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We’re from the government and we’re here to help you…generate alpha.

For the last two months, we’ve written about “Desired Monopolies,” companies that fulfill consumers’ desire that there be a monopoly to provide a particular on-line service. One job search site (LinkedIn (NYSE:LNKD)). One industrial materiel broker (Ariba (NASDAQ:ARBA)). One restaurant reservation service (OpenTable (NASDAQ:OPEN)). And so on.

With this report, we’re shifting emphasis slightly. NIC, Inc. (NASDAQ:EGOV) is not a desired monopoly. But it does provide on-line services. And it has dominant market share. So dominant, in fact, that there is essentially no #2 player.

NIC is the leading merchant provider of on-line service solutions to state governments. Have you used the web to renew a Tennessee driver’s license? NIC built and operates www.tennessee.gov. Been issued a fishing license in Arizona? NIC did Arizona’s web site too. And so on. And beginning about a year ago, NIC began a relationship with the Federal government, handling an interstate truck driver certification program (the National Motor Carrier Pre-Employment Screening Program).

NIC is riding two major secular waves. First, the ongoing move toward on-line self-service. From on-line shopping, to making travel reservations, to huge, broad, multi-million dollar markets like education, to smaller niche segments like public relations, – individuals and companies engage with service providers via the Web (and frequently via mobile phones).

The second wave is the more obvious one: state governments are, in general, in dire financial straits. This means anyone proposing an essentially no-cost, transaction-funded version of a service that government is already providing at taxpayer expense, is immensely appealing.

NIC has exploited these two trends to become the web portal operator for 26 of the 50 U.S. states. Additionally, NIC has signed contracts with the states of Maryland and Oregon for those states’ portals. Most of the rest of the states have built and run their own web sites, often with help of merchant contractors. But we don’t think these hold-outs will hold out much longer. Who can resist spending less and getting more?

Data Sheet:

Name: NIC Inc.

Ticker: EGOV-NASDAQ

Price per share (12/19/11): $12.53

Market Cap: $791.9 million

Trailing 12-months Revenue: $176.7 million

Forward Price:Earnings Ratio (estimated): 28x

HQ: Olathe, KS

Founded: 1998 (predecessor companies date to 1991)

Description:

NIC is the dominant merchant provider of “eGovernment” services to U.S. states. As of today, NIC has contracts with and is recognizing revenue from 26 states, for which the company runs the official state portal. It also has signed contracts with two other states, Oregon and Maryland, from which the company expects to recognize revenue in the second half of 2012.

NIC’s core business is known as “portal outsourcing,” which accounts for 96% of its revenue and an equivalent percentage of profit. The remaining 4% of revenue is from related software and services division. In portal outsourcing, NIC enters into contracts primarily with state governments to design, build and operate complete Web-based portals on their behalf. The contracts are typically 3-5 years in length. Upon winning business, NIC creates separate subsidiaries, each with its own P&L statement and a high level of autonomy

NIC’s portals consist of websites and applications that it builds from scratch, but which often include applications the company has previously developed. This re-use (which we discuss later), is a key part of the company’s value proposition.

Examples of e-Government services provided through NIC’s portal partners:

  • Access to driver records;
  • Renewing a drivers license;
  • Renewing a vehicle registration;
  • Pay a speeding/parking ticket;
  • Reserve space/services at a state park;
  • Applying for a permit (hunting, fishing, etc.)
  • Providing/renewing documentation related to election laws;
  • Filing and paying taxes;
  • File a court document;
  • Doing criminal history searches;
  • Searching for registered sex offenders;
  • Registering/incorporating a new business.

NIC markets portal services to states with the value proposition that users can enter into and complete transactions on-line, rather than in a face-to-face encounter with a state employee in a state-owned facility. These on-line transactions arise when citizens enter into subscriber contracts that permit them to access the portal and the government information contained therein in exchange for transactional and/or subscription user fees. Making the proposition even more appealing to states is that NIC typically offers to fund up-front investment and ongoing operations and maintenance costs of the portal. NIC also enters into separate agreements with governmental agencies to provide services and handle transactions.

This self-funding business model allows NIC to obtain revenues by sharing in the fees generated from “eGovernment” services. As opposed to being paid directly by the state out of general or departmental tax receipts.

Doing business with state governments is a double-edged sword. Negotiations are slow and deliberate, often taking four to five years from first inquiry to a signed contract. Even then, it may be 9-12 months before NIC can recognize any revenue. The government and its internal agencies must approve prices and any price changes; sometimes price changes make a profitable service unprofitable, at least for the balance of the contract.

After completion of a defined contract term, the government agency is bound to receive a perpetual, royalty-free license to the applications for use in its portal only. An exception to this is service provided to the state on a Software-as-a-Service basis, which would then become available to the state on a Fee-for-Service basis. But so far, these post-contract requirements are strictly hypothetical, because in NIC’s 20-year history, the company has never lost a contract renewal opportunity or re-bid process.

