Description

Short FDS: FactSet, the financial data provider, is overvalued and losing subscribers. Their business is deteriorating as employment in financial services contracts. 

They have 2079 clients covering roughly 40,000 terminals and trailing revenue was $575m. They provide FactSet (company data and modeling tools), Marquee (realtime news & quotes), IBCentral (applications for investment banking workflow), FactSet Calendar (event transcripts and release dates), Factset Fundamentals (proprietary content), and wireless delivery applications.  Their main product competes with Bloomberg and CapitalIQ, while their proprietary data competes with Thomson, Compustat, Worldscope, and others. 69% of revenue is from the US and 24% if from Euope.

The enterprise value is $2B with no debt and $123m in cash. On a trailing basis, this works out to 9x ev/ebitda, 17x eps, and 19x free cash flow.  

Data points:

• User additions were down 43% in the last quarter ended Nov, and overall users contracted though an unspecified amount
• Annual contracts with clients renew throughout the year with a Q4 weighting, though also unspecified in magnitude
• 79% of their revenue is from the buyside
• 21% is from the sellside (mostly I-banking and research)
• Annual Subscription Value (ASV), as measured by the company, is the theoretical forward 12 months revenues from existing clients assuming no cancellations.
• ASV at end of November is $620m (includes assumed price increases of $6m)
• Management says “just under” 25% of ASV is from soft $ arrangements. 
• Management claims only 6% of ASV is from hedge funds (though the classifications are by paying firm and not according to who’s revenue is subject to a carry versus who takes a percentage of AUM)
• Their website home page prominently displays “users displaced by market conditions can now request complimentary access”
• Top 10 clients are 17% of revenue, single largest is 3%
• Revenue per Average User is approx $16,000 per year (640m ASV/40,000 terminals), though marginal user revenue for the larger firms is approx $6,000/user

Through this cycle, both the buyside and sellside are losing headcount. Sizeable layoffs are expected starting in January. There isn’t going to be much carry for hedge funds this year, and for many there won’t be much in 2009 as funds climb back to high water marks. For managers being paid as a percent of AUM, if assets are down 50% though a combination of performance and redeems, the corresponding reduction in comp and headcount expense to maintain margins (leaving alone maintaining actual profit) is a 65% cut.

Though individual clients may be growing or shrinking, the aggregate AUM of their clients is doing what the overall market is doing… So it’s down... 38% if you use the S&P, but fixed income funds are also getting crushed this year, as are arb funds, distressed funds, and emerging market funds. And though investment grade assets are swelling, it is a safe bet that the FDS client base is underweighted in this category of asset managers.

On the positive side this is quite a good business model. There are 33% operating margins with high free cash flow, high visibility, a healthy balance sheet, their content and real-time quotes & news deepen their user engagement level leading to 95% historical retention rates. Plus, though impaired in the current environment, there is pricing power. So, they aren’t going away. Management states the “overall macro environment has deteriorated” and explained that with their strong balance sheet they will take share in this downturn. In fact they are adding to their 600 person product development team and have recently begun supplying data to Bloomberg for the relatively new EVTS function which competes with StreetEvents and their own FactSet Calendar. My issue is that when the overall market is shrinking, everyone tries to take share though not all can succeed.

FDS had 138m in free cash flow in the past twelve months. This included some working capital squeezeouts and there is a quirk to the way their working capital moves as their business weakens. In Q1 there are compensation payments related to the prior year, so working capital takes an after the fact hit as business declines. In addition, DSO’s (currently 42 days) will extend in a weak environment. Management acknowledges that the working capital benefits of the past few years will be reversed in 09.

Another 09 drain will be their nacent FactSet Fundamentals business which has 649 clients and 5867 users. In time it may grow to scale, but for the short to medium term it bleeds money and has an ASV of only $3.8m embedded in the $640m figure. 

Some customers are on annual billing (though most are on monthly or quarterly). Those who pay annually leave a balance sheet footprint in Deferred Fees. For the year ended August 08, Deferred Fees went down by $2.6m per the cash flow statement though only $2.2m per the balance sheet (so there may be some reclassification of client accounts) but the implied drop in users is either 8.5% or 10.3% for the year. In the November quarter it dropped 7.2% implying an acceleration of lost users in the quarter from the prior year’s quarterly run rate.  

They should lose 20-30% of users though this downturn. With 40k terminals, at 25% that would be 10,000 users. Assuming they only lose marginal users at firms who remain clients ($6,000 per marginal user is much lower than the average user of approx $16k), the revenue drop would be $60m. That $60m along with some additional working capital tied up in the business will cut free cash flow at least in half. The figures get much worse if you assume some percentage of the user losses are full paying customers at $16k rather than marginal users at remaining customers. This will lead to multiple contraction.

Catalyst

There is going to come a time, probably in late January, when there will be boldface headlines from firm after firm about job cuts. Annual contracts won't be renewed, the user count will contract, margins will pinch, free cash will tank, the multiple will contract.