MI370: The Company Behind The S&P 500: Valuing S&P Global w/ Daniel Mahncke

26:33Fitch Ratings actually gives S &P Global an A - rating on its long-term debt borrowings, which is considered a healthy upper medium grade for large corporations. So S &P's balance sheet has almost 10 billion dollars of net debt. But that isn't as much as it sounds relative to the company's size and stability. Obviously the IHS acquisition was a big transaction and really your assessment of S &P's fair value today will be derived from whether you think its purchase of IHS created value or destroyed it. I would love to hear your take on S &P's outlook though, Sean. Sean O' It's a great question.

27:14I don't think you could really grasp the company's prospects without diving in a bit more into its market intelligence and ratings units, which are its two biggest. Starting with the ratings business, let's consider the different channels through which corporations borrow money and how this relates to ratings agencies. One option is the commercial paper market. This is a market for short-term corporate debt that is typically unsecured, meaning there's no collateral posted against the borrowed money. Lenders in the more than$1 trillion commercial paper markets take on this risk because the borrowings are very short-term, ranging from just a few weeks to a few months, and because companies in the commercial paper market usually have credit ratings that signal to lenders that they're not at imminent risk of being unable to repay these debts.

28:00The commercial paper market is great for companies to access short-term financing for payroll obligations or to finance monthly inventories, but it doesn't provide them with longer-term capital to invest in new projects or products with. And even for these limited borrowings, the status quo is very much that companies need to have credit ratings from the major agencies to participate in this market. Companies may also have revolving lines of credit with banks, which are like monthly or yearly credit card limits that they can tap into as needed. But companies in healthier financial positions tend to rely more on the commercial paper market since these revolving bank loans can have layers of embedded fees.

28:38Revolving lines of credit at banks largely go unused and are an emergency backstop to access short-term funds, but companies can also borrow via term loans from banks. Term loans are more similar to bonds where a company gets the full amount of loan money up front and pays back the interest over time and then must repay the principal amount at the end of the loan period. But there are trade-offs and limits to working with banks. Banks tend to be very conservative about the risks they take, so they're not going to make huge loans to companies. Companies then usually can't meet all their borrowing needs by relying on just banks.

29:11So the problem ultimately with bank loans is the scale. In many cases, they're more advantageous than bonds, but companies cannot borrow enough from banks to meet their needs and must turn to public markets to raise further funds. This is where ratings agencies like S &P really shine. While banks are equipped to underwrite the lending risks and doling out money to a certain company, the broader investing public of retail and institutional investors do not have the same capacity to assess every potential corporate borrower's creditworthiness. Because bonds are offered to the public to invest in, as opposed to being directly negotiated between a company and its bankers, bond issuances must be registered with the Securities and Exchange Commission.

29:51The benefit is that you can pull money from a much, much larger base of investors. For corporate bond markets to function smoothly, ratings agencies have really filled that void by providing assessments of each borrower's financial health on top of the ratings they provide for specific bond issuances. That way, you can trust that by purchasing an ETF, for example, of investment-grade corporate bonds, the bonds included in it are truly reputable and reliable companies. If you couldn't trust the ratings on these bonds or had to rate every single corporate bond out of the thousands that might be included in an ETF yourself, these products just couldn't exist.

30:26Having agreed upon third-party ratings helps ensures that you aren't taking undue and unexpected risks from investing in what you thought were relatively safe corporate bonds. Ratings agencies' trustworthiness is boosted by their careful regulation, given their importance to financial markets. Their internal processes, bookkeeping, communications, and business practices are all carefully monitored. From corporate borrowers' perspective, bonds allow them to lock in the interest rate they pay for years or decades. That is a huge advantage because your options for using that borrowed money expand dramatically when your payback date is pushed from, say, three months to 10 years.

31:03Turning back to S &P, the company commands over 50 % of the bond rating market share. It handles 54 % of ratings for government securities and 45 % of ratings for corporate issuers. When looking at S &P's rating business, you'd want to consider how borrowing trends are evolving. There are obvious questions like whether S &P's share of bond ratings is holding steadily overall and within narrower categories, but also whether the ways companies borrow money are changing and how that impacts the future stream of business coming to S &P. Companies turning more to banks, for example, would reduce the number of bonds for which S &P can charge ratings.

