FactSet Research Systems: Layoffs Affecting Licensing Revenue (NYSE:FDS)

Investment Thesis

FactSet (NYSE:FDS) reported results on the 21st of March, missing on revenues but beating on EPS. The share price dropped after the results and now trades on the 200-day moving average. The valuation multiple suggests this company has a wide moat but I believe it is narrowing and we could see the multiple contracts from here. With sales missing estimates and management reiterating that revenues are coming in at the lower end of guidance, I am recommending a Hold on FDS.

Background

FDS has a strong recurring revenue model underpinned by a subscription service for their core desktop offering. The company provides data to the financial services industry and more specifically buy-side and sell-side asset managers and research institutions. Research is the largest component of their Annual Subscription Value (ASV), followed by portfolio analytics and risk management (32% of ASV), and FDS’s fastest-growing segment, their data feed business, forms 25% of ASV. Users of this segment access data through API’s.

FDS continues to face stiff competition from other research providers such S&P Capital IQ, Refinitiv and at the high end Bloomberg. A lot of the competitors offer similar services so proprietary data is quickly replicated and depreciates over time. Also, some of the FDS’s data offerings are viewed as “nice to haves” instead of “mission critical” lessening their importance and therefore the competitive edge of the company. This isn’t promising given FDS’s main ASV source resides in research generated services.

On the Analytics and Trading Solutions side, the company has a competitive edge. Software in this segment is often embedded and results in high switching costs, which has led to FDS acquiring a narrow moat over the competition. The same can be said for the Data Feeds business, while the actual product is available at competitors, the switching costs involved for a Quant Fund utilizing the data are high and again form a narrow moat for the company.

Financials

In terms of market share and growth, FDS sits towards the median of the industry, with trailing twelve-month sales of $2.15 billion and a 5-year CAGR of 9.12%. This is behind S&P Global (SPGI), The London Stock Exchange (OTCPK:LNSTY), and MSCI (MSCI). Showing already that investors have alternatives in this industry that hold greater market share and are growing faster. The industry is incredibly profitable with median EBIT Margins of 30%, FDS has very stable EBIT Margins that have fluctuated between 25%-30% for the last 6 years. This level of profitability is behind competitors and sits just above the industry median. But looking at a longer timeframe EBIT Margins have declined due to less pricing power and growing competition.

The high operating leverage results in high net margins which drives strong free cash flow. FCF Yield stands at an impressive 23% which is comfortably above the industry median. It also delivers robust returns on capital that exceeds its cost of capital.

The company’s capital allocation strategy involves returning money to shareholders mainly in the form of share repurchases but also as dividends. In June 2023, the board authorized a $300 million repurchase program which is now underway. FDS has a strong record of share repurchases, prior to stalling the repurchase program due to the CUSIP acquisitions and debt repayments, FDS spent 20 cents for every dollar of revenues repurchasing shares.

Net Debt to Sales stands at 65% with the next principal in 2025 of $375 million. Under the current cash balance and with the company generating on average $520 million in free cash flow they are in a fine position to service this principal.

FDS reported a mixed set of results in Q2, EPS beat estimates by increasing 11.1% to $4.20 but revenues missed estimates, increasing only 6% to $546.1 million. Across their regions, America and Asia Pacific showed strong organic growth, growing 6.5% and 6.4% respectively, and EMEA marginally lagged, growing 4.8%. FDS’s ASV was $2.2 billion in the quarter, up 5.4% organically from a year ago. FDS also added 75 clients in Q2 bringing the total number to more than 8,000. Adjusted Operating Margins of 38.3% increased 130 basis points and management expect full year revenues to come in at the bottom end of the $2.2 billion-$2.21 billion range.

Job Cuts

FDS is exposed to hiring levels of the buyside investment industry. Staffing levels affect the monetization of the license revenue. Therefore, one predominant reason for the miss in sales and the lower end of revenue guidance is because of the ongoing asset management layoffs. FDS reported in their earnings transcript:

We saw increased pressure on client headcount as they sought further efficiency gains.

Many asset managers are cutting costs and axing employees as investors turn to lower-fee products. This is affecting FDS, as fewer employees, equals lower client spend.

Valuation

To arrive at my share price target of $438 I have EBIT Margins running into perpetuity at 30% aligned with a P/FCF multiple of 25x and a WACC of 8.90%. I have modelled working capital to increment cash flows at 0.25% and have CAPEX at the 20-years median of -3.9%. FDS took on a sizable portion of intangible assets after the CUSIP acquisition so I have an amortization of 8%. Also, adding to my thesis, Seeking Alpha ranks the overall valuation as an F.

Risks

The main challenge to my thesis is in the hiring and deal activity of the asset management sector. If hiring was to pick up again it could result in higher licensing revenue and upgrades. Furthermore, while only in the beta stage, FDS is leveraging AI to improve research capabilities and this could provide long-term support for growth. However, I believe the competition will be doing the same, as mentioned above building a competitive edge in the data you provide is difficult because it is quickly replicated.

When to buy? At current prices FDS is attractive, and the share price is at my target, I would just rather be toward the tail end of the asset management layoffs and I think they will continue into 2024.

Conclusion

FDS missed on revenues, and for a company trading at a multiple close to 30x that is going to impact the share price. I don’t believe the multiple reflects the level of moat this company has, and we could see it contract going forward. I also don’t expect the current trends in asset management hiring to reverse, so we will continue to see pressure on the topline. Therefore, I am initiating a Hold on the company.