Good day, ladies and gentlemen, and welcome to the MSCI 4th Quarter and Full Year 2016 Earnings Conference Call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and 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.
Stephen Davidson, Head of Investor Relations. You may begin.
Thank you, Sonia. Good day and welcome to the MSCI 4th quarter and full year 2016 earnings conference call. Earlier this morning, we issued a press release announcing our results for the Q4 fiscal year 2016. A copy of the release and the slide presentation that we have 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 are cautioned not to place undue reliance on forward looking statements, which speak only as of the date on which they were 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 ks and our other SEC filings. During today's call, in addition to GAAP results, we also refer to non GAAP measures, including 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 evolution of results. You'll find a reconciliation to the equivalent GAAP measure in the earnings materials and an explanation of why we deem this information to be meaningful as well as how management uses these measures on Pages 20 4 to 28 of the earnings presentation.
On the call today are Henry Fernandez, our Chief Executive Officer and Kathleen Winters, our Chief Financial Officer. With that, let me now turn the call over to Mr. Henry Fernandez. Henry?
Thanks, Steve, and good day to everyone. As you have seen from the newswires this morning, we have been very busy and there is a lot to be excited about at MSCI. We are pleased to share with you our 4th quarter and full year financial results. We executed very well against our strategy and we continue to create new products and services designed to help our clients solve their most challenging investment problems and capitalize on their significant investment opportunities. As a result, MSCI is even more embedded in the fabric of the global investment process, therefore creating a valuable network effect with our clients.
Please turn to Slide 4 for a review of our financial results for full year 2016. A 31% increase in adjusted EPS was driven by a 7% increase in operating revenue, a 2% decrease in adjusted EBITDA cost, an 18% increase in adjusted EBITDA, a lower effective tax rate and a 12% decrease in our share count. We have been able to achieve these strong results because the management team has been keenly focused on 3 areas as we have been reporting to you each quarter. We're focused on investing in new products and services to drive our top line growth, striving for greater efficiency and productivity gains to create an even more efficient organization and ensuring that capital at MSCI is right sized and optimally deployed in the highest return opportunities to enhance shareholder returns. 1st, in terms of revenue growth, we recorded a 7% increase in revenue, driven principally by a 10% growth in index revenue.
Excluding the foreign exchange impact on subscription revenues, operating revenues would have been 8% higher. I should say, it would have been an increase of 8%. This was the 12th consecutive quarter of year over year double digit growth in our index subscription run rate, which is a testament to the strength of our index franchise as well as the strong contribution from innovative new products. Analytics revenue grew 3% on a reported basis or 5% on an FX adjusted basis. While 5% constant currency revenue growth in analytics in a challenging market environment is a solid performance, we are not satisfied with this growth rate and continue to take measures to improve it.
We have successfully restructured the analytics product line under Peter's and Gary's leadership and now it is well positioned for the next phase, which we hope will lead to increasing levels of revenue growth in line with our long term targets for this prototype. As announced earlier this morning, we're very excited that Peter will be replacing Remi Breanne as Global Head of Research and Product Development. As we will discuss in just a moment, this role is one of the most important ones at MSCI and it's even more important now given our drive to accelerate the pace of innovation and growth. Peter will be succeeded in his role as Head of Analytics by Jorge Mina, who has led analytics in the Americas and has also led the business side of the development of our new analytics platform. This move is just another example of our ability to tap a very deep bench of talent and deploy it to critical areas of focus at MSCI.
Revenue from our other product segment grew 7% on a reported basis or 13% excluding the impact of FX. ESG continues to register strong top line growth of approximately 20% on record sales in the quarter and record sales for the full year. The success in this product line is being driven by the increasing integration of ESG factors into the mainstream of the investment process, resulting in strong sales and leveraging MSCI's existing client base as well as some new clients. These strong ESG sales mainly to existing MSCI clients demonstrate the power of the MSCI franchise with our clients as we're leveraging our brand and our existing relationships to sell ESG reserves and ratings at an accelerated pace. In real estate, we realized our commitment to achieve profitability driven largely by disciplined expense management.
Real estate is one of the largest and fastest growing asset classes in the world. So we believe that the restructuring of this product line that is underway will begin to pay dividends in the near future for us. In summary, in the overall area of revenue growth, we're very focused on innovation and new products and services to accelerate the top line. Turning to operational efficiency. The strong top line numbers were complemented by a 2% decrease in adjusted EBITDA expenses, but flat versus the prior year on an FX adjusted basis.
We were able to achieve this strong performance because of our continued obsession with efficiency and our focus on redirecting capital to high return potential investment. We expect to see more improvements over time in our operating tax rate, primarily driven by ongoing efforts to better align our tax profile with our overall global operating footprint. We believe there are more opportunities to achieve operating efficiencies at MSCI and we're only just getting started. Some of the areas that we're focused on include increased automation within our technology infrastructure, improve distribution of our products and services through our applications and that will allow our clients to have better access to our products, which will result in operational efficiencies, but would also result in higher growth of revenue. Finally, in terms of capital optimization, we continue to be strategic investors in our stock, repurchasing 11,100,000 shares for a total of approximately $824,000,000 at an average price of about $74.18 throughout 2016 and through January 27, 2017.
We have delivered on our commitment to optimize our balance sheet by increasing our gross leverage to levels that allow us to enhance shareholder returns, but also maintain flexibility to pursue other capital deployment options as our management and board determine. In summary, 2016 was a very strong year for MSCI and we're very excited by the opportunities for growth and further efficiencies that lie ahead. In 2017, we will continue to be extremely focused on innovation and how we can accelerate the growth of the company. We will continue to be positioned positioning ourselves to achieve superior operational efficiencies. And again, we will be focused on optimizing the deployment of capital, not just through dividends and share repurchases, but also across all capital deployment options that will enhance our shareholder returns.
