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Urbem's 'Wonderful Business' Series: FactSet Research Systems

Connecticut-based FactSet Research Systems Inc. (NYSE:FDS) provides financial information and analytic software for investment professionals, including analysts, portfolio managers and investment bankers, at financial institutions worldwide. As of the end of fiscal 2019, the company serves 5,574 clients (defined as "companies with an annual subscription value of $10,000 or more") and 126,822 users (defined as "individuals accessing FactSet services across all client sites") - both figures reached new all-time highs - with at least one of its workflow solutions (i.e., Analytics, Research, Content & Technology Solutions and Wealth).

As you may have expected, the company focuses on the installed-base business model, which generates highly recurring sales streams from annual subscription and professional services. At the end of fiscal 2019, the total annual subscription value (referred to as "ASV") was $1.457 billion, of which 62% came from the Americas (5% year-over-year growth), 28% from Europe, the Middle East and Africa (4% year-over-year growth) and the remaining 10% from Asia Pacific (11% year-over-year growth).

Thanks to the subscription-driven, asset-light model, FactSet has been able to generate more free cash flow than net income in most years over the past decade (see below). We noticed that capital expenditures are usually 2% to 4% of annual sales.

The financial information services industry looks highly competitive at the moment. Major players that FactSet competes with include Bloomberg, Refinitiv (acquired by London Stock Exchange Group (LSE:LSE)), MSCI (NYSE:MSCI), S&P Global (NYSE:SPGI) and Morningstar (NASDAQ:MORN).

The installed base provides a good source of the economic moat as long as the switching cost is high. Investment professionals can be sticky to FactSet's products and services with flexible modularity and high specialty once they have been trained and gotten used to them. Many of them have their models and workflows built with the functions provided by FactSet's solutions, which may incur a considerable cost in switching over to other vendors. The company is typically able to retain roughly 90% of its subscribers, which implies a high switching cost and gives long-term visibility of the business' future cash flow.

Additionally, the segment is dominated by a few platforms with a comprehensive spectrum of data and functions. It should take a massive amount of effort, capital and time to come up with a comparable product, which poses a robust barrier against new entrants.

According to the chart below, FactSet has consistently earned a higher return on assets than its peers over the decades, implying a sustainable competitive advantage and the management's decent capital allocation skills.

We do acknowledge the scale disadvantage at FactSet, which generates annual sales of around $1.4 billion and employs roughly 9,600 staff, compared to $10 billion in sales and 20,000 employees at Bloomberg and $6 billion and 18,500 employees at Refinitiv.

Moving forward, we believe that the highly scalable business at FactSet can continue its global expansion. Investors should be aware that the management does conduct mergers and acquisitions from time to time to drive inorganic growth. In this regard, capital efficiency and margins should be closely monitored.

In terms of investment risks, we see pressure on subscriber acquisition costs as well as the industry headwind due to the ongoing shift from active to passive investing. It is worth pointing out that buy-side clients account for roughly 84% of the ASV at FactSet.

A bright spot is that the business does not seem cyclical, mainly thanks to reliable cash streams coming out of the subscription business. As you can see below, neither the revenue nor the operating income dropped during the past two recessions.

Disclosure: The mention of any stock 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 own shares of FactSet Research Systems.

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This article first appeared on GuruFocus.