Good day, ladies and gentlemen, and welcome to the MSCI Third Quarter 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.
Steven Davidson, Head of Investor Relations. Sir, you may begin.
Thank you, Esther. Good day, and welcome to the MSCI Third Quarter 2016 Earnings Conference Call. Earlier this morning, we issued a press release announcing our results for the quarter. 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 of 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 to 24 of the earnings presentation.
On the call today are Henry Fernandez, Chief Executive Officer and Kathleen Winters, Chief Financial Officer. With that, let me now turn the call over to Mr. Henry Fernandez. Henry? Thanks, Steve, and good day to everyone.
Please turn to Slide 4 for a review of our financial results. We continue to make significant progress in executing our strategy to be a leading provider of mission critical tools to the investment community worldwide. And this translated into strong financial results again in the 3rd quarter, A 28% increase in adjusted EPS was driven by a 7% increase in operating revenue, a 3% increase in costs and 11% increase in adjusted EBITDA an almost 200 basis point decline in our effective tax rate and a 13% decline in Shercam. In terms of revenue growth, the 7.3% increase in revenue was driven principally by double digit growth in recurring subscription revenue in Index. In index, I am very pleased that MSCI was selected by the Wealth Management Association or WMA in the U.
K. To replace a competitor as the provider of 5 multi asset class indices used by the group's membership. The WMA in the U. K. Represents wealth advisory firms that together manage $1,100,000,000,000 in assets on behalf of more than 4,000,000 clients.
This win marks a significant milestone in our strategy to market our products and services to advisory firms in the wealth management industry worldwide. Analytics revenue grew 4.1% on a foreign exchange adjusted basis. And while this revenue growth was not yet where we wanted it to be, This was a strong quarter for us in terms of delivering new products and capabilities that will significantly enhance our capabilities in fixed income analytics, one of our targeted growth areas in this product line. Order revenue grew 12.4% on a foreign exchange adjusted basis and excluding the real estate occupiers sale, which we closed in early August. Within all other, ESG continues to register strong top line growth of high teens in revenue, accounting revenues and low 20s in run rate and on the back of record sales in the quarter.
Turning to operational efficiency, our second pillar. The strong top line numbers were complemented by a 3.7% increase in adjusted EBITDA expenses or a 5.8% increase on a foreign exchange adjusted basis. During the quarter, we continued our relentless expense management process and our strong productivity gains to fuel both continued strong organic investment and profit margin expansion. We are confident that we can continue to do both and they cannot be mutually exclusive. As a result of the success of these processes, we are lowering our fiscal year cost guidance.
Kathleen will go over the new cost guidance in her section. Our tax reduction project is continuing and we're now in the final stages of planning. We expect to implement these new plans in early 2017 and see the benefit in about 200 basis point reduction in the effective tax rate by sometime in 2018. Our 3rd pillar is our capital optimization. Our Board authorized management to explore financing options in late July.
We executed in early August and we opportunistically tapped the debt markets for $500,000,000 of 10 year senior unsecured notes with a very attractive coupon of 4.75%, one of the records at that time for a high yield issuer. This debt financing was has temporarily moved us above our stated gross leverage range of 3 to 3.5 times and we expect to move back into this range over time as our adjusted EBITDA grows. In the Q3 and through October 21, we repurchased a total of 923,000 shares at an average price of $79.48 for a total of $73,400,000 Most of these repurchases were executed after quarter close where we took advantage of volatility in the market. We continue to have same capital allocation policy that we have had for the past couple of years and we are committed to returning capital to our investors. So the philosophy guiding our share repurchase programs and dividend policy continues to be the same.
In any given quarter, however, we may be subject to blackout periods or other restrictions on repurchasing of our shares, which may slow the pace of repurchase activity in a quarter. These are just tactical actions and we remain committed to our strategic goal of returning capital through share repurchases. Furthermore, we are strategic investors in our stock and we always look for opportunities to take advantage of volatility in the markets to buy more shares. We are willing to be patient and wait for those opportunities in those volatile markets. So this discipline may also impact the pace of repurchase activity in any given quarter.
So in summary, continued strong revenue generation and a relentless focus on expense management drove an 11% increase in adjusted EBITDA, which combined with an almost 200 basis point decrease in our tax rate and a 13% decrease in our share count drove a very impressive 20% increase in adjusted EPS. And year to date, adjusted EPS is 34% above the prior year level. Turning to Slide 5, we highlight here one of our largest and key product areas, recurring subscription revenue in index. Year over year, index recurring subscription run rate has been growing at a compound annual growth rate of 10% for the past years ending Q3 2016 and is a key component of the overall growth of our company. The investments we're making in index have been the driver of this consistent high quality revenue stream and our focus is to continue to innovate and invest to ensure that the compounding effect is maintained.
As the slide highlights, compound annual growth of 8% in our largest contributor, developed market indices and growth of 10% in our 2nd largest contributor, emerging market indices, are complemented by double digit growth in both factor, ESG and thematic indices and customized and specialized indices, giving us a combined run rate growth of 10%. We believe this combined growth rate is sustainable. In order to support growth in all areas of our equity index product line, we are focused on capturing what I call the waves of growth in the market. And I like to think of these waves in 2 dimensions. The first dimension are the waves by actual investment objective.