Please turn to Slide 5, which illustrates what we call the integrated franchise at MSCI that we bring to clients to help them capitalize on their significant investment opportunities and solve their most challenging investment problems. This franchise is the basis and the foundation for a partnership like relationship with our clients as opposed to a vendor like relationship. We're very pleased that the investment community has embraced our segment reporting that we released in 2015. It has provided our investors and the analysts that follow us with the transparency they needed to give them the ability to track profitability and better value of our assets. But it is absolutely critical to understand that MSCI is increasingly one integrated company.
This integration is evident across several areas, including our approach to client relationships, I. E, our go to market strategy, our product development efforts between various areas of the product line and the content and application combination that power the tools that we provide our clients. Let me touch on each one of these areas briefly. 1st, in terms of client relationships, we are taking an integrated approach by having a dedicated account manager for each of our top 100 clients. Each manager is responsible for coordinating all client interactions within MSCI.
These account managers are focused on understanding our clients' strategy, the various initiatives that our clients have that drive those strategies and who the key individuals in the senior management team of our clients that are responsible for these strategies so that we can help them address those opportunities and those challenges that they have in their investment processes. So in addition to the relationship that we have with those clients at the expert or user or product level, This overlay of the relationship allows us to apply a solutions approach that drives the interaction with us at the senior level between MSCI and the client organization, so that we become a partner in what the client does and not just a vendor to the various experts in the organization. Next, MSCI is increasingly integrated at the product development level, where we use all of our different IP across the company to deliver complex solutions to our clients. Let me give you a few examples. Just a few, there are many more, just a few.
For example, in equity factor models and equity factor indices, which are critical collaboration between 2 product lines. We've talked about this extensively in the past. ESG research and rating and ESG indices provide our clients with an integrated perspective on the equity market opportunity with a view that cuts across market cap, factor weight and ESG factors. So you get all these 3 combined, the market cap approach to indices, you get the factor approach to the opportunity set and then you get the ESG factor approach in order to give our clients one view of the equity markets in which they can build their portfolios and it becomes very powerful in their search for alpha and differentiation. Lastly, in our analytics product line, we have integrated our equity risk management products and services with our multi asset class risk products and services, and we are now in a further developing our fixed income risk products into one holistic view of risk of the total portfolio, equity, fixed income and other asset classes and from the portfolio management part and the risk management approach in a holistic way.
The 3rd area of integration within MSCI is between what we call content and applications. As further illustrated in this slide. The most successful firms in our space will be those that master the integration of both the content, I. E, the models and the methodologies and the right data, the algorithms or calculators, the content that we provide with the applications that are so critical in enabling that content for the maximum use and utility in investment processes of our clients. The combination of content and application creates more value than the sum of the parts because of the ability of using content and applications combined to address more use cases and solve more problems and create more opportunities for our clients.
So our goal is to be the best provider of content through either our clients' applications, 3rd party applications or our own applications, all of it as long as we get paid on our content. So we're working on this integration as shown by our new analytics platform, which integrates data, analytical content and models and algorithms all in one platform. The integrated franchise that we're building at MSCI is very powerful. It's got some ways to go. There are a lot of areas that we can continue to further integrate, but we believe that we're just getting started and that the opportunity is massive.
As I travel around the world, we're seeing clients especially at the C level, I hear more and more that they want us to do much more for them, that they want us to become a partner to them in their investment process, not just a vendor. And therefore, we can solve more and more use cases with our tools. So we believe that this integrated solutions based approach in addition to what we have built at the user level will serve our clients very well and will drive substantial value creation for our clients and our shareholders for a long time to come. Before I turn the call over to Kathleen to go through the quarterly numbers, I would like to welcome Jacks Perrault, our new independent member of the Board, who will officially start with us on March 6. We issued a press release and an 8 ks earlier this morning and we are absolutely thrilled to have someone of Jack's deep experience in the asset management industry to join MSCI at this exciting time in the evolution of our firm.
Kathleen?
Thanks, Henry, and hello to everyone on the call. I'll start on Slide 6, where I'll take you through our 4th quarter results. We closed out the year with a very strong Q4. We delivered a 7% increase in revenue, driven primarily by a 6% increase in recurring subscription revenue and an 11% increase in asset based fee revenue. Adjusting for the impact of foreign currency exchange rate fluctuations on subscription revenues, total operating revenue would have increased 8%.
As a reminder, we do not provide the impact of foreign currency fluctuations on our asset based fees tied to average AUM, of which approximately 2 thirds are invested in securities denominated in currencies other than the U. S. Dollar. On a reported basis, operating expenses increased 1% and adjusted EBITDA expenses were basically flat. Expenses that are exposed to foreign currency exchange rate fluctuations represented about 40% of adjusted EBITDA expenses in Q4 and the full year 2016.
Excluding the impact of foreign currency exchange rate fluctuations, 4th quarter operating expenses and adjusted EBITDA expenses would have increased 3.5% and 2.7% respectively. The primary currency move that drove this benefit was the British pound, which was substantially weaker year over year. We delivered a 17% increase in operating income and a 16% increase in adjusted EBITDA, with an adjusted EBITDA margin of 50.2%. Our effective tax rate was 29.7 percent, in line with the 29.8 percent effective tax rate in prior year Q4. The 2015 4th quarter tax rate benefited primarily from higher net tax benefits, mainly associated with various research and production related credits and deductions.
