Connecticut-based FactSet (NYSE:FDS) is a pick-and-shovel fintech play for the financial services industry and, within that industry, it operates mainly in the asset management niche.
The company provides integrated financial information and analytical applications for financial professionals worldwide to drive productivity and improved performance. As of the latest fiscal year, buy-side and sell-side clients represented 84% and 16% of the company's total sales, respectively.
FactSet differentiates itself from competitors through its simpler, high-quality offerings with excellent client services at relatively lower costs (for example, FactSet is roughly half the price of Bloomberg).
Thanks to the subscription model of its business, what we find most likable about FactSet is its predictable cash flow. The annual client retention rate over the last three fiscal years ranged between 89% and 91%, indicating the strength of the business model along with the recurring nature of the revenue. We observe that the majority of the user stickiness comes from FactSet's flexible modules often embedded in clients' operations and workflows, as well as high specialty typically requiring considerable up-front training. The resulting switching cost makes the business more of a bond proxy.
To get a sense of the stability and consistency of the company, take a glance at the remarkable track record of 39 consecutive years of revenue growth as a public company achieved by Factset. Additionally, the business delivered a more than 18% return on assets every year for the past two decades, covering two U.S. recessions.
The latest quarterly filing (for the three months ending May 31) also shows year-over-year increases in revenue, profit and cash flow. During a tough time like this, the company appears committed to investing free cash flow to widen the economic moat and fuel long-term growth. Throughout the last quarter, capital spending on facilities and technology remained at a similar level to the same period of the previous year. According to FactSet's latest 10-Q filing:
"Our revenue, earnings, and ASV are relatively stable and predictable as a result of our subscription-based business model. To date, we have not seen the COVID-19 pandemic having a material impact on our revenue or ASV, although we anticipate that there may be some level of revenue and ASV weakness going forward due to longer sales cycles and lower incremental client billings."
The business at FactSet requires little CapEx to operate and grow, contributing to the strong cash flow for owners. For the last ten years, the free cash flow margin was consistently above 20% and the company was able to convert one dollar of profit into more than one dollar of free cash flow.
Adding to the quality of FactSet's business is the ability to reinvest retained cash at an attractive rate of return for shareholders. For the past three years, FactSet generated an almost 60% return on its incremental equity capital. This is a superior rate of return and would be theoretically the growth rate if the company retains and reinvests all its annual net income. Unfortunately, FactSet typically returns approximately 90% of its operating cash flow to shareholders through share repurchases and dividends.
Sharing only 5% of the market, the company should see a sizable runway ahead. During recent years, it has proved its capability to win market share from competitors, including Bloomberg (a 33% current market share) and Refinitiv (with 22%).
Last year, the management started to talk about its three-year plan to accelerate investments in content and technology and aim for a low-teens growth in EPS. Over the longer term, we think that FactSet has multiple areas to reinvest its cash in the business (e.g., global expansion, new vertical and R&D) and that a high-single-digit growth rate may seem more sustainable.
We at Urbem define the Value Yield as the sum of the current yield and the sustainable growth rate and use the metric as a total return indicator for those businesses producing predictable cash flow and steady growth. Hitting its all-time highs, the share of FactSet was recently yielding less than 3% in free cash flow. Adding the high-single-digit sustainable growth rate, we come up with a Value Yield of just above 10% for the stock.
Major risks to our investment thesis include a lack of insider ownership, the industry headwind for asset managers, as well as intensifying competition.
While we appreciate the management team's track record of capital allocation, it is worth mentioning that no single executive or board director owns more than 1% of the company. All directors and executives represent less than 2% of the total shares outstanding, which seems insufficient in light of the company's market cap of $14 billion.
Moreover, we notice that the unfavorable trend of passive investing, alongside the "Race to Zero" on in investment transaction fees, could cause headwinds to any asset management software provider.
Lastly, it cannot be ruled out that larger players in the space would not pursue a more aggressive customer-acquisition strategy through price incentives.
While we at Urbem appreciate the high predictability of the business at FactSet, we would stay cautious of the low free cash flow yield of the shares. The stock has returned more than 30% so far this year, nearly 25% for the past twelve months and 30% annually over the last three years, all primarily driven by the multiple expansion instead of the growth in business fundamentals. An estimated 10% Value Yield (i.e., current free cash flow yield plus sustainable growth rate in free cash flow) does not attract investors like us who aim for at least mid-teens long-term total equity returns.
A 10% total return out of a highly predictable, cash-rich, asset-light business protected by a competitive moat should not disappoint any equity investor, including us, especially given the current ultra-low-rate environment. In the meantime, we generally look for at least a mid-teen return prospect to initiate a new position in search of alpha with enough margin of safety. Therefore, in the case of FactSet at its current price level, we would pass and allocate our capital to better opportunities.
Thus, despite the superior quality of the business, we can only assign a hold rating to the stock, watch the business development and wait patiently for a better entry price.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We do not own any security mentioned in the article.
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This article first appeared on GuruFocus.