FactSet (NYSE:FDS) latest quarter was strong in some areas, but overall it disappointed. Sales increased 9.7% y/y but missed estimates, and EPS came up short as well. The stock is down 5% but we still think it's too expensive based on some major risks to the outlook.
Higher cancellations from buy-side and hedge fund clients were the main reason why sales missed estimates. However FDS still kept its client retention rate above 95%. Client renewal rates rarely drop below 95%, and this is the key strength of FDS's business model. FDS bundles a broad range of services, data, and information onto a single platform, which makes the product an attractive one-stop shop for clients. Once its services are installed, it makes little sense for customers to switch to another information provider, thus switch costs are high, customer loyalty is strong, and FDS has pricing power. In the latest quarter, annual subscription value (an indicator of demand for the next 12 months) grew 8.8%. The buy side, which accounts for 82.6% of ASV growth, increased 9%, and the sell side ASV increased 7.6%.
Operating expenses in the latest quarter grew at a faster pace than revenues due to a sizeable increase in headcount and costs related to the Portware acquisition. Adjusted operating margin declined from 34.6% to 33.4%, but the decline in profitability shouldn't be a big concern for investors. As Morningstar points out, FDS experienced post-acquisition margin dips in prior years, but margins subsequently expanded thanks to higher leverage of technology fixed costs. And, thanks to its subscription-based revenue model, FDS doesn't have to invest much in order to generate incremental revenues and profits. This keeps margins and returns on invested capital high: over the past five years, FDS has averaged a five year median operating margin of 32.9% and a ROIC in the mid-to-high 30s.
Despite these strengths there are major risks to the outlook and investors should avoid FactSet. Financial markets around the world are in a bubble. Thanks to low interest rates and quantitative easing valuation ratios continue to expand even though the underlying economic growth is absent. FactSet's business is highly exposed to a market correction, and we think one is likely to occur within the next couple years. During crashes or periods of high volatility, customers trim their budgets and it becomes more difficult to raise prices. The second major risk stems from the secular shift from active to passive investing. Active investors attempt to generate alpha by analyzing financial data and selecting specific stocks that they expect will outperform the market, while passive investors simply purchase ETFs that mimic broad market indices. Studies have shown that active investors actually underperform the market after fees, and ETFs are proving to be a more efficient and cost-effective way to invest. Passive investment doesn't require extensive research or access to financial data, and while the shift to passive investing will be gradual, it poses a huge threat to FactSet's business.
Investors should avoid FactSet even after the selloff. The company may possess some strong advantages and a capital-efficient revenue model, but FDS is exposed to significant short term and secular risks that pose a real threat to the business.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.