These benefits impacted Q4 'fifteen adjusted EPS by $0.04 The current quarter's tax rate benefited from higher 2016 profits recorded in lower tax jurisdictions than previously estimated, as well as several favorable discrete items, including the settlement of a tax audit and a recent tax rule change. These benefits increased Q4 2016 adjusted EPS by $0.04 per share. Diluted EPS and adjusted EPS increased 28% and 23%, respectively. Free cash flow increased over 100% to $127,000,000 in Q4 2016. In summary, Q4 was a great performance capping off a strong year as we continue to execute very well against our strategy.
On Slide 7, you can see the different drivers of EPS growth in Q4. Adjusted EPS increased 23 percent from $0.66 per share to 0 point subscription and asset based fees contributed $0.15 per share. Investments net of efficiencies in our product segments and operations reduced earnings by $0.04 In terms of capital optimization, share repurchases benefited EPS as well. We reduced our average weighted diluted share count by 9%, which benefited adjusted EPS by $0.08 with a partial offset from higher net interest expense to net $0.03 per share benefit. And lastly, FX had a net $0.01 per share positive impact due to the impact of currency moves, primarily the pound on adjusted EBITDA expenses.
On Slide 8, we highlight our record 4th quarter sales. We delivered record sales this quarter despite the continuing challenging market headwinds that select client segments have been experiencing as reflected in the higher level of cancels in analytics over the past 3 quarters, which I will address in an upcoming slide. The record gross sales of $50,000,000 represented an increase of 21% and was driven by strong growth across all regions and product segments, with particular strength in Asia where gross sales were up 45%. The growth in Asia was driven by a broad mix of new client acquisition and module upsells and index as well as strong growth in analytics, especially in Greater China and Japan. We believe that this strong sales performance in a challenging market is a reflection of our ability to identify new and innovative use cases that leverage our product and service offerings for our clients.
Strong recurring index sales, up 26% were complemented by strong analytics recurring sales, which were up 13%, driven by strength in the banking client segment and higher sales of risk manager and equity model. We also had record ESG sales with recurring sales up 54%, driven primarily by ESG rating sales, leveraging both MSCI existing client base as well as new client growth. These record sales helped offset higher levels of cancels, resulting in a 37% increase in net new recurring subscriptions. We're maintaining a high level of retention at approximately 93% on a much larger book of business. Our pipeline remains strong and we remain optimistic, but cautious as we move into 2017.
On Slides 9 through 14, I'll walk you through our segment results. Let's begin with the Index segment on Slides 9 through 11. Revenues for Index increased 11% on a reported basis, driven primarily by a 9% increase in recurring subscriptions. We saw growth in benchmark and data products broadly with growth in core products, factor and thematic products, usage fees and custom products. Additionally, we saw an 11% increase in asset based fee revenue.
In terms of our operating metrics, record quarterly sales were driven by record recurring subscription sales of $17,000,000 Aggregate retention rate remained high 3% in the quarter and 95% for the full year, in line with the prior year period. Index run rate grew by $54,000,000 or 9% compared to December 31, 2015. This was driven by an increase in subscription run rate of $38,000,000 or 10% and a $16,000,000 or 8% increase in asset based fee run rate. The adjusted EBITDA margin for index was 71.1% versus 68.9% in Q4 2015. Turning to slide 10, you have detail on our asset based fees.
Starting with the upper left hand chart, overall asset based fee revenue increased $6,000,000 or 11%, driven by $3,000,000 or 26% increase in revenue from non ETF passive funds and a $2,000,000 or 5% increase in revenue from ETFs linked to MSCI indexes, other than 11% increase in average AUM. The strong revenue generation from non ETF passive funds was primarily driven by higher revenue from new product launches, including increases in higher fee products. In the upper right hand chart, we ended the 4th quarter with $481,000,000,000 in ETF AUM linked to MSCI indexes, driven by cash inflows of $15,000,000,000 partially offset by market depreciation of 9,000,000,000 For the full year, ETF AUM linked to MSCI indexes increased $48,000,000,000 or 11% on inflows of $37,000,000,000 and market appreciation of $11,000,000,000 From January 1, 2017 through January 31, 2017, ETF AUM linked to MSCI indexes has increased to $509,000,000,000 driven by $13,000,000,000 in inflows $15,000,000,000 in mark depreciation. We hit an all time high of $511,000,000,000 on the 27th January. More equity ETFs track MSCI indexes than any other provider.
As shown in the lower left hand chart, quarter end AUM by market exposure of ETFs linked to MSCI indexes reflected the decline in EM after the U. S. Presidential election, which was accompanied by increases in developed markets. EM, however, remains well above prior year levels. Lastly, on the lower right hand chart, you can see the year over year decline in the average run rate basis point fee from 3.32 to 3.1.
The decline in the average basis point fee is primarily due to cash flows favoring lower fee segments of the ETF market. However, we've experienced a stabilization of the average basis point fee over the last three quarters and this has continued through January 2017. On Slide 11, we provide you with the AUM of ETF linked to our indexes classified in 3 discrete components illustrating our differentiated index licensing strategy. This strategy is designed to further expand our index licensing franchise for the ETF market beyond our flagship indexes, increasing the adoption of new index families and U. S.
Segment index families. The first component of this strategy primarily reflects the licensing to ETF providers of our flagship indexes. In other words, market cap index is focused mainly on exposures outside of the U. S. With exposure to large and mid cap stocks only.
This component represents the majority of the ETF AUM linked to MSCI indexes as well as most of the approximately dollars benchmark to MSCI indexes overall. This category of licensing would include EFA, EM and our single country market cap indexes. The ETF AUM linked to these indexes has been growing at a 3 year CAGR of approximately 6% and pricing has been steady. The next component of our strategy is the licensing of indexes, which primarily include non U. S.
