Equifax (NYSE:EFX) is one of the three major credit bureaus that supply credit score and related analytics to corporate and individual customers to facilitate more-informed business and personal decision-making, the other two being Experian (EXPGY) and TransUnion (TRU).
As moated businesses with strong earnings power and secular growth, the credit bureaus have been Wall Street darlings year in and year out. Typically, only during a major bear market or in company-specific misfortunes do stocks of these firms become so much undervalued as to offer value investors an adequate margin of safety for an entry (Fig. 1). Because such untoward occasions do not come often, interested investors should act decisively at the sight of them.
On September 7, 2017, Equifax announced that a massive data security breach occurred from mid-May through July 2017 which may have impacted 143 million U.S. consumers, whose names, social security numbers, dates of birth, addresses, and driver's license numbers were accessed, and about 209,000 U.S. consumers whose credit card numbers were also accessed. The company also identified unauthorized access for certain U.K. and Canadian residents (see here). The cyber-attack was discovered on July 29, 2017, by the company. Shortly after the notorious discovery, three executives at the firm unloaded nearly $2 million in company stock (see here), into which DOJ already opened a criminal probe; on August 21, 2017, a so-far unrevealed person purchased a 2,600 September puts struck at $135 for a quick 25-bagger (see here).
Facing consumer uproars and lawsuits by Attorney Generals of Massachusetts, New York, and possibly more states, Equifax management proves itself to be not only lacking in adequate public relations skills but also of dubious integrity; the company was quick to blame the historic data breach on a vendor software flaw (see here) but was slow to offer full remedial measures to the individuals affected by the hacking. In a move to shift public anger from Richard F. Smith, who has been the CEO since 2005, to underlings, the firm said that the Chief Information Officer David Webb and Chief Security Officer Susan Mauldin were retiring immediately (see here); adding irony to a catastrophe and further fueling public wrath, Mauldin was found to have majored in music composition at college and have gone on to earn a master degree in, guess what, music composition (see here). Among Equifax, Wells Fargo (WFC) and United Airlines (UAL), the three recent major public relations disasters in American business history, it is left to the public to decide which company has a CEO who is the most incompetent in doing his job, most callous to public concerns, and of the most hubris, after the House Subcommittee on Digital Commerce Consumer Protection hearing, scheduled on October 3, 2017 (see here).
As all these were happening, the stock of Equifax dropped by 35% in 5 days of trading from the $140s down to $90s (Fig. 1). As contrarian investors constantly in search of deep value, we cannot help but ask: Is this one of those proverbial opportunities, in Warren Buffett parlance, to "be greedy when others are fearful?" Or is it the beginning of an end of an American corporation which was once so invincible and is now joining the hapless bunch of Arthur Anderson and Lehman Brothers all of sudden? As usual, we will follow the procedure below to arrive at rationally-considered answers:
Fig. 1. Stock charts of EFX, EXPGF, and TRU, modified after barchart.com.
2.1. The oligopoly
The credit data-vending industry is categorized into two separate groups, i.e., the credit reporting agencies (CRA), aka, credit bureaus, and credit rating agencies. Equifax, in combination with Experian and TransUnion, dominates the credit bureau group, forming a textbook oligopoly. These nationwide credit reporting agencies are the result of an industry consolidation of some 2,250 local firms that began in the late 1970s. These three CRAs make up about 73% of industry revenue as of 2Q 2017, up from 64% as of 2010, with Experian maintaining a global lead over Equifax, the number two, and TransUnion (Fig. 2).
The three nationwide CRAs have very similar product mixes serving the same targeted customer base; they compete in geographic, product and service markets on the one hand, while they collaborate on the other hand, e.g., they formed in 2006 a joint venture, VantageScore, to provide scoring solutions in competition against third-party credit score providers.
Minor players in the group include Fair Isaac Co. (FICO), which provides analytic tools including the FICO score on which credit analysis is based, and Dun & Bradstreet (DNB), which supplies business-level credit scores and analysis. Investment banks, brokerage firms, and institutional investors also compete in some isolated areas.
