MSCI Inc

NYSE:MSCI

Earnings Call Transcript 2018-Q3

[Operator]

Good day, ladies and gentlemen, and welcome to the MSCI Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session where we will limit participants to one question and one follow-up. Further instructions will follow at that time.

As a reminder, this conference call is being recorded. I would now like to turn the call over to Mr. Andy Wiechmann, Head of Investor Relations, Strategy and Corporate Development. You may begin.

[Andrew Wiechmann, MSCI, Inc.]

Thank you, Imani. Good day and welcome to the MSCI third quarter 2018 earnings conference call. Earlier this morning, we issued a press release announcing our results for the third quarter 2018. A copy of the release and the slide presentation that we've prepared for this call may be viewed at msci.com under the Investor Relations tab.

Let me remind you that this call may contain forward-looking statements. You're cautioned not to place undue reliance on forward-looking statements, which speak only as of the date on which they are made and are governed by the language on the second slide of today's presentation. For a discussion of additional risks and uncertainties, please see the risk factors and forward-looking statements in our most recent Form 10-K and our other SEC filings.

During today's call in addition to GAAP results, we also refer to non-GAAP measures, including but not limited to adjusted EBITDA, adjusted EBITDA expenses, adjusted EPS, and free cash flow. We believe our non-GAAP measures facilitate meaningful period-to-period comparisons and provide a baseline for the evaluation of results. You'll find a reconciliation to the equivalent GAAP measures in the earnings materials and an explanation of why we deem this information be meaningful, as well as how management uses these measures on pages 22 to 26 of the earnings presentation.

We will also discuss organic run rate growth figures, which exclude the impact of changes in foreign currency and the impact of any acquisitions or divestitures.

On the call today are Henry Fernandez, our Chairman and CEO; Baer Pettit, our President; and Kathleen Winters, our Chief Financial Officer. With that, let me turn the call over to Henry Fernandez.

[Henry A. Fernandez, MSCI, Inc.]

Thanks, Andy, and good day everyone. The exceptional results from the third quarter, including the 11% growth in organic subscription run rate, reflect the power of MSCI franchise and highlight the growing importance of that franchise in an investment industry undergoing a significant transformation.

We continue to benefit from favorable secular trends, particularly with the continued growth in global investing, utilizing passive strategies, adopting ESG and the factor criteria, and using risk management frameworks.

On top of these secular trends, we have a very diversified business at MSCI, basically an all-weather franchise with natural hedges and in a wide range of market regimes.

We benefit one way or another in any market where there is active or passive; risk on or risk off; high volatility or low volatility; developed or emerging market; U.S., Europe, or Asia; sustainable investing or not; asset owners, asset managers, or trading firms; strong dollar or weak dollar; high valuations when we sell businesses, like we've done in the last few months, or low when we buy them, hopefully someday in the future; high MSCI price, when we feel good, or low MSCI price, when we buy lots of shares. We basically have a franchise that capitalizes in most market environment.

Let me now give you a few example from the clients' perspectives. In these volatile conditions, our clients are increasingly using our risk management tools to better understand their exposures, run scenario analysis, and position their portfolios for various market shocks. To gain insight into the drivers of performance and risk and to build portfolios in this volatile market environment, our clients are showing elevated interest in our factor analytics and factor indices.

For investors that expect sustained economic growth with moderate inflation and gradually rising interest rates, our factor analytics and factor indices help them build portfolios around strategies that have performed well in these scenarios, such as growth, momentum, and progressing in all (5:09) sectors.

Alternatively, investors that believe that trade wars, increasing inflation, and rising interest rates will hinder economic growth use our factor tools and factor indices to help them take advantage of strategies like minimum volatility, quality, value, high dividend yield, or defensive sectors.

Given the weakness in emerging markets, our clients are showing a strong interest in all our emerging market content from indices to risk models to ESG. Our emerging market and single country risk factor models, including our recently released China Equity Model 6, help clients better understand the drivers of performance and risk in those markets.

Recently, we are seeing a growing level of attention on companies that lack transparency, engage in socially unacceptable behavior, damage the environment, or are governed in ways not aligned with shareholder or constituent interest. This trend continues to drive and fuel the growth of all our ESG products and services.

In summary, MSCI's strength is that we have tools to help the investment community in any market environment.

We look forward to keeping you posted on our progress and our future successes. We are hosting an Investor Day on February 28 of next year to provide deeper dive into the ongoing industry transformation and how MSCI is well position and has attractive growth opportunities in that transformation.

Let me now turn the call over to Baer Pettit.

[C. D. Baer Pettit, MSCI, Inc.]

Thank you, Henry. Our ability to help clients is reflected in both the strong product growth shown on slide 5, as well as by the double digit subscription run rate growth we are seeing across asset managers, asset owners, investment consultants, wealth managers, and broker dealers, which collectively represent more than 87% of our subscription run rate.

As Henry mentioned, this success is amplified in the current market environment. But it is also being driven by our continued investment and strong execution in three key areas.

One, expanding our research and content in order to remain at the forefront of providing insights into the latest investment trends; two, enhancing our go-to-market strategy in driving an integrated client solutions approach, including building out and enhancing the effectiveness of our global sales and client service organization; and three, delivering flexible cutting-edge technology, including our new platform.

This consistent execution is allowing us to further differentiate ourselves relative to the competition. This has been particularly noticeable within Analytics. By delivering new content, improved platform functionality, and continual enhancements to our client engagement model, we have further differentiated our best-in-class offerings and our ability to deliver actionable solutions for our clients. These efforts have driven improvements in Analytics growth, as well as better positioned us to help clients in volatile environments.

Among other enhancements in the third quarter, we introduced a new mortgage prepayment and rate model; as well as expansions of our fixed income, asset pricing, and benchmark curves; a new multi-asset class factor model suite with capabilities for strategic asset allocation; in addition to a new China equity model, adding increased insights into emerging markets; full integration of our ES&G content into all Analytics applications, allowing our clients to easily integrate ES&G ratings, data, and indexes into their security selection, portfolio construction, stress testing, and risk analysis. Additionally, a broad range of enhanced functionality across our Analytics platforms enables us to help our clients more effectively and efficiently achieve their investment objectives.