Exposure to large, mid and small cap stocks, which include indexes that are used as the basis of the U. S. Listed iShares Core Series and USA Factor Indexes such as the MSCI USA Minimum Volatility Index. The assets in this component represent roughly 10% of total AUM and have been growing at a CAGR of over 90% over the last 3 years. Generally, the pricing for these products is lower than ETFs that license our flagship indexes.
The third component of our strategy is the licensing of more segmented U. S. Indexes, including sector and REIT indexes. AUM has been growing at a CAGR of approximately 30% over the past 3 years and represents about 15% of overall AUM. The pricing in this component is generally lower than ETFs that licensed our flagship and new index families.
So you can see our strategy is to diversify our licensed ETF franchise and maximize revenue. This differentiated strategy has been successful as evidenced by the strong growth in AUM and revenue, even though the faster growth in the lower fee product areas has contributed to a lower overall average basis point fee based on run rate. While we expect to have periods where product mix will impact the average fee we earn, through our differentiated licensing strategy, we look to maximize the price volume trade off over the long term. Resilient pricing in our flagship funds plus strong AUM growth have more than offset pricing declines on fast growing lower fee ETFs. On Slide 12, we highlight the financials for the Analytics segment.
Revenues for Analytics increased 3.4% to $114,000,000 on a reported basis, which includes $2,400,000 negative impact from FX. Excluding the impact of FX, analytics revenue increased 5.6%. The increase in revenue was primarily driven by higher revenues from Risk Manager, Equity Models and Borrow One. We had a strong increase in recurring sales, which were 13% higher compared to the prior year Q4 due to higher equity model and risk manager sales. Gross sales, which include non recurring sales, were up $2,900,000 or 15.1%.
We did, however, see elevated cancels in Q4 due to seasonality driven by the higher number of contracts up for renewal in the 4th quarter as well as continued challenging market conditions in some client segments. Analytics run rate at December 31, 2016, grew by $15,000,000 or 3 percent to $452,000,000 and would have increased 4%, excluding the impact of FX. Adjusted EBITDA margin was 29.1%, up from 27.9% in the prior year, notably approaching our long term margin target range for this segment. Turning to Slide 13, this provides you with sales and canceled history for the Analytics segment. The chart shows gross sales and cancels for Analytics over the last 3 years.
The higher level of sales in 2016 broke us out of the $60,000,000 range of the previous 2 years, driven by strong risk manager and equity model sales. Over the past several quarters, we've seen heightened cost pressures and budgetary constraints among our bank and bank owned asset and wealth management clients, which resulted in a $10,000,000 or 34% increase in cancels for analytics in 2016. Roughly $5,000,000 of the $10,000,000 increase came from 2 clients in the second half of the year. These cancels have been primarily in the U. S, but we've also experienced higher levels in Europe, principally in our risk manager product area.
Approximately 70% of the cancels for 2016 were principally related to closures, changes in strategy and cost pressures, so market factors beyond our control. So while we're disappointed with the increase in cancels in select client segments, we're very pleased with our strong sales numbers in the quarter, specifically in the bank segment, where risk manager gross sales were up 138% and the pipeline remains strong. Turning to Slide 14, we show results for the All Other segment. Revenues for All Other increased 4% to $19,000,000 on a reported basis and grew 15% after adjusting for the disposal of occupiers and the impact of FX. First, in terms of ESG, a $2,000,000 or 20 percent increase in ESG revenue to $12,000,000 was due to strong ESG ratings revenue with record ESG recurring sales in the quarter, which increased 54%.
Growth in ESG continues to be driven by the increasing integration of the ESG into the mainstream of the investment process and leveraging the existing MSCI client base as well as new client acquisitions. Real Estate revenues decreased $1,000,000 or 13 percent to $8,000,000 on a reported basis. Excluding the impact of foreign currency in the sale of Occupiers business, real estate revenues increased 10%. The all other adjusted EBITDA margin was 2.3%, up from a negative 16.1% in the prior year. The increase in the adjusted EBITDA margin was driven by continued strong growth in the ESG revenue as well as lower real estate costs, primarily due to a reduction in headcount and strong cost management as we make progress towards improved profitability in our real estate product area.
Turning to slide 15, you have an update on our capital return activity. We continue to return substantial amounts of capital to investors. In Q4 and through January 27, we repurchased and settled a total of 4,200,000 shares at an average price of $80.27 for a total value of 339,700,000 Since 2012, we've returned almost $2,300,000,000 for share repurchases and dividends, and we've repurchased 35,000,000 shares of the company. There is an $806,000,000 remaining on our outstanding repurchase authorization as of January 27, 2017. On Slide 16, we provide our key balance sheet indicators.
We ended the quarter with cash and cash equivalents of $792,000,000 This includes a $208,000,000 of cash held outside the United States and a domestic cash cushion of approximately $125,000,000 to $150,000,000 which is a general policy we maintain for operational purposes. We continued to repurchase shares in January and have bought over $60,000,000 Furthermore, we pay our annual cash incentive compensation in the Q1. As a result of this, coupled with interest, dividends and tax payments, CapEx disbursements and the aforementioned buybacks, our deployable cash balance in Q1 'seventeen will be lower than what was available as of Twelvethirty Onetwenty 16. Our gross leverage was 3.7x at the end of the quarter, down from 3.8x at the end of the Q3 of 2016. Over time, we expect that we will return to our stated range of 3 to 3.5 times as our adjusted EBITDA grows.
On Slide 17, we highlight the key drivers of the outperformance for the full year 2016 free cash flow generation. Free cash flow increased 53% to $392,000,000 for the full year versus 'fifteen. The outperformance was driven primarily by 2 factors. First, we saw strong customer collections in Q4 with some clients even paying early. Therefore, we experienced pull forward of about $20,000,000 in collections into 2016.