31:40S &P does also issue ratings for some bank loans, but loan ratings aren't nearly as common as ratings for bonds. The biggest disruption in this space has been with the rise of private credit, which we mentioned briefly earlier. These are non-bank investment firms making loans to companies and private deals, meaning they aren't directly registered with regulators like the SEC, which also means they aren't accessible to the general public to invest in. According to a report from S &P in April of this year, the private credit industry has ballooned the past decade, reaching a size of nearly$1 trillion in the US and$500 billion in Europe.

32:16And this increase in private lending has certainly pulled some capital out of public bond markets, though the industry has largely been built up around smaller companies than those that borrow in the bond markets. In particular, private credit has stepped in to fund a lot of private equity buyouts of companies, which was formerly the domain of bank lenders. So arguably, the rise private credit has been more disruptive to banks than it has been for traditional bond markets. But S &P isn't going to let the opportunity and private credit pass them by either. According to the company's CEO, S &P has worked closely with private credit investors to provide analytics that is still relevant for them even if every loan they make doesn't get a credit rating from ratings agencies.

32:58S &P's ratings division revenues from private markets rose 70 % year-over-year in the second quarter, which is very promising. And on top of that, there's also an opportunity to provide credit ratings on securitized products tied to private credit, where essentially a number of private credit deals might get lumped together into a single asset, similar to the mortgage-backed securities and collateralized debt obligations that became popular in the early 2000s. There are honestly probably limits to how much the private credit industry can expand before it makes regulators uncomfortable, since many of these transactions occur beyond their purview.

33:33It's still a big part of the story for S &P, though my takeaways have been that S &P benefits most directly from more bond issuance and ratings on those bonds, but its ratings unit can still profit from borrowing that occurs in private transactions too. What also makes ratings such a great business unit is that it doesn't require much invested capital to keep it running. It needs to maintain a large staff to oversee and monitor the ratings it has issued in the past and to assist with new ratings, but this is not a unit that needs to invest in new data centers or warehouses to expand. It also already has created many of the formulas and processes to calculate ratings over its decades of experience, which reduces the amount of incremental work needed to update or issue new ratings.

34:14From 2015 to 2021, capital expenditures for the ratings unit fell 31 % to about just 1 % of revenues. On top of that, the ratings business is not a winner-take-all industry. It has become standard practice for borrowers to receive two or more opinions on their debt, which means that S &P and Moody's, for example, aren't really directly competing with each other. A borrower will likely go to both Moody's and S &P for a rating rather than trying to pick one over the other. The elephant in the room here is what happened in the 2008 financial crisis and how some saw the major credit ratings agencies as being complicit in contributing to the bubbles in the financial system.

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38:43Ratings agencies collectively failed, like so many different financial institutions at the time, to accurately model and understand the mounting risks. One of the best examples of this was in structured finance, where different assets like mortgages would get bundled together into a single product. S &P stamped some of the highest possible credit ratings on these products, which were thought to be so diversified that investors were taking very little risk overall by investing in them. The problem, of course, is that the wave of defaults that hit the housing market in 2008 was unprecedented, which revealed that these financial products were nowhere near as safe as thought.

39:19These inaccurate credit ratings alone could have been enough to severely damage the big credit ratings agency's reputations, but even worse was that there were allegations of S &P and Moody's engaging in pay-to-play schemes where they worked with investment bankers to help them sell subprime mortgage-backed securities by slapping their seal of approval on them in exchange for fees. From 2000 to 2007, Moody's rated more than 45 ,000 mortgage-backed securities, and S &P probably rated a similar amount. The Financial Crisis Inquiry Commission, which was tasked with investigating the 2008 crisis, estimated that by April 2010, of all mortgage-backed securities Moody's had rated AAA in 2006, 73 % were downgraded to junk.

40:02So this was a big scandal for all of the ratings agencies. The commission-side credit rating agencies at the time were, quote, key enablers of the financial meltdown. Despite those misleading ratings, the ratings agencies enjoyed some of their most profitable years ever leading up to the crisis. After all was said and done, there were hundreds of millions of dollars worth of lawsuits, and the SEC significantly strengthened its ability to supervise the ratings agencies. The whole thing was a mess. Ratings agencies were understaffed, employees were underpaid, and the system was ripe for abuse as Wall Street bankers tried to play the ratings agencies off of each other to get more favorable ratings for the structured financial products tied to real estate that they were hoping to sell.

