Description

Thesis

I would characterize MRKT as (i) a high quality business with a strong competitive position (ii) that generates significant free cash flow (iii) with the potential to reinvest capital at ~10% post-tax ROIC, available at a reasonable price. Currently the stock trades at 18.5x 2016 EPS. MRKT is likely to be a steady compounder, with earnings growth and share price appreciation of ~13-16% over the next several years.

MRKT is a leading provider of pricing information and trade processing for financial instruments, primarily in the fixed income markets. It also provides enterprise solutions and managed software services for the financial services industry. It operates in 3 segments: Information (46% of revenue, 49% of EBITDA), Trade processing (27% of revenue, 32% of EBITDA), Solutions (28% of revenue, 19% of EBITDA). I could not do a better job of describing the segments and products than what is available here: http://www.markit.com/Company & http://www.markit.com/Product/

MRKT has several competitive moats and attractive characteristics in its business model:

Recurring revenue streams:

95% of revenue is recurring, 57% of which is from recurring, fixed annuity type contracts (basically subscriptions to price/data feeds on a per user basis) and 37% from recurring, variable contracts (paid on a per transaction basis). MRKT derives 80+% of its EBITDA from the recurring revenue streams.

Highly defensible market position:

Particularly in the information segment, MRKT is the market leader in CDS pricing and its client roster includes all the big banks. MRKT is the number 2 player in loans pricing, where they co-exist with Reuters (the market leader), because clients often require two sources of data. MRKT essentially goes to market makers, gathers, cleans, aggregates data and sells it as packaged products as subscription services (E.g. price feeds, historical price datasets, indices etc.). Hence they have a competitive advantage in terms of the depth, breadth and quantum of data they have aggregated and distributed to clients over several years. I think it might be hard for a new entrant to replicate this, primarily because the source of the pricing data for asset classes such as CDS and loans (big banks) is the customer itself. Additionally, the same pricing data goes into ETFs and indices that are created, maintained and sold by MRKT. This gives a sense of how entrenched MRKT’s data is within the customer ecosystem. The switching cost for the customer is very high owing to the importance of data integrity and continuity.

Low wallet share but of high value to customers:

MRKT’s products and services account for a small portion of its client’s expenses but offer very high value due to criticality of data integrity and continuity.  Moreover, increasing regulations and focus on reducing costs in the financial services sector is a positive for MRKT. A good example is KYC (Know Your Customer). It appears that the top 10 banks spend ~$1Bn/year to comply with KYC norms. This is an area readily outsourced, given that it is not a core competency for banks. If we were to assume that the banks would want to save 50% of their KYC costs, the TAM is ~$500M. Illustratively, if MRKT can capture 20% market share, KYC could contribute ~$100M of revenue, $32M of EBITDA over the next few years. This is just from the top 10 banks that are MRKT’s existing customers. The pie is potentially much larger. MRKT has a partnership with Genpact where MRKT provides the underlying technology and Genpact provides the headcount needed to verify and clean the data and post it to MRKT’s database. This partnership structure is important because it will help retain MRKT’s positioning as a data company and prevents it from being viewed as just an “outsourcing” vendor.

Platform that enables accretive M&A:

MRKT’s offerings span across pricing, trade execution, compliance reporting & documentation and related enterprise software and services, thereby extending its reach across various departments of its clients. There is no single competitor with this exact combination of complementary offerings which lend themselves well to cross selling opportunities, which potentially makes MRKT a preferred acquirer for small businesses in the FinTech and/or financial software space. Each segment, however, is quite competitive with large and deep pocketed peers such as Bloomberg, FactSet, Reuters, CapitalIQ, and Interactive Data etc.

Stable ROIC and capital allocation track record:

Acquisitions are an integral part of management’s strategy to achieve 10%+ earnings growth. MRKT has concluded 20+ transactions worth ~$2Bn over the past 10 years, while maintaining conservative leverage levels (<2x Net Debt/EBITDA). I did some rough math on the acquisitions completed during 2010-2014, to figure out the ROIC on M&A and came up with ~11-12% post-tax. Management has displayed reasonable conservatism in their short life as a public company, both in terms of guidance as well as staying away from expensive M&A  and focusing on ROIC rather than just earnings accretion.