The industry participants operate in a competitive environment, each facing competition in geographic, product and service markets. They compete not only on price but also on differentiating factors including quality, innovation, responsiveness, and user-friendliness. When a customer request is received, the products and services from different agencies are combined to generate a credit report.
Fig. 2. Global market share of the publicly-listed credit bureau peers in terms of latest full-year revenue from company SEC filings, after Experian presentation of September 2017 (see here). Notes: 1, year ended March 31, 2017; 2, year ended December 31, 2016; 3, year ended September 30, 2016.
2.2. The industry ecosystem
The CRAs exist in an ongoing ecosystem involving the furnishers of information, public record repositories, users of credit reports, and consumers. All of these industry participants have defined roles with specific obligations under the Federal Credit Reporting Act, with the basic plumbing of industry data flows shown in Fig. 3. Most furnishers of credit information are creditors who are also users of credit reports; public records, e.g., judgments, bankruptcy filings, and tax liens, form another key source of information for the CRAs. Financial institutions voluntarily furnish the bulk of the tradelines, typically monthly in a standardized data format called Metro 2.
Fig. 3. A simplified diagram of the information flows in the credit reporting system, after CFPB. NCRA, Nationwide Credit Reporting Agency, i.e., Experian, Equifax, and TransUnion; CRA, Credit Reporting Agency.
2.3. Credit reports
Credit reports generated by the industry play a vital role in the lives of consumers. Credit issuance, from mortgage loans, auto loans, credit cards, and private student loans to rental housing, automobile and homeowners insurance premium-setting (in some states), and job applicant hiring, uses information contained in credit reports as part of the decision-making. Credit reports mainly enable creditors (and housing landlords and hirers) to better-informed credit and service decisions, manage their portfolio risk, automate or outsource certain payroll-related, tax and human resources business processes.
Although the CRAs compete on the completeness of information in their credit reports among other things, many items in a consumer’s credit report are common to all of them, thanks in large part to the standard formats that furnishers use to report information. However, some differences across the CRA databases are introduced by the fact that some furnishers, including some small banks and many debt collection agencies, do not report to all three CRAs, by their difference in the gathering and treating of some public record information, and by the varying time lags in processing incoming data (see here). In addition, there are inevitably inaccuracies in some credit files and credit reports, which justify the use of data from multiple CRAs to create credit reports. After all, the consequence of the potential credit risks far outweighs the moderate cost of using an additional credit report.
Equifax reports in four divisions, namely, the U.S. information solutions (USIS), the international, workforce solutions, and global consumer solutions. The workforce solutions and the international segments are the lines of business where faster growth are obtained; the company leads the former but tails Experian in the latter. The company generates the vast majority of its revenue from commercial and government customers, e.g., creditors, with the exception of 11% which is derived from the consumers (Fig. 4). This business service provider operates in 25 countries, with the U.S. being still its most important market.
3.1. The databases, analytics and consulting services
At the core of Equifax is a set of proprietary databases as the repository of all incoming information. The databases contain data for credit, telco & utility, property, wealth, employment & income, ID & fraud, and third-party information; there are over 820 million consumers, more than 91 million businesses worldwide, 278 million employee files contributed from some 7,100 employers, 5,750 million trade accounts and 201 million public records in the databases. They include consumer-specific data, including header information, tradelines, income, employment, asset, liquidity, net worth and spending activity, and business data, including credit and business demographics (Fig. 5). The company obtains the data from a variety of data furnishers, from credit granting institutions, via employers (for employee income and tax information), to survey-based marketing information, and then processes them utilizing proprietary information management systems.
