Factset Research Systems Inc (FDS) — Q4 2015 Earnings Call Transcript

Thank you, operator. Good morning and thanks to all of you for participating today. Welcome to FactSet’s fourth quarter 2015 earnings conference call. This conference call is being transcribed in real time and is being broadcast live via the Internet. A replay of this call will also be available on our website. Our call will contain forward-looking statements reflecting management’s expectations based on currently available information. Actual results may differ materially. More information about factors that could affect FactSet’s business can be found in our filings with the SEC. Annual Subscription Value, or ASV, is a key metric for FactSet. Please recall that ASV is a snapshot view of client subscriptions representing our forward-looking revenues for the next 12 months. Lastly, FactSet undertakes no obligation to update publicly any forward-looking statements as a result of new information or future events. Joining me today are Phil Snow, Chief Executive Officer; Scott Miller, Director of Global Sales; and Maurizio Nicolelli, Chief Financial Officer. Now, I’d like to turn the discussion over to Maurizio Nicolelli, Chief Financial Officer.

Thank you, Rachel and good morning everyone. Here is where we will focus our time for this call. First, I’ll review the fourth quarter results. Second, I’ll cover guidance for the upcoming first quarter. Third, Phil Snow will discuss our recent agreement to acquire Portware. Lastly, we’ll close by addressing your questions. So let’s proceed with our fourth quarter results. FactSet performed very well in the fourth quarter as we achieved record highs in all of our key metrics, which include ASV, revenues, client count, user count, and EPS. During the quarter, our organic ASV grew $36.9 million continuing our market share expansion. Our growth rate accelerated to 9.2%, up 30 basis points from the third quarter and up 190 basis points versus the prior year. In terms of geography, ASV from our U.S. operations totaled $715 million, while international operations accounted for $343 million or 32% of the total. Buy-side clients, which include off-platform data sales and the market metrics business accounted for 82.5% of ASV, while the remaining ASV was generated by our sell-side clients, which include M&A advisory, capital markets, and equity research businesses. Please note our results contain two discrete items; first, operating expenses included a $3 million pre-tax charge primarily from the vesting of performance-based equity instruments. Second, income tax expense includes a $2.3 million benefit from finalizing prior year tax returns and other discrete items. Excluding these two items, our adjusted operating margin grew to 33.9%, while our adjusted EPS rose 13% to $1.48. This quarter marks our 21st consecutive quarter of double-digit EPS growth. Let’s now turn to free cash flow. We define free cash flow as cash generated from operations less capital spending. Over the last three months, we generated $73 million in free cash flow, an increase of 12% over the same period last year. Free cash flow increased during the quarter due to high levels of net income, lower income tax payments, and a reduction in deferred fees due to timing of when we invoice our clients. Our cash and investments balance was $182 million, down $500,000 during the quarter. This quarter, we spent $78 million on share repurchases. As of quarter end, $134 million remained available for future share repurchases. We’ve also paid regular quarterly dividends of $18 million. Now, let me walk you through our P&L. Revenues grew in the fourth quarter to $261.8 million, up 9.1% organically over last year. Adjusted operating income, which excludes a $3 million pre-tax charge due to the vesting of performance-based equity instruments grew to $88.7 million, an increase of 11.7% over last year. Adjusted net income advanced 11.9% to $62 million and excludes the after-tax expense of $2.1 million from the vesting of performance-based equity instruments and income tax benefits of $2.3 million from finalizing prior year tax returns and other discrete items. Adjusted diluted EPS grew 13% to $1.48. In the fourth quarter, our U.S. revenues rose to $176.5 million, which equates to 8% organic revenue growth compared to the same period last year. Non-U.S. revenues rose to $85.3 million. Excluding the impact of foreign currency, the international revenue growth rate was 11.6%. More specifically, revenues in the fourth quarter from Europe and Asia-Pac regions were $65.2 million and $20.1 million respectively. Excluding foreign currency effects, year-over-year growth rates were 10.4% in Europe and 15.5% in Asia-Pacific. Now, let's now review the revenue growth drivers this quarter. The organic ASV growth rate accelerated to 9.2% and was driven by broad-based global growth from both buy and sell side. The growth rate