Why I Just Sold FactSet Data Systems

Jun. 1.12 | About: FactSet Research (FDS)

I have owned shares of FactSet (NYSE:FDS) for a while now, and I have been rewarded handsomely. The stock's consistently high returns on equity, high profit margins, and cash-rich, low-debt balance sheet are evidence of this company's excellent operating history. That healthy operation easily transfers into shareholder wealth because 85% of the Operating Cash Flow is converted into Free Cash Flow, which can be used for growth, dividends or buybacks.

So why have I sold my stock? Simply put, the current valuation does not give FactSet a tempting risk/reward ratio.

(Source: Finviz.com)

The stock is trading near all-time highs. However, the earnings growth rate does not support the current P/E ratio. The pre-tax income growth year-over-year for the quarter ended February 29, 2012, was 16.1%. (I am using pre-tax income growth for last quarter because net income was lowered substantially by the expiration of the research and development tax credit. This credit was extended on May 17, so this was a temporary effect to net income.)

This 16.1% growth rate compares with a P/E of 26.8, giving a trailing PEG of 1.66. I typically like to invest in companies with a PEG less than 1, however FactSet commands a premium because of its earnings stability.

To get a sense of that premium, let's look at the 10-year valuation history:

10 yr. Valuation History (Source: MSN Money)

(Data Source: MSN Money)

The current trailing PEG of 1.66 is higher than the 10-year average trailing PEG of 1.25. So even if FactSet continues its 16.1% growth rate, it would be overvalued compared with its historical valuation. However, I do not think the current growth rate will continue; 82% of FactSet's clients are investment managers, like hedge funds, and the remaining 18% are sell-side clients, who primarily rely on FactSet's systems for merger and acquisition work.

The stock is still coasting on better-than-expected performance for the period ended February 29, 2012. This growth was largely caused by an unsually high number of new hedge funds in 2011 - 1113 new funds, near the all-time high of 1197 new funds back in 2007.

Equity funds were the most popular type of new hedge fund. But global equity markets have just had their worst month since the European credit crisis began in September, and as FactSet has stated in its 10-K, "extended declines in the equity markets may reduce new fund or client creation, resulting in lower demand for services from investment managers." I think markets are going to continue to get worse before they get better, so FactSet's buy-side client growth should decrease.

FactSet's client growth on the buy side was partially offset by shrinking numbers of sell-side clients. As FactSet explains, "lack of confidence in the global banking system could cause declines in mergers and acquisitions funded by debt." I believe merger and acquisition activity will decrease as the European credit crisis continues to erode confidence in the global banking system.

FactSet's Director of Global Sales Michael Frankenfield commented on the last conference call, "when the sell side is hot, it's really hot, and when it's not, it's horrendous." I think it's about to get horrendous.

FactSet's stock performance has historically been loosely correlated to the Financial Services Industry:

(click to enlarge)Factset vs iShares Financial Services ETF (Source: Google Finance)Click to enlarge

(Source: Google Finance)

FDS tends to increase when the iShares Financial Services ETF (NYSEARCA:IYF) is increasing and tends to decrease when the ETF is decreasing. However, the two recently decoupled following the earnings release on March 13. I expect the market will restore the correlation in the coming weeks, ahead of FactSet's earnings announcement on June 12.

I can't be too sure of the results that will be announced on June 12. The great performance of U.S. stocks during the first quarter may have lured more equity funds and investors into the market, however this will be offset by the temporary effects of the tax credit expiration, and a continuing bad environment for sell-side clients. Whether or not FactSet reports better than expected numbers, I do not expect a pop similar to the one following the March 13 announcement, because the market bias is far more negative now.

I don't expect the fallout from the European Credit Crunch to have long-term impacts on the success of the business. FactSet's business model is still strong and I expect the number of clients to increase in the long-term as FactSet continues to gain market share from its competitors, Bloomberg and Thomson Reuters (NYSE:TRI). But, in the short term, I expect FactSet's stock price to trend lower as the market discounts financial services companies as a whole.

In the meantime, why not begin to accumulate other financial service companies that have already been discounted? For example, I like Intercontinental Exchange (NYSE:ICE) at current prices. It is trading at a trailing PEG of .60, and it's part of a virtual duopoly on energy and agricultural commodity trading, so it has a large competitive moat. In addition, it recently posted record trading in its Brent energy contracts, and the CEO is working on a deal to purchase the highly-profitable London Metals Exchange (1, 2), so there are signs that its high growth rate will continue.

Occasionally, overvaluations can cause even great companies like FactSet to become a sell. During times like these, when so many stocks are undervalued, it is better to own stocks that are priced low enough to have a large margin of safety. I think it is time to get out of FactSet shares and wait for a pullback to buy them back for cheap.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ICE over the next 72 hours.