Description

Introduction

When Canada's richest family realized that the high-profile adventurous merger of its largest owned entity, Thomson, with Reuters, for $ 17 bn in 2008 to become the largest global data provider was a fatal decision, it was too late to change tracks. This was perhaps the most flawed capital allocation decision, orchestrated by Mr. Beattie, the then head of Woodbridge (family's investment vehicle), who was later fired along with the then TRI's CEO – Tom Glocer, who came along with the Reuters merger.

Later, David Thomson, the third-generation scion of the empire's founder, and another family loyalist Mr. David Binet (who replaced Mr. Beattie as the head of Woodbridge), steadied the ship with a management overhaul in 2012. 

The opportunity cost, however, out of the Reuters merger was huge. Terming it as a "lost decade" would not be an understatement, with little meaningful economic value addition. But I do also have a caveat - the "greatest reset" is behind us now after the split-off of Refinitiv (financial data business from Reuters), and now's the time to enjoy the fruits of riding a family-owned business.

Why's the opportunity?

Carrying the baggage of Reuters, Thomson Reuters (TRI) has been perceived to be a perpetual restructuring play. The sale of Refintiv took three years, testing investors' fatigue before it finally found a home with London Stock Exchange (LSEG) this year. Moreover, many still associate Thomson Reuters with the economics of the latter part of its name. 

But, if you were to peel off the layers, you'll find stunning business underneath, with ~80% of revenues now emanating from the Legal, Tax and Accounting (I'll refer to them as "Big 3"). These businesses are standing at the threshold of a quantum shift in business model as customers undergo structural, behavioral changes in embracing the cloud. 

Today, TRI has an exceedingly attractive and resilient business profile that is highly cash generative with solid entry barriers. Products are deeply embedded in customer's daily workflows as they build mission-critical offerings around TRI's ecosystem. This creates high stickiness in revenues. For example, TRI's retention rate of ~90% is the best-in-class, which even other information services companies like S&P Global, Moody's pale in comparison. 

Moreover, almost 80% of TRI's total revenues are recurring, generated on a subscription basis. A high subscription rate (deferred payments) provides negative working capital as a source of cash – high FCF and lower reinvesting needs.

Why does the sale of Refintiv create an opportunity?

The split-off of Refinitiv has cut the top-line by more than half. A bold move when managers elsewhere are obsessed with size. With the distraction out, the family is serious about accelerating the organic growth for the remaining business. We had seen many similar playbooks being played out when S&P Global (SPGI) came out of the shadows of its publishing conglomerate, McGraw Hill, in 2013. Similarly, European competitors like Relx and Wolters Kluwer added the maximum value for shareholders when an accelerated growth kicked off the economy of scale (details later in the note). 

1. Understanding the "Big 3"

2. Why capital allocation matters 

3. When incentives provided the impetus to the family-owned business 

4. Is playbook similar to RELX, Wolters & S&P Global?

5. Can the unit economics allow further lever-up? 

6. Financials

7. Valuation – Would you like to own a stock at its lifetime high? 

1. Understanding the "Big 3"

TRI has built strong positions across legal, tax and corporates through its key proprietary content assets made on a combination of 100+ years of editorial expertise combined with software. 

The "Build once, sell many times" model offers impressive economies of scale with high incremental margins and free cash flows. Bloomberg is a rich man's social network; TRI is a must-have for small and big firms, equally. The market infrastructure provides a strong network effect with deeply embedded workflows tools that enables stickiness and pricing power. 

Let's delve further into them:

Source: Company filings; EBITDA excludes corporate costs not assigned to segments.

1. TRI entered the legal business via the acquisition of West Publishing in 1996.  Today it is the largest segment. Right from the entire U.S. Federal Courts, DoJ to the Global 100 law firms, the whole ecosystem uses its products. This creates a strong network effect. After all, no attorney would like to ignore what a judge or a competitor is using! The retention rate is therefore significantly high at 90%, indicating a stickiness with clients. 

This segment has been stable and resilient. Even during GFC, organic growth clocked +2% despite a massive structural change in the client's business models. Software is leading the growth compared to content. Legal has been the slowest adopter of technology, but the trend got accelerated during COVID. For example, for the first time ever, the court proceedings went online last year. 

TRI is the #1 player with ~23% share in a market growing at 4-6%. Traditional competitors include firms providing content and software such as Relx's LexisNexis and Wolters Kluwer's Cheetah. Bloomberg BNA and Aderant are providers of either content or software only. Multiple start-ups (Kira, Brevia, Avvo, RocketLawyer, Clio, Luminance etc.) have come with innovations and success.