from buy-side clients grew 50 basis points to 9% during the fourth quarter. The growth rate from sell-side clients was 9.8%, a decline sequentially from the third quarter, but up 130 basis points from last year. Our net user count increased by 3,210, which is our highest ever increase in a single quarter. Net user count of FactSet terminals totaled 62,205 at quarter end, which represented a year-over-year growth rate of 14%. The fourth quarter typically includes new users from both buy and sell side as our largest clients bring in their new higher classes. Sell-side growth accounted for a little more than half the user increase. Growth in the IPO and M&A marketplaces have also been a boost for our banking clients this year. During the year, FactSet released a new user interface with an emphasis on ease of use and search. We believe this new UI also contributed to the net user increase. Also contributing to our growth, we have seen accelerated demand for our fixed income portfolio products, portfolio analytics suite of products, sales of equity attribution, and multi-asset class risk models. Our stable of value-add products in equity and fixed income analytics boosted strong sales in the U.S., European, and Asia-Pac regions. Our solutions in portfolio services also continued to do extremely well, as clients seek out areas to outsource services around daily integration, enrichment, quality control, and process monitoring. They are turning more to our managed services in this space. Selling content in both data feeds continues to be a strong and developing product line for us. We’ve had success leveraging the distribution network of third-party providers. Large clients value our industry-leading content such as news, geographic revenue, entity data, Fundamentals, Estimates, and Ownership. Finally, our research management solutions, which includes both our IRN and Code Red products continue to grow in the fourth quarter as clients now have a choice between our hosted and local solutions. Now, let's take a look at the expense side. Total operating expenses were $176.1 million. Our adjusted operating margin was 33.9%, which excludes the $3 million pre-tax charge from vesting performance-based equity instruments. Cost of services, expressed as a percentage of revenues, increased by 230 basis points compared to the year-ago fourth quarter. This increase was driven by a higher compensation expense including stock-based compensation. Employee compensation expense grew as we expanded headcount of 11% year-over-year, primarily from our new college graduate hiring in consulting and software engineering and acquired employees in connection with the February 2015 Code Red acquisition. Stock-based compensation grew due to the vesting of performance-based equity instruments. SG&A expenses expressed as a percentage of revenues decreased by 180 basis points in the fourth quarter compared to the year-ago period due to lower compensation expense from employees performing SG&A roles and a reduction in occupancy costs, partially offset by higher stock-based compensation expense. At the end of our fiscal year, we had 7,360 employees, a year-over-year increase of 11%. We hired 409 net new employees this quarter, primarily within our software engineering and consulting classes. The fourth quarter effective tax rate was 27.7%, down from 30.4% a year ago driven by income tax benefits of $2.3 million from finalizing prior year tax returns and other discrete items. Excluding these income tax benefits, our current year annual effective tax rate was 30.3% down 10 basis points over last year. Now let’s turn to guidance for the first quarter of fiscal 2016. Our guidance does not include results from the expected acquisition of Portware. We will update our guidance when the acquisition closes. We expect that revenues will range between $265 million and $269 million. Operating margin should range between 33% and 34%. The annual effective tax rate should range between 31% and 32%. This range also takes into account the expired Federal R&D tax credit and assumes it will not be re-enacted before November 30, 2015. We expect that diluted EPS will range between $1.46 and $1.48. This estimate accounts for the expired Federal R&D tax credit which has the effect of lowering each end of the range by $0.02 compared to the just completed fourth quarter. The midpoint of the range suggests 13% year-over-year growth after adjusting for the expiration of the R&D credit. Please note the R&D tax credit has expired only once in its 34-year history without being retroactively re-enacted to previous years. Should the R&D tax credit be re-enacted on or before November 30, 2015, diluted EPS would range between $1.51 and $1.53, recognizing a benefit of $0.14 per share if the credit could be retroactively applied to previous periods. And now I would like to turn the discussion over to Phil Snow, Chief Executive Officer.