Next, we benefited from a combination of tax refunds and discrete cash tax benefits of about $40,000,000 Normalized free cash would have been approximately $330,000,000 for the full year of 2016. For 2017, we are guiding to free cash flow of $310,000,000 to $370,000,000 reflecting ongoing strong cash generation in 2017, partially offset by incremental interest payments, cash taxes and lower collections due to the pull forward. Lastly, before we open the line for Q and A, on Slide 18, we're providing you with our full year 2017 guidance. Operating expenses are expected to be in the range of $690,000,000 to $705,000,000 and adjusted EBITDA expenses are expected to come in between $605,000,000 $620,000,000 FX spot rates at the end of 2016 are the basis for this expense guidance. In 2017, we're expecting that roughly half of the $32,000,000 year over year increase in adjusted EBITDA expenses will be from carryover and inflationary increases.
The other half of the increase will be investments in sales, marketing and products and services. We expect the full year 2017 adjusted EBITDA margin in analytics to be flat or slightly better than the 4Q exit margin for the product area. Interest expense is expected to be approximately 116,000,000 dollars Net cash provided by operating activities is expected in the range of $360,000,000 to 410,000,000 dollars CapEx is expected to be in the range of $40,000,000 to $50,000,000 in line with 2016. Free cash flow is expected to come in between $310,000,000 $370,000,000 below the free cash flow generated this year because of items I discussed earlier. Effective tax rate is expected to come in between 31.5% and 32.5%.
In the Q1 of 2017, we are adopting the new accounting guidance related to employee share based compensation. Under the new standard, all share based compensation, excess tax benefits and tax shortfalls will be recognized in income taxes in the statement of income as discrete items in the reporting period in which they occur. Previously, they were recognized as a component of stockholders' equity. We expect the impact, assuming current stock price levels and based on the stock vesting and option expiration timetables to result in a tax benefit of approximately $3,500,000 for the full year of 2017. Given that the majority of our stock awards vest in the Q1 of each year, we expect about 2 thirds of this estimate to occur in the Q1.
Please note the impact of this change is just an estimate, which could change significantly based on changes in MSCI stock price, employee forfeitures and when employees elect to exercise options. We are reaffirming our dividend payout ratio of 30% to 40% of adjusted EPS and our objective to maintain gross leverage in the range of 3 times to 3.5 times. Also beginning with Q1 2017, adjusted EPS will include amortization expense associated with internally developed capitalized software on a prospective basis. The impact of prior periods was not material. We're making this change because internally developed capitalized software will become a more meaningful component over time as we continue to invest.
We believe that only intangible amortization related to acquisitions should be excluded from the adjusted EPS calculation. For modeling purposes, amortization of internally developed capitalized software that will be included in adjusted EPS is expected to be between $5,000,000 $6,000,000 in 2016. Lastly, as a follow-up to the issuance of our long term targets in 2015, we are reaffirming those targets as of this call. Summary, we executed well throughout the quarter the year, and we're very pleased with our strong results. We are continuing to invest in and innovate with new products that will position MSCI to continue to grow in the quarters and years ahead.
With that, we'll open the line to take your questions.
Thank And our first question comes from Alex Kramm of UBS. Your line is now open.
Hey, good morning, everyone. Maybe just starting with the environment and the outlook a little bit. Clearly, the cancels are still elevated and the but the sales were really, really strong. So what are you seeing out there, I guess, particularly on analytics, maybe to some degree on index in terms of confidence level that the sales can remain elevated or even increased. So what are you seeing out there?
Where what's the selling environment? On the cancellation side, do you feel like a lot of the kind of one timers are done now? Or when you look at the customer base, there are still some areas that you think should be struggling, so we might continue to see some of these elevated levels? Thank you.
Yes. So the pipeline remains pretty solid going into 2017 and in January. So that we remain cautiously optimistic about the prospects of gross sales and recurring sales this year. I think the environment I mean, we had obviously very strong financial results despite the our in client environment. We sell quite a lot to active managers around the world.
And that's a lot of our subscription business is based on that. Clearly, our asset based fee business is based on passive managers. And that client base, the Active Management client base is offering from 2 areas, cyclical pressures, The value of stock picking is less when you have sort of asset prices being determined by monetary policy around the world. And you have secular issues such as passive management encroaching a lot in what they do. So throughout the year, all the way to December, those trends have continued.
To the extent that the new environment that we're seeing of higher growth around the world, the U. S. Or Europe or Asia, more emphasis on deficit spending or fiscal policy rather than monetary policy, higher inflation. So our end client base can benefit from that and the prospects will get better than what we are currently seeing. Too early to tell at this moment.
Clearly, there was a big run up of banks and asset managers and insurance companies and the like from November to December. Some of that some of it has been reversed in January. But again, it's too early to tell. We try not to count on that or focus on that. What we try to do is be extremely focused on understanding the client and what the client is facing positively or negatively and try to help them with that.
So with respect to cancel, I think that it's hard to say. Clearly, we have high sales because of all the efforts we're doing and the new products and the new services, the new approach to go to market, the solutions that we're trying to come to our clients with, etcetera. So all of that has benefited the gross sales. I think there will continue to be some level of elevated cancels given the structural changes that are going on. Maybe they get a little lower because of less pressure on the cyclical changes, but again it's too early to tell.
And therefore, the conclusion from our part is good pipeline. We're executing well against that. We hope to continue at a decent pace of sales. But again, I don't know if we'll do every quarter like we did last quarter. But we are assuming that the cancels will continue to be elevated at some level given the environment unless that environment turns.
