Wednesday, August 22, 2012

An Overlooked Defensive Stock

As the market grapples with the consequences of the Greek election, I thought it would be interesting to look at a stock which could give balance to a portfolio. In its own odd way, FactSet Research Systems Inc (NYSE: FDS) has a combination of defensive characteristics and cyclical growth prospects.  Unfortunately, given that its main activity is providing financial information, the stock is well known to the investment community, so retail investors won't be discovering an under researched company here. It has had a good run this year, however, the recent fall -caused by moderately weaker guidance- could provide a decent entry point.

The last results were pretty good but the market sent the stock down 13% because next quarter’s revenue was forecast to be $208m vs. analyst consensus of $210.5m. Non-GAAP diluted EPS was forecast to be $1.15-1.17 compared with analyst estimates of $1.21 and, in these turbulent times, those numbers were enough to disappoint investors. The commentary around the results contained the familiar refrain of Europe and the macro economy. So why do I think FactSet is worth a second look?


Facts about FactSet

Firstly, the company offers the opportunity for a ‘trading down’ play. In other words, when the environment gets tough, financial services firms can make incremental cutbacks by expanding their provision of FactSet services rather than, say, buying a license for a Bloomberg terminal or Thomson Reuters Corporation (NYSE: TRI) desktop. FactSet also competes with Standard & Poor’s which operates within McGraw-Hill Companies (NYSE: MHP).  Both Thomson Reuters and S&P offer a range of prices based on products and content type. What differentiates FactSet is that it tends to offer a substantial amount of varied content with its offerings.

Secondly, financial firms do suffer when an economy weakens but there are many different asset classes within their operations, some of which are not necessarily tied to the economy. For example, if equities are doing badly, firms could expand their bond, FX trading or absolute return research support. Moreover, while the financial industry is at the epicentre of any shock to the system caused by a potential hard default by Greece, we are nowhere near 2008 conditions, and even then, FactSet managed to report revenue and earnings growth.

Thirdly, given a resumption to the European growth following the forced expulsion of Greece from the Euro, I think that FactSet will offer some decent upside exposure. I suspect financial firms have held off hiring and expansion plans while adopting a ‘wait and see’ approach. Should the uncertainty be resolved, a release of pent-up hiring should see expansion opportunities for FactSet.


Key Metrics Declining?

One of the concerns with the last results is the confirmation that Annual Subscription Value (ASV) growth appears to be moderating. While ASV implies that it is a good indicator of future growth, investors should understand that clients can give FactSet notice and add or delete parts of the service at will. Therefore, ASV should be looked at it in conjunction with client growth and the outlook for financial firms future spending. The tricky part is judging whether the recent moderation in growth is due to the wider environment or due to competitive positioning.


Note from this chart that ASV annual growth didn’t go negative, even at the height of the financial crisis. However, there does appear to be a graduated moderation of growth here even as client growth is doing ok. The industry is very competitive and increasingly firms may be able to source information and analytics from specialized providers or alternative sources. FactSet’s offering covers a wide range of interests so, for example, an equities analyst may use and regard the system in a vastly different way to a wealth manager. Companies like Bankrate (NYSE: RATE) or Morningstar (NASDAQ: MORN) will provide more specialist research in the fields of banking/insurance and mutual finds respectively.

It is noticeable how Morningstar has struggled as equity mutual funds have seen redemptions. In fact, across the industry it is the only one that has seen significant downgrades to estimates this year
All of which, leaves each individual offering from FactSet to be susceptible to competition from a more specialized provider in that field.  In view of this I would suggest incorporating a margin-of-safety approach with this stock.


So What Next for FactSet?

Investors will want to follow the stock with a view to deciding whether the moderation in ASV growth is a consequence of the economy or not. It is hard to tell at this stage. However, in future quarters if the macro environment improves but ASV does not accelerate, than I think it is safe to assume that there is some sort of competitive pressure building.

Moreover, the stock is hardly cheap. It trades on a forward PE of around 20 and that is not cheap for a stock exposed to the financial services sector. Free cash flow has averaged around $184m for the last three years and this puts it on a FCF/EV yield of 4.6%.  Again, I don’t think this is particularly attractive for a business in a competitive market. I would want a larger buffer built into this stock before buying it.

Nonetheless, it is a stock with a lot of attractive drivers and investors would do well to keep an eye on its developments.