These ongoing enhancements are improving our client value proposition and helping us secure new opportunities across a broader range of use cases. Here are a few examples from Analytics in the third quarter.

Through our best-in-class content and strong client relationship, we won a large upsell with an existing U.S. asset manager to use our models and applications in order to run factor exposure analysis and stress testing for their global equities team. As a large and longstanding client of the firm, the client's internal risk system is already powered by our risk analytics API, and the client leverages our equity portfolio analytics.

The additional license will enable them to stress test their equity portfolios in a way that is more helpful to the portfolio managers with factor shocks and historical stress analysis.

In another example, we won a large new deal with the derivative structuring desk of a major European bank to use our risk analytics API to provide scenario analysis and risk analytics to holders of swaps issued by the firm, allowing them to offer differentiated insights to their derivatives clients.

We won the deal through the breadth and uniqueness of our analytics capabilities and our ability to combine those in a way that helps the clients achieve their specific business objectives.

Similarly, we won a significant contract with a very large Asian securities firm to license our WealthBench offering to help them transform their wealth business from a brokerage model to an advisory one by allowing 5,000 advisors across 155 branches to deliver tailored investment planning proposals to their clients.

We won the deal because of our high touch service model, institutional quality analytics, and our ability to analyze a wide range of securities and a very large number of portfolios.

Beyond Analytics, we continue to roll out new content and capabilities across the firm that position us to better help our clients. Here are a few further highlights from this quarter that illustrate our progress across product lines.

We launched several new ES&G indexes, such as the MSCI ex Tobacco Involvement Indexes, which are designed for asset owners to standardize their divestments from companies involved in the tobacco business.

And we launched our MSCI Real Estate Enterprise Analytics offering, an interactive application that provides real estate investors and managers with the ability to evaluate and analyze the drivers of their portfolio performance, as well as review exposures and concentrations across market asset types and segments.

We remain excited about the wide range of opportunities in front of us. And I look forward to keeping you posted on our progress in creating more client and shareholder value.

With that, I turn the call over to Kathleen.

[Kathleen A. Winters, MSCI, Inc.]

Thanks, Baer, and hello to everyone on the call. I'll start on slide 6. Q3 was another quarter of great execution. Our disciplined approach to investment continues to yield strong results, as we delivered exceptional revenue and EPS growth as well as strong cash flows.

Revenue growth in the quarter was driven by strong momentum in our recurring subscription revenue, growing 10%, with continued strength in Index and ESG, up 12% and 34% respectively.

ABF revenue, which comprises 23% of our total revenue, grew 13% and was driven by higher AUM of equity ETFs linked to our indexes and our non-ETF passive business.

Average AUM in MSCI linked equity ETFs was up 16% from the same period last year, largely driven by strong cash inflows over the last 12 months. ABF revenue from non-ETF passive funds linked to MSCI indexes was up 21%, mainly driven by an increase of 15% in average AUMs.

Moving to slide 7, you can see the key drivers of our adjusted earnings growth. Our subscription business was the largest driver. In addition to strong new sales, we continue to maintain a very high retention rate, 95% this quarter. EPS also benefited from a reduced corporate tax rate due to U.S. tax reform and, to a smaller extent, our tax restructuring work, which better aligns our tax profile with our global operating footprint.

Now let's turn to our segment results on slide 9. Within the Index segment, we have strong subscription revenue growth, driven by our core market cap weighted products, as well as our custom and specialized Index products.

We see our investments around new datasets and faster production paying off. For example, in recent quarters, we have developed and licensed numerous custom ESG and factor indexes for several large asset owners, which are being used for a wide range of uses, including as benchmarks for active mandates and for passive replication.

Our Analytics segment grew 6%, excluding the impact of foreign currency and the divestiture of our FEA business, largely driven by our focus on expanding use cases.

Multi-asset class solutions contributed about two-thirds of the growth, driven mainly by demand for our risk and liquidity analytics toolsets.

On July 30, we announced the divestiture of InvestorForce, which was subsequently completed on October 12. As a reminder, the run rate impacted about $17 million.

In our All Other segment, the growth is mainly driven by ESG with run rate up 28% versus the prior year. We continue to see strong growth in EMEA and Asia-Pac with run rate growth of 32% and 61% respectively, as investors increasingly integrate ESG into their investment processes.

Slide 10 provides a summary of our key operating metrics by segment. Organic subscription run rate growth continues to accelerate, up 11% with growth across all client segments. Asset owners and asset managers were up 13% and 11% respectively.

In Index, we had strong growth in both asset base fees and subscription run rates, up 13% and 11% respectively. Asset based fees have benefited from licenses of our indexes for new equity ETFs and new asset owner mandates for passive funds.

However, recent market volatility and particularly the market depreciation of emerging market equities was a drag on ABF growth rate in the quarter.

Within the Index subscription run rate, newer modules continue to drive robust growth. Run rates for factor and ESG modules grew by 42% and 48% respectively. Custom and specialized modules have also performed very well, growing at 24% and 14% respectively, as clients are turning to MSCI to help them provide differentiated product offerings.

Our largest client segment asset managers grew 9% in Index subscription run rate, as we continue to broaden and enhance our content.

We've also had great success selling our Index content to asset owners and wealth managers with subscription run rate growth in these client segments of 24% and 28% respectively. Our ability to expand content has allowed us to capture new business across all client segments, as indexes are increasingly being used by clients to develop and reflect their investment strategies.

Year to date, Index for current sales are up 19%. And the Q3 Index retention rate remains very strong at 96.1%.

Within Analytics, our accelerating growth has been attributable to broader content and capabilities, new use cases, and our One MSCI go-to-market approach. The Analytics retention rate was 94.1%, compared to 93.4% prior year Q3. The recurring net new growth for Analytics was up 27% versus the prior year, benefiting from a large WealthBench win in Asia as Baer described earlier.

On slide 11, we provide an update on two key areas of integrated content, factors and ESG. We continue to see strong client demand in both areas. In factors, AUM in equity ETF linked to MSCI factor indexes grew to $84 billion, up 40% year over year, driven in part by increasing usage by wealth management firms.