Much of the data therein are historical, dating from decades ago, and can no longer be reproduced by a new entrant should there be one. The humongous volume of accumulated data, the immense array of attributes used to describe these data, the complex data-furnishing network and sunken costs in information processing, the know-how to process the daily influx of new information in large quantity, and the countless hours and dollars spent on quality control, tradeline matching, and tradeline dispute resolving make it highly unlikely, if not totally impossible, to reproduce these proprietary databases. Databases like these form extremely high barriers to entry for aspirant interlopers.
In the peripheral of the core database, Equifax has developed a series of analytical applications that can be used to generate value-added insights from its proprietary data (Fig. 6). As of September 2017, the company features 57 solutions and 149 products for businesses from 12 industry sectors (see here); and 10 solutions and 19 products for government agencies in healthcare, law enforcement and homeland security, social service programs, and tax and revenue (see here).
Equifax also offers consulting service to clients to deliver customized decisioning solutions (Fig. 6). The consulting service ranges from solution design and delivery, via project management, to technical delivery of client applications.
3.2. Sustainable competitive advantage
As we discussed above, it is incredibly hard to replicate the central asset of CRAs - the databases - and, as time passes by, it only becomes harder, with new data added daily to more than a century of proprietary information already there. Because of the recent hacking, some data furnishers such as banks may become even more reluctant now to share their customer information with a newcomer to the industry. The proprietary databases erect high barriers to entry which deter potential invaders, limit industry participants to a small number, disincentivize cutthroat competition on price, and assure high profitability for the entrenched players. In addition to their main task of maintaining and updating the core databases, the industry participants focus on differentiating their respective offerings by developing various analytical tools and providing bespoke consulting services to customers, thus deemphasizing competition on price.
Credit reporting is critical to the underwriting decisions of Equifax's customers, who are more concerned about data quality than the price; after all, the price of the credit reports is insignificant relative to the loan amounts at risk. The credit reporting industry has consolidated since the 1970s into a stable oligopolistic structure. Users gladly use the credit reports from more than one of the big three side by side, delivering high profit margins to the CRAs.
On top of the barriers to entry are some enviable economic peculiarities of the CRAs. On the revenue side, over 80% of the sales are pulled down through multi-year subscription (see here); in other words, the revenue is recurring and highly visible. This leads to a stable profitability. On the cost side, staff compensation, one of the major expense items, is kept in check by a quirky consequence of owning nearly permanent databases. Data quality control and error correction are repetitive tasks that can be performed by relatively low-skilled labor if not yet automated; even the less mundane analytics and consulting center around less creative tasks of extraction and manipulation of data and delivery of routine solutions to clients. Therefore, Equifax does not need to retain a star-studded team as in the investment banks. Regardless of how the corporate propagandizes about employees being cherished and pampered, owning a database unlikely to be replicated guarantees that revenue will continue to stream in no matter who walks off the job, be he a data analyst or the CEO. This seems to be a universal situation throughout the data vending industry sector.
Fig. 7. Operating margin and net profit margin of Equifax, author's chart based on data compiled from the company annual reports and quarterly releases.
The afore-mentioned economic characteristics of Equifax conspired to create high profit-margins: the operating margin averaged 25.1%, while the net profit margin 15.3%. Even in the years of macroeconomic malaise, e.g., in the aftermath of the internet bubble burst and during the Great Recession of 2008-2009, net profit margin only slightly softened, which speaks volumes about the stability of profitability of the company (Fig. 7).
According to our DuPont analysis shown in Table 1, between 2006 and 2016, a combination of high and stable net profit margin, an asset turnover of 0.58, and a leverage ratio averaged 0.54 resulted in an average ROE of 19.1%.
3.3. Asset quality and capital efficiency
On the one hand, the company turns over assets within every two years; on the other hand, the assets have an implied life of 23.4 years, with the ratio of depreciation and amortization to total assets at 4.28%. As a matter of fact, the company needs so little capital for maintenance purpose that it only expensed an average of 4.56% of the revenue on depreciation and amortization. This is a capital-light operation with high-quality assets.