And retaining ownership of all the software applications has real, tangible benefits. On its most recent earnings release conference call in November, CEO Harry Herington gave an example of code reuse:

During past calls, you've heard me talk about reuse, taking foundational code and design elements from a service in one of our portals and using it in another. In the third quarter, West Virginia took our reuse approach and launched Child Support Direct, a new service for the West Virginia Bureau of Child Support Enforcement that allows businesses to file and pay employee child support obligations online. Because of reuse from this service already in place in Virginia, we were able to launch the application in half the time it would have taken to build it from scratch. And after a three month pilot period, the service has already processed thousands of transactions.

Market Opportunity/Addressable Market:

NIC’s market opportunity can be divided between a) the remaining U. S. states that are not yet NIC clients; and b) everything else.

Other U.S. states: Although NIC has signed contracts with 28 states, the remaining 22 states represent 59.64% of the U.S. population. This is because nine of the top 10 most populous states are not (yet) NIC clients – Texas being the exception. Together, those nine states represent 45.3% of the U. S. population.

Investors should consider that NIC’s business is mostly related to the number of portal transactions (e.g., fishing licenses issued, tax bills paid, businesses incorporated), and this is only partly related to a state’s population. In fact, some states like Delaware with its many thousands of incorporated business headquartered elsewhere could contribute a disproportionately large share of revenue and profit compared with its population.

Everything Else: Beyond adding more states, there are a variety of dimensions by which NIC can grow revenue and profit:

  • More Federal U.S. departments;
  • More applications cross-sold across existing states;
  • New applications.

It’s worth monitoring NIC’s Federal opportunities, considering that a single contract represents, on average, the same financial impact as winning a state portal. In 2009, NIC Technologies entered into a contract with the U.S. Department of Transportation, Federal Motor Carrier Safety Administration to develop and manage the National Motor Carrier Pre-Employment Screening Program. Like other NIC contracts, this uses a self-funded, transaction-based business model. This operation went “live” in the second quarter of 2010. The initial contract runs for five years, renewable year-by-year.

By all accounts, this effort is meeting the expectations of all parties. The primary negative is that bureaucratic slowness is even worse at the Federal level than at the state level, making predictions about success in this area impossible to forecast. But NIC is making a major commitment to winning Federal business.

Recent Financial Performance:

After the market close on November 3, 2011, NIC reported its third quarter, which ended September 30. The company reported non-GAAP earnings per share of $0.11, two cents better than the $0.09 consensus estimate. Reported revenue in the quarter was $46.7m (up 12% year-over-year), just slightly below the $47.0 million consensus estimate. Reported EPS was positively affected by about $0.01/share because Sales & Marketing expenses were unexpectedly low. This occurred because of a $900,000 Directors’ & Officers’ insurance payout related to the continuing SEC action against NIC’s chief financial officer.

NIC management has previously stated that its, “long-term goal is to grow same state revenues 10-15% per year, absent online DMV price increases.” Just for perspective, same-state portal revenues grew 8% in 2010, 12% in 2009 and 11% in 2008.

In FY11 Q3, same-state non-DMV business was up 16% year-over-year, while same-state DMV revenue was up 1%. So it seems that NIC is getting its growth from the right places. Additionally, Q3 was the first full quarter of revenue from the State of Mississippi portal. And NIC signed new deals with Maryland and Oregon. Revenue from the Federal Pre-Employment Screening Program doubled to $1.6m from the year-earlier quarter, but was up only 5% from the second quarter. We believe this reflects an expansion of the program from the largest interstate carriers (with thousands of drivers) to mid-size and smaller firms, who are more numerous, but ultimately represent fewer drivers per shop.

Takeaways from NIC’s third quarter financial performance:

  • Operating profit margins in the 23-24% range are up year-over-year and reveal neither pricing pressures nor competitive threats;
  • Non-DMV business is now driving growth for the company;
  • Strength in the relatively new Federal driver screening program is impressive (revenue up 100% year-over-year) but we expect it to decelerate to company-wide growth rates of 10-15% annually.
  • Cash flow remains very strong, allowing the company to easily support another annual dividend, which was authorized earlier this month. The payout of $0.25/share, equals a yield of about 2%, a level in-line with the four prior annual dividends.

Concerns/Risks/Issues:


Lingering legal issues and expenses:

For several years, NIC and several of its senior officers have been subject to an investigation and official complaint by the Securities and Exchange Commission. This origin of this investigation revolves around the re-imbursement of expenses to the former Chairman and CEO of NIC, Jeffery Frasar (who is no longer involved with the company).

After a multi-year investigation and millions in legal fees, NIC (the company) and its current Chairman and CEO, Harry Herington, reached a settlement with the SEC. However, NIC’s current Chief Financial Officer, Stephen Kovzan, remains party to the original complaint and has not settled with the SEC.

