S&P Global (SPGI): A Fast-Growing Dividend Aristocrat With a Wide Moat

With 30 consecutive years of dividend increases under its belt, S&P Global (SPGI) is a member of the dividend aristocrats.

 

S&P Global is one of the most unique companies in this group for a number of reasons, making it an interesting stock to keep an eye on for long-term dividend growth investors.

 

The company’s business model requires very little capital, generates excellent free cash flow, and enjoys a handful of significant competitive advantages.

 

While SPGI’s yield is much lower than the payouts offered by some of the best high dividend stocks here, S&P’s double-digit growth potential and large moat can still make this company an interesting consideration for a long-term dividend growth portfolio.

 

Business Overview

Founded in 1888 in New York City, and formerly known as McGraw Hill Financial, S&P Global’s 20,000 employees provide independent ratings, benchmarks, analytics, and data to the capital and commodity markets in 31 countries under several well known brands including: Standard & Poor’s (S&P), S&P Capital IQ, Platts, and SNL.

 

 

 

In 2016, S&P Global rated over $3.7 trillion in corporate and government debt, and the company operates in three business segments:

 

Ratings: provides credit ratings, research and analytics, information, and benchmarks to investors and debt issuers. S&P Ratings has been providing important information for over 150 years to help investors make better decisions and improve companies’ access to capital markets.

 

Market & Commodity Intelligence Segment: offers multi-asset-class data and research and analytical capabilities. Capital IQ, SNL, Platts, and J.D. Power are included in this segment.

 

S&P Dow Jones Indices: provides global indices that investment advisors, wealth managers, and institutional investors use to benchmark $11.7 trillion of assets.  This segment makes money from exchange traded funds (ETFs), derivatives, and index-related licensing fees (e.g. the S&P and Dow Jones names). It is well positioned to grow from the trend toward passive investing.

 

The company derives its revenues from a mix of subscription fees, as well as various corporate, insurance, and government clients around the world. You can see that corporations accounted for just over half of the firm’s revenue in 2016.

 

 

 

In 2016, 58% of the company’s revenues were derived from the U.S.

 

Business Analysis

S&P Global primarily benefits from its strong brand recognition and the mission-critical nature of its data. After all, participants in financial markets and executives in commercial markets need extremely reliable, accurate, and trustworthy information to make critical business and investment decisions.

 

The company’s primary brand, Standard & Poor’s, has been around since 1860, establishing long-lasting customer relationships built on trust and quality. McGraw Hill purchased S&P in 1966 and hasn’t looked back.

 

In addition to hard-to-replicate brands built on reputation and trust, S&P’s business benefits from the U.S. Credit Rating Agency Reform Act of 2006 that requires financial market participants to use nationally recognized statistical rating organizations (NRSROs).

 

These are the only ratings agencies that the U.S. Securities and Exchange Commission permits other financial companies to depend on for regulatory purposes.

 

There were only 10 NRSROs today, which limits competition and helps S&P maintain strong market share and profitability.

 

Registration with the government is very difficult, and new players have no reputation built up, which keeps barriers to entry high for the company’s S&P Ratings segment.

 

As a result, in its bond rating segment, S&P really only competes with Moody’s (MCO) and Fitch, which collectively enjoy 95% market share in this large and highly lucrative business.

 

In addition to regulations, this oligopoly is due to the fact that bond ratings, which tell investors the risk that a company or government will default on its debt, are based on highly specialized and copious amounts of data.

 

For example, S&P’s letter grades for debt are derived from over 100 years of  proprietary data and algorithms. This means that, despite the high margins in this industry, it’s almost impossible for an upstart to break into the market and steal significant market share from the entrenched three giants in the industry.

 

 

As a result, S&P has limited competitive in this vast and steadily growing market. Take corporate debt, for example, which represents nearly a $10 trillion market.

 

 

S&P’s fee for rating debt is typically about 0.1% of the bond offering, which means up to $10 million and $100 million high-margin revenue on a $1 billion corporate bond or $10 billion major sovereign bond issuance, respectively.

 

This wide moat is even stronger in S&P’s other businesses, because there the company’s high margins are protected by strong network effects generated by its mountains of data, highly trusted analysts, and recurring revenue in the form of subscriptions.

 

For example, its Markets & Commodities division is largely a subscription-driven business mode, in highly cyclical industries such as oil & gas, mining, and agriculture.