The globalization wave where investors are expanding the scope of their investments from a domestic biased view to more of a global view incorporating all developed markets, emerging and frontier markets and globally small caps. Investment institutions around the world are still very far from a steady state in this area. The factor investing wave, which clients are incorporating factors into their active and passive investment approach, we are just getting we are just at the beginning of this wave. And lastly, the ESG wave as environmental, social and government criteria are integrated more and more into the mainstream of the investment process. These are still very early days in this wave.
The other dimension of these waves of growth in the market is by application or by use case. So first, we saw the wave of growth in active management. That continues, but it's still but it's a little more mature. This is now followed by the wave of growth in passive investing in all types of wrappers, whether it's ETFs or mutual funds or pool vehicles or separately managed accounts, etcetera. And lastly, the derivative wave, which supports growth in exchange traded futures and options and in structured derivative products in multicountry, multicurrency equity indices.
This wave is in its infancy since the market has been dominated by single currency equity index derivative products, especially in the exchange credit sector. We believe that MSCI by capturing these ways of growth through our strategy to capture new client segments, upsell to our existing clients or establish new use cases, we believe MSCI is extremely well positioned to growing areas in the overall investment process. And we are terribly excited and all of this underpins our belief in the growth rates that we have in all these 3 categories, which is subscription, passive fees or asset base fees and derivative fees. Let's turn to Slide 6, which highlights the strength of our franchise as a leading provider of indices to the ETF marketplace, one of the many segments that we were addressed. The global ETF landscape is comprised of many ETF providers who even within their own product lineup have various pricing, client, product and distribution strategies.
Similarly, MSCI's ETF licensing business consists of diverse of a diverse group of over 850 ETFs sponsored by a range of ETF providers and listed on various exchanges around the world. As a result of this diversity and the strength of our indices, we've been able to license to many different type of ETF providers and assets under management in ETFs linked to our indices have grown 57% over the past 3 years from about $300,000,000,000 in Q3, 2013 to about $475,000,000,000 in the current quarter. We are focused on both sides. On one hand, AUM linked to our indices and on the other hand, the revenue we derive from them. Even though there are significant changes and some fee pressures in the ETF industry, we remain focused on revenue growth and do not see any let up in our revenue growth rates in this area.
I should note that the recent pricing change announced by one of our largest clients in the ETF space affects only 5 ETFs linked to MSCI indices. Those ETFs have about $33,000,000,000 of the total $475,000,000,000 linked to our indices. And given the structure of our arrangement, there is no impact to our revenue related to this pricing announcement. This lower cost ETFs linked to MSCI indices are designed for more price sensitive retail investors where there has been more pricing pressure in the U. S.
As a result of competition between ETF providers to attract assets. In addition, the recent announcement of the Department of Labor with respect to the fiduciary rule is expected to drive more retail assets into passive investment products like ETFs and is expected to benefit ETF providers and index providers like MSCI even if the fees of these products are reduced. So in line with the strategies being implemented by some of our largest clients, we believe that over time the trade off in ETF between price and volume is favorable to us and to many ETF providers and we're well positioned to benefit from this trade off. Let's turn to Slide 7, which shows our long term adjusted EBITDA margin target for analytics compared to where our margin is this year and where it was last year. The long term target for analytics are upper single digits revenue growth and adjusted EBITDA margins of 30% to 35%.
As we shared with you last year during our Q3 2015 earnings call, the adjusted EBITDA for full year 2014 for analytics of $72,000,000 is the baseline for evaluating the progress towards the long term targets. The annualization of our Q3 2016 Analytics adjusted EBITDA results in an annualized adjusted EBITDA of about $126,000,000 or about 28%. We will continue to look for additional opportunities to pull cost out of the product line or reallocate cost to higher to other higher yielding opportunities within analytics. So we remain confident that over time, we can achieve the longer term targets of EBITDA margins of 30% to 35%. The next step in our plan toward achieving our long term targets will be driven by incremental revenue from several key initiatives that will continue to require incremental investment in the quarters years ahead.
The 3 key areas that we're focused on to generate this incremental revenue are as follows. First is fixed income analytics. This is a very important initiative for us. We are building relationships with. The delivery of the new fixed income factor model, transaction based performance attribution and several upgrades to both Risk Manager and Bar 1 this quarter support this initiative.
Next growth area is services. We are right now in the process of identifying client operational pain points that will help us refine our service offering to this client and lead to potential future managed service opportunity. As we evolve to a more services focused approach from a more product centric approach, the opportunity for MSCI to leverage our workflow tools are amplified significantly. And lastly, our 3rd growth area is the new analytics application platform. This single point of entry for all of our analytical data and content is in beta testing right now.