In ESG, we passed a substantial milestone. Our ESG ratings and research run rate, combined with ESG index run rate in our Index segment, surpassed the $100 million mark, more than doubling in just three years.

We see strong ESG demand across all client segments with 27% subscription run rate growth in our largest segments, asset managers and asset owners who are integrating ESG into their investment processes. We're also seeing wealth platforms and retail brokers building ESG focused model portfolios.

New clients contributed about 60% of recurring sales in the quarter for ESG. We are accelerating our investment in ESG, as we continue to broaden our ratings coverage and incorporate broader datasets, including a wider range of alternative data points.

Turning to slide 12, we highlight the drivers of our asset-based fees in more detail. In non-ETF passives, our strong institutional investor relationships are driving a growing number of mandates tied to indexes. And in futures and options, we're excited about the increasing volume, which is driving more liquidity.

Year-to-date futures and options volume is up roughly 23% versus the prior year and run rate was up 21%. We believe revenue from these products have a long trajectory of growth ahead.

Overall, growth in ABF revenue has been moderating the last couple of quarters. On a year-to-date basis through September 30, we've seen market depreciation reduce AUM in these equity ETFs by $16 billion, driven by the emerging and developed markets outside the U.S., while cash flows increased AUM by $37 billion.

We remain confident in the long term growth prospects in equity ETFs, including factor and ESG ETFs. Year to date, we've licensed our indexes for 83 new equity ETFs, 51 of which are based on our factor and ESG indexes.

Total AUM of these equity ETFs have grown by 11% sequentially, bringing the total to $108 billion as of September 30. While favorable long term secular trends remain intact, we do expect ABF run rate growth to continue to moderate in the near term, as AUM growth potentially remains constrained by market pressures.

In Q3 we saw effective basis fees decline by 0.06 basis points. This was consistent with our expectations for continuing fee pressures and was primarily driven by a shift in product mix. We continue to expect lower fee products to capture a disproportionate share of new flows into equity ETFs. And we expect a further decline in our average basis point fee levels, as part of our efforts to capture volume and achieve continued run rate growth.

Our ETF partners are continually evaluating their market opportunities for existing and new products, as well as the optimal positioning and pricing of those products. As such, we have discussions with all of our key ETF partners about our fees and fee constructs on an ongoing basis.

Now let's turn to slide 13, where we provide some additional detail on quarterly net cash flows. Equity ETFs linked to MCI indexes are heavily diversified across strategies and geographies with about 22% exposure to the U.S. market and the remainder spread across emerging markets and developed markets outside of the U.S. Across the global ETF landscape in Q3 there was about $100 billion in net inflows into equity ETFs, up sequentially from the $60 billion in Q2.

Investors continue to favor the U.S. with about 72% of Q3 flows going into U.S. exposure ETFs. Last quarter, about 80% of the flows went into U.S. equity ETFs.

Outside of the U.S., cash flows into non-U.S. equity ETFs have been relatively muted with only about $28 billion in Q3. The overwhelming majority of these flows were into domestic equity ETFs, where the ETF exposure and the listing country is the same, pointing to investors concerned about investing in the global market.

Now turning specifically to MSCI linked ETF flows, we experienced similar dynamics to the market. On a year-to-date basis, we've seen solid flows into equity ETFs linked to MSCI indexes with U.S. exposure, capturing about 10% of total U.S. exposure equity flows, roughly in line with our share in this market.

Equity ETFs based on our indexes in key growth areas, such as factor and ESG, continue to gain momentum. Equity ETFs based on our factor and ESG indexes on a combined basis captured 43% of cash flows into factor and ESG ETFs on a year-to-date basis.

In Q4, we continue to see additional pressure on AUM levels, given broad market volatility. Despite the recent market headwinds, we remain confident in the long-term secular move to index based investing and our ETF provider licensing strategy to increase our market share through volume growth and drive long-term run rate growth.

Turning to the next section, we provide an update on our capital, liquidity, 2018 guidance, and our 2019 planning framework. On slide 15, we provide our key balance sheet indicators.

Our balance sheet remains strong, allowing flexibility and giving us the firepower to capitalize on the right opportunities at the right time. Having this flexibility will allow us to generate strong returns for our shareholders, as we evaluate the best uses for our cash.

Year to date, we've repurchased about 2.6 million shares at an average price of about $151 a share for total value of $388 million.

Turning to slide 16, we have some updates to our guidance. We're raising the bottom end of our operating and adjusted EBITDA expense target. In Q4 we expect some additional costs related to compensation, investments and marketing for our widely used indexes, and also severance, as we continue to optimize the organizational structure.

Operating expenses are expected to be in the range of $743 million to $750 million. And adjusted EBITDA expenses are expected to be in the range of $658 million to $665 million, likely coming in at the high end of those ranges.

Before we get to our planning framework, I'd like to take a moment to highlight our substantial progress over the last three years and the alignment of our long-term compensation strategy with shareholder interests.

Reflecting on the company's evolution, our strong financial results have been directly attributable to our focus on client needs, innovation, and the consistent execution of our strategy. We've delivered a nice acceleration in our growth rate, particularly in our recurring subscription business. We've improved our subscription run rate growth from an organic growth rate of 8% in 2015 to 11% this year.

We believe that our all-weather franchise brings great value to our clients through different market cycles. We're well-positioned to serve a wide spectrum of investors in multiple client segments.

Furthermore, we've been highly focused on driving efficiency and productivity gains to free up resources to enhance our products and further improve profitability. As a result, we've delivered a healthy rate of margin expansion.

Finally, we're very focused on ensuring that capital is optimally deployed to enhance shareholder return. The market has recognized the company's success and has driven an increase of over $6 billion in shareholder value over the last three years.

We're highlighting this value creation because of its significance and because it is aligned with the multiyear PSU awards granted to our executives in 2016. These awards were intended to align our executive compensation program with our three-year strategic plan and shareholder interests. The value is based on the achievement of a challenging multiyear TSR CAGR performance metric.