 

 

Thanks to the high-quality of its research, S&P offers numerous businesses, commodities and futures traders, and asset managers essential information and prediction models through brands such as S&P IQ and Platts, which have subscription retention rates of 90%.

 

Recurring subscriptions help smooth out results and continue delivering free cash flow when the company’s transaction-based revenue (e.g. bond issuance) takes a dip.

 

And as for its S&P Dow Jones Indexes business, the company’s moat is very wide here as well.

 

That’s because this business unit literally mints money by maintaining, tracking, and licensing the world’s most famous and widely followed market indexes, including the S&P 500 and the Dow Jones Industrial Average.

 

Even better? S&P licenses the name rights to various popular passive funds, such as the world’s largest exchange traded fund, iShares SPDR S&P 500 ETF, which has $243 billion in assets under management.

 

Just how lucrative are these deals? Well S&P gets 0.03% of the ETF’s assets under management, which adds up to over over $100 million in operating profits each quarter just from these fees. In fact, thanks to this essentially free money, this business segment is the company’s most profitable with 66% net margins.

 

Meanwhile, not only is S&P likely to continue to benefit from the shift away from high fee active funds and towards lower cost passive vehicles ($2 trillion in just the last nine years), but its market share among indexed ETFs continues to grow strongly as well, despite its rather steep licensing fee.

 

 

 

When you combine all three of these wide moat, high margin, and steadily growing businesses, you get solid top and bottom line growth over time.

 

 

And due to the low overhead nature of this industry, S&P has been able to generate strong economies of scale through cost cutting, resulting in not just very strong profitability, but steadily improving margins and returns on shareholder capital.

 

 

In fact, over the past 12 months, S&P has managed to generate not just much better profitability than its industry peers, but also the single most profitable dividend aristocrat.

 

 

Part of the company’s success is driven by management’s actions in recent years to refocus the firm on its strengths in the financial services market.

 

The company sold its education publishing business in 2013 for $2.4 billion and agreed to sell its J.D. Power business for $1.1 billion in August 2016, for example.

 

In addition to divestitures, S&P has actively acquired companies that fit its strategy. Most notably, the company acquired SNL Financial for $2.2 billion in 2015.

 

SNL is a major news and data services provider that serves the financial, real estate, energy, media, and metals & mining sectors. This deal will help S&P offer a more compelling bundle of services to its existing customers.

 

SNL’s services largely complement  the S&P Capital IQ business and widen the reach of S&P’s Platts business in commodities markets. S&P also has plenty of opportunity to expand SNL’s services overseas (over 90% of its revenue was from the Americas at the time of the acquisition).

 

The company’s solid profitability has allowed it to aggressively return capital to shareholders, not only with 30 straight years of rising payouts, but with steady buybacks to the tune of 3% annually for the last dozen years.

 

 

This reduction in share count, combined with increasing economies of scale, is why management believes it can continue to convert mid to high single-digit long-term sales growth into mid-double-digit EPS and FCF per share growth, which bodes well for payout growth potential.

 

Overall, S&P’s growth should benefit as the company continues expanding and improving a portfolio of mission-critical financial assets that can be cross-sold to existing customers, increase switching costs, generate higher deal values, and scale easily.

 

However, there are several major risks to be aware of.

 

Key Risks

S&P faces three main risks going forward.

 

First, its greatest competitive advantage in its largest business segment, debt rating, is dependent on the company’s ongoing credibility and the trust its brand carries in the world of high finance.

 

As we saw during the financial crisis, when numerous AAA-rated mortgage backed securities proved to be worthless (and nearly destroyed the global financial sector), S&P can and has been wrong before.

 

This means that another financial crisis, especially one in which S&P-graded debt is the primary destructive catalyst, could greatly harm S&P’s brand, and thus its market share and pricing power.

 

 

Speaking of financial crises, this also represents another key risk, but for slightly different reasons. Specifically, such an event could force large scale deleveraging on the part of corporations or even governments.

 

That’s because, after decades of heavy borrowing, the Institute of International Finance reports that total global debt/GDP now stands at $217 trillion, or over 325% of GDP.

 

This means that future borrowing could very well be lower than in recent years, which would mean a substantial decline in S&P’s debt rating revenues as occurred during the Great Recession when bond issuances declined by 22%.

