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It's All Adding Up for FactSet

From Standard & Poor's Equity Research

Standard & Poor's favorable opinion of FactSet Research Systems (FDS

; recent price, $44) reflects our belief that, at current levels, the shares do not fully reflect the company's positive business momentum. We see solid fundamentals for its target market, the global financial investment community, and we expect that international markets will offer strong revenue-growth opportunities. We continue to think the company has an important, entrenched position in a niche market with significant barriers to entry.

We view the company's financial condition as sound, and its revenue and profit growth as solid, as reflected in its A- (above average) S&P Earnings & Dividend Rank. We believe that with renewed economic growth, anticipated strong cash flow, and no meaningful long-term debt, FactSet Research has the financial flexibility to invest in future growth initiatives and gain market share. We have a 5 STARS (strong buy) recommendation on the shares.

Founded in 1978 and publicly traded since 1996, Norwalk (Conn.)-based FactSet is a leading provider of economic and financial data to the global investment community. FactSet aggregates data from more than 200 databases from multiple providers and makes it available to its clients over a private wide-area network. Clients can access this data through a desktop using FactSet's proprietary interfaces and download this data into internally generated reports.

Third-party content is an important part of the data provided by FactSet. The company currently aggregates content from 50 providers including: BARRA, Dow Jones, First Call, I/B/E/S, Lipper, Reuters, Standard & Poor's, and StarMine. A number of these third-party data providers are customers of FactSet; however, several of them also offer or are currently developing competing services to that offered by FactSet.

ATTENTIVE TO CUSTOMERS. Since contractual relationships with third-party vendors can be terminated with just one year's notice, the company tries to maintain relationships with at least two vendors for each type of data, whenever possible. Another strategy used by the company in order to maintain or increase its available content is the acquisition of content providers. Since 2001, FactSet has made eight acquisitions, five of which have been content providers.

FactSet also provides comprehensive technical support and on-site training for the use of its products and services. Its client-support call centers are generally available 24/7/365, and it encourages customers to view its services team as an extension of their IT staffs. We think this focus on customer service and support has helped FactSet perpetuate the "stickiness" (i.e., high switching costs or reluctance by customers to change vendors) of its applications and maintain its high client-retention rates.

Revenues are derived from monthly subscriptions for the company's products and services, including workstations, database access, and financial applications. Customers can pay FactSet through the use of soft dollars (designated commissions from client brokerage) or cash. To facilitate the payment for services in commissions, a subsidiary, FactSet Data Systems, is a registered broker-dealer and a member of the National Association of Securities Dealers (NASD).

WEATHERING THE STORMS. As of the fiscal second quarter (ended in February), FactSet reported 1,666 clients (up 16% from a year ago), 27,700 users (up 19%), and a subscription-bookings balance of $380.3 million (up nearly 24%). Subscription bookings represent forward-looking revenue for the next 12 months, and the mix of FactSet's business has been fairly stable at 25% sell-side, versus 75% buy-side.

We view FactSet's growing subscriptions balance favorably, as we think it adds visibility to future company results. We note that FactSet has managed to grow its subscription balances even through a difficult period for the financial markets; to us, this is indicative of the company's strong market position.

Despite the emergence of several competing market-data products and services, we believe FactSet remains a vendor with one of the broadest set of functionalities. An indicator of the company's competitive position, in our opinion, is that it has been able to introduce higher premium-based pricing across its client base (although not adopted by all customers), and despite ongoing competition from larger vendors, client and password counts continue to show gains.

HEALTHY FUNDAMENTALS. FactSet enjoys a distinct advantage, in our view: considerable barriers to entry to its market. We believe it would be difficult for another vendor to replicate the extensive database agreements FactSet currently has in place. In addition, we believe FactSet's applications, supported by its comprehensive customer support and service offerings, are entrenched in the workflow of many financial professionals, given the downloading functions and portfolio analysis/screening capabilities that they offer. As a result, we believe the company's products have become central to investment analysis and decision-making for clients.

The company boasts an installed client base with retention levels above 95%. We believe high barriers to exit exist with respect to FactSet subscriptions. While customers may add, reduce, or cancel services at any time, we think switching costs are fairly high.

We also have a positive outlook for FactSet shares because we see solid underlying fundamentals for the investment-banking and brokerage and asset-management end markets. Standard & Poor's current outlook for investment banking and brokerage end markets is positive. S&P believes stock-market gains in recent years have contributed to generally improving investor confidence, resulting in higher capital-markets activity, commission revenues, and asset-management fees. We expect a rebound in equity-oriented corporate finance activity.

STRONG VALUE. We forecast a 21% rise in net subscription revenues for the fiscal year ending in August, 2006. Our outlook for a 19% rise in subscription bookings drives our revenue forecast. We see the client count rising by nearly 12% in fiscal 2006 and forecast the number of users to grow by about 11%. We expect gross and operating margins to narrow in fiscal 2006, impacted primarily by the expensing of stock-based compensation and to some extent by recent acquisitions. Our earnings-per-share estimate is $1.52. We project fiscal 2007 EPS of $1.74, on 11% subscription growth and modestly wider gross and operating margins.

FactSet adopted accounting standard SFAS 123R on Sept. 1, 2005, and expenses the value of employee stock options and similar awards. The company does not currently have a pension plan or other postretirement benefit plan. As a result, we expect that S&P Core Earnings estimates, which adjust for these differences, will equal reported financial results under generally accepted accounting principles.

Our 12-month target price of $55 is derived from our valuation of discounted cash flows. We expect FactSet to continue to grow revenues at a low double-digit rate through fiscal year 2010, and we look for growth in the high single digits thereafter. We expect capital expenditures to rise modestly through fiscal 2010, but to remain fairly stable as a percentage of revenues. We also forecast modest annual increases in net margin over our 20-year horizon period. We see free cash flows rising by about 13% on average from fiscal 2006 to fiscal 2010 and at a high single-digit rate thereafter. At recent prices, we view the shares' valuation as compelling.

MARKET RISKS. We have a favorable view of certain of FactSet's corporate-governance practices, including that a majority of the company's board of directors is comprised of independent outsiders, and that the nominating and compensation committees are both made up of independent outside directors. We view less favorably that the board size can change without shareholder approval and that shareholders do not have cumulative voting rights.

Risks to our investment recommendation and target price include the impact of any potential downturn or weakness in the financial markets on clients' willingness to hire and, as a result, invest in additional seats (users or passwords) or add-on products. We believe that rising interest rates and commodity prices could add to market volatility and uncertainty.

INSIDER SALES. In addition, we believe investors in FactSet stock are keenly focused on growth in subscription bookings and the number of users or passwords as indicators of future revenue growth; in our view, any declines in the company's subscription-bookings balance or slowdown in user growth could negatively impact the shares. While the company has had success in growing its subscription-bookings balance during periods of slow growth for capital markets, FactSet posted negative year-to-year comparisons for user growth from the May, 2001 quarter to the May, 2003 quarter.

FactSet is thinly traded, with an average daily trading volume of slightly less than 240,000 shares over the past three months. In recent months, there have been notable insider stock sales, including 3.6 million shares by the estate of Howard Wille, a founder of the company. In view of the limited trading volumes, such sales could adversely impact the share price. The stock has a limited float of about 37.6 million shares, of which insiders held about 14% as of Oct. 24, 2005.

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