The quality of assets is defined in terms of profit-generating capability, rather than by high proportion of tangible assets as some have thought. To understand this point, one needs to look no further than the oil E&P companies, which have a high proportion of quickly depreciating PP&E in total assets but profitability can be lackluster especially in down cycles. Equifax's assets are overwhelmingly intangible; as of 2Q 2017, 67.1% of the non-current assets are in goodwill, another 22.6% in other forms of intangible assets, while tangible property and equipment only account for a poultry 8.2%. Strategic acquisitions and purchases introduced a large amount of goodwill and other intangible assets into the balance sheet (Fig. 8), which in fact consist mostly of digital properties, i.e., data. In December 2012, Equifax bought the credit reporting business unit of Computer Sciences for $1 billion, which resulted in an addition of $926 million of intangible assets. In late 2015, the company spent $1.8 billion on the acquisition of Veda, the leading credit bureau in Australia and New Zealand (see here), which added some $1.4 billion of goodwill.
What is remarkable about Equifax is that its capital-light assets throw off a lot of cash. The return on invested capital, aka, ROIC, averaged 13.5% from 2006 to 2016, beating the WACC of 6.9-7.9% by a wide margin, which signifies the existence of a sustainable competitive advantage. Since 2008-2009, such an edge, though still strong, seems to have been eroded to a certain extent thanks to the SEC and other government agencies which imposed tougher regulations upon the industry in the aftermath of the financial crisis. In the previous era prior to the Great Recession, the company routinely achieved higher-than 20% ROICs (Fig. 9).
3.4. Profitable growth
The low capital intensity made it possible for the company to deploy a relatively small portion of its capital expenditure toward asset maintenance, and the majority to the pursuit of growth. In the ten years from 2006 to 2016, the company spent $3,872 million on capex and acquisitions, while it only expensed $1,692 million on depreciation and amortization (Fig. 10). Less capital spent on asset maintenance means more capital allocated to growth.
In recent years, Equifax has been seeking high-growth in the international realm and in new business lines like workforce solutions. The revenue contribution of the workforce solutions segment has grown to 21% now; in this new field adjacent to its core business of credit reporting, the company seems to have successfully transformed its first-mover advantage into new barriers to entry, especially in the employment verification area.
Internationally, especially in the emerging markets where the rise of the new middle class has led to explosive credit expansion, the company faces fierce competition posed by Experian, its larger rival, which seems to have won the battle in the attractive Brazilian market. Equifax obtained a 49% stake in an Indian start-up, but it will take many years to build a database from scratch before a meaningful revenue contribution therefrom. However, the recent acquisition of Veda, the largest in the 117-year history of the company, extends its footprint to the great down under.
In the more mature market of USIS, credit as a whole still expands secularly; in consequence, the credit reporting business experiences slow yet steady growth. Protected by barriers to entry, the secular expansion of credit reporting is shared exclusively by the entrenched players, ensuring a foundational profitable growth for Equifax (see here).
From 2006 through 2016, the company grew the operating revenue at a CAGR of 7.4%, net income at 6.0%, EPS at 6.7%, and free cash flow at 6.9% (Fig. 11). According to its projection made prior to the recent data breach, the company expects to grow revenue 7-10% per year, increase EPS 11-14% yearly, and deliver a 12-16% annual total return to shareholders (Fig. 12).
Fig. 10. The three-year moving average of depreciation & amortization in relation to capex + acquisitions of Equifax, author's chart based on data compiled from the company annual reports and quarterly releases.
Fig. 11. Annual operating revenue, net income, EPS, and free cash flow for Equifax, author's chart based on data compiled from the company annual reports and quarterly releases. CAGR for 2006-2016.
We will first estimate the value of Equifax in a business-as-usual scenario and then make adjustments for the effect of the 2017 data breach, to reach an intrinsic value estimate.
According to Greenwald et al.'s three-element valuation approach, a business has three measures of value, i.e., net asset value, earnings power value, and growth value. As we discussed above, around 90% of Equifax's assets are intangible; they are the databases in digital form, which may retain its value better than the amortization consideration. Because of this peculiarity, we take the company's book value per share at $25.09 as an approximation of the net asset.