 

 

Finally, be aware that because S&P’s business is so closely tied with those of financial markets, the company’s rate of its dividend growth is not nearly as steady as some other dividend aristocrats.

 

For example, if you look at the annual dividend growth rate over the past three decades, you’ll note that during market and financial downturns, the rate of growth is very low.

 

 

Thus anyone who requires strong consistency in their rate of annual dividend growth might want to look elsewhere.

 

Finally, it’s worth mentioning that longer term, the greater availability and affordability of data is likely to remain a theme. Information is becoming cheaper and easier to access every day.

 

Depending on how this plays out, it could begin to erode some of S&P’s competitive advantages, although for now it seems extremely unlikely that its customers would have a trusted, deep enough alternative to consider.

 

S&P’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

S&P has a Dividend Safety Score of 99, indicating an extremely secure and dependable dividend. That’s not surprising given that S&P has been growing its dividend every year since 1986 in all manner of global economic environments.

 

 

This high level of safety and consistent growth is due to two main factors.

 

First, management is very disciplined to make sure that the company’s EPS and FCF payout ratios are low enough to allow for the dividend to be well insulated by its earnings and cash flow, even during times of unexpected company stress, such as during large market downturns or financial crashes.

 

 

The second protective factor is S&P’s strong balance sheet, specifically a relatively small net debt position, well serviced by its rich free cash flow, as well as its strong current ratio (short-term assets/short-term liabilities).

 

 

In fact, when we compare S&P’s credit metrics to its global capital market peers, we can see just how strong its financial position is.

 

 

Note that the super high leverage ratio (Debt/EBITDA) of most of its rivals doesn’t actually represent corporate level debt, but rather bonds held on behalf of asset management clients.

 

Still, S&P’s low leverage ratio, stronger than average current ratio, and high interest coverage ratio indicates that there is little risk that it will have to divert free cash flow from dividend payments to service debt or other liabilities in the future.

 

Overall, S&P’s dividend appears to be very safe. The company’s low payout ratio, strong cash flow generation, recurring revenue, and healthy balance sheet make it a dependable dividend payer.

 

S&P’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

S&P’s Dividend Growth Score of 81 indicates investors can expect above-average dividend growth (relative to the S&P 500’s 20 year dividend median growth rate of 5.7%) going forward.

 

That may initially be surprising given the fact that S&P’s long-term dividend growth rate hasn’t actually been that impressive, hovering in the mid-single-digit range.

 

 

On the other hand, with a very low FCF payout ratio below 20% and management seeming to indicate a stronger penchant for dividend growth going forward (S&P’s 2017 dividend increase was the largest in the company’s history on a percentage basis), it seems safer to believe that S&P’s dividend should be able to grow at least in line its long-term EPS and FCF per share growth.

 

And given that management’s goal is 14% to 15% bottom line growth, S&P’s dividend over the next decade could increase at around 12% to 14%, factoring in some extra safety cushion to account for future market and industry downturns.

 

Valuation

Over the past year S&P Global has outperformed the S&P 500 by around 10%, creating some rather frothy valuations.

 

For example, SPGI’s forward P/E ratio of 24.6 is much higher than both the forward P/E ratio of the S&P 500 (17.7), its industry peers (19.8), and its own historical norm (15.6).

 

However, note that this last figure is artificially low because until 2016, S&P’s growth rate was dragged down by the text book arm of McGraw Hill, which it no longer operates.

 

However, the fact remains that the current yield of 1.1%, is much lower than either the S&P 500’s 1.9%, the industry median of 2.7%, or the company’s historical 1.8%.

 

In other words, despite the potential for long-term annual total returns in the double-digits (1.1% dividend yield + 14% to 15% earnings growth), S&P Global appears to be highly overvalued at this time.

 

And given how sensitive its business is to financial markets (especially debt issuance), the next market correction is likely to present a far better share price for long-term investors to consider.

 

Conclusion

While S&P Global certainly isn’t for everyone, especially retirees who plan to live off dividends, the company has solid potential thanks to its likely ability to leverage its wide moat and impressive profitability into long-term double-digit payout growth.

 

Nonetheless, at today’s inflated valuation, it’s probably best to keep S&P Global on your watchlist and wait for the next market correction to offer a more appealing buying opportunity.