We expect to have a commercially viable platform ready in the first half of twenty seventeen and then we expect incremental sales to begin in the latter part of 2017 and build up on 2018. And accompanying all these key initiatives, we continue to implement a more systematic process of price increases in analytics commensurate with the enhancements that we make to our systems for the benefit of our clients, while continuing to maintain high retention rates. With that, let me now pass it on to Kathleen.
Thanks, Henry, and hello to everyone on the call. I'll start on Slide 8, where I'll take you through an overview of our Q3 results. We delivered a very strong Q3 across all of these measures and was very pleased with our overall execution as well as the strong rebound in AUMs and ETFs linked to our indexes. So let me walk you through each measure. We delivered a 7.3% increase in revenue, driven primarily by a 6% increase in recurring subscription revenue and a 10.6% increase in asset based fee revenue.
There was a negligible impact from foreign currency exchange rate fluctuations on our subscription revenues. 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. Operating expenses and adjusted EBITDA expenses were up 3% 4% respectively on a reported basis.
Expenses that are exposed to foreign currency exchange rate fluctuations represented approximately 40% of adjusted EBITDA expenses in Q3. Excluding the impact of foreign currency exchange fluctuations, operating expenses and adjusted EBITDA expenses would have increased 5% 6%, respectively, reflecting an approximate $3,000,000 FX benefit. The primary currency move that drove this benefit was substantially weaker quarter over quarter. Additionally, there were smaller benefits from the Mexican peso, the Indian rupee, the Swiss franc, offset in part by yen strengthening. We delivered a 13% increase in operating income and an 11% increase in adjusted EBITDA, resulting in a 2 10 basis point increase in our operating margins and a 180 basis point increase in our adjusted EBITDA margin to 49.7%.
Our effective tax rate was 33.1 percent, down 190 basis points from 35% in the prior year, as we continue to better align our tax structure with our global operating footprint. Diluted EPS and adjusted EPS increased 15% and 28%, respectively. Diluted EPS in the Q3 of last year included the benefit of a 6 point $3,000,000 gain on sale of an investment, which was excluded from our adjusted EPS. Free cash flow was up 9% year over year at $133,000,000 primarily driven by higher billings and collections from customers and lower cash payments for income taxes, including the impact of tax refunds, partially offset by higher interest payments. In summary, this was a very strong quarter.
On Slide 9, you see a walk showing the different drivers of EPS growth in Q3. Adjusted EPS increased $0.17 from $0.60 per share to $0.77 per share or 28% in comparison to Q3 2015. Strong revenue growth from both subscription and asset based fees contributed $0.12 per share. Investments in our product segments and operations reduced earnings by $0.05 We continue to spend in the highest growth, highest return areas with growth in costs across index and ESG somewhat offset by continued efficiencies in real estate. The lower effective tax rate contributed $0.02 per share.
Next, in terms of capital optimization, share repurchases benefited EPS as well. We reduced our average weighted diluted share count by 13% with a partial offset from higher net interest expense, resulting in net accretion of $0.06 per share. And lastly, FX had a net $0.01 per share positive impact. On Slides 10 through 13, I'll walk you through our segment results. So let's begin with the Index segment on slides 1011.
Revenues for Index increased 11.4% on a reported basis, driven primarily by a 10.6% increase in recurring subscriptions with growth in core products, factor and thematic usage fees and custom products, as well as a 10.6 percent increase in asset based fee revenue. We also had higher non recurring revenues, which increased $1,000,000 year over year, mainly due to one time history data purchases by several clients as well as other non recurring services. In terms of our operating metrics, recurring subscription sales in the quarter were basically flat compared to prior year and aggregate retention remained high at approximately 96%, in line with the prior year and the previous quarter. Index run rate grew by $59,000,000 or 11% compared to September 30, 2015. This was driven by an increase in subscription run rate of $34,000,000 or 10% and a $24,000,000 or 13% increase in asset based fee run rate.
The adjusted EBITDA margin for index was 70.8% versus 72.7% in the prior year and up from 70% in Q2 2016. Turning to Slide 11, you have detail on our asset based fees. Starting with the upper left hand chart, overall asset based fee revenue increased $5,000,000 or 11% over Q3 2015, driven by $3,000,000 or 24% increase in revenue from the non ETF related passive product area. The increase in revenue from the non ETF related passive product was primarily due to initial fund fees recognized in the quarter. Non ETF passive assets linked to MSCI indexes were flat year over year and experienced a slight improvement in the average basis point fee, so core revenue growth was slightly above the prior year.
The remaining $2,000,000 increase was driven by 2 components. First, dollars 1,000,000 or 4% increase in revenue from ETFs linked to MSCI indexes, resulting from a 12% increase in average AUMs partially offset by the impact of changes in product mix. And additionally, we had a $1,000,000 or 60 percent increase in revenue from exchange traded futures and options contracts based on MSCI indexes. Total trading volume in these contracts increased 37% year over year and are running up 45% year to date versus prior year. In the upper right hand chart, you can see that we ended the 3rd quarter with a record $475,000,000,000 in period end ETF AUM linked to MSCI indexes.