To err on the conservative side, we assume that the current data leak debacle will help reduce its consumer segment by half, which as of 2Q 2017 contributes 11% of the revenue. We further suppose that the commercial segment will experience a 5% decrease in sales for two-quarters and flat revenue in the next four quarters before secular growth is resumed at the average rate of 2006-2016. Such historical rate of growth, which is lower than the company's outlook (Fig. 12), is justified because there is no evidence that the credit reporting industry has escaped from the post-financial crisis regulatory environment and entered a new phase of rapid growth as the company seems to suggest. Under these assumptions, the discounted cash flow model indicates that the earning power value, i.e., the net present value at zero growth is estimated to be $43.2 and $57.0 per share corresponding to WACC of 7.85% and 6.89%, respectively; the growth value of the company is estimated to be $82.9 and $108.6 per share at a WACC of 7.85% and 6.89%, respectively.
The differences among these three value measures carry important economic meanings. The $18.1-31.9 variance, on a per-share basis, between the net asset value and earnings power value signifies the franchise value originated from the competitive advantage that Equifax currently enjoys. The $39.7-51.6 difference between the earnings power value and growth value, on the one hand, results from the fact that the company draws significant benefits from the privilege of growth under the protection of the barriers to entry and, on the other hand, arises from the backdrop of global secular credit growth and rising demand for the type of data that the company provides.
According to section 6.2 below, the average impact of the 2017 cyber breach comes to the neighborhood of $641 million or $5.26 per share, which is at best a ballpark figure of what may prove to be eventually. Net of this one-time adjustment, the intrinsic value of the company is $9,463-12,597 million, or $77.6-103.3 per share.
Table 2. Net present value of Equifax prior to the 2017 data leak adjustment, author's calculation based on parameters derived in the main text. The WACC is calculated assuming a 6% constant market risk premium (for mrp) or using the implied market risk premium of market-risk-premia.com (for imrp).
Enough has been said by the media about how ill-prepared the Equifax executives have been in the management of the current crisis. The public certainly has the right to be angry at the company and its management over such a grievous infringement of the privacy of so many people. However, we should bear in mind that those executives were hired as managers to deliver desired operational results. It may be true that none of them proved to be a leader in such a critical time, but it is only fair to evaluate them according to what they were hired to do.
They mostly pursued growth initiatives in the company's core business - credit bureau - which is protected by high barriers to entry and hence assures profitable growth. They made quite a few acquisitions over the years (Fig. 13) but they seem to have not strayed out too far from their comfort zone. In the few cases when they step out of its credit reporting roots, they chose to stay in areas which the firm not only may parlay its core competency into but also can enjoy attractive economics; an example of such frontier areas is the company's employment verification business as part of the workforce solutions segment, which seems to have emerged as a bolt-on franchise to its legacy operations. Here, we must give credit to whom credit due.
We also find that the management of Equifax uses the pile of cash generated by the business to repurchase shares (Fig. 14) and distribute dividends (Fig. 15). From 2006 to 2016, the weighted average number of shares shrunk 0.7% per year; during the same time, dividends increased 23.5% annually, with the dividend yield currently at 1.55%, though the company may scratch dividend payment to pay the expected fine in the next few quarters. The management is commendable for their using profit to reward shareholders instead of squandering the cash on a shopping spree.
Not many CEOs have such a discipline. The data vending industry, unfortunately, attracts more than its fair share of mediocre yet self-grandiose honchos who mistake the fine economics of their moaty business as a proof of their talent. One of the things that many CEOs in this industry are most fond of doing is to buy companies whether or not the acquired targets are incongruent to their core business. In a majority of the cases, they will end up running a bloated company with lousy profitability; IHS Markit (INFO) is a case in point. As compared with these lousy CEOs, the management at Equifax is really not that bad. Nonetheless, we do not know whether the management can survive the public outcry over the data breach.