Thank you, Maurizio and good morning everyone. My prepared remarks today will cover two topics. First, I'll address the strategic rationale behind acquiring Portware given that this will be FactSet's largest acquisition. I will also touch upon our capital allocation strategy. Second, I will offer some thoughts about our 2015 results. Let’s start with Portware; yesterday we entered into a definitive purchase agreement to acquire all of the outstanding membership interests of Portware for $265 million in cash, partially offset by expected income tax benefits with an estimated present value of $50 million. We plan to fund the acquisition with an expansion of our existing revolving credit facility. We expect it will close in late October or early November. From many perspectives I am very excited about the acquisition of Portware. Strategically, Portware will be a platform to expand our presence in large global asset managers by becoming part of their trading ecosystem. We expect to combine our leading expertise and portfolio analytics with Portware's innovative suites of trade automation solutions and cross-sell the solutions at FactSet's blue-chip global buy-side client base. To be clear, we still need to do significant work over the next couple of years to execute our plans and capture market share that is meaningful to our overall growth rate. Importantly, we believe that eliminating different systems between middle and front offices is high on the wish list of our global asset manager clients. We can streamline our clients' workforce by capturing more of the trading lifecycle and integrating it into FactSet. I very much look forward to welcoming all the employees of Portware to the FactSet team. I can tell you that there is a high level of internal excitement and momentum to unify our product, enhance the workflow of clients, and drive the value of our joint offering. Regarding our capital allocation strategy, little has really changed. We have been looking at many ways to expand our trading capabilities over the past few years during which time we developed a strong belief that buying a proven winner in the marketplace with the best path forward is ultimately beneficial. We analyzed many opportunities and have been impressed by what we found at Portware. Our acquisition strategy has not changed since I assumed the CEO role and I do not anticipate a significant shift in our strategy on this front. Regarding the size of the acquisitions and FactSet’s leveraging of its balance sheet, I have a few thoughts I would like to share with investors. One, the additional $265 million invested into our balance sheet is more a function of record low interest rates rather than a strategic shift. Like most corporations, we focus on returning capital to shareholders in the form of share repurchases and dividend payments in light of the low returns available on cash balances over the last few years. We believe that our return on capital far exceeds our cost of capital by a wide margin. We continue to ensure the luxury of great financial flexibility given our annual free cash flow generation of $281 million. Second, the size of this acquisition is well correlated to the size of the opportunity for FactSet. FactSet has made amazing strides in growing organically, but I recognize along with our executive team that there are times when an acquisition rather than building a system internally is the best course of action to capture significant business on a global scale. Finally, we view the task of optimizing capital very seriously. Whether investing in existing operations, acquisitions, or returning capital back to shareholders, maximizing our EPS accretion is what drives us. Excluding amortization of acquired intangible assets, we believe the Portware acquisition will be accretive to earnings right away and open up future market opportunities within our core client base that will drive future growth. Now let me turn my attention to the just completed 2015 fiscal year. I'm proud of our many achievements and want to thank every FactSet employee for their hard work in driving up shareholder value. Our key metrics accelerated throughout the year and the accompanying growth rates reached three-year highs. Our organic ASP growth rate accelerated 190 basis points to 9.2%. We crossed the billion-dollar mark on ASV in February and ended the year at $1.06 billion. Clients and users reached record highs including a record Q4 of new user editions. Free cash flow grew by 13.5% to a record $281 million. We returned $323 million to shareholders through dividends and share repurchases. Return on equity was 46%, increasing our three-year average returns to 41%. We continued to reinvest in our business, as we increased global headcount by 11% to fuel organic growth. We completed strategic acquisitions in the past 12 months including Code Red. EPS grew by 16% in 2015. Finally, we established a path to a large opportunity within our core client base by signing an agreement to acquire Portware. To summarize, we had a strong year and I believe we are well-positioned for future growth in fiscal 2016. We have been successful in expanding our market share against competing products, we've made tremendous progress accelerating all of our key metrics, and we look forward to achieving our aggressive but achievable goals in 2016. Thank you and we are now ready for your questions.

