Updates #11

Equifax investor day, threats, opportunities, business composition, subscriptions revenues

Held.

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Equifax held its Investor Day last Tuesday, the 17th of June. It has been a regular fixture of the Updates as of late as it appears to be exiting a rather prolonged corporate transition. As readers will know, Equifax is becoming less of a credit bureau by the day, and more of a proprietary data business in what the company would call verification.

I think the Investor Day represented a pretty definitive statement by management on the direction of the business going forward - which I have been speculating on for the better part of 18 months. I think what has been communicated is essentially a “middle-way” between the more aggressive desires of someone like myself (and many others to boot), who would simply prefer the international business and the traditional credit bureau business to be separated from workforce solutions and for management to execute a levered recapitalisation, and what has been the “traditional” conduct of the company.

First, a quick note on guidance and financial targets. Management largely reiterated their long term guidance on the basis that mortgage (novel and refinancing) volumes will remain where they are - and that is to say at about one half of where trend volumes were pre-Covid, and at about 1/3rd of where they were in 2021. EFX expects an additional ~$1-1.3B in largely incremental revenues (transactional in nature) from a mortgage recovery to pre-Covid trend levels. The dark horse in that number is of course what happens to FICO score pricing in the intervening years to 2030, and what happens with the entire bi-merge transition debacle. Even if the bureaus are able to recoup lost credit reporting revenues via their holdings in VantageScore, those profits aren’t likely to be reported through the income statement.

An important chart as this informs our opinions on FICO, the bureaus, and the GSE’s.

Even more importantly, the windfall proceeds from mortgage normalisation will be returned to shareholders. The capital return regime that management has now effectively locked themselves into is: the current dividend will grow with the delta change in EPS and the $3B share repurchase program will be extinguished opportunistically. It’s certainly better than spending excess capital on a cloud transition to nowhere. To the extent that you believe North American mortgage volumes will eventually normalise - although in a post-Covid world who can say what “normal” actually is - the room for not uninteresting financial performance is apparent.

On a less optimistic note, management’s guidance with respect to the longer term margin profile, including what they expect during a mortgage recovery, was less encouraging. Peak EBITDA margins in such a scenario are expected to be 39% in 203. The focus on EBITDA (or let’s say heavily adjust numbers) has been disappointing in the past decade or so - the consequence of EFX’s transition to the cloud and long history of M&A has been that management’s adjusted numbers have diverged greatly from what proceeds are actually available to shareholders. To steel-man management - we can probably expect for some reversion to the mean here over time, and indeed that would be one of the reasons for owning the stock. Management are eyeing 95% FCF conversion.

Additionally, management expects $500M-$700M in annual M&A activity. That is only somewhat less than what they plan on returning to shareholders. The acquisitive impulse was an imperative during the heyday of the credit report, but it remains less clear to me why this is the case where verification (and its associated services) are concerned.

Not well known by me (ex ante anyways), is that the credit bureaus are amongst the great American consolidation and automation stories. Credit reporting finds its origins in North America in the credit reference books maintained by 19th century merchants. These books kept a tally of customer and counter-party transactions over protracted periods of time, and most commerce depended on credit and forwarding merchandise on delayed payment terms. By the early 20th century, the age of the department store catalysed in-house credit departments. Store credit and lending was something of a licence to steal before the advent of more sophisticated consumer credit products. In time a cottage industry developed to outsource this function; a process that was sped up by the decline of merchants and retailers owning the customer relationship.

The Mercantile Agency, its rival Bradstreet & Co., and later Retail Credit Company (Equifax’s progenitor founded in 1899) were amongst the first true credit reporting agencies. They operated on a distributed model of small retail outlets in the localities, which returned and requested data from a central office. At its peak over 40,000 individual store credit departments operated, and in the 1930s as many as 1000 separate credit bureaus existed. Today that number is 3.

Along the way the introduction of computerised records in 1965 and the passage of the Fair Credit Reporting Act of 1970 sent consolidation into overdrive. The Act demanded standardisation and computerised records gave incremental efficiency gains to the early adopters. The aggregation of credit files and information made sense as the returns to incremental files increased dramatically. Eventually the consolidated status of the big three was recognised by the likes of Fannie and Freddie. The government, as well as technology, created scarcity where there was none before. In any event, credit reporting consolidation has been afait accompli for more than four decades.

EFX’s 2007 acquisition TALX of course chartered a very different course for the company. TALX, which housed The Work Number and which is now EWS, had essentially fallen backwards into a spectacular feedback loop: the advent of outsourced back-office processing in the 1980’s allowed them to accidentally aggregate payroll information before anyone knew how valuable it could be. They had essentially turned an internal cost-centre for a large corporate into a 100% incremental margin revenue stream. The payroll processors would find the same offer equally as tantalising.

But in in truth EWS has grown not by acquisition, but by consolidating record holders on a business development level. This started with the Fortune 500 who had the scale to in-house HR and payroll functions, and then rolled out sequentially to ADP and the other out-sourced payroll processors. One could only really acquire market share (so to speak) by offering the biggest carrot. The core of EWS’s value proposition to its customers, record suppliers, and indeed the source of its business franchise is: record leadership results in TWN being called for the marginal, non commoditised, record and record exclusivity results in pricing power through which the record holders participate as a percentage of that transaction.

What is lost in the ongoing discussions over EWS’s market position is that at the limit it is in the record holder’s interest to enter into an exclusive arrangement with the most scaled player. In a world where record holders commoditise their own records by promiscuously supplying them to EWS’s competitors, they effectively dilute the profitability of their records. In any given year there are only so many verification requests, and just because you supply your records to three vendors instead of one doesn’t mean you’ll get three times as many record hits for your. On the contrary, verifiers will simply ping the most cost-effective vendor for your record in their waterfall. Record suppliers are ultimately paid as a percentage of the royalty-like income earned by EWS or their competitors.

The “and then what” question is: why doesn’t someone like ADP just provide verification services themselves? The answer to that is likely two-fold. First, they would trade a present 100% gross margin, nearly passive income stream for an internal business unit that they would need to build out. Second, they would no longer get to participate in the pricing power of the currently scaled verification providers. EWS ultimately has pricing power for a simple reason: they have a large pool of exclusively held records which the record holders go to great lengths to keep exclusive. You can imagine trying to verify the income of a potential borrower for example. Truwork offers a lower cost per record return so you place them at the top of your waterfall (the waterfall is the term for what order you ping various databases for income verification). However, when you ping Truwork you don’t get the record you were looking for. So then you go down the list. You eventually get to TWN and have to ping it because it’s the last game in town. You succeed, and get the record, and pay TWN. Funnily enough you find that when you place TWN at the top of your waterfall your per-record cost goes down. However, when you consistently hit TWN last you find that costs rise, about to the equilibrium level of where it would have been otherwise. Curious.

The more likely competitive threat is - as always - to come from obviation rather than substitution (so long as the record advantage can be maintained).