A shift to a subscription-based platform has improved the recurring revenues (93%) and margins. This was aided by the launch of Westlaw Edge two years back. An ability to charge premium pricing from new offerings has led to a stupendous ~600 bps margin improvement over the last five years. Noteworthy was that this segment had an incremental margin of ~86% (i.e. out of ~$300 m of new revenues, it converted 86% of it into profits). 

Source: Company filings, segments were realigned in 2018 

2. Corporate is the second largest segment. Its products are deeply entrenched within the corporate and tax departments of Fortune 100 firms. These departments are mostly seen as cost centers. Hence they are under pressure to bring more work in-house and use automation tools to drive efficiency. As a result, technology adoption has been the fastest here. TRI had an early mover advantage to migrate from legacy systems to SaaS-based solutions. This ensured success in subscription-based business, with 84% revenues being recurring in nature today. 

TRI is #1 with a ~14% share in a market growing at a fast rate of 6-10%. Primary competitors here are Wolters Kluwer and LexisNexis (RELX). Avalara, MitraTech, Vertex and Sovos are a few software competitors out of the many that stand out. Many times, Big 4 accounting firms are both customers and competitors.

Corporates often have to deal with complex and ever-changing direct and indirect tax needs. They cannot afford to have room for error. Imagine if a firm cannot accurately determine the tax amount at a point of sale without slowing down the sales process. TRI was a pioneer in recognizing many such pain points in their workflows. Its multi-tenant cloud solution services, ONESOURCE tax solutions, are deeply valued by customers with a retention rate as high as 88%.

This segment has an incremental margin of 40%. Margins are lowest within the Big 3 despite having the highest software content. This is mainly because of the mix tilted towards the large-sized customers. 

Source: Company filings, segments were realigned in 2018

3. Tax & Accounting caters to tax, accounting, and audit professionals (except the Big 4). Technology adaption here is lower than the corporate segment but higher than legal. Although the pandemic accelerated this trend with clients sitting on the fence now ready to embrace the cloud. For example, many have become comfortable in uploading tax returns or confidential data on the cloud. Products such as Checkpoint are well-established market leaders providing a fully integrated suite of software solutions and best-in-class customer service. 

Small-mid firms (4-29 professionals) offering a full range of services to individuals/businesses are the largest customers. Next in-line are large-sized firms with more than 30 professionals (like BKD, CohnReznick, AndersonTax, Baker Tilly) serving the more complex needs of corporations. 

Interestingly, the largest of these firms are less than 1/10th of the size of the largest of the Big 4. Therefore, even these largest customers do not have the budget to invest in technology. So they look to TRI to make that investment for them. This results in the same stickiness and high retention (90%) play here as well. 

From tax filing deadline shifting for the first time to small businesses being highly reliant on their accountants to help them navigate relief efforts, the clients value a trusted brand like Thomson over others.

With an estimated market share of 14%, TRI is the market leader. CCH (Wolters Kluwer) is the leading competitor. Bloomberg is an emerging competitor in content. Intuit, Drake Software, CaseWare and Sage compete in software. Karbon, Canopy and Liscio have emerged as notable software disruptors. 

The segment enjoys similar EBITDA margins to Legal, with an incremental margin of 76%. 

Source: Company filings, segments were realigned in 2018

2. Why capital allocation matters 

"All roads in managerial evaluation lead to capital allocation. Academic research shows that rapid asset growth is associated with poor total shareholder returns. Further, companies that contract their assets often create substantial value per share."

• Michael J. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places 

The timing of the Reuters acquisition couldn't have been worse than coinciding with the GFC. The financial services industry was deeply hit. Higher exposure to Europe, desktops, and sell-side made Refinitiv even more vulnerable. The launch of Eikon in 2010 did not meet expectations either. Despite all of this, a no. of missteps continued. In a race to remain ahead of Bloomberg, multiple platforms were acquired through 150+ acquisitions between 2009 till 2013, clogging the network. 

Then at the start of 2012, Jim Smith was appointed as the new CEO by the Thomson family. Under his leadership, TRI brought the focus back on accelerating growth. Eikon was relaunched in 2013. Platforms were consolidated. Businesses were slimmed down dramatically. Toronto Technology Center was set up with 350+ data scientists. Finally, the great reset happened in 2018 with the sale of Refintiv. 

TRI had begun its journey from a "product to a customer-focused platform company." 

After going back 20 years to analyze the capital allocation history, I believe that Jim Smith did a decent job. His tenure could be explored under two phases. The first one would be from 2012-2016. I'll term this as the "Reset phase," wherein he tried hard to stabilize Refinitiv. After all, TRI was the largest listed information services company by revenues. Growth was still elusive as Refinitiv's underperformance outweighed Big 3's positive change. 

