FactSet is a data provider to financial service firms. If you work at a bank or on the buy-side, you're probably familiar with their products. FactSet's core desktop platform is used widely by analysts to pull data for research purposes or to monitor a portfolio. Sentiment among the Wall Street investors has declined significantly; among the major brokers, there's 1 buy, 10 holds, and 5 sells. The stock has held in relatively well, but has had significant drops around earnings as the company has missed revenue expectations. While the company fundamentals and its stock has performed well on an absolute basis, there is growing evidence supporting the bear-case around the stock.
FactSet Pressure Driven by Exposure to Pressured Customers
FactSet's key financials are slowing. FactSet's revenue and ASV (annual subscription value) trends have decelerated for numerous quarters. ASV is important as it is a leading indicator of revenue trends for FactSet, which bills customers on long-term contracts. Revenue only recognizes a portion of these contracts at a time, whereas ASV is a better indicator of real-time trends in their billings. FactSet's most recent quarter saw organic revenue growth decelerate to 7.0% and organic ASV growth decelerate to 6.5%.
Importantly, these figures have fallen short of investor expectations each time, disappointing investors and sending the stock down abruptly.
There are a number of factors related to this slowdown, but the primary reason is FactSet's exposure to the financial services sector. FactSet's client base is composed primarily of buy-side clients (83% of revenue), with a bit of sell-side banks sprinkled in (17% of revenue). Both clients have been pressured significantly over the last several years from several major factors.
- Regulatory pressures - Dodd Frank and several other regulatory measures were put into place after the financial crisis and have put pressure on bank profits. In turn, cost pressures have reduced data budgets for banks and reduced headcount.
- AUM shift from active to passive - Morningstar reported that in 2016, 40% of total US equity funds were in passive equity vehicles compared to just 18.8% of funds in 2007. A similar trend has occurred in bonds, where nearly a quarter of all US bond fund assets are now in passive vehicles vs. < 10% in 2007. As funds move from actively managed funds to passive funds, active fund fees decline, thereby putting pressure on their expenses. And with active funds continuing to underperform passive funds, there are no signs to suggest that this trend will reverse any time soon.
The result of these major shifts has been a reduction in headcount among the financial services sector. Investors closely watch data from BLS to see how employment has shifted in these areas as pricing and revenue is determined largely by the number of users on FactSet's products. Since mid-2016, headcount growth in portfolio management has been decelerating, and now sits in the low-single digits.
This might not seem so drastic. But the headlines and anecdotes suggest that the underlying deceleration may be steeper:
- Caxton, Och-Ziff, and Tudor have all reduced investor fees to remain competitive. Average fees have now dropped from 1.7% a decade ago to 1.4%.
- Pension funds are reducing hedge fund exposure given their high fees and underperformance. The trend was kicked off by Calpers and has continued with several other large pension funds.
- Anecdotally, my peers in the finance community have all been affected, and believe it will continue
These pressures have been felt by the financial services sector for multiple years now, but has decelerated further in recent quarters. As it relates to FactSet's revenues, the prevailing thought was that headwinds were largely cyclical factors affecting the industry, but that they would likely bottom at some point. FactSet has received numerous questions about this, including the following question from their F1Q earnings in December:
As shown in the trends above, the deceleration has continued, putting into question whether the issues are cyclical, temporary factors, or more permanent structural issues. Such structural issues would carry heavy implications:
- FactSet's longer-term organic growth rate target of 10% would be at risk. The company believes they can achieve this longer-term largely through market share gains. However, if the investment industry headwinds are structural, we may not see double-digit organic revenue growth again.
- Margin pressure. Management noted that they expect the company's margins to grow longer-term as they integrate their acquisitions and gain scale over their fixed costs. Recall that the company's adjusted operating margins have contracted over the last several quarters as management noted that they were investing in the business. If revenue continues to decelerate, it may be harder for FactSet to get margin expansion, even as their acquisitions gain scale.
- Relative positioning compared to other competitors such as Bloomberg, Thomson Reuters, and S&P is in question. While all financial information players are exposed to financial services headcount, FactSet is almost entirely exposed to it, whereas other companies have a more complete offering that insulates their revenue more from potential secular changes. For example, S&P owns the Indices business, which offsets some of the shift towards passive investments.
- Multiple compression. FactSet's multiple has downside risk given the above headwinds. FactSet currently trades at a premium compared to competitors. While great for when the market and financial services sector is booming, it's not so great when signs emerge that the buy-side and sell-side could be facing slowing growth from (potentially) structural issues. Because of their premium, the multiple could have further to fall than other financial information providers if earnings were to decelerate further from the above-mentioned revenue and margin pressures.
As management's response indicated in the quote above, FactSet is focused on providing an entire enterprise offering to offset headwinds. The company has been fairly active in the M&A market, purchasing software outside of their core desktop market. These acquisitions have outperformed and have been good drivers of their performance, but it has not fully offset the core slowdown in their key desktop product (which many banks estimate make up roughly 60-80% of FactSet's revenue). Management has likely recognized the importance of diversifying revenue streams and being less dependent on active equity investors. To be clear, management's actions are a positive for the company and it demonstrates that they've recognized the importance of what's happening to their clients. However, it is also a clear recognition of the changing industry landscape.
Another a potential headwind is clients' ongoing consolidation of data vendors. On the last conference call, management noted that they have seen clients consolidating their data vendor usage in certain circumstances. From the client's perspective, as they consolidate vendors, it becomes more economical to go with one vendor that offers lower bundled pricing as opposed to having many products from different vendors. FactSet noted that they are losing customers in some instances as their product offering does not cover client's entire workflows.
In sum, a key pillar of the bear thesis is that FactSet revenue and margin trends will continue to decelerate as the buy-side consolidates and succumbs to ongoing secular issues. As revenue and margin fall short, earnings will fall short as well, thereby putting pressure on the multiple and the stock. Going forward, investors will be closely watching the organic ASV and revenue growth rates to see if they will continue to decelerate or if they will stabilize and reaccelerate (as consensus revenue estimates currently suggest).
Bull Case - Solid Product with Significant Room for Share Gains
The bull case is that clients are undergoing temporary cyclical issues, but once they subside, FactSet's core product strength and expanded offerings will become more apparent.
Solid product: Even with those issues, the company still owns a solid product that is widely used by clients. And while the product has grown significantly from a $250 million business in 2004 to $1.1 billion in 2016, the company estimates that their products own just 10% of its entire addressable market, suggesting much more potential upside for the company.
Cross-selling: As management expands its product offering, each product presents an additional cross-selling opportunity as they fill in each customer's workflow needs. Non-desktop offerings have grown in the double digits, supporting the company's overall growth rate. The company has also begun to gain further penetration into new markets such as wealth management, which has been the primary driver of user growth (although these customers have lower ACV values associated with them)..
Margins currently loaded with up-front costs from acquisitions: As stated above, management believes that margins will grow over the long-term. Currently, margins have been depressed in part by higher company investments, and in part by those acquisitions mentioned above. These acquisitions brought along a significant cost base. And while FactSet may need to invest further to fully integrate these products into their suite of offerings, at some point, they will begin to gain more scale, which should generate margin expansion over time.