- Ratings: provides credit ratings, research and analytics, information, and benchmarks to investors and debt issuers. S&P Ratings has been providing important information for over 150 years to help investors make better decisions and improve companies’ access to capital markets.
- Market & Commodity Intelligence: offers multi-asset-class data and research and analytical capabilities. Capital IQ, SNL, and Platts are included in this segment.
- S&P Dow Jones Indices: provides global indices that investment advisors, wealth managers, and institutional investors use to benchmark over $12 trillion of assets. This segment makes money from exchange traded funds (ETFs), derivatives, and index-related licensing fees (e.g. the S&P and Dow Jones names). It is well-positioned to grow from the trend toward passive investing.
- Data (Market Intelligence + Platts): 35% adjusted operating margin
- Ratings: 55% adjusted operating margin
- Indices: 70% adjusted operating margin
S&P generates 60% of its sales from the U.S., with 40% coming from overseas. This includes fast-growing emerging markets such as China.
These are the only ratings agencies that the U.S. Securities and Exchange Commission permits other financial companies to depend on for regulatory purposes.
There were only 10 NRSROs today, which limits competition and helps S&P maintain strong market share and profitability.
Registration with the government is very costly and difficult, and new players have no reputation built up, which keeps barriers to entry high for the company’s S&P Ratings segment.
As a result, in its bond rating segment, S&P really only competes with Moody’s (MCO) and Fitch, which collectively enjoy 95% market share in this large and highly lucrative business.
This is because more regulations mean higher compliance costs. For example, according to Morningstar, prior to the financial crisis S&P had $35 million in annual compliance costs.
Since then, the annual cost of complying with many new and complex regulations have soared to $100 million per year. While S&P's enormous revenue stream means that compliance costs make up just 1.6% of it revenue, smaller rivals see these regulatory costs eat into far more of their revenues. This hampers their ability to grow and compete with the industry's dominant players.
In addition to regulations, the industry's oligopoly is due to the fact that bond ratings, which tell investors the risk that a company or government will default on its debt, are based on highly specialized and copious amounts of data.
For example, S&P’s letter grades for debt are derived from over 100 years of proprietary data and algorithms, allowing S&P's statisticians to more accurately develop risk models. It’s almost impossible for an unproven upstart to break into the market and steal significant market share from the entrenched three giants in the industry.
And since global debt levels are usually rising over time (growing in line with GDP), this means extremely stable business for S&P. Typically S&P charges 0.1% of the debt offering to rate a bond offering. That might not sound like much, but remember that the global debt market is enormous.
Corporations frequently issue $1 billion bonds (generating a $1 million fee for S&P), and governments frequently sell $10 billion bonds ($10 million fee). While this isn't recurring revenue, debt is usually refinanced rather than paid off.
As a result, companies need to keep returning to S&P to help service their long-term debt needs. And since a rating requires deep knowledge of a company or government's finances, clients are unlikely to switch rating agencies because it would take significantly longer to get a rating (and thus obtain financing).
S&P is also a leader in providing data about a company's environmental footprint, social responsibility, and corporate governance. In recent years various large institutions (sovereign wealth funds, pensions, asset managers) have become more interested in aligning their investment goals with social responsibility.
Meanwhile, the company's S&P Dow Jones Indices segment is perhaps the most lucrative of all because the company licenses its name to ETFs like the S&P 500 Trust ETF (SPY). With over $250 billion in assets under management, this is the world's largest exchange traded fund.
S&P gets $600,000 per year plus 0.03% of assets under management. This means that over the next year S&P will likely collect about $80 million in licensing fees from this one ETF alone. Other asset managers running ETFs also pay about 0.03% of AUM to use its benchmarks.
Not only are passive index funds becoming more popular over time, but S&P's market share is also increasing. For example, in 2003 about 35% of the assets in index funds were benchmarked off S&P indices. In 2016 that figure had increased to 55% (approximately 20% annual growth in S&P index-linked AUM).
S&P's reputation and brand is so strong that despite its steep licensing fees, its highest margin business is likely to keep growing quickly for the foreseeable future. In the first quarter of 2018, approximately 14% of the company's revenue came from this lucrative asset-indexed source.
This means that over the long term the company will retain about 25% of free cash flow to fund its long-term growth efforts. Those efforts are focused on a few key areas:
- Expanding its operations in China (massive debt rating market there)
- Expanding Dow Jones Indices to include smart beta (factor investing) and socially responsible products
- Investing in bolt-on acquisitions to increase its data flow from various industries (enhance its Market Intelligence and Platts segments)
- Continue improving its Market Intelligence platform user interface to make it easier to use and enhance customer retention
SNL is a major news and data services provider that serves the financial, real estate, energy, media, and metals & mining sectors. This deal helped S&P offer a more compelling bundle of services to its existing customers. S&P also has plenty of opportunity to expand SNL’s services overseas (over 90% of its revenue was from the Americas at the time of the acquisition). All told, between 2015 and 2017 S&P acquired full or partial stakes in 11 companies for about $2.7 billion).
S&P's expanding margins, share buybacks, and exposure to several favorable trends (index investing, corporate debt issuance) have enabled the firm to record double-digit earnings growth in each of the last seven years.
S&P seems likely to continue this trend, which should fuel double-digit dividend growth as well. The firm should benefit as it expands and improves its portfolio of mission-critical financial assets that increase switching costs, generate higher deal values, scale easily, and can be cross-sold to existing customers,
As we saw during the financial crisis, when numerous AAA-rated mortgage backed securities proved to be worthless (and nearly destroyed the global financial sector), S&P can and has been wrong before.
This means that another financial crisis, especially one in which S&P-graded debt is the primary destructive catalyst, could harm S&P’s brand, and thus its market share and pricing power.
Normally a recession isn't going to drastically reduce the firm's sales because its clients still need to have their debt rated (to refinance existing loans), as well as data to make investing decisions.
However, as you can see in the chart below, in the event of a financial crisis where debt markets are disrupted, S&P can see drastic swings in its top line. Despite its highly recurring revenue stream, the company is sensitive to the health of financial markets.
The world's debt burden has grown to potentially unsustainable levels. At the end of 2017, for example, the Institute of International Finance reports that total global debt/GDP exceeded 300%. Corporate debt levels in many markets are at record levels.
While that has been great for S&P, perhaps one of the bigger risks that could occur over the next several years would be a slowdown in the number of bonds issued, which would dent demand for the company’s ratings services.
Volatile financial markets are also less favorable environments for companies to issue debt in, and financial clients such as investment banks and asset managers have less money to spend when M&A deal volumes fall, trading volumes drop, and assets under management decline in value. These are all bad things for S&P's business in the short term, although they arguably have little impact on the company’s long-term earnings power.
Closing Thoughts on S&P Global
The company's cash-rich business model, when combined with high amounts of recurring revenue and a shareholder-friendly dividend policy, indicate that investors can likely look forward to many more years of strong payout growth.
S&P Global's low yield doesn't make it a great fit for some portfolios, but it is an appealing dividend aristocrat for investors seeking a company that offers potential for strong long-term dividend growth and capital appreciation.