This resulted from market appreciation of $24,000,000,000 and cash inflows of $11,000,000,000 during the quarter. As shown in the lower left hand chart, quarter end AUM by market exposure of MSCI linked ETFs reflected strong growth in EM, which increased approximately 47% year over year and recorded $15,000,000,000 in inflows in Q3 alone. Lastly, on the lower right hand chart, you can see the year over year decline in the average basis point fee from 3.4 to 3.11. This decline was driven primarily by increased asset flows to and market appreciation in lower cost ETFs linked to MSCI indexes. Compared to 2nd quarter, the average basis point fee was essentially flat and benefited from the strong flows into EM market cap funds in late Q3.
On Slide 12, we highlight the financials for the Analytics segment. Revenues for Analytics increased 2.7% to $111,000,000 on a reported basis, which includes a $1,500,000 negative impact from FX. Excluding the impact of FX, analytics revenue increased 4.1%. The increase in revenue was primarily driven by higher revenues from equity models driven by the increasing focus of hedge funds on factors to explain investment performance. Additionally, we had higher risk manager and investor force revenue in the quarter.
We had a very nice increase in recurring sales, which were 26% higher compared to the prior year Q3 due to higher risk manager, equity model and borrower 1 sales, partially offset by slightly lower investor force sales. And gross sales, which include non recurring sales, were up $3,700,000 or 31%, so a very strong new sales quarter. However, we did see higher cancels for analytics in the quarter. We're continuing to see cost pressures and budgetary constraints among some clients, particularly banks and wealth management subsidiaries of banks. Also, we continue to see a challenging environment for hedge funds, primarily in the U.
S, which resulted in higher levels of risk manager cancels in the quarter in the U. S. And in Europe. The cancels were $10,500,000 for Q3 and are a function of the challenging market for our clients and the continuation of the market conditions we saw in Q2 and as discussed on last quarter's call. We are continuing with our systematic price increases in analytics.
This process is going well and cancels are market driven and not a result of our price increases. As a result of the higher cancels in the quarter, which get annualized to determine the quarterly retention rate, analytics retention declined to 90%, down from 95% a year ago, but year to date retention remains high at 92% compared to 94% in the same period last year. Analytics run rate at September 30 grew by $22,000,000 or 5 percent to $462,000,000 compared to prior year and the impact of FX was not significant. Adjusted EBITDA margin was 28.3%, up from 27% in the prior year. While we are seeing some elongation of the sales cycle, the overall analytics pipeline remains strong and the importance of our risk tools in helping our clients gain deeper insights into portfolio performance and respond to increasingly complex regulatory reporting requirements is only increasing.
Turning to Slide 13, we show results for the all other segment. Revenues for all other increased 3% to $19,000,000 on a reported basis and grew 12% after adjusting for the disposal of the occupiers business and the impact of FX. First, in terms of ESG, a $2,000,000 or 18% increase in ESG revenue to $11,000,000 was due to strong ESG ratings revenue on record ESG sales. Growth continues to be driven by the increasing integration of ESG into the mainstream of the investment process and new client acquisition. Real estate revenues, however, decreased $1,000,000 or 14% to $8,000,000 on a reported basis.
However, excluding the impact of foreign currency and the sale of the occupiers business, which closed in early August, real estate revenues increased 6%. The all other adjusted EBITDA margin was 0.4%, up from a negative 17.4% in the prior year. The substantial increase in the adjusted EBITDA margin was driven by continued strong growth in ESG revenue as well as lower real estate costs, primarily due to a reduction in headcount and strong cost management as we make progress toward improving profitability in our real estate product area. On a sequential quarter basis, all other revenue declined $7,000,000 primarily due to normal seasonality. Q2 of each year is seasonally strong for real estate when the majority of annual portfolio analysis service reports are delivered to clients.
This seasonality also drove the sequential quarter decline in the adjusted EBITDA margin for the segment. Turning to Slide 14, you have an update on our capital return activity. As you know, we've returned substantial amount of capital to investors in recent years. Specifically, since 2012, we've returned almost $2,000,000,000 through share repurchases and dividends. In Q3 and through October 21, we repurchased and settled 923,000 shares at an average price of $79.48 for a total value of 73,400,000 dollars Yesterday, our Board approved a $750,000,000 increase in our outstanding authorization, bringing the total repurchase authorization outstanding to $1,100,000,000 There has been no change to our capital allocation policy.
We will always be looking at the full array of options before us to deploy capital. Given this, there may be times when we are subject to blackout periods or restrictions on repurchasing our shares because of any number of factors. We view ourselves as a strategic buyer in our own shares and we will be flexible as we look to take advantage of market volatility to repurchase more shares. On Slide 15, we provide our key balance sheet indicators. We ended the quarter with cash and cash equivalents of $974,000,000 This includes $188,000,000 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.