Fig. 14. Weighted average number of shares, diluted, author's chart based on data compiled from the company annual reports and quarterly releases.
Fig. 15. Dividends per share and payout for Equifax, author's chart based on data compiled from the company annual reports and quarterly releases.
6.1. Will Equifax go bankrupt?
Credit reports are a fact of the financial life in our society. The role of credit bureaus will become more and more important as credit expands globally (see here). The high barriers to entry existing around Equifax’s core credit bureau business make it highly unlikely for new entrants to barge in and replace it, as we discussed at length above. The credit reporting ecosystem actually has a vested interest in there being more than two credit bureaus to exist (see here). It makes economic sense too for the consumer lenders, which are also the main customers of Equifax, to have it around for years to come. Employers use Equifax's data to vet job candidates while government agencies use it to determine staff security clearances and similar work-related privileges (see here); such an interdependence developed over years may be weakened to some extent but will probably continue to exist.
Furthermore, it is highly unlikely for the current administration in the White House to hand a European company, i.e., Experian, the dominant position in the credit reporting industry. At least four major data breaches happened in recent years which involved all three of the credit bureaus, with the most serious incident having occurred at Experian (see here). There is no reason to only single out and go after Equifax now.
Over this data breach, Equifax has the sin of negligence rather than the guilt of willfully committing a crime. There is a difference in the degree of flagrance between Wells Fargo's account-opening scandal, which borders on identity theft, and Equifax cyber leak, where Equifax is, after all, a victim of criminal activities. If the continuous existence of Wells Fargo is any guidance, Equifax should survive the incident.
6.2. The cost of the incident
The potential cost to Equifax can be categorized as follows:
Items (2) to (4) were incorporated into the continuing operation-based modeling in the section of valuation. The size of the expected fine is obtained by averaging several estimates based on analogous data breaches, including that of GPN (see here), Anthem (see here), as well as Target and Home Depot (see here, here, here, and here), and is shown in Table 3.
6.3. Will Equifax be able to grow again?
As long as the public censure persists, the company will be in a crisis management mode; the management's attention will be diverted from the business operation and growth will be foiled. Wells Fargo's recent public relations crisis, which we consider to be far more serious, peters out after approximately one year's time. So we think the storm over Equifax will eventually pass as well.
By then, the company will find that its competitive advantage has sustained perhaps with some minor scratch, which will assert its power in due time. In the meanwhile, the global credit expansion will, of course, continue as a secular trend, blowing tailwinds to aid its resumed growth.
Our survey of Equifax in the aftermath of the recent data breach reveals the following:
Equifax has erected high barriers to entry around its core business - credit reporting - and has established a new franchise in workforce solutions. Its strength lies in the ownership of a set of proprietary databases that are unlikely to be replicated by any aspirant new entrants into the oligopolistic industry and in the strong ecosystem the credit reporting agencies have built around them over the past century.
The credit bureaus are wonderful businesses, with a high percentage of recurring revenue, relatively low labor costs, and low capital intensity. Equifax for one enjoys a sustainable competitive advantage that is evident from the high yet stable profit margin and large surplus return on invested capital over the WACC. There is no wonder that the company has posted an enviable track record of profitable growth. Thanks to such a strong franchise, Equifax will survive the current crisis and resume growth probably in the near future. The management hopefully will follow the same trajectory, who we find to be adequately able to operate the company prior to the strike of the crisis.
The stock of Equifax must have been very overpriced prior to the data breach incident because a 35% drop only managed to bring its price to the level around the estimated intrinsic value. The stock clearly deserves a position in the portfolio for any conservative investors with a long-term horizon, but a prudent entry may await the presence of an adequate margin of safety, which requires a decline of another 15%. We hope that such an entry opportunity will appear in the near future; after all, the crisis still seems young.
Fig. 16. Stock chart of Equifax, after barchart.com.
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Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EFX over 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.