From a sustainability and profitability standpoint, Dun & Bradstreet is a very attractive business. The company's long history, established customer relationships, high retention rates (over 90% of risk management customers renew their subscriptions), and unmatched database of 150 million business records gives this company an appreciably wide moat. Although there is some competition in risk management, particularly Experian and Equifax (EFX), Dun & Bradstreet is the market leader. Two classic long-term competitive advantages apply here. One is the company's huge database, which would be nearly impossible for a competitor to build and maintain in any reasonable amount of time. Second is the "network effect". Companies want to be included in DNB's database because that is where creditors look for information, and creditors look for information at DNB because that is where the best client data comes from. These two factors together combine to create very high barriers for new competitors, and for the competitors that do exist, makes it difficult for them to gain market share. And, of course, in a market with few serious competitors, pricing usually remains rational, so the threat of a cost war is minimized.
The quality of the business also shows up in the financial statements. DNB is exceptionally profitable, with operating margins steady at about 27% over the past 5 years. Free cash flow generation has been similarly steady, averaging about 19% of revenues. The balance sheet at first blush does not look great - cash holdings are just $84 million with a debt burden of $891 million. But we have to look deeper to see if financial health is truly at risk. It isn't here. DNB has virtually no debt maturities in the next 12 months, operating income covers interest requirements 9.8 times over, and DNB's stable, mostly non-volatile business generates enough cash to easily cover commitments. The company has recently made paying down debt a priority, so I expect strengthening metrics going forward. Financial health is not a concern.
However, there are two main concerns with DNB that are holding the valuation down: anemic revenue growth and weakening margins. DNB's trailing 12 month revenues sit 2.5% below 2007 levels, and have declined each of the past 2 years. With the height of the recession now almost 2 years ago, we should be seeing some revenue growth here. Q1 might have been the first sign of light, with sales growing about 2%. Analysts are expecting about 4-5% sales growth for the year, on the back of new products the company is rolling out. However, DNB will never be a fast grower, as their core North American market is largely saturated.
This leaves margin expansion, capital return (share buybacks and dividends), and market valuation increases as the main avenues to provide shareholder value. Margins have recently been lower, but this should be a short-term phenomenon. DNB is in the middle of a "strategic technology investment", a ~$60 million program to upgrade its technology and software to provide faster, web-based access to its information products, while phasing out legacy systems. Long-term, this investment will hopefully drive revenue increases through improved product offerings. But short-term, it is costing DNB about $10 million a quarter and crimping margins, which in Q1 were just 22.5%. The strategic technology investment is expected to be completed in the first half of 2012, after which margins should rebound to historical 27-28% levels, and possibly higher.
Combined with this, DNB also is aggressive in returning capital to shareholders. Share buybacks have been particularly robust, with an average annual decline of 5% in outstanding shares over the past 5 years. The dividend is decent at a 1.9% yield, and well supported with just a 28% payout ratio. However, DNB's dividend hikes have been anemic over the past 2 years (about a 3% raise each year). I'd like to see more out of such a slow grower.
This is a really conservative MFI pick. Accounting for the expected rebound in margins for 2012, and very modest growth going forward, DNB stock looks reasonably worth $87, about a 16% margin of safety from current prices. Given the company's stability, it makes a decent choice and I have a positive opinion. However, I like to invest at a minimum of 25% upside, so this does not make the cut for a formal recommendation at this time.
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Steve does not own DNB.
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