MI, CI, Mobility, and Indices are strong historical revenue growth, pricing power, high margins, low capital intensity and customer stickiness to various degrees. Once the businesses are integrated, synergies realized, and the debt issuance environment normalizes, I believe SPGI will be returning significant amounts of cash flow to shareholders in both dividends and stock repurchases. With the new leverage target and likely EBITDA growth, cash from borrowings will be available in addition to free cash flow to further enhance equity value. Given the starting valuation and what I believe to be a very high likelihood of double-digit growth in free cash flow per share, returns from here could be very strong. Unfortunately, the stock price has run up quite a bit over just the past month as rates have fallen, but I believe investors can still do quite well from the current stock price.

Catalyst

• Continued rebound in credit markets
• Execution of remaining Accelerated Share Repurchase program by year end
• Successful realization of cost synergies