This incentive has worked very well and will cliff vest in Q1 2019. While the award is accrued over the vesting period, that is Q1 2016 through Q1 2019, there will be a related payroll tax upon vesting in Q1 2019. This will be offset by an income tax windfall benefit driven by this vesting. The actual impact will be dependent on the share price over the measurement period and on the vesting date, but it is likely to be a net benefit.

The multiyear PSUs granted in 2016 cover three years of the annual PSU component of long-term incentive compensation for senior executives. And therefore, these executives did not receive any PSU grants in 2017 or 2018.

Given the uniqueness of the size of the grant, we will be excluding the payroll tax expense as well as the income tax windfall benefit from our adjusted figures in 2019. The dilutive impact of these shares are already accounted for in our diluted share count.

Now let's turn to slide 18, so I can take you through how we're approaching 2019. We're currently working through our planning process. And we'll give you our 2019 guidance when we report Q4 2018 results. But in the meantime we wanted to provide you with some color around what we're seeing in the market and what we're doing to capitalize on these trends.

We believe that market trends remain overall favorable. Globally, professionally managed assets continue to grow. Investors are focused on drivers of performance and risk, and the value generated by managers.

Growth in index based investment also continues to be a key element and tailwind for our business, driving strong demand for our content and services. Investments we've made in these areas are paying off. And our subscription business continues to benefit from these trends.

Our ABF revenues are also benefiting from these investments with strong growth in areas like factors and ESG, which continue to gain traction with investors and are increasingly becoming a key component of the investment decision process.

However, ABF revenue may at times face near-term challenges, depending on flows and pricing. We expect to continue to invest in high return projects. We've improved our systems, processes, and culture, which has enabled us to quantitatively track and manage our investments and expense base to drive continued innovation, effective capital allocation, and enhanced return on investment and shareholder returns.

Finally we continue to approach share repurchases in line with past practice, by repurchasing more shares when there is softness in the market and when we have more excess cash, and fewer shares when volatility is low and we have lower excess cash balances.

In summary, our recurring subscription business continues to grow at a very healthy pace. We expect to continue to invest in areas around content, technology, and services to drive top line growth. Our results this quarter have demonstrated our consistent strategy and execution, which has resulted in robust shareholder returns. We're confident in our long-term growth prospects. And we look forward to keeping you updated on our progress.

With that, we'll open the line to take your questions.

[Operator]

Thank you. Our first question comes from Alex Kramm with UBS. Your line is now open.

[Alex Kramm, UBS Securities LLC]

Hey, good morning, everyone. Wanted to start on the Index subscription side of the business. I think some of you, and I think Henry you as well, mentioned that there's been more interest in the U.S., and EM in particular struggled, I think non-U.S. developed as well. So I noted the – or I noticed the 3Q's nonrecurring subscription sales in Index being a little bit softer here. We're really flat with last year.

So just wondering if those customers clearly are having a little bit of a harder time? At some of your core customers, is it harder to get pricing? Is there a – is the sales environment tougher? And in particular, what's the look into the fourth quarter, given that that environment continues to be pretty poor, and the fourth quarter is supposed to be a big sales quarter for you generally. Thank you.

[Henry A. Fernandez, MSCI, Inc.]

Yeah, Alex. No real change whatsoever on our clients with respect to Index subscriptions and interest in all the various categories. So our pipeline remains healthy. There is no abnormal situation one way or another. I think there are always timing considerations. And, Kathleen?

[Kathleen A. Winters, MSCI, Inc.]

Yeah. No. Alex, thanks for the question. To your point, recurring sales being flat year over year, a couple things to kind of point out to kind of take that in context.

Number one, prior year Q3 was fairly strong, so some of it is just related to comps year over year. But really importantly, Q2, remember, was a really high sales quarter. In fact, highest recurring sales ever, up 53%. So we had a really strong Q2.

When you look at it over a longer period of time, rather than just discrete quarters, on a year-to-date basis, we feel really good about the performance of the Index product segment and particularly the subscription portion of that franchise. Recurring sales year to date are up 19%. All the regions look pretty good, particularly seeing great strength in EMEA and Asia-Pac. And in fact, our retention is very high at 96%.

So when you look at it in the context of the full year performance, we feel pretty good about it.

[Alex Kramm, UBS Securities LLC]

Okay. So no worries about the environment or the expected 4Q, big quarter usually in the fourth quarter I guess is what I'm hearing here.

[Kathleen A. Winters, MSCI, Inc.]

Exactly. I mean nothing really. As Henry said, pipeline looks pretty good right now.

[Alex Kramm, UBS Securities LLC]

All right. Then just shifting gears real quick on the expense side. I appreciate all the commentary. But you're clearly acknowledging the challenges on the ABF side. And it sounds like maybe next year there could be a little bit of a reaction if I heard you correctly.

But I'm still a little bit surprised that you're getting rid of InvestorForce. Clearly, it's a tough environment. And you've been seeing that coming. And people have been asking about your expense flex. But now you're coming in at the higher end of the range it seems like.

So maybe just flesh it out a little bit. I think some people would have hoped for a little bit more reaction quicker to what's going on in the marketplace.

[Henry A. Fernandez, MSCI, Inc.]

So on InvestorForce and FEA, the commodity analytics business that we sold earlier in the year, the – it's an answer to we are dramatically always looking at our focus, our strategy. And anything that deviates from that strong focus on the strategy and doesn't belong will be sold. And especially in a very good high market valuations.

So that's that one. On the overall sort of tone of the market and psychology of our clients, it's pretty robust. Clearly, there's been volatility around recently. But we haven't seen any issues or any cracks or any concerns or any worries that have been reflected in their budgets or in our sales to them or our dialogue to them at this point. So we remain cautiously optimistic about our continued success with those clients.

Look, on the expense base and the rate of growth of expenses, our view – we kept expenses in the 5% to 6% expense growth range when revenues were only 200 basis points above that. Now that revenues are increasing, particularly subscription revenues, we want to deliver operating leverage. But we want to continue to invest in the business. Everything we do basically gets expensed, and therefore that will be reflected on a higher expense base and expense growth of the company.

