Downside Risk For FactSet Investors

By Ryan C. Fuhrmann | March 17, 2011 AAA

Investment research platform provider FactSet (NYSE:FDS) continued to see strong sales growth and impressive profitability during its second quarter. Unfortunately, the stock already reflects much of the current and future growth momentum in the underlying operations.

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Second-Quarter Recap
Revenues jumped 13% and reached $177.6 million as U.S. revenue grew 14% to account for just over 68% of the total top line. International revenue improved 11% to account for the rest. There are 44,800 investment professionals that now use FactSet, and this number grew by 1,200 users during the quarter. Retention rates also remain strong at over 90%, and they provide impressively stable during the credit crisis. (For related reading about the credit crisis, see Credit Crisis: Introduction.)

The company's measure of revenue for the coming 12 months grew 11% and reached $723 million. It stated that buy-side clients, which include firms that focus on money management such as Legg Mason (NYSE:LM) and Federated Investors (NYSE:FII), accounted for 82% of this backlog. The sell side, which performs M&A advisory and equity research, and other key investment banking functions, includes firms such as Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), and made up the rest of the backlog broken down by client group. (Learn more about M&A, see The Basics Of Mergers And Acquisitions.)

Higher expenses tempered the increase in operating income to 6.7%, but the operating margin remained very high at 32.7% of sales. However, a large drop in income tax expense sent net income ahead by 25.3% to $45.3 million, or 95 cents per diluted share. This came in ahead of analyst projections. Operating cash flow increased 3.4% to $72.5 million as free cash flow reached $42.9 million. (To learn more about free cash flow, see Free Cash Flow: Free, But Not Always Easy)

Outlook
FactSet said to expect third quarter sales in a range of $181 million and $184 million and earnings between 90 cents and 92 cents per share. The company didn't provide full-year guidance, but analysts currently project sales growth of more than 12% and total sales of just over $718 billion. The consensus earnings estimate is $3.57 per share.

Bottom Line
At a forward P/E of 27.5, most of FactSet's future growth is already a foregone conclusion and already priced into the stock. For investors to get sufficient returns on the stock, it must post a decade of more of double-digit sales and cash flow growth. This is possible, but definitely not certain and means there is quite a bit of downside risk for prospective investors.

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