Very helpful. Thank you. And then just, I need to address, course, the asset based side in terms of ETF fees and other index fees. I mean, thanks for the color in terms of the mix. But obviously, when you think about your biggest customer, BlackRock, you saw some of the moves that they just made on the custody side moving $1,000,000,000,000 over to JPMorgan from State Street.
And I think in the process, they also said that they are getting more conscious with some of their vendors. When you combine that and you see other moves like Schwab, for example, lowering fees aggressively for their index products even on the index mutual fund side. Like it just seems like the fee pressure is still out there. So any updated thoughts on how that how you fit in if there could be anything coming, if your discussions have changed with some of the customers of yourself? Thank you.
Yes. So Alex, I think the first thing is that we tried the best that we could to provide you kind of an inside look of how we view our licensing strategy and that was the comments by Kathleen. The flagship product line, new index families that we're launching that, of course, have less sort of value at the moment than the flagship ones that have been around for 20, 30 years. And then the domestic ones, the U. S.
Domestic ones have a fairly different competitive dynamics than the prior tool, right? So a lot of what we're doing is like we don't just want to rest on the flagship product line and the wonderful things that we've done there. We want to continue to expand dramatically into all areas of the ETF marketplace, regardless of the competitive dynamics, good or bad, as long as we it's a good return on our capital and on the effort. So that's what we're trying to exemplify here in as good of a way as we could. I think that the BlackRock is an example of that of the partnership approach that we're taking with our largest clients in which we're together trying to optimize the revenue to them and consequently the revenue to us in the same way we do it with a lot of other clients on the active side and on the passive side as opposed to just being a vendor and worse yet just being the lowest cost vendor to them.
So we believe that there are segments of the market like flagship indices that will have less cost pressure or less fee pressure because there's a unique IP there and unique properties. But there are other segments of the market that we have more fee pressure. And we're not afraid of going into them. To us, it's not a question of fees, it's a question of return on our capital, return on our efforts. And if we have great returns and built upon an already low cost marginal it's all very low marginal cost infrastructure.
We're going to be in all those places.
Yes. So look, it's a space that is going to continue to grow and gather substantial amount of assets over time, right? And we're focused on how we capture that market share through new product innovation and our differentiated licensing strategy. Over the long term, we're pretty confident that the volume price trade offs make sense for us.
All right. Very good. Thanks again.
Thank you. And our next question comes from Bill Warmington of Wells Fargo. Your line is now open.
Good morning, everyone.
Good morning. Good morning.
So a question for you also on the analytics side. That's an area where you guys have been putting through some price increases. And so even though you had elevated attrition there, margins were still up 120 basis points on a year over year basis and even 30 basis points on a sequential basis. So was it just that some low margin clients left or are you taking more of a up and out up or out, I should say, for some of the more marginal clients?
No. I think overall, Bill, the approach has been how do we take a very aggressive and proactive management of the product line on all aspects of it, all aspects. So we started by saying what is the value of these products to our clients and how does that value compare to the price that we're charging. And we saw and realized that some of these products have incredible value. Clients are running their entire infrastructure in many cases on this and therefore deriving immense value and the price that they were paying us was lower.
So we said, okay, over time, we're going to try to equate value and price on that. So that's the genesis of the price increases and things like that, right? The price increases have not driven the cancellations by any meaningful way at all. So that's one approach. The second approach is that we look at all of our activities.
The tool analytics is composed of a lot of different activities and a lot of different products inside that and we say what how much capital how much effort and expenses or capital will be flowing to one area versus another area versus another area and we started cutting back significantly the effort and the capital in some areas in order to deploy it into higher yielding opportunities and the like. So that yielded a significant amount of savings and we put a lot of that in the margin. But importantly, very critically, a meaningful part of those savings are being deployed on our on what I mentioned briefly our efforts on fixed income analytics, fixed income risk and fixed income analytics. And we've been able to self fund that significant effort last year and in coming years out of that and still be on our way to achieve those targets. So if you were to think about it, it's almost like management 101, right?
Understand your value proposition and the price that you're charging and what clients are you doing it and understand your how you're deploying your people internally and what activities and at what cost. And we are very pleased with what we've done, but we believe we also believe and recognize that we have we still have a long way to go to yield even better financial results. And as we said a couple of years ago when we launched this whole program of restructuring and reengineering and transformation of analytics, we knew that the first half of the program was going to be margin expansion and the second half had to be revenue growth. And that's what we're focused on on the revenue growth.
One more if I might. On leverage, you pointed out the on slide 16, the gross leverage at 3.7x, which is a slightly above the target at 3x to 3.5x. But really what stands out is the net leverage at 2.3 times, which would tend to bring the comment that you've got a fortress balance sheet, way over capitalized, a high class problem, of course. But are you thinking you've got a lot of cash there. So are you thinking about doing some M and A or are you going to be more aggressive on the buyback?
So I think the way to think about it is clearly the excess capital or excess cash. And the gross numbers look big and all of that, but when you take the money that is outside of the U. S, which you can't bring it unless there is some tax Unless there's a
tax reform with
the repatriation portion. Yes. So that's $200,000,000 that is kind of locked away, right? Then the money that is in the U. S.
Dollars 500 plus 1,000,000 and you got to have operating cash to run the business. And so that roughly at the moment gives you $400,000,000 plus or so in that, but we haven't yet paid the cash bonuses and the dividend payments this quarter and the tax interest payments and all of that. So we're getting close to kind of steady state in which we're shutting off the excess capital and excess cash. And as we do, we will continue in the same path of what we've done in the last 2, 3 years, mostly organic growth and mostly sort of return of capital through dividends and buyback, then occasionally acquisition here and there. But the less excess cash on your balance sheet makes you to be even more opportunistic and discriminating on the purchase of your shares.