We do not want to – so let say if we were to grow substantially higher than we currently are growing on the top line, we do not want to widen the operating leverage of the company, given the huge opportunities we have available. We want to take advantage of that incremental growth to share it with shareholders. Part of that gets invested and therefore reflected in the EBITDA expense growth. And part of it gets dropped to the bottom line in operating leverage.

[Kathleen A. Winters, MSCI, Inc.]

Yeah. So just to add to that a little bit. As Henry alluded to, look, our priorities and focus continues to be driving strong top line growth and controlling expenses.

But as Henry said, look, we've got some great opportunities here. And we're very confident in our ability to execute. We've got an excellent management team, our bets are paying off, and we've got a track record of high return projects that are paying off, factors, ESG, fixed income helping drive multi-asset class. So it makes sense that we kind of look at these high return projects and execute them as fast as we can.

Now if you look at the kind of ramp up in the run rate in expense level, there are some non-recurring type things expected in the balance of the year, which I referenced, including some investment from the marketing side and particularly some severance, a little bit higher severance in Q4. So and we think that that's the smart thing to do to kind of optimize the cost structure as we go into 2019.

[Operator]

Thank you. Our next question comes from Bill Warmington with Wells Fargo. Your line is now open.

[William A. Warmington, Wells Fargo Securities LLC]

Good morning, everyone. I was going to ask you about the Analytics business. Looks like the net new recurring subscription sales there are the strongest that we've seen so far this year. So if you could comment on that.

And then also the – this is your fourth quarter of 7% organic growth in Analytics. And sort of with an outlook towards can you sustain that level?

[C. D. Baer Pettit, MSCI, Inc.]

Yeah. Thank you for the question. So it is precisely because related to the question you're asking that we kind of put an emphasis on that in my comments, my – in the script. So we feel increasingly confident that we have built the basis of the ability to have steadily increasing growth.

We have actually been relatively conservative in the way that we've communicated around that to you all. And we wanted to give some color as to the examples that are driving that.

So this is very much what I would call the accretion of functionality, the accretion of client focus, which we continue to believe will deliver more value.

So this is more of a steady story than a rapid change story. But everything that we're seeing in terms of our client relationships, our pipeline, and the nature of the analytics we're adding to the pipeline leads us to believe that this will continue in the right direction.

[William A. Warmington, Wells Fargo Securities LLC]

Got it. Thank you very much.

[Operator]

Thank you. Our next question comes from Manav Patnaik with Barclays. Your line is now open.

[Manav Patnaik, Barclays Capital, Inc.]

Yeah. Thank you. Good morning. Sorry. Kathleen, I just wanted to follow up on that comment on the high return projects. And I think I fully appreciate that.

I was wondering like outside of factors, ESG, fixed income, which obviously – the obvious ones, like what are some of the other ones in there that you guys are spending some of that money in?

[C. D. Baer Pettit, MSCI, Inc.]

Yeah. So I think that, across each of our product lines we have significant opportunities. Kathleen in her comments I believe had referenced some of our custom index growth. We're investing in that infrastructure in the Index business. And in general our ability to deliver a range of different types of content, such as thematic indexes in the Index world.

We have pretty significant investments in fixed income, which are cross product lines. So some of those are mostly focused in Analytics, where I reference them. Also some new initiatives in Index. We were investing in our platform in Analytics, which is initially building out for Analytics itself that segment. But as I referenced in my comments, it has positive impacts in things like ES&G, where that content is going forward.

So I would say that within each of our product lines, we have some pretty attractive opportunities, many of which I think have been referenced over the calls in the last few quarters.

[Manav Patnaik, Barclays Capital, Inc.]

Got it. Okay, that's good to hear. And then just one other question from me. So with the cash balance you have, it sounds like maybe buybacks remains a key priority. But just curious like, what kind of deal would make you do M&A over a buyback?

[Henry A. Fernandez, MSCI, Inc.]

It will be a high return to the investment, to the capital outlay and a very strong strategic focus.

And unfortunately, we're not seeing much of the former in terms of the properties that get sold are being sold at extremely high valuations. And therefore we sit it out.

We're hoping that at some point, market conditions will create opportunities for us to see better returns and coupled with very strong strategic focus on what we do.

But in the meantime, we spent a lot of time in last 12 months looking at our strategic focus and found these two areas. So the FEA, which is the commodities part, and the InvestorForce. And we had an opportunity to sell them to people that would make better benefit of it.

[C. D. Baer Pettit, MSCI, Inc.]

Right.

[Manav Patnaik, Barclays Capital, Inc.]

Got it. Thanks a lot.

[Operator]

Thank you. Our next question comes from Chris Shutler with William Blair. Your line is now open.

[Chris Charles Shutler, William Blair & Co. LLC]

Hey, guys, good morning. On the guidance, it implies a sequential step up in adjusted EBITDA expense, sequentially I think of $6 million to $13 million. What are the top two – top one, two items driving that increase? And, Kathleen, can you quantify the one-time items that are in that implied Q4 expense guide?

[Kathleen A. Winters, MSCI, Inc.]

Yeah. So let me talk about Q4 first and then we can go into 2019. Yeah. I mean, we've got a little bit higher in terms of severance in Q4, a couple million dollars higher. And then some incremental investments, both technology and some marketing around our most widely used indexes.

In terms of implications then for 2019, I mean when you think about the cost base and the ramp up, 2018 to 2019, it's really similar to what we've talked about in the past in that you think about the cost structure that we have and our cost base being primarily people and technology, and 60% of our census (44:29) being in emerging market, when you kind of think about that and layer on kind of year-over-year merit, if you will, and investments that we want to do in all of the areas that Baer just articulated, that's really the path when you think about a 2018 to 2019 walk.

[Henry A. Fernandez, MSCI, Inc.]

And we'll spend a bit more time on this on Investor Day. But it is very important to emphasize that we continue to be highly focused on a balance between continued margin expansion, which we want, we like, and investing in the business to capitalize on the significant opportunity that we have. And we'll create higher revenue growth.

So it's a balancing out between the short term. We do not want to be milking the franchise at all. We want to be investing in the franchise. We have been doing that even in the face of major margin expansion the last three years. And obviously it's been rewarded by shareholders.

