I am recommending a long position in Dun & Bradstreet. DNB is a good business with a strong "moat" around its franchise, healthy balance sheet and strong cash flow generation. For those of us who remain negative on financial stocks generally, it also a good balance to financial shorts as a counter-cyclical play on the increasing importance of understanding counter party risk in typical business transactions.
DNB provides business-to-business credit reports (60% of revenue), customer prospecting tools (30% of revenues) and online business information (10% of revenue.) It generates 25% of its revenues internationally. In a nutshell, DNB helps businesses understand how credit-worthy their customers, suppliers or other counter-parties are prior to doing business with them. In my conversations with private business owners, many have stressed the increased importance of understanding the financial stability of the firms with which they trade given the current credit environment. DNB has a near monopoly on risk management products that are vital for most businesses, and currently has a ~90% share of U.S. business-to-business credit reports. DNB's database of more than 140MM companies around the world serves as a massive barrier to entry to new competition; it is also highly leveragable and generates very high incremental margins and returns.
Management has made many smart moves over the last several years. Most notably, they have made a concerted effort to move their customers to subscription-based products. The obvious advantage to this model is that is provides more predictable revenues and creates an even "stickier" customer. In 2005, only 25% of its risk-management products were sold on a subscription basis vs. over 70% currently. The company is a strong cash generator, with free cash flow typically exceeding net income. Furthermore, management has been diligent in returning this cash to shareholders, primarily through shares buybacks. The share count has been reduced from 76MM in 2003 to 55MM at year end 2008, an impressive 27% reduction.
From a valuation perspective, I believe DNB will generate ~$6 in FCF in 2008 and a similar level in 2009, putting it at a nearly 8% FCF yield. The balance sheet is quite clean at only 1.2x net debt to ebitda and no near-term maturities. A move to a 5% FCF yield would lead to 57% upside in the stock. On the downside, I think a worst case scenario for 2009 earnings would be $5/share with ~$5.50 in FCF/share. At $55/share (27% downside), the stock would trade for 11x EPS and a 10% FCF yield.
The primary risk to DNB is that the US/global recession is so severe in 2009 that the curtailment in commerce trumps the increased need to understand the credit worthiness of counter parties in commercial transactions. The 30% of revenues exposed to business prospecting is most exposed to recessionary forces, and I am assuming a 10% decrease in this business in my baseline numbers (with a 2% increase in risk management products.) Given the database/subscription model, operating leverage is obviously quite high, a larger than expected drop off in the top line would have an out sized negative impact on profits.
- Market realization that risk management tools are counter cyclical - Further execution of share buybacks or dividend increase - Multiple expansion/FCF yield contraction as market recognizes valuation too low for high quality, large moat franchise