So we'll continue to do it but in a smart way.
All right. Well, thank you very much.
Thank you. And our next question comes from Toni Kaplan of Morgan Stanley. Your line is now open.
Hi, good morning.
Good morning. Good morning.
You mentioned some cash collections that were expected in fiscal 2017 that were received in the Q4. And so I was wondering if that dynamic impacted your new sales level during the quarter as
well? Well, you look at those 2 events or data points and look we had strong sales in the quarter. We're very happy with that. Actually in the second half of the year sales were quite strong. And then, we had the really healthy cash collections, which is an interesting thing to see.
You don't often see that where clients are actually paying ahead of the due date. So optimistically, I'd like to think that, okay, the environment looks pretty healthy right clients have some incremental cash and are paying early. But yet still we look at the overall environment, we look at some of our client segments that have been challenged over the last several quarters. So we're still a little bit cautious, but, yes, to your point, 2 good data points there.
Okay. And you've mentioned a couple of times the tax initiatives this year that will impact next year's tax rate by about 200 basis points by sort of positioning your business more globally from a tax perspective. And so would potential tax reform in the United States, if there were to be a reduction to a federal level of call it, 20%, would that impact your strategy or what you would do going forward for achieving your tax initiatives?
Well, so first of all, I'd say, there are a lot of unknowns with regard to tax reforms in terms of, what it looks like, when it takes place, when it's effective. So we're waiting to see how that plays out. We're watching that very closely. It depends on what form it takes, right? Reduced corporate tax rate obviously would be beneficial.
So then there are other considerations too and unknowns like what happens with interest deductibility. So we're watching to see how that plays out. But generally the work we've done on the tax side really just aligns our tax structure with our operating structure. So where we employ our people, where we're generating our assets, where our clients are located. So all of that makes sense.
And we're waiting to see what any incremental changes might be with tax reform. Thank you.
Thank you. And our next question comes from Joseph Foresi of Cantor Fitzgerald. Your line is now open.
Hey, guys. This is Mike Reed on for Joe. Thanks for taking my question. Just could you go into a little bit what you think other impacts from the new administration could be outside of possible tax reform that you might expect to see?
I think the bigger one for us or more obvious one would be to the what I said before, to the extent that there is higher growth in the U. S. That may potentially be higher growth. We're seeing higher growth in Europe in the last few days, few weeks, more emphasis on fiscal policy rather than monetary policy, a little more inflation. All of that will be very beneficial to our client base as managers, hedge funds, banks, wealth managers, etcetera.
And that will have 2 effects. They will buy more products from us that they wanted to buy, but the budgets have been constrained and they may be less slashing and burning their cost basis. You could see that a major weakness, not a major weakness, but a relative weakness in our when you look at our cancels has been the bank owned asset managers, especially in Europe, the bank owned wealth managers, even the bank balance sheets themselves. We did well in the last quarter, but in general, the banks have been clearly slashing and burning expenses. So to the extent they feel better about trading, to the extent the asset managers feel better about flows and feel better about stock picking and all of that, that can potentially have a very leverageable effect on us because we are right there.
We're the partners. We're helping them in a lot of things. So it may have a 2 sided benefit. It will be higher sales and lower cancels and that will be highly leverageable for us. But it's too early to tell because that may be coupled with geopolitical risk or trade risk and things like that.
So we're cautiously optimistic, but we have to wait and see how it all pans out.
Okay. Thanks. And then just switching over to the margin side. After the strong expansion in the last few years in the overall company EBITDA margin,
what kind
of runway do you see left in the medium and longer term for overall company margins?
Well, I mean, we continue with the same policies that we have outlined so far. So there is no change on that at this point.
Okay. Thanks guys.
Thank you. And our next question comes from Keith Housum of Northcoast Research.
Your line is now open.
Good morning, guys.
Thanks for taking my call. I just want to clarify on the tax rate guidance, the 31.5% to 32.5 percent that includes the stock based compensation change in the Q1?
Yes, Keith, it does include that.
Okay. And then can you also just follow-up the question to that. In terms of the cash collections, I guess, help me understand the logic about why would customers pay early because obviously people like to further hold their cash unless obviously they're paid for it to do it otherwise. But why do people pay early here in the Q4?
That's a really good question.
We don't know.
We asked ourselves that question, but we were happy to take the $20,000,000 Wow.
So these guys came to you and said, hey, can we pay early?
They sent it to us.
All right. Thanks. Appreciate it.
Thank you. And our next question comes from Warren Gardiner of Evercore. Your line is now open.
Yes. Thanks. Actually just on that last question too. So was the did it impact gross sales in the 4th quarter? Just to clarify that.
No, it didn't. Like what
did it have been in 1Q, had you not gotten the cash payment, the gross sales?
If it hadn't come if it had not come in Q4, that cash would have come in Q1. And that cash was across a pretty broad group of clients. So it's not like one client or 2 clients. There was quite a number of clients that pay early.
And by the way, this is all in the normal policies of cash collections. So there were no incentives for them to pay us earlier or anything like that or some people do discounts or whatever, it's 0. I mean it was all in the normal course of collecting cash.
But what did the with the sales the gross sales number, would that have been any different? I guess it was more No. Okay. Thank you. And then my other question was on the index subscription base, it was a really nice quarter for growth again.
So obviously a lot growing right there. But I did want to ask because you've seen the growth in the number of kind of non U. S. Mutual funds kind of slow pretty significantly recently. So I mean how are you guys thinking about that trend maybe impacting that gross sales outlook for the index subscription base?
