by Michael Corty, CFA
We believe IHS (IHS) has a wide economic moat as the company faces minimal direct competition and has pricing power based on its must-have information to locked-in customers. We think IHS is one of the most intriguing growth stories in our coverage universe, as it has continuously increased wallet share from its existing capital-intensive clients, especially those in the energy industry. Energy and natural resources firms account for about half of total sales and the information and analysis (especially proprietary databases) provided to these customers represent the widest portion of the economic moat. With the shares sitting just above our $100 fair value estimate, we view IHS as a great growth company to keep on the radar screen, but not cheap enough to put new money to work.
IHS provides information and insight to a diverse customer base. The firm has more than 5,500 employees, including 1,400 researchers and 1,400 data transformation specialists, serving tens of thousands of customers and hundreds of thousands of end users in more than 165 countries. We estimate that customers in the energy and natural resources industry contribute about 50% of overall sales. The company focuses on six capital-intensive industries: energy and natural resources; government, defense, and security; chemicals; transportation; manufacturing; and technology, media, and telecom.
The company's information and services are used to facilitate decision-making, support key processes, and improve productivity. IHS adds value by aggregating, managing, updating, and packaging the information specifically to meet the demands of its clients. The company pulls together data from hundreds of private industry and government sources with the help of an informal global network. IHS' industry experts continuously update and verify the accuracy of data.
IHS Has Carved a Wide Economic Moat
We view switching costs as high for IHS customers. The company provides a comprehensive collection of vital technical information, which is very difficult--and with some products, impossible--to replicate. This gives the company strong pricing power that has helped contribute to average organic sales growth of about 10% during the past decade, according to management (as the period predates its 2005 initial public offering).
About 77% of sales are generated through annual subscriptions. IHS has long-standing relationships with its clients and achieves a nearly 100% renewal rate with its top 1,000 customers. Renewal rates are high, as IHS' software, data, and analytics are often embedded in the customers' work flow. Moreover, the firm does not have a substantial competitor that can offer a similar breadth of services. It surveys hundreds of thousands of users of its products, and 49% of those customers say IHS has no competitors, while the other 51% list 1,100 competitors in total, with no competitor named more than four times.
A single competitor would be hard-pressed to match the breadth and depth of IHS' information. IHS is not the only energy information provider, but it is generally the only company offering the specific information and analytics that it specializes in, which happens to be crucial for everyday decision-making.
We estimate that customers in the energy and natural resources industries account for roughly 50% of total company sales, and we think the information and analysis (especially the proprietary databases) provided to these customers represent the widest portion of the economic moat. The firm's energy products and services encompass exploration and production of hydrocarbons, from distribution to power generation to consumption. IHS owns production information on more than 90% of the world's oil and gas wells (which dates back to the 1800s) and continuously adds current, real-time data. The oil and gas well data include comprehensive geological information on more than 4 million current and historical wells around the world. Additionally, IHS maintains energy activity data that include comprehensive current and future seismic, drilling, and development activities in more than 180 countries.
While data aggregation, creation, and collection are the core of IHS' value proposition, analytical tools and consulting services are an expanding part of the mix. For the major oil companies with resources to try to capture global energy info outside their own assets, the relatively small amount they pay IHS does not make it worth the hassle to do it themselves.
Energy Information and Analytics Are IHS' Crown Jewels
IHS' data are virtually impossible to replicate, and the value of IHS' energy information and analysis is increasing. Historical oil and gas production data help geologists with clues about current projects. Understanding the historical production of an oil well helps in solving the puzzle of how much oil might still be left in the ground in a specific target area. IHS is tracking about 90% of the world's oil production across 4.6 million wells in more than 100 countries and has production data going back to the mid-1800s.
The firm's oil and gas well data include as many as 20,000 elements, including geological information, permit and drilling activity, and completion records. An infrastructure database provides location, capacity, and ownership on oil and gas facilities. Decision and support tools integrate all of these databases onto customer workstations, allowing the end user to model potential drilling costs, project economics, and potential transportation issues.
IHS also has long-standing client relationships in other capital-intensive industries like aerospace and defense, construction, electronics, and automotive. We believe IHS has carved out unique niches in these categories, mostly through acquisitions that its energy customers initially suggested. Customers subscribe to IHS' products and services across categories, as they prefer to deal with as few vendors as possible.
CEO Plays a Major Role in the Success of IHS
We think Jerre Stead has played a key role in transforming IHS during the past decade. He was invited to join IHS' board in 2001 when the foreign-based private company was in bad shape; it was generating negative cash flow and was grossly inefficient despite its valuable set of assets. Stead eventually became chairman, fired the entire management team except the CFO, and put a new team in place, drawing from a wide network of people he had mentored in past leadership roles.