40:48Books like Andrew Ross Sorkin's Too Big to Fail cover this all in far better detail than we possibly could, but some 15 years later, the ratings agencies are alive and well. Yes, they're closely monitored, and at S &P, the ratings business is almost completely siphoned off from the rest of the company. Employees of the other divisions are essentially supposed to have no contact with those who work on ratings. But for better or worse, they did survive. Ratings agencies weren't nationalized like Fannie Mae and Freddie Mac, and they maintained their critical role in global markets. Any blow to their reputations has not really had a lasting impact.

41:26Even in 2011, the big three ratings agencies issued 97 % of all ratings in the US that year, so there wasn't even much of a fall-off in the immediate aftermath. While regulators had hoped to encourage more ratings agencies to join the scene as competitors to the big three, none did. Their ability to survive a crisis of this magnitude, as well as regulator attempts to break up their market share, is really a testament to the strong moats and network effects that defend their businesses. You may have your own opinions on whether ratings agencies should be public or private institutions, and whether they were sufficiently punished after the great financial crisis, but if there was ever going to be a time to reform their oligopoly on credit ratings, it would have been probably 15 years ago.

42:08The political momentum to do so has pretty much been lost in the meantime. From the perspective of a shareholder in these businesses, I would feel pretty assured that short of a great financial crisis 2.0, there's no reason to think that they will lose market share anytime soon. That might sound bad to say, but I also don't think that broadly speaking, ratings agencies have a parasitic effect on markets. They really are important and valuable, though the lead up to 2008 was a huge blemish on the record. With all that said about ratings, what are some of the risks you're seeing in the market intelligence business, Daniel?

42:40There's some reason for concern that financial institutions may purchase fewer subscriptions for access to things like Capital IQ Pro if they end up shrinking their staffs, namely because fewer workers are needed thanks to AI tools. It's not implausible to imagine that AI will come for jobs in white-collar industries, especially finance, where a lot of jobs are based around organizing and entering data into Excel or other modeling tools. But at this point, concerns that financial institutions will reduce their subscriptions with S &P have already been baked into the company's projections and stock price, at least according to its CEO.

43:24Peterson also makes the point that while certain banks have been cautious about hiring and spending, that isn't true of most of market intelligence's clients. He told investors that the sales and renewal cycles with insurance companies, pension funds and sovereign wealth funds, among others, have remained normal. It's also worth mentioning that AI tools go both ways. Even if some financial institutions laid off more workers than they hire in the coming years, meaning reduced spending on market intelligence subscriptions, S &P could also plausibly make use of AI tools to reduce its own staff and unlock offsetting cost savings.

44:06Peterson outlines additionally that S &P has real advantages in AI since it owns so much proprietary financial market data and data inputs are everything to developing AI systems. So far it seems like S &P has no interest in licensing this data to the outside world and is instead choosing to train their own models to license while keeping all the data in-house. Overall though, despite its size, the market intelligence business has the least attractive profit margins. Its operating profit margin for 2023 was 33 % compared with 56 % for the ratings business. That gap in profitability, generally speaking, stems from the fact that the market intelligence business is just a lot more competitive.

44:55Companies like Bloomberg, Refinitiv and FactSet are all competing with S &P for many of the same clients who are looking for access to financial market data. While many of these subscriptions for market intelligence products can be quite sticky, it doesn't have nearly the same modes as the ratings business. The more I've come to learn about S &P, the more I've really come to see the company as simply a winner from the inevitable expansion of financial markets. As our world becomes more and more financialized, S &P is really the company sitting in the middle of that in multiple different ways, ready to extract value.

45:33And they've done an incredible job with this. There's one key metric that is popular among legendary stock investors like Warren Buffett and Terry Smith, and that's return on capital, as in how profitable is a company relative to the amount of debt and equity invested into it. With S &P, we can estimate that by looking at the return on capital employed metric. Basically, you can calculate this by dividing a company's earnings before interest and taxes by the total capital employed, which can be calculated by just subtracting total assets from current liabilities. Another way to say that is to divide operating earnings by shareholders equity plus long-term debt.

46:09S &P's returns on capital employed on average over the last five years is an impressive 28 % per year. This is a capital light business that really spits off free cash flows, which is an accounting term for the money available to companies to use as they please after paying for everything else. It's similar to the concept of net income, but it accounts for the amount of cash companies actually have on hand, whereas net income includes non-cash items like depreciation. With those free cash flows, the company announced a plan in 2022 to repurchase 30 million of its outstanding shares, which amounts to about 9 % of its total shares outstanding.