That we plan to continue on that balancing out, not to – we're not planning to decline margins or anything like that. We want to continue margin expansion. But if we grow faster, we will increase EBITDA expenses faster. We will not keep them flat. And therefore it'll – based on the investment opportunities, I have a major margin expansion that will feels – make us all feel great, including me as a big shareholder of the company, but take away the value creation in years to come.

[Kathleen A. Winters, MSCI, Inc.]

Yeah. As Henry said, look, it's a balancing act, right, because there are several things that are important to us in that we're absolutely focused on and obsessed with quite frankly. And that is strong top line growth and continuing the momentum and the trajectory there. Controlling expenses, while also being able to fund the really good investments that we have. And positive operating leverage over the long term. And just smart capital allocation, making sure we're using our capital and cash and putting it towards the best use all the time.

[Henry A. Fernandez, MSCI, Inc.]

And by the way, this is not a change of direction. We're not seeing really any change. This is what we've been doing for the last three years. Now we were more constrained in doing it when the rate of growth was lower, and therefore, we had to keep the rate of EBITDA growth lower than if we are growing faster. But we're committed to continue margin expansion at the same time as obviously investing for even higher growth in the company.

[Chris Charles Shutler, William Blair & Co. LLC]

Okay. Thanks. And then regarding the three-year equity incentive plan, as it comes to a conclusion here in the near term, what should we expect the new incentive plan to look like, at least at a very high level? I'm curious if there will be a similarly heavy emphasis on total shareholder return for top execs.

[Henry A. Fernandez, MSCI, Inc.]

Yeah, we like that huge alignment, me as a shareholder that happens to be the manager of the company, really like that complete alignment of shareholder interest and board interest and management interest in one objective, and that is to drive the share price higher.

And therefore, whatever we end up doing in the next few years will be focused on TSR. There is obviously a little bit of a focus in RSUs that are time vested, are not sort of share price driven in order to dampen that volatility in some of the members of the middle management team of the company. But at top of the house, including me, it has to be driven by complete alignment with shareholders.

So now the second question is, whether we end up doing a multiyear plan or an annual plan, I think it's – those are discussions that are going on with the board. We have – we want to align the incentive plan to the strategy. The last, the three-year plan, had the three-year front-loaded shares, were aligned to a three-year strategy that we agree with the board. And it was very effective.

And we don't know yet if that's going to be similar, or it's going be annual grant. But whatever it is, it's got to be a high level of sort of a manager/shareholder interest and a high level of drive of alignment on share price.

[Chris Charles Shutler, William Blair & Co. LLC]

All right. Thank you.

[Operator]

Thank you. Our next question comes from Toni Kaplan with Morgan Stanley. Your line is now open.

[Toni M. Kaplan, Morgan Stanley & Co. LLC]

Thanks. Good afternoon. Thanks for taking my questions. Kathleen, in the past you've talked about the downturn playbook. And just given the volatility in the equity markets in October, did that trigger you to implement your downturn playbook? Is that what's driving the 4Q severance? Or basically is – are the severance actions more a normal course of business? Yeah, just any color on that.

[Henry A. Fernandez, MSCI, Inc.]

Yeah. So, Toni, let me introduce the concept. And then Kathleen can comment on the specific numbers.

The – what we have been doing in the company is in our constant strategy, trying to understand all of our opportunities to service clients and grow the franchise and therefore create more shareholder value.

And in the process of doing that, we also review our organizational structure, our different management teams. Are they are in the right place, in the right seats, in the right locations? And all of that.

And to the extent that we don't see a complete alignment on that, we are taking actions with changes on the organizational structure or changing of the individuals. So that's what's driving.

This is not any different that we've done in prior years. There is always an undercurrent, an underlying amount of severance in every year. This quarter, fourth quarter, will be a little bit higher, because it just happened to a group, a lot of those changes. But that is the underlying driver and philosophy on all of this.

[Kathleen A. Winters, MSCI, Inc.]

Yeah, that's right. And thank you. So, Toni, we're always looking at kind of the organizational structure, the cost structure, and always questioning, how we do things better, more efficiently?

So there's always going to be a little bit of this sort of activity. It's a little bit elevated in Q4.

But in response to your question about the downturn playbook and kind of let's think about that in terms of looking toward 2019. We are also always looking at that downturn playbook and how do we strengthen it? How do we modify it? How do we enhance it?

And so as we think about that and we think about the possible scenarios and market conditions in 2019, it's very important to us that we kind of ensure that we are a nimble organization and able to kind of adjust up or adjust down from market condition.

And so we're always kind of looking at and refining that downturn playbook and thinking about it in the context of, what are the things that are kind of self-adjusting costs and costs that don't impact top line growth? Versus the things that you want to go to last, in other words, pacing of investment.

So that's kind of how we think about it. And we're always kind of looking at it and refreshing it to make sure we're ready to go.

[Henry A. Fernandez, MSCI, Inc.]

I would just add something else, given that there have been a few questions on this topic is, clearly, any kind of market volatility, any kind of global economic potential slowdown or trade wars or tensions, we need to be humble about them and the impact on them.

But we want to stress to you, we are not seeing any changes to our business because of that. And on the contrary, part of us think that those things present significant opportunities to enhance our franchise.

So we're not giving you an indication of, we're concerned, we have problems, or whatever. On the contrary, we feel that that's – those were the comments about the all-weather franchise. We feel that this presents major opportunities for our clients to use our products.

[Toni M. Kaplan, Morgan Stanley & Co. LLC]

Okay, that's helpful. And just for my follow-up, I know this has been asked before in a couple different ways. But I just want to make sure I'm very clear on the message here.

So the last time you had an Investor Day, there was a pretty significant investment ramp-up in expenses and basically lower margins as a result. And what I think I heard you say, Henry, is that now it's more that you're committed to expanding margins. There will be some investments, because you do have these growth opportunities. But we shouldn't really think of this as a repeat of 2014. Is that the right way to think about it?

[Henry A. Fernandez, MSCI, Inc.]

Correct. It's not a repeat of 20 – whenever that was, 2014. It's to give you an update of how we're thinking. We haven't done one in a long time. Tell you how excited we are about the opportunities that we see ahead of us. How we can increase growth of the top line commensurate with those opportunities. And what are the investments that are required to achieve that in the content of an expanding margin?