We credit Stead with the firm's disciplined acquisition strategy as well as getting IHS started on improving its infrastructure and customer-facing platforms more than six years ago. Stead put IHS on the path to having world-class systems, infrastructure, and customer interfaces and believes the firm has reached about 80% of its goal. IHS made efforts to improve the systems, as before the 2005 IPO it had never spent much on infrastructure. The company has put in place a common salesforce automation system; at one point, it had 63 billing systems around the world and 21 general ledger systems. Additionally, the company is almost done merging 34 customer-care centers into 3 global centers. By 2013, IHS will complete its goal of combining 69 datacenters into just 3.
Improving the Customer Experience Bolsters IHS' Entrenchment
IHS' information and analytics are extremely difficult to replicate, but IHS has further separated itself from potential competitors by investing in better customer interfaces. A recent and important example is IHS Connect, a dashboard that allows customers to access databases and analytics with a single login. IHS Connect also has a version that works on the iPad. Aside from creating a better customer experience, it should drive more upsell in future years as most users subscribe to only one third of available products and previously never had an integrated way of seeing the full product menu. Before IHS Connect, customers accessing different information would have to navigate through distinct applications. IHS Connect is open-source, which allows customers to pull in other non-IHS data; this is an example of how IHS is ingrained as a part of a client's work flow. The company will roll out versions for other categories like chemicals and automotive within the next year.
Acquisitions Enhance Competitive Position
Buying growth usually destroys shareholder value, and most companies are not good at it. However, IHS is an exception to the rule based on its record of the past six years. The company has walked away from deals because the price was too high, and in some instances it pulled the trigger on deals several years later when the price was more reasonable. According to management, more than 80% of acquisitions closed in the past five years have been customer-driven, in which customers wanted information not already in IHS' portfolio. We view the firm's acquisitions as a form of capital expenditure or reinvesting for growth.
The company has a small merger and acquisition group that handles all aspects of deals, from due diligence through integration. Several baseline criteria must be met for IHS to take serious interest in a business. The deal has to build on IHS' existing offerings and have a simple business model, but most important, the culture has to fit. For IHS, culture means no sense of entitlement among management or key personnel running the target business. It typically buys smaller companies that have a particular product or service that fills a gap. We like the fact that IHS does not use bankers and does not participate in auctions.
IHS Can Continue Its Run of Strong Organic Revenue Growth
Seventy-five percent of IHS' revenue comes from its 1,000 largest accounts, and the company estimates that it is about 20%-30% penetrated in those accounts today. We think the company can achieve 8%-10% organic revenue growth over the next five years, even without the help of a robust macroeconomic backdrop. At first glance, our forecast may seem aggressive given that the company claims to have already generated 10% organic sales growth on average during the past 10 years. However, we believe IHS will be able to pull on several levers to retain its strong growth. The company should be able to attain a few percentage points from wallet share, getting existing clients to buy more of its current offerings. We think it has 3%-5% worth of pricing power and can gain another few percentage points of growth from rolling out new products.
IHS Is on Our Short List in the Event of a Price Pullback
Our discounted cash flow-based fair value estimate of $100 implies forward fiscal-year price/earnings of 25 times, enterprise value/EBITDA of 18 times, and a free cash flow yield of 3.3%. We expect acquisitions to help the firm achieve 17% sales growth in fiscal 2012, and we forecast sales to increase at a 10% average annual clip through fiscal 2016. We think the premium relative multiples for IHS are justified based on the company's dominant competitive position and strong growth prospects.
Our five-year organic growth projection sits at the low end of management's long-term goal of 9%-15%, as we assume some economic slowdown occurring over the next five years and we view the nonsubscription portion of sales (23% of total) as somewhat cyclical. Still, IHS' organic revenue growth has proved to be recession-resistant in the past, driven by organic subscription growth. We believe IHS' energy domain (about half of sales) will be the major driver of organic sales dollar growth as customers--which include major global energy producers--spend more on exploration and production information as well as tangent services over time. However, we think some of its much smaller offerings, such as those in environmental sustainability, are likely to grow at faster clip than the overall business.
We expect margins on earnings before interest, taxes, depreciation, and amortization (which includes stock compensation expense) to reach 28.8% by 2016 and average about 27% through 2016, higher than the 23% EBITDA margin posted in the fiscal year ended November 2011. We're confident IHS can achieve 120 basis points of margin expansion, on average, through 2016. Management's baseline margin expansion goal is 100-150 basis points per year. The company talks about profitability in terms of adjusted EBITDA, which among other minor items does not include stock compensation expense, which historically has hovered around 6.5% of sales. If we assume stock comp expense stays at 6.5% of sales, our 2016 EBITDA margin forecast excluding stock comp expense is 35.3%.
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