Hi this is actually Greg calling on behalf of Manav. Just wanted to ask a little bit more about the cross-sell opportunity with Portware, and maybe along those lines, who is the typical Portware user for the buy-side client and are a lot of these guys already FactSet users?

Hi Greg, it's Phil Snow. So Portware is a great strategic fit for us. Many of the more recent wins have been at the large buy-side client user base which is one of our core areas as well. We see this as a great strategic fit. We have great penetration within the middle office of our clients, and we have a good footprint with analysts, portfolio managers, and traders. This really gives us a great opportunity to further penetrate the buy-side trading user community.

Some of the articles I've read about Portware have been talking about their rapid growth on the FX side. Can you talk about your thoughts there, what FactSet currently offers on the FX side, and what you guys are thinking there?

We don’t currently have a lot of FX capabilities, which is one of the exciting parts about this acquisition. What I can say is that our strategic focus has to become more of a multi-asset class solution for our clients, and we’re excited about the fact that Portware is a multi-asset class solution that provides us with more flexibility and opportunities in that area.

First, could you give us a sense of the growth in wealth management users during the quarter? Was that a key contributor to the 14% growth?

Hi Toni, it's Scott Miller. We don’t break out growth rates by client or product segment, but we’ve been very happy with the growth in the wealth space; it's continuing to outperform our overall growth rate and we see great opportunities remaining in that space.

Secondly, now that you've announced a large acquisition in Portware, how does that affect your appetite for future acquisitions and can you talk about what you view as an optimal leverage level, especially given that rates are so low?

Hi Toni, it's Phil Snow. So, as I mentioned in the comments, our strategy hasn’t changed. We continue to look at many interesting opportunities that come across our desk in the content analytics or platform delivery area. This is our largest acquisition on a dollar basis, but as a percentage of FactSet’s size at the time, we've made other acquisitions that are similarly large, so we feel like we still have a tremendous amount of flexibility. If we wanted to execute something of a similar or larger size, we certainly have seen some compelling opportunities.

Do you have the target leverage level or is it just whatever makes sense that you will evaluate?

Hi, it's Maurizio Nicolelli. We still have tremendous flexibility in our capital structure. We will have $300 million in debt when our EBITDA is far larger than that, and our capacity to continue to allocate capital to where it’s best allocated, whether share repurchase, dividend, or acquisitions is still very much there, so there is no target level as of today.

How should we think about the growth of Portware? In the first quarter, the company had 40% year-over-year growth, is that indicative of the way the company is growing? Is it continuing to accelerate from there? We are just trying to understand how we should think about this over the next year or so?

I guess I will answer that, Shlomo. I'm not sure where that 40% comes from, but what I can say is that Portware has had a tremendous amount of recent success in the marketplace, driven by a significant shift in their strategy towards creating strong analytics in automation to free up trade time for areas that provide the most value. We really love the analytics component of the Portware offering, and we see that as a very good complement to FactSet and our suite of portfolio products.

Where I got that from. On their website, they stated in the first quarter that they have grown 40% year-over-year. It seems like the strategy you're talking about is indicative of solid growth, and I was just wondering if there is potential for expansion within the approximately 60 clients they have into more of FactSet's nearly 3,000 clients?

There is a lot of potential. FactSet’s great buy-side client base represents 80% of our ASV. That's about a 75% overlap with their client base. So, 75% of the Portware clients are already FactSet clients; that 25% represents a cross-sell opportunity for other products. The largest cross-sell opportunity is for Portware to penetrate the rest of the buy-side client base.

What size of clients are typically buying something like this? You talked about blue-chip clients; is there a specific asset under management where someone would spend?

Some of our very largest clients today on the buy-side use Portware; some of the very largest sovereigns globally use Portware. They also have good penetration within the hedge fund space.

Is this how the software is priced? Can you discuss that a little bit?

That is something we cannot discuss, Shlomo.

