Description

Equifax is more cyclical than the average information services company due to the company’s higher proportion of transactional revenues. A range of macro factors including interest rates or economic disruptions could impact spending trends and lead to reduced demand for Equifax’s credit data. Banks are cutting back on lending as the prospect of a rising level of non-performing loans makes them risk averse and encourages them to tighten credit standards. Less lending causes less demand for Equifax’s services. As shown below, 19% of the company’s revenue comes from the financial sector and 4% from the consumer sector. These areas could be at risk. Furthermore, the auto market (6% of revenues) shows little signs of reprieve with record delinquencies: https://thedeepdive.ca/auto-loan-delinquencies-rejections-push-at-record-high/

It is interesting to note that despite revenue from US and International Information Solutions businesses being 70% and 140% greater than their respective sizes in 2007, the operating income from both segments is roughly flat with where it was in 2007. Margins have declined considerably. If these business units were to experience a decline similar in magnitude to the 07-09 cycle, revenue would decline by $485 million (20% decline) and EBIT would fall by $210 million. This represents 20% of total 2022 EBIT of $1.055 billion. Presumably, management could offset at least half of this with cost reductions, which were expected to take place already and are embedded in analyst estimates.  

One factor that could additionally pressure operating income over the medium term, however, is a change that occurred in late 2022. The Federal Housing Finance Agency (FHFA) announced a plan to change the credit requirement from the current tri-merge (Equifax, Experian, and Fair Isaac) to a bi-merge report. This means that Fannie Mae and Freddie Mac will only be required to provide credit reports from two of the three nationwide credit bureaus. It is unclear regarding the timing for this but there could be volume implications for EFX’s mortgage business. Furthermore, this change in regulation promotes more competition between the three credit bureaus, which could further pressure margins.

EFX discloses its revenue breakdown by industry. The business has changed considerably since the 08-09 GFC. The workforce solutions business is now the company’s largest segment. While this may make the company appear to be less vulnerable to a credit cycle, the increase in exposure to the mortgage industry from 11% in 2008 to 24% in 2022 is most likely a result of the mortgage verification services included in the workforce solutions segment. Furthermore, this division is tied to employment and other factors that are subject to macro forces. It is worth diving into the workforce solutions division, which has a great moat but is under new competitive pressures that have emerged within the last 2-3 years.

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The Work Number (TWN) is EFX’s crown jewel asset and it comprises over 80% of the Equifax Workforce Solutions business. This is a database of income and employment data that is used for verification services for mortgages, consumer lending, human resources, and the government. Equifax has about 144 million records and 110 million unique individuals in the database, which represents 70% of the 165 million US nonfarm payrolls. EFX has amalgamated the records from a variety of sources. Roughly 55% of the records are obtained directly from the employer. While these services are not contractually exclusive, it is rare for an employer to provide these records to multiple parties given their confidential nature. The vast majority of the remaining 45% of records come from partnerships with payroll processors that EFS partnered with beginning five or six years ago. Payroll processors collect a royalty every time a contributed record is utilized in a verification service. ADP is not an exclusive arrangement, and it contributes approximately 35 million records to Equifax and any other company with which it partners.

Equifax clearly has a nice moat in this business, which has enabled it to implement significant price increases over the years, with 8-10% annual pricing in the mortgage industry, but much more significant pricing in the background screening industry. In fact, Stifel estimates that background screening clients report the price has increased by 500% over the last five years. Not surprisingly, background screening companies are looking for alternatives. HireRight (HRT), one of the top 3 background screening companies, announced on its 3Q22 earnings call that one of its large customers was using TWN for employment verification decided to cease usage due to the large cost to the company, and that the client is looking for alternatives. During its 4Q22 call, HRT management said with regards to EFX, “ I don't want to overstate that vendors' influence. They're not the only -- they're certainly not the only game in town, there are lots of options some that are already -- that we are already taking into account and availing our sales of services as well as doing manual verifications that we've built. We just built and deployed a new -- entirely new module just for education….it is certainly less than half the time that this vendor can fulfill that.” During its 4Q22 conference call, another large background screening company, First Advantage (FA) was asked about EFX price increases that have been implemented and are further planned to be applied later in 2023. The response from FA CEO, Scott Staples, is telling, “Yes. We're getting -- pushback maybe not the right word, but I'd say massive frustration. These prices from this one vendor have gotten to a point where clients are, I'm going to use this word purposely, literally begging us for alternatives. And I think that gives us a competitive advantage, because we have the alternatives. We have our own database. We have all these integrations for these other verification partners. We have the ability to do it in-house. But I think, that's again one competitive advantage for us, but it's really the only vendor where we're seeing those price increases, everybody else is pretty reasonable on their price increases. And keep in mind from a contractual standpoint, we can pass through price increases. So, as vendors increase their prices to us, we pass them through to the end customer. But this one vendor has gotten to a point where the pricing is just too high and customers are literally begging us for alternatives. Luckily, we've got those alternatives.” As discussed below, FA is attempting to directly compete with Equifax so Staples may be speaking his own book to a certain extent. Another interesting data point comes from the 4Q22 conference call of the third large background screening company, Sterling Check Corp. They were asked if there has been any pricing moderation from their suppliers. CEO, Joshua Peirez stated, “most of our providers with maybe one exception on the verification side, have generally remained consistent or in some cases even reduced our pricing for competitive reasons. And then of course we do have the one big provider who continues to increase prices, we continue to pass those along and have those baked into our expectations, both on revenue and margin.” It is interesting that EFX competition has been reducing prices. In response to the price gauging, new competitive entrants are encouraged into the market.

