Description

Buying Equifax today is a bit like buying Moody’s or another high moat business that faces cyclical headwinds. You are buying ahead of a known period of weakness, in the case of Equifax due to declining mortgage issuance. In exchange, you are getting a high-moat, high-quality business with reasonable organic growth at a pretty good multiple. It’s likely street estimates will come down about ten percent to reflect higher mortgage rates and a weakening economy. I'd guess that is largely reflected in the stock, but it's always tough to know with these things, so probably the prudent approach for someone who's thinking of buying is to let the company report 2Q first - they will absolutely adjust their numbers down at that point for current mortgage levels.

Assuming a ten percent estimate cut, Equifax shares trade at roughly 20x estimated 2023 EPS (excluding amortization) roughly in line with the other credit bureaus. The company is in the mid-innings of transitioning from consumer credit to employment and salary verification, a business that doesn’t face much competition at present or for the foreseeable future. As of 1Q22 Equifax Workforce Solutions (EWS) represented half of the company’s revenue (up from less than a quarter in 2017) and 60% of EBITDA. EWS revenue is growing faster than Equifax’s other businesses and 70% to 80% of that revenue converts to gross profit. By 2025 EWS should represent 75% of Equifax’s total EBITDA.

EWS has doubled in size over the last three years, largely through organic growth. In addition to mortgage issuance tailwinds, the business has grown its employee database, leading to more positive searches (customers only pay for successful searches). EWS has also increased direct system integrations with customers (which increases utilization versus online access), added new data categories, and expanded its offerings for government and health care. These steps have increased customer utilization and supported higher pricing. The company has offered that there is still plenty of room in the years ahead to continue these initiatives and drive further growth, particularly the expansion into government and ‘talent’ services, which includes health care services. There’s also some potential for international expansion, given the service is US centric today. The company has early-stage verification businesses in Canada, Australia, and the UK.

EWS’ high incremental profit margins result from selling lenders and employers access to a vast database of employee work histories, compensation, and related information. Half of that database is built from the voluntary submission of work records by employers. It is easier and generally cheaper to have Equifax confirm an employee’s work history than to have a dedicated internal HR function. That organically sourced data is supplemented by data purchased from ADP, Paychex, and other large payroll providers.

The direct receipt of employment records from businesses represents a significant barrier to entry. While competitors can buy data from payroll providers it’s far more difficult to get employer buy-in at scale. There’s a network effect in having a complete database, as it maximizes positive search results, encouraging further employer participation. Data sharing integrations are time consuming, meaning most employers would rather work with a single provider, and favor the one that has most complete records and usage. EWS has over 100 million current employee records on file (over 500 million records including historic employment), covering roughly 2/3 of the non-farm workforce. The company continues to add records through new agreements with payroll providers, sometimes on exclusive terms.

Equifax’ greatest competition likely comes from ADP, the largest US payroll provider, as well as resellers of ADP data. ADP currently has active information on roughly 26 million US workers, a fraction of the EWS database. ADP is also far less focused on providing comprehensive employment histories. In some cases ADP packages their employment solution with other services and customers use it as a ‘good enough’ lower cost option. That said, the problem for customers seeking lower cost alternatives is that no competitor comes close to Equifax’s depth of records, meaning more failed searches that cost time and money. In theory customers could try adopting a ‘waterfall’ approach, where they first try ADP data and then move to a more expensive EWS search. From a practical standpoint however, an unsuccessful search may take a day or more to conclude, making it prohibitive from a time standpoint. It’s also worth noting that other verification services such as GoodHire and Sterling are actually EWS resellers, limiting their ability to compete aggressively on price. There are lots of other companies providing background and related data that offer some form of employment verification, but they are either sourcing that data from EWS or working with limited databases which they’ve sourced from ADP and other third parties. It’s not clear to me how competitors can close the records gap anytime soon, given the large proportion of records sourced directly from employers. As a result, while EWS will continue to face limited competition they appear to have a multi-year runway to build the business and further strengthen their competitive position.

Mortgage inquiries represent 30% of EFX’ total revenue and 40% of EWS revenue, so concerns about issuance volumes this year and next account for much of the pullback in the stock from prior highs. The company’s current earnings guidance assumes a 34% mortgage market decline in 2022, which now trails Fannie Mae’s published estimate of a 40% decline followed by a 13% decline in 2023, suggesting EFX will have to revise its 2022 revenue guidance by at least two percent (30%*6%) as the company pegs its mortgage guidance to agency estimates. That should largely de-risk refinance issuance, but there’s likely to be a further reduction on new purchase issuance, which recent data suggests is declining. A mid-teens rest of year decline in home purchases (amounting to a mid-single digit full year decline) would likely be an additional 2%-3% revenue headwind to EFX 2H revenue. I’d guess that would approach the bottom for annual mortgage issuance volumes. In addition, looking out a few years, mortgage issuance will likely reverse and become a tailwind, given the very low levels of projected refinancing this year and next, as well the potential for improvement in purchases next year and beyond. Its also likely that if the economy weakens late this year or next the company will need to lower its expectations for the traditional credit bureau which currently represents about a third of 2023 EBITDA. As of 1Q22 EWS full year revenue growth was projected at 15%. The changes I’ve described would move that to mid-single digit full year growth, likely followed by mid to high single digit growth next year. In the years subsequent, as mortgage headwinds abate, I’d expect top line growth in line with management projections of 13-15% for EWS, supporting overall corporate revenue growth of 8-12% (7%-10% organic). Given the operating leverage inherent in the EWS platform, operating income growth would likely be mid-teens. There’s also free cash flow leverage, as capital expense is likely to remain around current rates of $500 million, supporting high teens free cash flow growth. By 2025 EFX should be generating close to $1.5 billion of free cash flow. Assuming a 20x PE multiple that would imply a $30 billion market cap, or roughly $245 share, representing a 47% gain (inclusive of dividends), or roughly a 14% CAGR.

Growth projections include bolt-on M&A. Recent acquisitions include Appriss (2021, $1.8 billion) which added a deep database of incarceration records, expanding the services the company can provide to government agencies, and Kount (2021, $640 million) which added new capabilities in user authentication and fraud prevention.

Equifax’s traditional credit check businesses are also doing fine outside of the significant headwinds from lower mortgage issuance.  The three player credit bureaus are an entrenched oligopoly that benefits from the pooling of consumer credit information contributed by lenders at no cost. Lenders are incentivized to contribute that data by the high greater value of pooled information than single franchise information. The bureaus are entrenched in most high-volume consumer underwriting processes including mortgages and auto loans. This part of the business could see some pressure from reduced consumer borrowing in the event of a bad recession.

Other risks

As noted, I think investors are largely focused on the EFX’s exposure to the mortgage market, but there are a few other notable risks.

One that is difficult to quantify is privacy, ie the potential for legislation that mandates some form of GDPR for employment records. I’m not aware of any developing action on this front. And I think to the extent there was action, and it was actually passed (a big if), its impact would depend a lot of the policy details. It’s possible that the company and employers would find workarounds and that as the large incumbent provider, Equifax’s position would become more entrenched.

Up until a year or two ago people also would mention that EFX was one more credit breach away from a serious brand problem. The company invested massively in cybersecurity after the 2017 breach, and prior executives report that it has one of the most secure infrastructures of any fortune 500 company. Nonetheless, data security, somewhat related to data privacy, is an ongoing risk.

Catalyst

Inflection of mortgage market, time