The second phase, 2017-2019, is what I'd term as the "Acceleration phase." The top-line was cut by more than half with the sale of IP&S (~$1 bn revenue) and Refintiv ($6 bn). Growth accelerated to the pre-Reuters level of 3%. Notably, the growth of "Big 3" came at a touching distance of 5%. 

Source: Company filings

Now, if we glance over to market outperformance. It was no surprise that the highest outperformance of 34% came in the acceleration phase. A more interesting fact is that this also had a $10 bn buyback, which is not reflected in the performance! 

Source: Kyofin

First Outsider CEO in TRI's history

Fast forward to March 2020. The current CEO, Steve Hasker, was appointed. He's the first CEO appointed by the family from outside the firm. Interestingly, Steve has more of a private equity experience (TPG capital and McKinsey) than corporate (Nielsen). 

Is it that the Thomson family is serious about looking out for ways for value creation? 

A slew of other noteworthy appointments couldn't go unnoticed. Mike Eastwood (a long-time company veteran) as the new CFO, David Wong as a new Chief Product Officer from Facebook, among others, further substantiates this observation. 

The most recent hire was from Amazon – Charlie Claxton, as head of the product design. Charlie led the design team for AWS, Retail and Alexa. 

I tie the knots below in "Management incentives" and "valuation" paras on how digital embracement can change the company's DNA to become customer-obsessed via these hires. 

Was Refintiv split-off the right capital decision?

By now, you might have got a good indication that the sale was the best solution for TRI. But whether they got the best price is debatable.  

The sale of Refintiv involved a three-step process.  

It sold a 55% stake to Blackstone for $17 bn cash (equity value) in 2018. The entire business was valued at $20 bn or a mere ~11x EV/EBITDA. Certainly, this was not a great multiple, especially after having stabilized the business—this even created friction within the family. 

However, the opportunity cost matters, in my opinion. The proceeds were efficiently utilized into buybacks, debt repayment ($3 bn) and software acquisitions ($2 bn). Moreover, the distraction was partly out. 

Later Blackstone/TRI sold Refinitiv to the LSE Group in 2019 for a valuation of $27bn. A 35% step-up in valuation in 1.5 years. My rough calculation suggests TRI's realized IRR is somewhere ~8% on Refintiv (2008-2025), assuming LSEG stake is monetized at the end of 2025 at current valuations. 

3. When changes in Management Incentives provided the impetus to the family-owned business 

While having family-owned businesses as a part-mandate in my previous firm at Credit Suisse, TRI was always on my watchlist. Various works of literature point out the benefits of owning a family-owned entity. But TRI never enthused me, honestly.

The stock, however, got my attention after two watershed events – 1) Refintiv sale and 2) change in incentives. 

In 2019, the long-term incentives criteria were changed from a mix of Adj. EPS and FCF per share to an equal combination of  Organic revenue growth and FCF per share.

Similarly, the short-term compensation was also changed from a mix of 1) Revenues 2) Adj. EBITDA less CapEx and 3) Book of business to - 1) Organic revenue 2) Adj. EBITDA less capex and 3) Organic book of business ("organic" was added a year later).

Voila! Now, the ingredients were falling in place. Organic growth was the key!

Allow me to explain why organic growth was the game-changer in the next section. 

4. Is playbook similar to RELX, Wolters & S&P Global?

Companies like TRI have a high fixed cost base. Stable organic growth is required for economies of scale. Usually, a 3-4% growth for these companies is considered decent for operating leverage. 

Historically, we have seen how compounders like rating agencies (SPGI, MCO), credit bureaus (EFX, TRU, EXPE) created economic value as their growth jumped to a sustainable high-single-digit (HSD). Of course, it is not an apples-to-apples comparison. 

 So let's see an example where comparison is feasible – RELX and Wolters Kluwer.

RELX outperformance started in 2012, shortly after it broke the 3% organic revenue growth bar. A similar pattern followed for Wolters Kluwer. The inflection point was 2015 (broke the 2.5% bar) followed by 2018 (broke the 4% bar).

Source: Kyofin

Interestingly, both RELX and Wolters didn't break these barriers because of Legal and Tax. But because they had other segments (Risk, Analytics & Exhibition for RELX; Insurance for Wolters Kluwer), which performed exceedingly well than the Refintiv (others for TRI).

Below is the segment distribution comparison showing the importance of other segments. 

Others segment is significantly high for RELX	Insurance is high for Wolters

Source: Company filings

TRI's Big 3 always had an edge, encouragingly. Big 3's growth already crossed the 3.5% bar in 2017 and ~5% in 2019. 