In August, we issued $500,000,000 of senior unsecured notes due 2026 at a very attractive coupon of 4 point 7 5%. As a result, our gross leverage was 3.8x at the end of the quarter. Over time, we expect that we will return to our stated range of 3x to 3.5x
as
our adjusted EBITDA grows. Lastly, before we open the line for Q and A, on Slide 16, we're updating our full year guidance. Based on the progression of our investments and the efficiencies that we've achieved year to date, we are lowering our full year adjusted EBITDA expense guidance to $580,000,000 to $590,000,000 down from our previous guidance of $600,000,000 to 615,000,000 dollars We're very happy with our progress on our productivity initiatives, and this is reflected in the guidance. Next, we're increasing our full year 2016 interest expense guidance to $102,000,000 reflecting the impact of the recently issued senior notes due in 2026. 1 of the key strengths of our financial model is that it is highly cash generative.
Given our strong operating results and the benefit of lower cash taxes and Q3 tax refunds, we are increasing our full year net cash provided by operating activities to $350,000,000 to $375,000,000 and our free cash flow range to $305,000,000 to 3 35,000,000 Lastly, we're narrowing our full year CapEx guidance to $40,000,000 to $45,000,000 based on the $32,000,000 that we have recorded year to date and our outlook for Q4 spend. In summary, we're very pleased with our results for Q3. We executed well throughout the quarter. We delivered solid financial results. We continue to execute a consistent capital allocation strategy, and 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're happy to open the line and take your questions.
Our first question comes from the line of Alex Kramm with UBS. Your line is now open.
Yes. Hey, good morning, everyone. Good morning. So just Henry, you already proactively addressed the whole ETF fee pressure debate that's been going on. But maybe you can flush it out a little bit more.
I mean, surprising to hear the no revenue impact. So maybe if you can talk about the pricing structures a little bit more, why is there no revenue impact? And then also looking forward a little bit, how do you feel about incremental pressure that could be coming beyond those 5 that you highlighted? Like, do you think it's consistent with the revenue impact should be limited? Do you feel like there could be more pricing pressure on the institutional side at some point and maybe you'll leverage there a little bit different.
So just a little bit more color so we can put the debate a little bit more to rest. Thank you.
Yes. So thanks for that question Alex. Look I think we got to start from obviously the bigger perspective and that is the ETF industry is growing by leaps and bounds all over the world, but especially in the U. S. And Europe.
And we're trying to make it grow fast in Asia, but it's been a bit more challenging. That ETF industry is going to gather large amounts of assets in market beta, if you want to think about them and in factor beta and eventually in ESG betas. And hopefully also in actively managed funds, although so far that segment of the market is not that large. We believe that that continues to be a fairly large growth part of the investment process. And as I said, we will gather quite a lot of assets.
So that part of the volume, so to speak, will benefit us and many ETF managers significantly. Then inside that global ETF industry, there are a lot of different participants with a lot of different pricing strategies, market segments and product offerings and all of that. And there is increasing levels of competition, particularly in the U. S. And especially for retail investors.
So we are likely to see a TER erosion of the CTF product line particularly in the more competitive areas of the market
since we're in
the U. S, particularly the retail competition and leading up to this fiduciary rule by the Department of Labor is going to drive some early adopters of lower fees and all of that in order to capture more assets, particularly assets away from mutual funds and actively managed mutual funds. So clearly all of that is happening and we at MSCI are partners with a lot of the CPS managers and we want to remain partners with them and help them achieve those strategies. And as we have talked about in the past with particularly one entity in iShares, we've had a differentiated pricing between the large and mid cap standard MSCI indices globally and the ETF on those which are more targeted to institutional investors with higher liquidity, higher bid ask spreads and all of that and the more the core funds which are the old cap indices around the world and have lower management fees and have had lower have already have lower licensing fees from MSCI. So I think that our focus is on 2, 3 things.
One is the size of the industry and how we capture a lot more assets, I. E. The volume, and that will lead to a lot of revenue and large growth of revenues. Secondly, working with our partners to adjust and be flexible with our on that in any of these announcements that have been going on. And then 3, innovate with a lot of new products so that those new products not only can be priced attractively for us, but also capture a lot of market share.
So I think in a nutshell, the announcements and the sort of reports that have come out in the last few weeks have not really changed the strategy of MSCI and have not really changed the of MSCI.
All right. Thanks for that. And then just secondly maybe on the retention rate that came down, again, you addressed it already a little bit too. But on the analytics side in particular, do you feel like most of what led to that low retention, you kind of threw that in terms of any sort of hedge fund pressure that is maybe leading some incremental cancels? Or do you think the environment is still very uncertain on the retention rate?
[SPEAKER JOSE RAFAEL FERNANDEZ:] Yes. So look, that's a good question as well. And let me try to abstract from it again. We at MSCI continue to produce very strong financial results. But we do so and we do so with a lot of strong wins in our back in terms of passive investing and in terms of VGSG investing and risk management and all the things, globalization, all the things that we always talked about.