Experian became the largest direct competition to Equifax when it entered the business in late 2020. EXPN has pursued a combination of partnerships with various payroll processors on both an exclusive and nonexclusive basis. The company has made four acquisitions over the last two years for $400 million in consideration. These acquisitions consist of HR-related assets which is similar to how Equifax initially built out its business. The Experian Verify business currently has 43 million active records (up from 28 million in 2020). The company has a “mid-term target” of 80 million records, which is still well below the 135 million records held by Equifax. Experian will generate $150 million in revenue for its fiscal year ending March 2023, up from $100 million in FY22 and $10 million in FY21. It has signed over 125 contracts serving 3 of the top 9 financial institutions, 4 of the top 10 card issuers, 3 of the top 8 auto lenders, and 6 top fintech organizations. When it launched services, Experian talked about the practice of income and employment verification becoming more ubiquitous outside of just mortgages since the onset of the COVID pandemic, with targeted lenders including credit card, personal loan, auto and mortgage lenders, as well as tenant and employment screeners.

Transunion has also entered the verification space in 2020 with a different approach. IT is focusing more on working with upstart FinTech providers to aggregate consumer permissioned data. In 2020, it partnered with ADP and open finance fintech MX Technologies and made an investment in FinLocker. TRU has no illusions that it will be a major competitor any time in the near future. It is trying to provide a differentiated, tiered offering by leveraging its partnerships with alternative data. TRU offers clients a rate that is much lower than Equifax if clients position TRU first on the income and employment verification process. The client could then go to EFX if it does not come back with a hit on TRU’s database, and could potentially save money on a cheaper TRU check. EFX has countered this move by offering discounts if EFX is at the top of the waterfall, and much higher price points if it is not.

Beyond the two large credit bureaus, there are many smaller consumer-facing fintech players. The fintech approach generally requires a consumer to allow third party access to the consumer’s information through various permissions.

TrueWork is the largest of the emerging players. TrueWork was formed in 2017 and appears to be building its equivalent of Equifax’s TWN, called the Payroll Network. Several current payroll provider contributors include ADP, Rippling, Zenefits, Paylocity, UKG, BambooHR, Gusto and others. This network covers 35 million US employees and is used by over 15k lending, background screening, and other organizations needing to verify applicants’ income and employment data. Truework states that 7 million of its 35 million records are exclusive; the balance presumably comes from ADP. In contrast to EFX, which is a database of stored information, the Payroll Networks is a network of connections through APIs that is used to produce the income and employment verification. Additionally, contributing payroll providers and human capital management platforms allow employees tailored privacy settings which enables them to have control of their own employment and income data. This is in contrast to EFX that collects employee data directly from their employers without any permission or privacy preferences. Truework users can be notified by default any time a third party requests to view employment and income information. Truework has partnered with Plaid Income (Plaid’s income and employment verification offering) to integrate into Truework.

Truv, formerly known as Citadel API, provides API connections to payroll accounts to enable income and employment verification for lenders. As of a recent company presentation, Truv counted 48 supported payroll providers, including ADP, Paycor, Paylocity, SAP, to name a few. According to Truv, its “consumer-permissioned instant verification” covers over 146 million US employees. Combined with its document upload product and other partnerships, Truv says it covers 85+ percent of the U.S. workforce. Interestingly, in the same presentation, Truv list Experian alongside the likes of AmeriSave Mortgage under a “trusted by leading financial firms” heading.