Source: company filings

But TRI lagged on company-wide growth stats, only until the split-off of Refinitiv. Refintiv struggled with a decline of ~1% (2010-2017), but "other segments" of RELX and Wolters Kluwer each grew at ~4%. Finally, post-Refinitiv, TRI's total growth has also crossed the 3% bar. 

The difference between TRI's Big 3 and total growth comes from Print (secular decline; ~10% revenue) and Reuters (~10% revenue). 

Source: Company filings

A caveat: the purpose to show the price performance rather than valuation multiples was only to highlight the changes in market expectations. 

S&P Global's secret sauce?

S&P Global showcased a value creation scenario that valued organic growth above margins on its investors' day. The model states that a 1% improvement in top-line growth creates 5x more value than 1% of margin expansion.

"We are developing valuation models with some outside help to try to understand the correlation between the levers that can create most shareholder value in the future. And the conclusion of those models is very interesting - it's showing that revenue growth is by far the most important element. 

In fact, what it is telling is, a 1% improvement of our top-line growth creates 5x more value than 1% of margin expansion in our businesses." 

Source: SPGI Investor day filings

Rule of 40

This rule, popularized by the VCs, has been used as a shorthand to invest in SaaS companies. The shorthand rule simply states that revenue growth rate + profitability margins should equal at least 40%. The economics of the information sector, encouragingly, make many of them a great fit to pass these strict criteria. 

Only four companies qualified in 2020 vs. eight in 2019. As per my assumptions (detailed in the valuation section), TRI will soon join this league, where organic growth will play a crucial driver. 

Source: Bain Capital

5. Can unit economics allow further lever-up? 

With a customer base of ~500k, an average annual spend per customer is $9.5k at a high level. This might look like a healthy stat, indicating lower growth potential at first glance. Along with this, TRI already has a high penetration within large-sized customers. Hence, it is often argued that there is little scope for improving economics. 

But if we peel the layers, a whopping 80% of its customers (~400K) spend less than $10k! This clearly suggests that the largest customers have skewed the distribution. The per-unit approach has also become largely redundant as TRI has transitioned from seat-based to enterprise-based pricing. Enterprises are offered flexible pricing depending upon the relationship. 

For example, the median pricing of Westlaw for small firms (which is the only available for online purchase without relationship) is $2,352 annually. 

A Bloomberg terminal costs anywhere north of $20,000, but most professionals use only a few functionalities. On the contrary, TRI's average customer uses less than 2 of its current solutions. TRI is evolving into a platform ecosystem wherein software add-ons will lead to higher cross-selling. Today just 15% of total sales are driven by cross-selling.

With the advancements in software solutions, TRI targets increased penetration into small and elite customers. There are thousands of small firms in North America that have no relationship with TRI. 

These enhancements are a horizontal expansion into services like audit, fraud, risk, investigation, etc. For example, its fraud platform can deter high-profile frauds like Wirecard and Luckin Coffee.  Or, investigative platform was used by federal agencies to detect the distribution of counterfeit COVID  test kits. Equifax evolved from a plain vanilla consumer credit bureau into a risk management solutions provider. 

A bank could be indifferent to Moody's or S&P Global credit ratings. The brand and trust are almost the same, with hardly any other edge. But here, TRI has an advantage over RELX and WK through its combination of thousands of attorney editors providing unique metadata to its data scientists. 

Many smaller software companies have evolved as formidable competitors to TRI. Technology is mainly open-source today. But what is scarce is the data and the talent working on it. Editorial assets like headnotes, key numbers, and key cite connect and track legal arguments across jurisdictions with remarkable precision. This is only possible because of the level and richness of patterns. Low-resolution legal data has very limited potential for machine learning and AI.

Ture, the NPS sucks for TRI. Many customers value TRI because of its great content but agree it has never been user-friendly. I had to navigate through multiple websites to search the pricing. TRI admits to having 350 websites!!. But this is where senior executives from Facebook and Amazon have been roped in to overhaul the design. It shifted its data centers to AWS one year ahead of schedule. And guess what, customer obsession has now been introduced as a KPI for compensation. 

So I believe both the growth and reinvestment opportunities are promising. 

6. Financials 

The management aims to achieve organic revenue growth of 5-6%, EBITDA margin of 38- 40% and FCF of $1.8 bn-2 bn after investing $600 m over the next 24 months. It calls it "Change Program initiatives," which should bolster its digital transitioning opportunity. 

I have assumed organic revenue growth to return to pre-COVID levels of between 3-4% in 2021, expanding to 5-6% in 2023. Big 3 will grow 6-7% in 2023, partially offset by a decline in Print and Reuters News.