But we are really selling into an investment industry around the world in which significant segments of that industry are being challenged. Equity active managers are being challenged. Banks, hedge funds, funds of funds, wealth managers, subsidiaries of banks, not because the wealth managers are not doing well, it's because when the banks when the senior management of banks decide to have cost measures, cost management measures, they do so across the board in order to have the wealth management subsidiaries, which are doing well, contribute larger amounts of profitability to compensate for the pressure that they see on the investment bank or the commercial bank. So that leads to some pressures in segments of our marketplace. There are other segments that are doing well for us like non bank subsidiary non bank owned wealth managers, patient funds, sovereign wealth funds and all of that and we can talk a lot about that, right?
So the pressure continued. In this particular quarter, we saw meaningful pressure on fund to funds for our hedge platform product line. We saw meaningful pressure from the wealth management subsidiaries of U. S. Banks.
We saw pressure from the investment banks in Europe as well and the like. And therefore, the majority of this $10,000,000 in cancels were attributed to those cost pressures and resulted in partial cancels, resulted in shutdowns of hedge funds, shutdowns of funds of funds. As an example, reduction of services from wealth managers and all of that. We believe that that trend will continue. Now it will be bumpy.
There will be some quarters in which the retention will zoom out because the cancels were lower and other quarters in which the retentions will go lower like it did in the Q3 and the cancels will be elevated. We there's nothing new there in the way we're looking at the product line and our strategy and all of that. We believe that the health of the business is also demonstrated by the strong recurring sales in analytics and the strong one time sales, non recurring sales in analytics. But I think we will continue to have those pressures. And every quarter when there is pressure maybe a different set of client segments.
There will be more in one area, more in another area. It may be compensated by lower retentions in other areas or much higher sales in other areas like pension funds and sovereign wealth funds. But it will continue like this. But net net, we think that the product line continues in its progression of growth. We wanted it to be more rapid in the top line, but for sure growth in profitability.
Yes. And Alex, maybe I could just add to that a little bit. We did talk about in Q2, we saw these conditions as well. And Q3 here is really a continuation of that. And as Henry said, probably will continue in the near term, right?
And if you look at historically, Q4 is usually a higher quarter for us in terms of cancels. So we'll see how that goes in Q4. But let's just put it in the overall context for analytics. For the quarter, organically, analytics revenue up 4% and in fact, new sales, recurring sales up 26 percent and then if you include even one time sales, up 31% for the quarter. In addition, continuing to make progress in analytics on margin expansion.
So we continue to execute there. Certainly concerned about the cancels being high. Don't like to see that, but we're working hard to minimize that.
Actually one other thought that I forgot because there's been some speculation that the and some reports that some of these cancels came from our across the board price increases in analytics. There's very, very little effect of our price increases in these cancels. They have very little to do with our price increases. Our price increases are going relatively well. Obviously, nobody likes to see price increases in our client base, but they're going well and we'll continue to execute on them.
Excellent. Thanks for the color.
Our next question comes from the line of Ashley Sarrao with Credit Suisse. Your line is now open.
Good morning. Henry, I just wanted to clarify your comment on Alex's question around the BlackRock fee cuts not impacting revenues. Is that because it's just too small as a percentage of AUM Or is it because contractually the pricing change doesn't flow through to you guys?
We already have a formula with them on the core shares, the core iShares that has a formula that is relative to the management fee, percentage of the management fee and it has a floor, it has a ceiling. And a lot of that was already in the lower end of that range. So as the management fee gets cut or the TR gets cut, we're already at those levels. And there hasn't been any change on the pricing of the product at all with them. Now over time for sure, right, as we try to capture assets, I mean, as they try to capture assets and want to be more aggressive, we may have other discussions about how to create pricing strategies that get us much more volume and even if it's a lower fees, but none of those discussions are taking place right now.
Okay. I appreciate the clarification. And then just on the analytics revenue projection over the next few years, does that include any contributions from potential wins from replacing the Barclays Bloomberg Point system, which I think was announced after you gave your initial guidance? And then how should we be thinking about the timing of the incremental investment for growth to flow through the business?
Yes. So all these projections that we show have in them both the investments, the organic investments that we refer to. So I don't want anybody thinking that this incremental investments that I referred to will be added to this and therefore lower our targets of EBITDA margin in the future. And secondly, they also do reflect the contributions to revenues from all these initiatives, right? The fixed income analytics initiative, the services offering analytics and the new platform, the new sort of technology platform analytic product line.
So all of that is there. Now they are back ended, because as you develop the fixed income capabilities for both, not only for fixed income analytics for fixed income portfolio management, but also fixed income analytics in the context of the multi asset class analytics offering, right? So the investments we're making there give you incremental revenue that are part of that progression of revenue growth, constant currency revenue growth to the high single digits. And the same thing with the offerings, the service offering on the new platform. But they are back ended.
So I don't anticipate us I will anticipate us getting closer to the 30%, 35% EBITDA margin first before we get closer to the high single digit revenue growth because the revenue is it gets back ended in terms of the investments and the progression of getting clients and all of that. And as you know, it just takes time to accumulate those run rates. So now within fixed income analytics per se, yes, this is a strategic area for us for many, many years as we've talked about. For many years we also wanted to solve this inorganically through some acquisition and we're praying and hoping that that will happen and properties have come to the market, But we haven't liked the prices. We've been very, very disciplined buyers and have passed, therefore.