In 2021, Plaid (following its failed combination with Visa) announced the launch of an income and employment verification product. Plaid’s website boasts better data coverage than Equifax: “~85% of the US workforce via payroll providers, connect with 12,000+ data partners, and get document coverage for pay stubs W2, and 1099s.” It offers three Income products: Bank, Payroll and Document. Unfortunately, there is not much information available on Plaid’s offering. I would like to corroborate what they claim.

First Advantage has been steadily building its own proprietary database, called Verified! over the past 5-7 years to reduce its reliance on Equifax. FA has more than 50 million employment and education history records today, up from around 36 million in 2021, 10 million in 2020, and 6 million in 2019. FA’s current education and work history data coverage can fill roughly 10% of all orders coming in that require both income and employment verification. Only about 20% of employment verifications can be fully fulfilled by Equifax according to FA, though many hits have incomplete information – which is frustrating for the purchaser since EFX charges full price for a partial fulfillment. EFX is usually able to provide partial fulfilment of information on about 60% of the queries. In totality, FA estimates that roughly 10% of verifications can be fully serviced by its Verified!® database, 20% fully from TWN, and another 1%-2% from alternative providers such as fintechs like Plaid and TrueWork. This means roughly two-thirds of the verification process still needs to be completed via manual processes through phone and email, which FA does internally or through partners. Although a manual process does take longer to complete, it allows FA to retain the data that it obtains manually, which helps build FA’s database. FA just recently started also using EXPN’s income and employment verification offering, and while it doesn’t have much history yet on the platform, FA indicated that initial results are encouraging. From a technology capability perspective, FA utilizes what it calls an “Intelligent Router” system to ascertain the lowest cost and fastest data source to complete a verification order before incurring any costs. This allows the company to avoid spending full verification costs with TWN for only a partial hit, effectively lowering the total cost of ownership for clients. FA is not a “top-of-the-waterfall” client for TWN, FA acknowledges that it will likely never have even 50% coverage and will always require the TWN database for something – it is not trying to compete with TWN, but rather to lower the level of dependence that its customers have on TWN.

It is difficult to ignore the sequential decreases in Workforce Solutions revenue over the past two quarters, especially in light of the recent emerging competition. The message from EFX had been that penetration opportunities would offset cyclical headwinds (e.g. lower hiring). Organic revenues declined by 6% in 4Q22 mainly due to declines in mortgage-related verification. Organic growth has been decelerating for the past 9 quarters and is expected to decline by 8% during 1Q23. During its 2Q22 call, management said that it expected the segment would be able to grow during a recession and the nearly unprecedented drop in mortgage activity.  The -4.3% reported growth in 4Q22 missed management guidance from its 3Q22 call of -3%. On a positive note, management guided to revenue growth for Workforce Solutions of 6% in 2023, which would be a rebound from -8% in 1Q23. This may be optimistic. Embedded in its assumptions is a mortgage revenue decline of 8% (mortgage is 25% of the segment). The non-mortgage businesses are expected to grow over 13%, despite a 10%+ decline in US hiring and a 15% decline in employee retention credit revenue which benefited from COVID. Growth is also expected to come from pricing and penetration. The expected growth from pricing comes at odds with some of the commentary from the large background screening companies.  During the 3Q22 call, management noted that it missed Workforce Solutions EBITDA margin guidance due to a negative mix (from lower mortgage revenue), higher sales and marketing costs and the costs of new databases. During its 4Q22 call, management cited increased royalty expenses related to the procurement of data. Are the higher costs in response to higher demand from the increase in the competitive universe?

The countervailing argument to becoming too negative on Workforce Solutions segment is that mortgage-related revenue in 2021 was 47% of the division’s revenue and it declined to 33% and 25% of 2022 and 4Q22, respectively. The company impressively outperformed mortgage originations by 35%. Is this due to pricing or market share gains. I expect it is due to the former. In order for the division to see more downside without competitive pressures would likely require a sharp fall off in hiring in conjunction with mortgage activity remaining at depressed levels (no rate relief).

Following the recent acquisition of Boa Vista, S&P revised the outlook on EFX from stable to negative as the pro forma leverage is in the 3-3.5x range. Given the somewhat elevated leverage and high P/E multiple on the stock (22x 2024 EPS and 28x 2023 EPS), a miss would likely be penalized harshly. If lending conditions tighten considerably, EFX will certainly have a miss and one could envision the stock falling to $140, or 20x $7.00 in 2023 EPS. This gives somewhat of a free look on the potential degradation from competitive pressures on the Workforce Solutions segment.  

Catalyst

Earnings miss/reduced guidance