[Toni M. Kaplan, Morgan Stanley & Co. LLC]

Thank you.

[Operator]

Thank you. Our next question comes from Joseph Foresi with Cantor Fitzgerald. Your line is now open.

[Joseph Foresi, Cantor Fitzgerald Securities]

Hi. I was wondering, can you talk about maybe a shift in the demand environment? Obviously with the more volatility in the market itself, maybe some of your products would be a little bit more relevant and some less relevant. Just trying to get a sense based on some of the shifting AUMs that we're expected to see and we have seen.

[C. D. Baer Pettit, MSCI, Inc.]

Sure, I'll make a few observations. As Henry said, clearly we don't have a crystal ball. We can't see the circumstances. And we're not complacent.

But I think actually some of the examples that I gave of our most recent sales and the general direction of where we're headed is that most of what we do is infrastructural to our clients. It's not highly dependent on market levels. It is the way that they run their business. It's the content they use. It's the processes they use. It's the exposures they have.

So having been through this now several times – we had difficult markets in 2000, 2001, 2002, clearly, the financial crisis. I feel quite confident that our products and the need for our products is very resilient in that context almost across the board.

The clear exception is of course those things which are linked to market levels themselves, which will by definition come down linked to the market. And then I think the other element is clearly in a sustainably difficult environment, our clients will – there are two things occurred. There's just generally cost pressure, looking everywhere for cost. And at the margin, that puts a little pressure on us. But it's not the nature of the need. It's just the clients' push for efficiency.

And then finally going even further, if consolidation in the industry accelerates, historically, we've found that our – major cause of our cancellations can be consolidation. But those are getting kind of well ahead of ourselves.

I think the most – my bias would be from my view of this in the past and my current vantage point, that in the early period and in a short term correction, we would have a tendency to be seen to be resilient compared to what's going on in the rest of the market and maybe some of our competitors.

[Kathleen A. Winters, MSCI, Inc.]

And back to that point Baer, I mean we've looked at – we've looked back a decade and looked at the subscription growth each and every year during that time period. And it's been quite strong in every year.

[C. D. Baer Pettit, MSCI, Inc.]

Yeah.

[Joseph Foresi, Cantor Fitzgerald Securities]

Got it. And then just one kind of question building on that. You talked about some of the trade-off of pricing for volumes, which I assume is market share. In the environment where there's more volatility, will you start to feel that pricing pressure on your core business? And in some of the newer initiatives, are those coming in at lower price rates? I'm just wondering as we look back historically, in those volatile markets does pricing become a larger issue? And in some of the areas you're switching to, is pricing coming in a bit lower again to gain market share? Thanks.

[C. D. Baer Pettit, MSCI, Inc.]

So as a broad observation, across what we're doing generally, the pricing is not coming in lower is the headline, right? So our pricing power is generally consistent or even in various categories, as we've spoken before on some of these calls, our pricing power has increased notably in Analytics as an example.

So my sense would be – and then if we go back historically, more of those things are linked to our competitive – I would say our competitive competencies at the time. So going back, let's say, a decade ago, we had some – quite a bit of pricing pressure on equity analytics, but that's because we weren't competitive enough in certain areas.

So my sense is we're pretty strongly competitive in our main categories. I do think that a tougher market always leads to some price competition. But for sure we're not feeling that yet.

[Joseph Foresi, Cantor Fitzgerald Securities]

Okay. Thank you.

[Operator]

Thank you. Our next question comes from Henry Chien with BMO. Your line is now open.

[Henry Sou Chien, BMO Capital Markets (United States)]

Hey, guys. Good morning. So I wanted to ask about the wealth management opportunity. If I'm hearing correctly, it sounds like that was a meaningful sort of growth driver for the subscription – or Index subscription business. Is that sort of the case? And is the dynamic there similar to the active asset management space? And in terms of the adoption of passive?

[C. D. Baer Pettit, MSCI, Inc.]

Sure.

[Henry Sou Chien, BMO Capital Markets (United States)]

And just any kind of color on what's going on there? Thanks.

[C. D. Baer Pettit, MSCI, Inc.]

Sure, yeah. So let me try to structure my observations in the following way. One, clearly the wealth segment is today significantly smaller for us than the asset management.

Two, the growth rate is higher. It's, I think, I believe, our highest segment growth by client segment in the last quarter. We're investing more there.

Many of the trends that we've seen in other segments, notably the growth of Index products, increasing risk management, and benchmarking, et cetera, are increasing. So our strategy is to continue to invest there. And our plan and hope would be that you will see sustained growth in that segment on the quarters going forward.

[Henry Sou Chien, BMO Capital Markets (United States)]

Got it. Okay, great. And just kind of following up to some of the prior questions. In sort of a more volatile environment, and I guess this is more of a high level question, are you seeing an impact in how your clients are thinking about the use of passives?

[Henry A. Fernandez, MSCI, Inc.]

Not really.

[C. D. Baer Pettit, MSCI, Inc.]

Yeah.

[Henry Sou Chien, BMO Capital Markets (United States)]

Really?

[C. D. Baer Pettit, MSCI, Inc.]

The volatility has been so short that it's a very, very short period. It hasn't affected structural behavior.

[Henry Sou Chien, BMO Capital Markets (United States)]

Got it. Okay. Great. Thanks so much.

[Operator]

Thank you. Our next question comes from Hamzah Mazari with Macquarie Capital. Your line is now open.

[Hamzah Mazari, Macquarie Capital (USA), Inc.]

Good afternoon. Thank you. My first question is just on productivity or efficiency, net of investment. I know you spoke a lot about incremental investment. But curious how you're thinking about productivity going forward in light of any initiatives, including One MSCI go-to-market? I know you highlighted $0.08 in the quarter. Just curious how we think about that number on a go forward basis?

[Henry A. Fernandez, MSCI, Inc.]

Yeah, look, we are extremely focused on that. And the two examples there will be, when you look at our head count on the last one or two years, head count increase has been very modest relative to the sales and revenues of the company and the amount of innovation we've done. And then secondly, our – on the client coverage side, our productivity levels have actually increased probably about 20%, 25% in the last two, three years.