I believe that digital will remain the key driver. Although the software is gradually taking a good share of revenues, it is still low at 35% of total revenue. The highest piece is within tax (~75%), corporates (~60%) and the lowest within Legal. 

Westlaw Edge was the largest Artificial Intelligence-led product upgrade in 2018 since the launch of Westlaw next in 2010. Westlaw is a must-have product for an online legal research platform. You can think of its importance as like FICO scores for lenders or MSCI for benchmarking. 

The launch has been a great success. The product has reached ~52% ACV penetration level. All this while preserving the premium pricing. Clients like Shearman & Sterling were on board from day 1. Gradually all U.S. Federal Courts, the DoJ came on board. Imagine the product pull and pricing power – the entire ecosystem adopted the new product. 

Source: Company filings

Margins - I am comfortable that economies of scale and digital will improve its EBITDA margins to 40%. Investments and stranded costs will keep it suppressed for the next 2 years. Excluding the Change Program investment, the adjusted EBITDA margin is currently 34%. Today around only 35% of its renewals are done entirely digitally. These are the low-hanging fruits. Revenues from providing news to Refintiv are on a cost-basis and hence a drag on margins. Print is highly profitable but is on a secular decline. 

Capital needs: Scaling, process improvements, cloud migration, etc. have reduced capex from <10% to 8.5%. I have modelled this to come down to ~6% as shared technology platforms are created, and platforms are further consolidated to improve customer experience. A similar playbook was followed during the transformation of Refintiv. 

7. Embedded Valuation – Would you like to own a stock at its lifetime high? 

Why would I buy a 55 PE stock? Oh wait, did I also say a lifetime high?

Honestly, I have no incentive to pitch this stock. I enjoy writing because I own the stock and wanted to document my thoughts to get push backs from the investment community. For the sake of disclosure, my effective buying price (after averaging up) is $85 with ~4% allocation. I might increase allocation in the future.

To explain my thought process, I did a reverse DCF by applying my assumptions to the current market price. This helps me understand the expectations that are built into the stock.

Market expectations show that revenues will grow at a CAGR of 5% over the next 10 years. I don't think this is demanding! RoIC's will peak at ~26% after 10 years. The industry average today is significantly higher at 40%. At the end of 10 years, despite the increase in ROICs, P/FCF will de-rate to 20x vs. the current multiple of 30x!

The current market cap of $47 bn will become a $68 bn market cap. As a matter of fact, S&P Global today is $90 bn+ & on its way to acquire INFO $42 bn. Moody's is $60+. The remaining companies within the sector are in the range of $20-40 bn. 

A $15 bn optionality 

Moreover, many things depend upon the management's capital allocation. For example, at the end of 2025, TRI will get ~$5.4- 7.5bn (post-tax, assuming average share price of LSEG in 2021) as the lock-in period ends. The value of LSEG will be optionality. Apart from this, TRI will generate $8.5 bn of free cash flows until 2025. A lot will depend upon skill-set on how the management utilizes reinvestment opportunities worth ~15 bn of cash flows (~1/3rd of the current market cap). 

Market consolidation

There are a lot of smaller assets in software that could be lapped up. The industry is going through a consolidation phase. After years of slimming down, SPGI is now bulking up with INFO acquisition. Bigger assets will be hard to come by. Can TRI gulp the tax or legal segments of either Wolters or RELX? I don't think it should be a problem considering the market share. Remember, TRI will become a net cash company by 2024. Plus, levering up will never be a concern. These types of companies are an ideal hunting ground for PE playbooks.  

Catalyst

Catalysts

I haven't modelled buyback worth more than $200 m/ year because it will increase the stake of the Woodbridge family, which is currently at 66%. Dividends will form a significant ~5 bn over the next five years.

Should the family take the company private and avoid the inefficient dividend outgo? 

The next catalyst is digitalization that will determine if growth can surpass my assumptions. 2023 will be a pivot year when the results of investments will be visible. 

The bottom line is that one Investing Principle that I've learned is that never underestimate the power of a business that requires minimal reinvestment needs or operates with OPM (Others people money). 

P.S. I'm greatly obliged if you've come this far to read the entire thesis. If you liked the idea, I'd love it if you'd vote for me to get reactivated. My previous ideas were CARR (2x; special situation) and UNP (20%+; compounder).

I plan to write a modified thesis on my blog www.theinvestingprinciples.com after the end of the exclusivity period.

It feels awkward to put on this platform. But if you liked my work, it will be a great favour to me if any of you could recommend me for an analyst position in any of the Canadian funds. After having an experience of 10 years working on 3 continents, I immigrated to Canada this month with my family.