46:45So far, it has repurchased around 13 million shares, and there's no expiration date on the program. In the first quarter, S &P was a buyer of its own stock at an average price of$433 per share and spent$577 million on quarterly repurchases. For reference, at the time of recording, the stock is trading at about$490 per share. And from 2012 to 2020, S &P repurchased 20 % of its outstanding share count by returning capital to shareholders via stock buybacks. Between buybacks and dividends, S &P has returned massive amounts of capital to shareholders while its business continues to grow since it needs comparatively little capital to be reinvested back into it.

47:26That's because its core business units are so sticky and profitable. Management's previously announced goal has been to return something like 85 % of free cash flows to shareholders. While management has a strong track record in running the company, it is a bit frustrating that the company's managers don't own more of its stock. The combined stakes of management and all the board members is quite modest. I would typically want to see management have more skin in the game, and I also find their compensation structure somewhat concerning. They're rewarded for engineering growth in revenue and earnings per share, which sounds great but can actually lead to poor investments for the sake of growth at all costs.

48:02A better compensation structure might further align management's interests with shareholders by rewarding management based on the returns on invested capital they're able to generate. Still, what they're doing seems to be working, and it's hard to complain when the company's returns have been so impressive. Around 60 % of S &P's revenues come from the US alone, which isn't too surprising given the outsized role that the US plays in global financial markets, but as capital markets develop in the rest of the world, particularly across Asia, there's considerable opportunity for S &P to expand into new markets.

48:35China's corporate debt market has exploded since 2008, hitting over 120 % of the country's GDP. In 2019, S &P became the first foreign-owned credit rating agency ever granted access to operate in China and provides ratings on its domestic bonds. So there's a reason for cautious optimism about S &P's ability to expand into China. In the company's most recent quarterly earnings call with investors, they shared some projections for the year. Management has actually largely revised its expectations for growth higher this year, with the ratings business expected to see the strongest revenue growth in 2024, growing 14 % to 16%, while the index business grows 10 % to 12%, and market intelligence grows by 6 % to 7.5%.

49:20Looking at S &P's current valuation, it is by no means cheap. This is an extremely high-quality, well-rounded company, and the market knows that. In fact, many on Wall Street may understand the company particularly well from using its products like Capital IQ Pro. Its stock has really run up recently too, up about 23 % for 2024 and almost 90 % over the past five years, which is a 13.5 % compounded return from price appreciation alone, not counting dividends. Today, it trades at a multiple of more than 45 times its earnings over the past year and 31 times its free cash flows. Price matters in investing, though truly great companies can make your entry price less consequential when investing with a multi-decade time horizon.

50:06I really can't get excited about buying the stock at around$490 per share. I'd start to get interested again if it falls below$400 and pretty excited at$350 per share. But even at$350 per share, the stock would be trading at roughly 33 times its earnings per share over the last 12 months, which is high relative to the market average, but more appealing given S &P's strong history of compounding earnings, sales, and 87 years of steady dividend payments. If the stock falls to around$300, depending on what caused the sell-off, I'd probably be buying shares up hand over fist. That would have to be a pretty stark sell-off though, and I could easily see it continuing to rise up above$500 per share.

50:49It's impossible to know what will happen in the short term, but based on everything we've discussed in this episode, it's a company I would absolutely love to own if I get an opportunity at the right price. Otherwise, at these levels, I think I can find similarly attractive opportunities with higher expected returns. Anything to add, Daniel? I feel similarly that it's an attractive company, but the stock is trading well above what I would probably consider fair value for it. It's just so rare that you find a company with three great businesses. I say three because I'm lumping together market intelligence, mobility and commodity insights as all being different variations of data-driven businesses.

51:31So I see the company's three parts as its signature ratings business, its index business and its data solutions. The index and ratings businesses by far have the strongest modes and quality, but much of the company's future growth will come from its data businesses, which are more competitive industries with lower margins. In a few different ways, S &P really is a powerful institution underlying much of the financial system, and I agree that if there's been a chance to buy into the stock at a more attractive price, it's a company I would love to own. Well said, Daniel, and thanks for joining me again.

52:10That's all we have on S &P Global this week. And for context, neither Daniel nor I own shares in S &P, but we do genuinely find the company compelling. I hope you enjoyed the episode, and I'll leave you with the following quote about investing from the great John Maynard Keynes. I think it's timely to our conversation about trying to determine the right price to buy into great companies. He says, quote, It is better to be roughly right than precisely wrong. I'll see you again next week. Thank you for listening to TIP. Make sure to follow Millennial Investing on your favorite podcast app and never miss out on our episodes.

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