Just maybe going back to the base business for a second, organic growth rates continue to accelerate strongly. Can you talk about what you're seeing out there and your confidence level in getting back to that 10% growth target? On the buy-side, we are increasingly hearing about volatility pushing asset managers to increase budgets, while AUM is down. On the sell-side, you've highlighted M&A and smaller boutiques as an area of growth.

Hi Alex, it’s Scott Miller. I'll address a couple of those points. Clearly, market volatility is something that we watch. The thing about volatility for us is that it requires better data and more analytics, which plays right into our sweet spot, so with the volatility comes opportunities for us. We feel really good about the opportunities out there across both buy-side and sell-side. Our growth has been broad-based across our regions and client base. We feel good about the opportunities moving forward.

Just going back to the acquisition and the strategy. When I think about FactSet, I think of you as primarily a desktop business with a strong value proposition; it seems you are expanding and becoming more of a broad-based financial technology provider. Should we think about FactSet as a broad fintech provider going after some competitive businesses?

I think the easiest way to think about our business is we have great penetration within the middle office of our clients - the performance, risk, and portfolio areas. We also have strong deployments within the front offices of our buy-side and sell-side clients. We provide solutions outside of the workstation. We believe there is a huge opportunity for us in all of those dimensions, particularly within the largest clients in the market.

The press release mentioned $41 million in ASV for Portware; is this the right way to think about annual revenue contribution in year one?

Yes.

Can you kind of speak to the margin profile of the company?

We included the accretion-dilution analysis in the press release. The only other thing you can really add is that the EBITDA margin is right around 20% right now.

About 20%. Great! Do you guys continue to do a good job lowering SG&A as a percentage of revenue? How much more room do you have in that area?

In general, we manage the business based on the overall operating margin. The difference between cost of service and SG&A is really driven by where we bring in employees. The majority of our hires in the fourth quarter were in cost of services from consulting and software engineering. But at the end of the day, we’re really looking at the total operating margin that we’re managing.

Phil, when you talk about looking to continue to expand asset classes for FactSet, you primarily consider to be an equity solution. What type of investments do you think are needed to really develop a robust buy asset class solution?

I’ll start with the second part of that question first. The philosophy here hasn’t changed. We aim to drive double-digit EPS growth rates, keep margins flat, and reinvest everything we can back into the business for our clients and our shareholders. Each year we go through a robust investment process where we evaluate opportunities in different business areas. This year again, fixed income and multi-asset class investments remain very prominent and we continue to fund and favor that versus some of our other areas.

On the assets from eps.com was there any measurable level of ASV contribution from that acquisition? Also, can you comment on the pricing environment and quantify how much pricing is contributing to overall organic growth for fiscal '15?

For the eps.com acquisition, there wasn’t any significant revenue that was part of that acquisition. It was more of a content acquisition. In terms of the pricing, you can expect the same low single-digits as in previous years.

On Portware, from a geographic perspective, is there significant overlap in the regions? Will this be R&D for you guys?

I don't have the numbers right in front of me, but there is a good overlap with the global offices we have, which is great from an integration standpoint. Like us, the bulk of their revenues are likely in the Americas, and they are starting to gain traction globally as well. There’s a good overlap and a presence within every region.

Regarding your core business, have you seen any signs from customers concerning hiring trends going forward this year due to market volatility?

Hi, Keith, it's Scott Miller. We haven't seen any indications of concern about hiring trends. We keep close contact with our clients throughout this volatility, and hiring trends still appear to be reasonably healthy. The recent graduate hiring classes looked solid, and attrition rates are fairly normal. We haven’t noticed anything alarming there so far.

I wanted to ask about strong international growth. What products have you seen the most success with in Europe and Asia? Are they in wealth management, fixed income, legacy desktop, or others?

Hi Will, it's Scott. It’s been broad-based growth across both sell-side and buy-side in Asia-Pac and EMEA. We structured our regions roughly eight months ago to have international split between EMEA and Asia-Pac, and growth has been broad-based.

