2024-01-18 05:45:54 ET
Summary
- FactSet Research Systems faces a weakened selling environment.
- The Company reported 7.4% organic revenue growth in 1Q24, but this was primarily driven by two significant deals, masking underlying growth deceleration.
- Management has implemented a cost-cutting program and lowered guidance, indicating a negative outlook for FDS's growth prospects.
Summary
Following my coverage of FactSet Research Systems ( FDS ), I recommended a hold rating as I remained negative on the business. My thought back then was that FDS was far from reaching the trough of this cycle yet. With FDS's outsized exposure to the hedge fund industry, I believed that was going to be a strong headwind to performance in the near term. This post is to provide an update on my thoughts on the business and stock. My negative outlook for FDS remains (remain neutral rated) as management revised its guidance and mentioned that the selling environment has weakened. The fact that FDS has to implement a cost-cutting program (mainly on personnel) is an indication, I believe, that there are no attractive selling opportunities in the market.
Investment thesis
FDS 1Q24 revenues saw $542 million, a 7.4% growth, which was in line with consensus. Reported revenue growth matches organic revenue growth of 7.2%, which was driven by organic ASV plus professional services growth of 7.1%. That said, the adj. EBIT margin was reported at 37.6%, coming below the consensus estimate of 38%. At the bottom line, adj. EPS saw $4.12, roughly in line with the consensus estimate of $4.11.
I believe we have not yet reached the trough of this downcycle. While FDS 7.1% organic ASV plus professional services growth might seem healthy at face value, I'm afraid the truth is far from there. The growth was primarily driven by two significant deals that closed during the quarter. First is a large 5-year wealth contract with 17k seats, replacing the incumbent provider. The second deal was FDS winning one of the largest asset managers in the US. One could argue that the closing of the deals was timely and favorable to FDS. Suppose the deals got delayed for whatever reason in 2Q; growth would be dramatically different. Take the 5-year wealth contract, for example. If we assume $50 per month per seat (you can assume any amount, either way, the fact is it would have impacted the percentage growth), that amounts to roughly $10 million in annual revenue. Without this $10 million, ASV plus professional services growth would be ~6.7%, a 70bps sequential deceleration, further anchoring the narrative that the FDS is still far from reaching the trough.
The selling environment has deteriorated over the last quarter, according to management, who cite factors such as longer sales cycles, smaller client budgets, fewer deals, fewer employees, and geopolitical unpredictability. Reflecting this pessimism, management lowered its full-year organic ASV plus professional services growth guidance to 6% from 7% previously, which is in line with my analysis that, in the absence of big deals, growth is actually decelerating. Further evidence that the weakness of growth is due to loss of demand and not delays can be seen from the breakdown in the ASV guide down. Among the 100 bps drop, management attributes 40 bps to pricing pressures and lower price realization, 30 bps to higher erosion and down-selling caused by client cost rationalization, and 25 bps to delayed spending decisions. Put together, 75% of the growth headwind is demand loss. Unlike a delayed decision that causes a growth slowdown, demand loss requires a longer time frame before it can recover. Take cost rationalization, for example; underlying clients might have closed down some overseas offices or laid off a certain number of employees; hence, there is less demand for FDS products. For this client to undo all these actions, it would take a long time and will only happen when the next up cycle comes.
Furthermore, I take the fact that management is implementing a cost reduction program in 2Q24, which is focused on variable and personnel-related costs, as an indication that FDS is preparing for the worst and that it does not require this many headcounts to run the firm. My assumption is that "variable" and "personnel" costs would come from the sales department, which implies there are not enough growth opportunities to justify maintaining a large team. For the bullish investors that are leaning on the fact that the Fed is going to cut rates, which will be great for FDS as the capital market recovers, management has called out that any positive impact from it will not be immediately reflected in the results. As such, there is no positive catalyst in the near term.
It should be noted that investment banking and banking hiring is a lagging indicator, okay? So we've had 500 basis points of interest rate increases. Times got tougher, and so hiring is in fact a lagging indicator. 1Q24 earnings results call
Valuation
Own calculation
My outlook for FDS remains negative in the near term, and I expect further growth deceleration from here. I believe management FY24 guidance of 6% growth is the first major leg of growth deceleration, and FY25 will be the second leg, mimicking the growth trajectory during the subprime crisis, where growth fell from 21% in FY08 to 8.1% in FY09 (first leg) and 3.1% in FY10 (second leg). Using historical trends, I assumed FY25 would grow at 3% as well. As for earnings, I used management guidance for FY24, which sees a margin expansion of around 245bps, primarily due to the cost-saving program. For FY25, as growth is deceleration (no operating leverage), I assumed margins would stay flat. Currently, it is trading at 27.7x forward PE, but as the growth outlook is weak, I don't think FDS should trade at a premium to its historical average of 25x forward PE. I assumed FDS would trade back down to its historical average in the near term and expect further downward re-ratings if growth falls further than expected.
Risk
FDS could continue to acquire large deals in the near term, which would drive an upside to my growth expectations. When the market sees that FDS can consistently meet consensus expectations or even exceed them, the stock narrative might turn positive, which could support the valuation at the current level for longer than expected.
Conclusion
To summarize, my negative outlook on FDS persists due to ongoing challenges in the selling environment and management's acknowledgment of a weakened market. Despite a reported 7.4% organic ASV plus professional services growth in 1Q24, if we exclude the 2 big deals, growth appears to be decelerating. The recent cost-cutting program and downward revision of guidance also paint a negative outlook. I believe growth will decelerate further from here, aligning with historical trends during economic downturns.
For further details see:
FactSet Research Systems: No, We Are Not Past The Worst Yet