Why Hasn't FactSet Surged Along With the Market?

The logic of buying a stock often appears easy. If "X happens, and I think it will, then Y will benefit." In the case of financial services information provider FactSet Research (NYSE: FDS  ) , it's usually a case of "if equity markets do well and the economy is recovering, then FactSet will benefit."

Unfortunately, that didn't entirely work out like that for FactSet in 2013, but what about its prospects in 2014?

FactSet Research disappoints
Equities aren't the only game in town, and FactSet sells a range of information including fixed income, fund, and wealth management information. However, there is no doubt that most financial firms' fortunes are tied to how equity markets perform. For example, wealth management firms find it a lot easier to raise assets during a bull market, and it's a lot easier to sell equity research when stocks are going up.

These sorts of drivers should lead to more bums on seats at financial services firms, something that should be good news for FactSet and industry peers like Thomson Reuters (NYSE: TRI  ) and Morningstar (NASDAQ: MORN  ) .

However, a quick look at FactSet's growth in annual subscription value, or ASV, and client numbers reveals that its growth has slowed despite strong equity markets. ASV is the key metric to follow for FactSet, because it's a useful proxy for its future organic revenue growth.


Source: Company presentations.

Organic ASV growth was only 5% in the last quarter, and analysts have the company on 6.2% and 6.8% overall revenue growth for the next two years. Meanwhile, earnings per share is expected to grow at 8% and 11% in the same period. It's fair to say that investors could have expected more given that the S&P 500 went up so much last year.

What's going wrong?
There are four, sometimes related, issues to consider with FactSet.

First, financial firms appear to have been affected by the financial crisis and seem to be a lot more reticent to expand and hire people. Moreover, they operate under an uncertain regulatory environment. In fact, on its first-quarter conference call, FactSet's management described its middle-market banking customers' hiring plans as being "fairly steady," while bulge bracket hiring was best described as "choppy." 

In addition, FactSet saw two large clients renew contracts in the last quarter, but with a reduced number of users on their contracts. According to FactSet, one had overbought in 2009, and the other had shut down its investment banking division in 2010. In a sense, FactSet is still suffering the lagged effect of the financial crisis.

Second, according to FactSet's Executive Vice President Michael Frankenfield, the financial information services industry is consolidating. On a conference call, he outlined:

The days where users had multiple platforms on their desks are behind us, and it's common for firms to reduce the number of platforms that each user has.

This brings good and bad news for FactSet. It's good as it helps FactSet retain clients, because it's a larger player and can offer a wider range of products than a small firm can. Indeed, its client retention ratio was greater than 95% of ASV in the last quarter.  

However, it's bad news because it makes it harder to sell products into other firms customers. In fact, Thomson Reuters shut down a product recently, and according to FactSet's management, when Thomson's product platform "went away, that workflow went to other products that were on their desk" without a new product replacing it.

Third, FactSet may well be suffering the effects of increased competition. As noted above, the days of analysts and brokers cherry-picking various platforms appear to be over, and this implies a smaller pie for Thomson Reuters, FactSet, Bloomberg, and Standard & Poor's to fight over. In addition, Thomson Reuter's scale (it's more than eight times the size of FactSet) means it can afford to bundle its research solutions to customers.

Financial environmental changes affecting FactSet and Morningstar
The fourth issue relates to the industry backdrop. At the start of the year, FactSet generated 19% of its revenue from sell-side research, but that has now fallen to 17.8%. The sell side (primarily mergers & acquisitions and advisory and sell-side equity research) is somewhat affected by takeover activity and the ability for sell-side firms to sell the research. If this turns out to be a structural rather than a cyclical issue, then prospects for the sell-side look dim.

On a more positive note, FactSet is seeing good growth from its wealth management solutions, and especially with portfolio analytics. This is somewhat expected given a strong equity market, and Morningstar is benefiting, too. Morningstar's solutions are more weighted toward investment and wealth managers, and it saw its investment management revenue increase 11.4% in the last quarter.

The bottom line
Frankly, it's become hard to tell whether FactSet is going to be a major beneficiary of another good year in equity markets. This makes investing in the stock somewhat problematic. If markets turn down, then FactSet will surely suffer, too, but if equity markets have a good year, there's no guarantee FactSet will inordinately benefit. On a forward P/E ratio of nearly 22 times earnings to August 2014, the stock is hardly a great value for this kind of proposition. 

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