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Morningstar | S&P Weighed Down By Slower Debt Issuance

Wide-moat S&P Global had an underwhelming third quarter. During the period, the company generated sales of $1.5 billion, representing year-over-year growth of 2.2%, but a sequential decline of 3.9%. The biggest variance from the previous quarter was in ratings, which saw a 9.7% year-over year decline in revenue as lower debt issuance weighed on S&P’s growth. Furthermore, management is now forecasting that global debt issuance to increase less than 1% in 2019. Despite this sequential decline in sales, S&P was able to achieve earnings growth as the company benefited from significantly higher margins. During the quarter, the company generated $1.97, a 7.7% increase from the second quarter. This quarter, S&P’s earnings growth were only made possible by lower costs resulting in a 380-basis-point improvement in operating margins. After adjusting our near-term expectations, we’ll be lowering our fair value estimate to $179 from $184, given the lower expected growth in the near-term. Currently, the stock is trading at a small discount to our fair value estimate and we’d encourage investors to wait for a larger discount before investing.

It does appear that the corporate tax cuts of 2017 are having an impact on debt issuance and S&P’s ratings business. During the call, management remarked that the some of the world’s largest technology companies--which haven't historically needed debt--were issuing bonds from 2015 to 2017. Now these companies are repatriating cash from abroad and putting it to work through acquisitions and share repurchases. Specifically, we found this quotation very telling: "In fact, the 15 U.S. companies with the largest overseas cash balances as of the end of 2017 issued $126 billion of debt last year. Among those companies, Coke is the only issuers so far this year. They issued an $800 million bond in the second quarter." We think this weighs on debt issuance in the near term, which is largely why we are lowering our fair value estimate.

As mentioned, S&P’s earnings growth was only made possible by lower expenses. Within ratings, operating expenses were $305 million, which is a $101 million improvement from the previous quarter. There is a highly variable component to ratings expenses. In the first quarter of 2016, the last time ratings revenue declined, ratings expenses fell by $56 million. Once S&P resumes growing, we expect these costs will return. In addition, the company has mentioned automation and data center rationalization. It does appear S&P is using some cloud and agile development strategy to increase efficiency in its information technology. We’ll be digging into this further since S&P, as well as many other companies, may have the opportunity to eliminate many bottlenecks and costs by combining cloud infrastructure with agile software development. Over the next quarter, we’ll be digging into S&P internal technology initiatives in an effort to discern specifically what the company is doing to lower these costs. In addition, we’ll be taking a closer look at the quarter filings to help determine the sustainability of these expense reductions.