The past 4 or 5 years have been remarkable for the financial services industry as far as how they interact with customers. Just over a decade ago, getting a stock quote often involved calling a broker on the phone or waiting for the newspaper and then wading through the pages of quotes in the business section.
Doing company research was even more difficult. Just getting a hold of the SEC filings to look at income statements and balance sheets was a tedious process, requiring a call to the broker, a wait for the materials to arrive in the mail, and then wading through literally hundreds of pages in dozens of documents. Sure, you could always use a research service, but the information still took days to arrive to you and could not be quickly searched, compiled, or compared between companies.
My, how things have changed. Today you can access SEC filings, research service reports, get up to the second stock quotes, compare dozens of stocks against each other, screen literally thousands of stocks by certain criteria, and so forth within minutes using online tools and services. The Internet has made stock investing infinitely easier than it was not that long ago, and there is no shortage of clients taking advantage of it. Financial services firms across the board, from independent sites like the Motley Fool and Morningstar (NASDAQ:MORN), to online brokers like E*TRADE (NASDAQ:ETFC) and Zecco, to large deposit and investment banks now allow clients to access financial data, information, and tools. But it would be expensive and inefficient for each of these firms to compile the data themselves. That's where today's Top Buy pick, Interactive Data Corporation (Pending:IDC), comes into play.
IDC provides the software that allows the end user sites to display and use financial data, without the burden of compiling it. The company is organized into four business units. Interactive Data Processing and Reference (63% of sales) is the bread-and-butter business of supplying quotes, dividend information, credit ratings, and basic background data on thousands of listed equities. Interactive Real-Time Data (20%) supplies up-to-the-second pricing information for real-time applications. Interactive Data Fixed Income Analytics (4%) sells data and analysis tools for analyzing bonds and other fixed-income instruments. The last is Active Trader Services (12%), consisting of the eSignal line of products designed for day traders and technical analysis buffs. IDC's main source of revenue is subscriptions to access its database, although some revenue is driven from advertising on websites hosted by the firm. 70% of sales are inside the United States, with most of the balance coming from the U.K. and Europe.
IDC possesses the 3 characteristics I like to see in a good MFI investment: growth potential, good competitive position, and strong financial health. The company has plenty of growth opportunities, especially through providing financial data for foreign markets. To this end, management has been aggressive in purchasing companies such as NTT, a Japanese market data provider, and Klers, who focuses on the Italian markets. Growth can also be achieved through adapting products to service new trends in investing, such as ETFs, wide-ranging indexes, options, and the latest trend: risk management. Financial services is an ever-evolving field, and it is evolving on the Internet - exactly where IDC offers value. IDC has been able to generate double-digit growth over the past 5 years, and I see no reason this trend can't continue, especially as the financial industry settles back down after recent turmoil.
Financial health is excellent. The company has $270 million in cash with no debt, setting them up well to execute on attractive acquisitions to stimulate growth. The business is extremely profitable and cash-producing, with a 25-28% operating margin and free cash flow margins approaching 20%, both top tier. MFI return on capital is also in the stratosphere at 170%, although when accounting for acquisition costs, return on capital is a more down-to-earth (but still good) 17%. By any measure, IDC runs an excellent business model with strong financial underpinnings.
IDC also has a very strong competitive position. There are competitors for its individual business, most directly Thomson-Reuters (NYSE:TRI) for quotes and general data, and FactSet Research (NYSE:FDS) for fixed-income products. Bloomberg also provides some competition. But IDC is one of the largest players in the field, servicing over 4,000 institutional clients and a plethora of active traders. Once IDC's application programming interfaces (APIs) are embedded into a client's website or desktop application, it is rare for them to be switched out unless a competitor offers significant value. This leads to high switching costs, which are reflected in IDC's 95% subscription renewal rate. The company's large existing client base also offers fertile ground for cross-selling new products, relieving IDC of the need to spend marketing dollars. Customer lock-in and IDC's scale advantage gives it significant advantages over existing or prospective competitors and provide it with a decent size moat, in my opinion.
What are the risks? There are two big ones. The first is the ongoing turmoil in financial services, which are the bulk of IDC's clients. Consolidation leads to fewer subscriptions. Two firms that both used IDC now becomes one subscription, or a firm that used to use IDC may be acquired by one that does not. Uncertainty also can cause clients to hold back on purchasing new services, and leads to pricing pressure amongst data providers. The second risk is currency effects, as IDC generates nearly 30% of sales in foreign currencies which have to be converted to U.S. dollars for reporting purposes. With a strengthening dollar as now, this is a negative. Also, IDC is majority-owned (62%) by media firm Pearson Plc, and they can basically determine the direction for the company, against shareholder interest if they want to. Lastly, IDC has a history of overpaying for acquisitions and then not integrating them well. This last point has been a focus for management over the past couple of years.
Still, IDC is one of the best all around picks on the MFI screens at the moment, sporting good growth prospects combined with an 11% earnings yield. As a bonus, the company also pays a very handsome dividend yield - 3.6% at current prices. A good all around pick, IDC is highly recommended for your Magic Formula portfolio and the newest MagicDiligence Top Buy.
Disclosure: Steve owns IDC