And now the time has come in which we got to do it organically because it's just we've been waiting too long. And we really need to start filling out this whole area, and that's what we're doing gradually now.
Okay. Thank you for taking my questions.
Our next question comes from the line of Chris Shutler with William Blair. Your line is now open.
Hi. This is actually Andrew Nicholas filling in for Chris. Just one question, I believe most of my other ones have been answered. On EBITDA expense, I believe your guidance implies Q4 of expense around 1 $150,000,000 at its midpoint. If I take that run rate into 2017, it looks like year over year growth on a constant currency basis would be around 3%.
I'm just curious if that's a fair way to be thinking about next year? And if so, or in either case, what are the key spending areas that we should be thinking about that would drive EBITDA expense higher than that Q4 run rate?
So as we think about our planning, Andrew, and as we've talked about, we think about our model being strong top line growth coupled with really controlling our expenses, right? And we talk about high single digit revenue growth rate, but capping expenses at a 5 ish percent growth rate. Now we're in the midst of our planning process right now, so I really can't say specifically what 2017 is going to look at. But when you just think about conceptually the nature of our expenses and our expense base and our expense base being primarily compensation related because we're a people business, right? And you think about the inflation associated with that year over year.
Add on to that, right, the investments that we want to continue to make in our fast growing spaces, particularly in index and ESG, in fixed income analytics. That's kind of how we think about our expenses. We want to be able to fund the fast growing parts of our business. But at the same time, we want to be able to find productivity to fund that really for all the projects that we see across the board that have high returns.
All right. That's helpful. That's all I had. Thank you.
Our next question comes from the line of Toni Kaplan with Morgan Stanley. Your line is now open.
Hey, good morning. Good morning. So as you mentioned, new sales in analytics were actually strong, and but clearly the retention rate in analytics was a little bit late as we've been discussing.
Could you
just give some color on whether there's a difference between the products that are being demanded on the new sales front versus the products that clients are canceling?
Yes. So on the cancel side, Tony, the epicenter, so to speak, of the cancels this past quarter, where in multi asset class risk manager product, the product line there, to Haitians, I mean smaller Haitians that shut down for example. Also to wealth in the U. S, let's say, to wealth management subsidiaries of banks in the U. S, which also offer that multi asset class risk manager product line.
So that was one area. Another area is hedge platform or fund to funds, much smaller negative impact. We have had relatively little cancels on BARRA 1, which is more the factor based multi asset class risk management product line. A lot of that is to asset managers and patient funds, so very little cancels there. If anything, good sales there.
Very strong sales in equity analytics models and applications, particularly to equity longshort hedge funds that are being asked by their institutional clients to report the performance and risk of their portfolios on a factor basis. That is definitely an increasing trend and we hope to capture that. Those have been the areas where some of these issues have been focused on.
Okay, great. And then you've mentioned the success in fixed income analytics. Are you targeting sort of existing customers that already have some of the equity analytics or multi asset class analytics? Or are you going after sort of new fixed income only shops?
Yes. Well, first of all, the success has been in just launching the product and putting cost in the company. We are hoping to have success in generating revenues, but not yet, right, because we just started this effort. Our main focus on clearly there are 2 focus, right? It's the fixed income analytics as it relates to the multi asset class offering.
And then there is the fixed income analytics for fixed income portfolio managers alone, right? So in that area, our main focus is to go to those clients that we already have a large relationship with in multi asset class analytics and in equity analytics for their equity portfolio management team and round up the efforts in fixed income portfolio management side. That's been one big effort. And the second big effort has been targeted in the high end of that as opposed to the low end, the small and medium sized clients, but the bigger clients that we've had very extensive relationship with. And that is there is a lot of changes that are going on in fixed income analytics because the providers of fixed income analytics have been changing hands and all of that.
So this has been driven by both. A lot of our clients have come to us and say, how can you help us manage these transitions? And obviously, we've been eager to help them as well.
Thanks a lot.
Our next question comes from the line of Joseph Foresi with Cantor Fitzgerald. Your line is now open.
Hi. Has the focus of your clients shifted towards cost versus quality, particularly in the index business? And could that shift get worse if the economy continues to do poorly? I'm wondering if you have any worries around pricing.
With respect to indices and our clients well, let me go back. With respect to our clients, particularly our active management clients, for sure there is a lot of emphasis on cost, not dramatically different than it has been in the last 2, 3 years. It's a lot of emphasis on cost. Now with respect to the index product line with those clients, we've been successful at selling them more things, particularly factory indices for example or emerging market indices because the emerging market asset classes began to come back or custom indices, ESG indices and the like. And therefore, our share of their wallet has increased because at a time in which they need us the most.
So obviously, that is coming at the expense of reductions in budgets of those clients from other providers.