Regarding the employee count, I know that was up almost 11%, but it sounded like much of that came from acquisitions. What would the normalized headcount growth look like excluding the acquisitions?

The acquisition of Code Red added only 40 employees in total, so the large majority of the additions during the year were from new hires.

Is that mostly offshore or onshore?

It’s a healthy mix.

Were there any client concentrations we should be aware of when it comes to Portware?

No, I think they do have some large client deployments, which is part of why we're excited about this; it's not particularly concentrated at the top.

Can you discuss the medium-term expectations for margins? Given the 20% EBITDA margin on the multiples that you paid, does that multiple reflect your expectations that the margins could move towards the corporate average, or is it more about growth potential?

With every acquisition, we conduct due diligence and think that the growth potential and strategic fit for future margins justify the price we paid, which we consider a good deal for FactSet shareholders.

Is the pricing for acquisitions getting more competitive in this sector? How is that influencing your strategy regarding expansions into broader financial data?

We certainly noticed some froth over the last couple of years as we looked at strategic acquisitions. However, this did not play into our thinking regarding the pricing of this acquisition; we feel we paid very fairly for the asset.

It looks like organic revenue growth in the U.S. has decelerated about 60 basis points. Can you talk about what's trending and how we should think about the run rate for organic growth in the U.S.?

Dan, it’s Scott. Over the year, we’ve seen acceleration across three regions; the Americas is our most mature market. The other regions are accelerating faster, but I feel comfortable with growth prospects for all other regions, and I like what we see in the Americas.

As a housekeeping question, one of the metrics seems to no longer be disclosed, specifically the number of workstations. Can you discuss why that is?

We still have the number of workstations mentioned in the press release. I believe we were up 3,200 workstations during the quarter.

Symphony, the startup messaging service, seems to be gaining attention. What’s your read on that, and is there an opportunity for FactSet to partner with Symphony?

Hi, Patrick, it's Phil Snow. We recently announced that we have joined the Symphony Foundation. We believe that an open messaging community is beneficial for the entire marketplace. This will be available for our users.

I missed that; thank you for pointing that out. Following up, during the quarter, McGraw Hill acquired SNL, highlighting SNL's dominance in key verticals, especially in financial services and real estate. Is there a chance for FactSet to target those markets more directly?

It's a great question; they have built a strong product. While they dive deeply into specific sectors, we also have our strengths. We don't delve quite as deeply into specialty industries. Each year we evaluate investments for potential expansion into those areas but currently, we coexist happily with SNL among many of our clients, offering value they can't.

Regarding Portware's margin profile, is it a function of the current 40 million revenue run rate simply not having scaled yet, with high incremental margins?

Currently, Portware has approximately a 20% margin; it is expected to grow over time as we anticipate the business to expand and align more closely with FactSet's margins.

This acquisition feels unique, focusing more on trading and analytics. Is this a direction that we could see in future acquisitions or internal development as well?

We've been building our own buy-side trading solution for some time. This acquisition significantly enhances that effort. Further, we evaluate adjacent workflows within our largest clients, contemplating the best options for partnerships or acquisitions.

Regarding the strong growth in user base of 3,200, while the fourth quarter is typically strong, it appears better than usual. Were there any atypical factors that contributed, or is there a concern for a sequential drop-off in Q1?

Hi, Glenn, it's Scott. There was nothing particularly extraordinary; growth was widespread. The sell-side contributed slightly higher than the buy-side. Typically, this time of year sees good growth from new hire classes. Overall, we experienced great growth across the board thanks to our sales force and client service group's strong efforts.

Maurizio, the Portware acquisition is expected to transition from being $0.03 dilutive to accretive in 12 months. What might that imply for FactSet's operating margins in about a year? Is revenue growth the main driver here, or are there specific cost takeouts planned?

Hi, Shlomo, it's Maurizio. You have it correct; this will primarily be driven by revenue growth. We expect little in the way of cost cutting from this acquisition.

So it is significant revenue growth that’s lifting margins and supporting the company's valuation?

Correct; that's the main substance over the next 12 months.

Thanks everyone. See you again next quarter.