[Kathleen A. Winters, MSCI, Inc.]

And so just on...

[Hamzah Mazari, Macquarie Capital (USA), Inc.]

Okay, great. And – sorry, go ahead.

[Kathleen A. Winters, MSCI, Inc.]

Yeah, I can just add a little more color there in terms of how we look at it. I mean, look, the culture here is that we're very, very careful about spending levels and always scrutinizing productivity and efficiency. And you've seen us kind of make some great strides the last couple years in terms of leveraging some emerging market talent. And you'll see us continue to do those sorts of things.

[Hamzah Mazari, Macquarie Capital (USA), Inc.]

Great. And just a follow up question, I'll turn it over. Just on ESG, you talked about the business doubling in three years. How do you think about that growth rate going forward? I realize it's the law of large numbers. But is the market big enough for the business to double again in three years? Thank you.

[Henry A. Fernandez, MSCI, Inc.]

Yeah, we can't obviously speculate whether it's going to double or not, but the opportunity is huge.

[Hamzah Mazari, Macquarie Capital (USA), Inc.]

Great. Thank you.

[Operator]

Thank you. Our next question comes from Keith Housum with Northcoast Research. Your line is now open.

[Keith Housum, Northcoast Research Partners LLC]

Good morning. Question regarding on the All Other (1:04:32) segment, following up the ESG question. Not much discussion of the real estate portion of that group. I wonder if you could add some color to that in terms of how it's performing? And what the expectations are going forward? Perhaps as you're really eyeing the cost structure here going forward?

[Henry A. Fernandez, MSCI, Inc.]

Yeah. So that – clearly, the big driver of the Other segment right now is ESG, real estate beginning to have an uptick in terms of sales and profitability. But it's not yet in a position of making significant contributions to that segment. But we're hoping that – we're very optimistic that it will.

[Keith Housum, Northcoast Research Partners LLC]

Got you. And then, Kathleen, just a little bit of housekeeping here. Interest income has obviously ticked up for you guys quite well over the past few quarters. Obviously you got an interest – a rising interest rate environment. And you guys have more cash on the balance sheet.

But has there been a change to your philosophy in terms of your investments that's helping drive some of that interest income as well?

[Kathleen A. Winters, MSCI, Inc.]

No, it's really just the cash balances and just better execution on the – and yields that we're getting. No change in strategy there.

[Keith Housum, Northcoast Research Partners LLC]

Okay. So just still going to see -what you see in this quarter and last quarter, we should still see that continuing?

[Kathleen A. Winters, MSCI, Inc.]

Yes.

[Keith Housum, Northcoast Research Partners LLC]

Okay. Thank you.

[Operator]

Thank you. Our next question comes from Vincent Hung with Autonomous. Your line is now open.

[Vincent Hung, Autonomous Research US LP]

Hi, just wanted some clarification on your previous comments in relation to timing considerations linked to Index sales. So can that be a function of the market environment at all, that as conditions worsen, that the signing get pushed out? Or it's just issues where a contract gets signed a few days late?

[Henry A. Fernandez, MSCI, Inc.]

No change with respect to the market environment. It's just simply the number of renewals that we've negotiated in the quarter gave you a little bit of overgrowth compared to the prior quarter and the future quarters. So it's just timing.

[Vincent Hung, Autonomous Research US LP]

Got it. And with the stronger growth in sales more broadly in recent quarters, is there any pull forward perhaps from 4Q? Or should we continue to expect that nice bump from 3Q to 4Q?

[Henry A. Fernandez, MSCI, Inc.]

Well, we can't – I mean we haven't done the call for Q4. So we can't be forecasting what's going to happen. So I think it's not appropriate for us to say in a call like this what will happen in Q4 at this point. Right? We'll – let's take you into the end of January.

[Vincent Hung, Autonomous Research US LP]

Got it. Thanks.

[Operator]

Thank you. Our next question comes from Patrick O'Shaughnessy with Raymond James. Your line is now open.

[Patrick J. O'Shaughnessy, Raymond James & Associates, Inc.]

Hey, good afternoon now I guess. For that ESG business, do you think of that as a benchmark type business with long term pricing power? Or as the business matures and more competitors come into the space, would you expect pricing to get more competitive over time?

[Henry A. Fernandez, MSCI, Inc.]

Look, we're definitely trying to create the standards for measurement and investing in – according to ESG criteria, one hand. On the other hand, I'm not sure that there will be just one absolute standard to this. There may be a few competitors in the space. And whether that leads to pricing pressure or not, I don't think so. I mean a lot of our clients are following the MSCI kind of metrics. And we've had meaningful pricing power there. But right now we're very focused on penetration on that across the world.

[Patrick J. O'Shaughnessy, Raymond James & Associates, Inc.]

Great, thanks. And then maybe a quick one for Kathleen. Just within the asset base fees, I think there was a $2 million quarter-over-quarter decline in your non-ETF, that institutional passive category. I know there's a bunch of moving parts in there and some of that is kind of recorded on a lag. But can you speak to that sequential decline that we saw in the third quarter?

[Kathleen A. Winters, MSCI, Inc.]

Yeah. I mean you're exactly right. There is some timing stuff going on. There's a one-quarter lag. If you look at run rate, year-over-year run rate is up 24%, lots of new licenses. It's part of the business that we feel really good about the trajectory and the continued growth here.

[Patrick J. O'Shaughnessy, Raymond James & Associates, Inc.]

Great. Thank you.

[Operator]

Thank you. This concludes today's Q&A session. I would now like to turn the call back over to Andy Wiechmann for closing remarks.

[Andrew Wiechmann, MSCI, Inc.]

Thanks, Imani. And thank you everyone for joining us today. We really appreciate the continued support and belief in the MSCI story. We look forward to keeping you posted on our progress. And as always, please don't hesitate to reach out with any additional questions. Happy to be helpful wherever we can. Thank you, everyone, and have a great day.

[Operator]

Ladies and gentlemen, thank you for participating in today's conference. That does conclude the program. You may all disconnect. Everyone, have a great day.