Processing segment overhang to recede and allow stable organic growth profile to be visible:

There is a current regulation that requires trade clearing and reporting of OTC derivatives to become fully electronic over the next 2 years. MRKT, in the interest of protecting its market share, has been proactively charging a lower fee for a fully electronic trade because there is less for them to do, when compared to a manual trade. The revenue impact of this price action on the processing segment is expected to be $60M. Despite the negative price action, cost cuts have enabled MRKT to earn 50% segment margin (where they expect it to bottom out at the end of 2015) compared to their initial guidance of 45% margin during the IPO. As the processing overhang recedes over the next year, the stable organic growth characteristics of the business should hopefully be visible again.

Financials & Valuation:

The business model would allow MRKT to grow organically at 5-7% CAGR for the medium term. EBITDA margins have been at ~46-47% and management has indicated that low-mid 40%s EBITDA margin is sustainable. The margin decline will be driven primarily by higher growth in the solutions segment which has ~32% margins compared to ~50% for the other two segments. Organically, I expect ~$1.75 of EPS in 2018, up from $1.41 in 2015. (7% CAGR)

With ~85% FCF conversion, MRKT will generate $4/share of discretionary FCF over 2016-2018 (after accounting for share repurchase to offset dilution from options) and have net leverage of ~1.3x Net Debt/EBITDA in 2016. Maintaining 2x Net Debt/EBITDA, and deploying the capital at 7-10% post -tax ROIC, 2018 EPS could be in the range of $2.30-$2.59 (vs. $1.75 organic). Keeping the multiple constant, valued at 19x 2018 EPS, MRKT could be worth $44-50/share. This implies a 2016 FCF yield of ~6% and annualized return of 13-19%. If they do not do much M&A the cash accretion on the Balance sheet and FCF yield should provide some margin of safety.

Comparables:

While MRKT’s is not exactly cheap at ~19x FY16 EPS and 10.5x FY16 EBITDA, it compares well to a universe of Financial Analytics (McGrawHill Financial, MSCI etc.) and Data Platforms/Exchanges (Reuters, FactSet, ICE), Software (SS&C Technologies), which trade at 18-26x FY16 EPS and 14x FY16 EBITDA.

Risks/Further Analysis/ Thoughts:

Capital Allocation/ Acquisitions:

While they have been disciplined with capital allocation, because M&A is a part of the strategy, overpaying for targets and integration risk will always remain.

What is management’s long term vision for the company?

Should one think about MRKT evolving into a high value data company such as Bloomberg with a sticky customer base and good pricing power? Or, at the other extreme, could MRKT over time devolve into to a service provider for financial firms to outsource what they think of as “low value, commoditized functions” with little to no pricing power? How can they prevent the latter from happening? The latter scenario seems quite unlikely based on my analysis so far, but is still a line of questioning worth pursuing with the management/customers/industry experts.

Pricing power & Competition: Today MRKT seems to command little to no pricing power, although MRKT, dubbed “the Bloomberg of credit markets”, appears to be the gold standard in loan valuation and credit data. The only way for higher pricing appears to be through product enhancements or finding more securities to price. As the company scales, would it be able to compete better with larger peers on pricing? How quickly is the competitive environment likely to change adversely for MRKT?

Volume growth:  Most of the growth today appears to come from increasing the number of users per customer, cross selling products to existing customers, introduction of new products etc. – all of which increase MRKT’s wallet share of existing customers. The customer base itself is not growing a whole lot because MRKT is well penetrated across the sell side. The buy side is relatively underpenetrated and remains an area of growth, especially in certain products. Does this imply MRKT has to run really fast just to hold its position? International expansion appears to be a future area of growth/focus. MRKT is not as exposed to non-US markets (~10% of revenue) as peers such as Bloomberg, Reuters etc. (12%+ of revenue). However international expansion comes with its own share of risks due to non-homogenous regulatory requirements and different market dynamics compared to the US.

Dependence on macro trends: It appears that growth/decline in the asset classes of fixed income and loans could matter significantly. Trade volume in these asset classes will remain important. I don’t know enough to figure out the impact of higher interest rate environment and would any value inputs/ comments.

Regulations: As described above, they have been/ expect to be impacted by the move to electronic trading of derivates. While future regulatory trends would remain an unquantifiable risk, as a portfolio of products, MRKT might be shielded and/or be able to manage to the risk.

Note:

A: I assume 7% post tax ROIC in the above table. If ROIC on acquisitions was 10% 2018 EPS would be ~$2.59

Catalyst

None