S&P Global, Inc.: Strong Network Effects And Sticky Products In The Non-Ratings Segment

Summary

I am bullish on S&P Global, Inc. (NYSE:SPGI) because of the strong network effects that it enjoys in the credit rating business. While the current high rate environment may put pressure on debt issuance, the historical cycle suggests that growth will recover eventually, and SPGI will be well placed to ride on the recovery growth as it is the largest rating agency in the world. SPGI’s non-ratings business should also support long-term growth given the value proposition it provides and, at the same time, reduce the volatility of SPGI’s overall revenue growth profile.

Company overview

SPGI is a well-known provider of credit ratings (a close competitor is Moody’s (MCO)). Aside from credit ratings, SPGI also provides services under its Market Intelligence [MI] segment (most popular for its CapitalIQ platform) that represent 32% of total revenue, the Indices segment (offers a wide variety of valuation and index benchmarks) that represent 11% of total revenue, Commodity Insights [CI] (most popular for the Platts product) that represents 16% of total revenue, and Mobility that represents 11% of total revenue. Collectively, non-ratings segments represent close to 70% of the business.

Core ratings business has strong network effects

SPGI is the largest credit rating firm in the world, slightly larger than MCO as of 1Q24 (SPGI had $1.062 billion of rating revenue vs. MCO’s $987 million). Combined, these 2 players account for a significant chunk of the market, at around 80% (number 3 is Fitch with ~10% share). Credit ratings have historically been a very good business due to network effects. From bond types held by regulated entities (such as banks and insurers) and big institutional investors to the structure and marketing of funds, credit ratings have been a key part of the fixed-income investment ecosystem. Ratings from SPGI and Moody’s are the global benchmarks by which participants in global credit markets judge the creditworthiness of one credit against another. Credit ratings from SPGI and MCO are preferred by bond issuers due to their widespread recognition and acceptance in global markets. For a new player to enter and disrupt SPGI’s position, it is almost impossible, as it needs to first convince industry players to use them, which, I think, is a very tough thing to do, given there are few incentives to do so. This competitive advantage gets larger as SPGI scales as it continues to extend its track record of providing accurate ratings (the main reason why global markets are willing to trust SPGI), which entices more end users to use its services.

A key reason why issuers want their debt rated is because it reduces the cost of financing (or cost of capital), and they are willing to pay because the cost of a rating is less than the savings it provides to the issuer in the form of a lower cost of capital vs. a non-rated bond. The fact that SPGI has been able to raise prices by 2–3% every year (as acknowledged by management in the 3Q21 earnings call) shows that the cost of its ratings remains cheaper relative to its benefits to issuers.

The near-term concern is that the high interest rate environment will dampen the growth outlook for the industry. I believe this is simply a part of the economic cycle that is inherent to the industry. In bullish periods, businesses take on more debt to fund growth, while in bearish periods, businesses reduce risk exposure, which leads to a fall in issuance. Just as with any downcycle, it will recover eventually. Historically, in the industry (using SPGI and MCO ratings revenue as the yardstick), growth has recovered after each downcycle: (1) subprime negative, but growth recovered to 10% in 2013; (2) cycle slowed in 2015 but recovered to mid-teens in 2017; the same trend was seen in 2018 and COVID as well. As such, I believe the current cycle will see its end eventually.

Non-ratings businesses are very sticky products as well

Of the remaining 70% of SPGI businesses, there are two segments that I am very positive about: the MI and CI segments.

In the MI segment, SPGI’s portfolio of capabilities helps users track performance, generate alpha, identify investment ideas, etc. This segment has high recurring revenues and margins because of how sticky it is. The gem in this segment is SPGI’s Capital IQ Pro platform, which is heavily embedded into the workflow processes of underlying users. The best way to illustrate the stickiness and pricing power here is to look at how Bloomberg has performed over the years (compared to Capital IQ Pro). In this article by the Financial Times, it was cited by a large customer that there is no good alternative and that it is really hard to replace it. For those who do not have access to FT, I have quoted the following:

But customers say, even if they are cheaper, none of them can touch Bloomberg’s overall integrated offering. “If it’s already on your desk, you can’t get rid of it. There is no really good alternative,” complains the CEO of one major Bloomberg client, with more than 100 terminals installed. “I have respect for their non-negotiable terms. I don’t like it, especially when I have to write them a big cheque every month, but I respect it.

Personally, I think Bloomberg is better than Capital IQ Pro because of all the integrated features, but because of the steep price tag (Capital IQ is cheaper and is a team-based pricing model, which makes it shareable), I think Capital IQ will be able to continue capturing portions of the markets, and the same dynamic will apply. Once users have built up their workflow processes around Capital IQ (from how they conduct their research to linking their models or data API to portfolio performance reporting, etc.), it will become extremely difficult to replace Capital IQ as well.

In the CI segment, SPGI also has a gem product, S&P Platts, which is the leading independent provider of information and benchmark prices for commodity and energy markets. Basically, Platts provides daily price assessments and comprehensive coverage of a wide range of commodities. It generates revenue from subscriptions, conferences, and sales-based usage royalties from the licensing of its proprietary market price data and price assessments. The nature of Platts is similar to that of the MI business. Platts’ pricing data typically gets embedded in users workflow processes and contract agreements, which makes it difficult to switch to other providers. This is particularly true for contract agreements. For instance, any entities that use the JKM LNG (Platts) Average Price Option as the basis for any agreements will likely need to subscribe to Platt’s data to make sure they have access to the live data. As such, this product is extremely sticky as well, giving strong pricing power to sustain growth for the long-term (historically grows at mid-to-high-single-digits percentage).

On an aggregated basis, SPGI’s non-ratings business has also helped to improve the resilience of its growth profile, as it is less tied to economic cycles. Even in the latest quarter (1Q24), non-ratings segments collectively delivered healthy high-single-digit y/y growth, with Indices and CI revenue up low-double-digits.

Valuation

I believe SPGI will achieve its historical growth CAGR of 10% over the next 3 years. There may be some variability in timing, but on a through-cycle basis, I think 10% is achievable given the sticky nature and huge value proposition of its products. Margin wise, I am assuming flat margins ahead, as SPGI may need to step up on investments, particularly in AI. Given my view of normalized growth ahead, I expect SPGI to trade in line with its 3-year average of ~29x forward PE. SPGI has already demonstrated its willingness to return capital to shareholders via buybacks. Over the past 2 years, management has reduced share count by 5% a year, which I am extrapolating for the next 2 years as well. Stringed together, I have a target price of $534 for SPGI.

Investment Risk

While I say that the issuance cycle is cyclical and should recover eventually, depending on how severe this cycle is, it could drag down near-term earnings by a lot more than expected. Note that while the ratings segment is 30% of revenue, it has a higher weight of 40% of total adj. EBIT. Similarly, although the MI segment is very sticky and less cyclical, the tough macro environment has shown that the segment can get hit as well. In 1Q24, the segment saw higher cancellations among smaller customers and pressures on discretionary spending.

Conclusion

In conclusion, I am bullish on SPGI due to its strong network effects in the credit ratings business and the stickiness of its non-ratings products. While the current economic climate may dampen near-term growth, historical performance suggests that growth will recover eventually. In the non-ratings business, SPGI’s Capital IQ Pro and S&P Platts platforms are the gem products that have high switching costs for users, which provides SPGI with strong pricing power and a visible stream of recurring revenue that mitigates the cyclicality of the ratings business. That said, the severity of the current economic downturn and potential customer churn in the MI segment pose downside risks.