Got it. And so and then my second question is how would you characterize the cancellations in the analytics business? Were most of those due to hedge funds going out of business versus just kind of not needing the product anymore? And if you could, I know this is very difficult, can you quantify the percentage of spending in that business that's typically discretionary? Thanks.
Yes. So the expense of this is typically mission critical
for sure. So some of these councils have been hedge funds, medium and small hedge funds shutting down because these are largely multi strategy hedge funds by the way, not equity longshore hedge funds. These are largely multi strategy hedge funds have done that or that they had partial reduction in service because their assets under management have declined significantly. And therefore, they're less processing or they've got out modules or whatever, right? That's been one area.
Clearly another area is fund to fund. We know that this is an area that is being challenged, the fund to fund industry in hedge funds. We've had some cancels there. We have wanted to make up those cancels by higher sales of our hedge platform product line to endowments, foundations and patient funds, meaning other forms of sort of asset owners. But that has we haven't spent as much time in increasing those sales.
We will in the future, but we haven't to make up for those funds of funds decline and the like. So that has been the nature of the trend.
Thank you.
Our next question comes from the line of Warren Garner with Evercore. Your line is now open.
Hey, good morning. So I was wondering if you guys could I know you sort of mentioned that there was no impact cancels had no impact on gross or on the pricing from the pricing increases during the quarter. But I was wondering if you guys could just quantify the impact on gross sales from maybe some of the pricing increases you've been passing through?
Yes. So on the analytics side, going back, I guess, a year or so, we really started to more systematically look at our pricing. And we continue to do that now at analytics. It really has not had an impact with regard to the cancellation. And we're going to continue to kind of focus on that as one of our key areas.
Usually around 15% -ish of our revenues.
For analytics and index or just analytics?
Yes, for analytics.
Okay, great. And then I think you guys mentioned some asset based fees from mutual funds in the quarter. I think you talked I think you termed them initial fund fees. I mean should we be thinking about that as a one off like event or is that the right run rate to use going forward for that line item?
So can you just clarify what you're asking?
So in the asset based fees, the funds from passive mutual funds, I think there's a nice tick up and I think you guys noted initial fund fees is one of the reasons. I was wondering if that's more one off or is this now kind of the right run rate to think about going forward?
Yes. I mean that can be kind of lumpy. I wouldn't assume that that's a I wouldn't assume that that's an ongoing run rate. That can kind of bounce around a little bit.
Okay, great. Thank you.
Our next question comes from the line of Keith Housum with Northcoast. Your line is now open.
Good morning. Adam, the adjusted expense guidance for the year has come down obviously significantly. If you look at over the past year, what's been the drivers of that decrease? Has it been driven the combination of like FX and delayed spending and just better performance? Or if you had to wait like where the savings is, how would you wait that?
So look, I think in general, it's been driven by a very, very tight management of the headcount, right? For example, in years past, we were growing our headcount aggressively. So we came to a situation where we felt that we had enough headcount all over the world and we needed to just focus on productivity of that headcount in the company. So what you see is almost flattish headcount growth that has helped dramatically to decrease the rate of growth of EBITDA expenses. Clearly foreign exchange has benefited us immensely there, but that's what we give you the numbers on a FX adjusted basis versus non FX adjusted basis.
And do you like anything else Kathleen?
No. I mean, we're, as you said, really strong kind of rigorous keeping an eye on expenses, on headcount, particularly driving for more efficiency in real estate and analytics. And you can see that in the margin rate. I mean, we've had pretty steady margin expansion and we're going to continue to keep an eye on that.
Okay.
As a follow-up, as I look at the guidance you guys gave a few quarters back in terms of your long term adjusted EBITDA margins, the index business is already at the top end of that range and the range was 68% to 72 percent now. Should we think that that range
should be bumped up or
are you guys going to be increasing your investment area commensurate with your revenue growth?
[SPEAKER DANIEL MARTINEZ
VALLE:] No, I think that range, I should stay like it is. There will be times in which we'd be at the lower end of the range like we have been in prior quarters this year on the basis of lower ETF fees or at the same time coupled with investments. There will be times in which we'll be a little bit over on the little bit on the upper side of the range. But given there clearly is a built in margin expansion in the index product line. But if we really would like to see this index product line expand for years years years to come, we need to continue to invest in a lot of new areas there.
And that's what we're doing and that's what we are capping, so to speak, the margin range to those levels. And the investments clearly factors. It's a huge part that we need to do that and everything that goes with factor distribution, client service, the production environment for factor indices and all of that, right, ESG indices, another part, etcetera.
Yes. So, as Henry said, we really are making it a priority to make sure we are funding our growth initiatives and innovation, right? So, look, we're very happy to be in that target range, the 68% to 72%. And it's clearly a priority for us. Look, we've got lots of great projects that we want to fund, high return projects, and we want to continue to be able to do that.
And it makes sense to do that for the long term growth of the business.
Okay. Thank you.
At this time, I'm showing no further questions. I would like to turn the call back over to Don for any closing remarks.
Thank you everyone. We went over a little bit to get everyone on the queue. So thank you and we'll speak again next quarter.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a wonderful day.