I mean obviously you have some other stuff that's going pretty well in custom and factor, but I'm just kind of thinking about the legacy sort of active mutual fund manager with the emerging market mutual fund or just anything along those lines?
Well, I think the value of our benchmarking product line to mutual funds all over the world has dramatically increased in the last few years, the value because on an average or general basis, mutual funds used to be sort of largely benchmarked to in the sense, but doing whatever they wanted. And with the pressure, intense pressure by passive investing, which is obviously the benchmark, you know, replicating the benchmark, the mutual funds have to spend a lot more time understanding the benchmark, which is in some respects the competition because that's where passive is coming from and really establishing a lot more discipline on what do they overweight, what do they underweight, if they run-in a little more concentrated portfolio, what the exam the risks are, all that and so on and so forth. So that has added to the impetus of our clients subscribing more to our information in more locations with more people, with more intensity and all of that. Secondly, we don't we typically constantly put more and more data, more and more new things into the same modules, into the same packages of data. So the client is constantly getting an upgraded product.
So if you say, if you do no price increases, the product is a lot bigger, it's a lot more valuable, but the prices remain the same. So you basically have decreased the price if you want to think about it that way. So that's what has added significant interest and potential to what we've done. The 3rd element is obviously the subscription here is a catch all. It's got subscriptions to market indices, but it also has subscription to factory indices.
Factory indices are not just being used for passive. We have clients subscribing to Factor indices in the benchmarking product line and the thematic indices and the ESG indices and all of that. So all of that is expanding our relationship with our clients and our value added to our clients Despite the headwind that pretty much every mutual fund in the world has, Clearly, passive is a lot stronger in the U. S, it's getting stronger in Europe, less strong in Asia. Asia is much more mutual fund driven at this point.
So different dynamics in different regions of the world.
Great. Thank you.
Thank you. And our next question comes from Patrick O'Shaughnessy of Raymond James. Your line is now open.
Hey, good afternoon, I guess. First question, just a little bit of housekeeping. The incremental $5,000,000 to $6,000,000 expenses you capitalized or you amortize your capitalized software in 2017, is that incremental $5,000,000 to $6,000,000 versus 2016? Because if I recall correctly, you said it basically a nominal this past year?
No, it's not incremental. It's $5,000,000 to $6,000,000 in 2017, but it was a pretty small number, a couple of 1,000,000 in 2016.
All right. Thank you. That's helpful.
And then my follow-up, curious if you can share any thoughts on that Morningstar open indexes initiative that they talked about last, I think it was December or November. It's kind of interesting from the perspective that there's a handful of buy side firms that express displeasure with their index licensing fees and certainly the initiative would be seeming to come after you a little bit. So curious about your thoughts on that.
Yes. So first of all, there's always been competition and new entrants. I mean, I've been running the company for 21 years. There's always been somebody creating another family of global indices. If you could look around there, you could look at 3, 4, 5 branded indices providers in 1 category or another who have international indices all over the world, right?
So that's not new. I mean, there's always been those offerings that have existed throughout the last 20 years. Secondly, is that it's very hard I mean, this is Aneeba. Our value proposition is to be a standard of communication and a standard of comparison, communication between the asset owner and the asset manager and a standard of comparison across investment products and across different entities. So that dethroning a standard like that is very hard because then you lose that standard.
Being fictitious here, if you say, okay, English is the language of the world and you say now, okay, now we're going to speak Swahili among 3 of us, well, good luck, right? Because the standard is English, right? So that's pretty hard to be drawn. The third element of it is that we are a high value added and obviously premium product line with that standard continuously innovating, continuously renovating the indices and the benchmarks and all of that continuously evolving. So it makes it also harder to catch up with that process as well.
Great. Thank you.
Thank you. And our next question comes from Chris Shutler of William Blair. Your line is now open.
Hi. This is actually Andrew Nicholas filling in for Chris. Just on the net sales front in the analytics segment, obviously those were solid numbers in the quarter, but it does look like constant currency run rate growth continues to decelerate. Just wondering if you can help me better understand what's driving that dynamic?
Yes, there was a slight FX impact on run rate. I don't have that number at my fingertips right now. We can get that for you, Andrew. But I think the key points here that if you look at the sales numbers for really the second half of the year, we've seen pretty healthy sales numbers in analytics in the Q4, 30% up and Q3, the recurring sales number was 26% up. So even despite the cancels, which are really isolated to those specific client segments that we referred to earlier, we're pretty happy with the overall performance.
Okay. Thanks.
Yes, I'm just checking the run rate numbers here, 3.4% up on a reported basis, 3.8xFX.
Right, right. It's just that's a little bit down from 2nd and third quarters. So that's why I was looking for a little more color. Yes. And then the second question, I think you provided a little bit of guidance on segment margins for analytics.
If I'm not mistaken, just curious if you could talk a little bit more about maybe segment targets for 2017 in the other segments and how that is kind of relative to your long term goals? Thanks.
Yes. So just to reiterate the long term targets, right, index 68% to 72% margin target, we're in that range and expect to continue Analytics, our margin rate our exit margin rate at the end of the year is almost at the long term target range of 30% to 35%. So that's a sustainable margin rate from our perspective and there is more improvement, more margin expansion to come to get us solidly into that 30% to 35%. You do of course have a little bit of lumpiness from quarter to quarter sometimes, but when you think about annual margin rate, we're pretty confident in continued progression there. And then, all other segment, we've made great progress with regard to restructuring in the real estate product area and we expect that progress to continue as well.
Great. Thank you.
Thank you. And ladies and gentlemen, this does conclude our question and answer session. I would now like to turn the call back over to Mr. Stephen Davidson for any further remarks.
Thanks everyone for your time and have a great afternoon. Thank you.
Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone have a great day.