The bottom line for NIC is straightforward. The investigation is a distraction for the company’s CFO. Possible outcomes include having the CFO step down from his role. But financially, NIC seems to have turned a corner, because most of the cash outlay for legal work is now more-than-covered by Directors’ & Officers’ liability insurance. Specifically, in the nine months ending on September 30, 2011, NIC recognized $2.5m in legal fees, which was more than offset by $3.3m in D&O insurance payments. Investors obviously hope the remaining legal issues can be resolved quickly. Financially, the worst seems behind the company.

The relatively short contract lengths:

Most of NIC’s contracts are in the three-to-five year length. Some, like the Federal driver screening program are only one year long, with annual renewals at pre-agreed terms. For NIC, which has never lost a contract renewal, this may not seem like much of a risk at all. But nothing lasts forever, and these short contract lengths limit the company’s ability to replace lost business with new work.

Upfront expenses:

NIC is typically responsible for funding up-front investment and ongoing operations and maintenance costs of the government portals. The upfront expenses are not insubstantial, and can precede revenues by many months. For example, NIC signed its agreement with Mississippi in the first quarter of 2011, and didn’t recognize material revenue from that project until the third quarter. Its contract with Delaware was signed in the third quarter, and will create expense, but no revenue until early 2012.

Given NIC’s track record of bringing portals on-line, we’re not foreseeing a problem. But this mismatch in timing has an unintended consequence, which we discuss in our next “Concern/Risk/Issue:

Cash Flow Growth below Revenue Growth:

Over the last seven years, NIC’s free cash flow has grown at a CAGR of just over 4%. Whereas the company’s revenue has grown at a 20% CAGR over the same period. Since profit margins and capital expenditures have remained largely steady over that period, it seems that the company may not be getting the most of its deployment of working capital. We need to watch this trend carefully going forward.

Competitive Landscape:

NIC’s competitive landscape is pretty straightforward. There is no other dedicated merchant competitor that comes close to NIC’s dominance of the state portal business. Thus, the two types of competitors are:

  • Existing state-government-led portals;
  • Merchant vendors such as CGI Group, Unisys and IBM.

In the first camp, the trend is to sign up NIC if you either can’t, or no longer want to build and manage your own portal. And the other merchant vendors in the second camp only do consulting work or manage portions of state portals, but not the whole thing. One certainly can’t be smug about the competitive landscape, but the fact is there’s NIC and then there’s everyone else, none of whom hold even a clear #2 market position.

Financial Analysis (DCF and Comparative):

As part of our analysis of NIC Inc., we built a Discounted Cash Flow (DCF) model for the company. We used the following parameters and values to arrive at our DCF value:

  • Term: 5 years;
  • Initial Cash Flow: $17.629 million (this represents the estimated annual free cash flow for the current fiscal year, 2011);
  • Short Term Cash Flow Growth Rate: 6% (slightly higher than the last seven year CAGR – see our comment in “Risks/Issues”);
  • Long Term Cash Flow Growth Rate: 5% (conservatively below NIC’s long-term revenue growth rate);
  • Discount Rate: 6.46% (derived using CAPM: Risk Free Rate = 2.85% from the 30–year Treasury Bond; 4.4% equity risk premium from Ibbotson; and an actual Beta of 0.82)
  • Current Share Count: 64.200 million.

Using these inputs, our calculated DCF value per NIC share is $20.71, about 60% higher than NIC’s current share price of around $12. While DCF valuation models have their flaws, they are most suitable for mature companies that produce steady cash flow and have a history of returning value to shareholders via buyback or dividends. Conveniently, NIC is a virtually perfect example of such a company.

While some may argue that a discount rate of 6.46% seems low, it isn’t when you place it in the context of a world with 0.25% T-bills and 2.85% 30-year Treasury bonds.

Now let’s look at NIC compared with its primary governmental portal competitor, CGI Group, as well as five other software-as-a-service peers.

NIC Inc.

CGI Gr.

LinkedIn

OpenTable

Ancestry.com

Zillow

Ariba

Ticker

EGOV

GIB

LNKD

OPEN

ACOM

Z

ARBA

Price (12/19/11)

$12.53

$18.28

$65.84

$40.15

$22.62

$23.02

$31.40

Market Cap

$804.1 m

$4.77 b

$6.42 b

$953.6 m

$996.8 m

$634.4 m

$2.94 b

LTM Revs

$176.7m

$4.16 b

$436.1 m

$133.1m

$378.2m

$55.7m

$443.9 m

Op CF Margins

15.1%

13.2%

28.8%

36.7%

29.8%

28.0%

17.1%

MRQ Rev Growth

11.9%

2.4%

125.7%

40.1%

30.0%

131.6%

44.6%

Forward P:E

28.5

9.62

129.1

27.1

14.9

74.3

27.5

EV: Revs

4.17

1.36

13.84

6.56

2.51

9.66

6.12

Float: Shares Out

0.910

0.775

0.445

0.683

0.681

0.238

0.987

Source:

Yahoo Finance

LTM=Last 12 months, CF=Cash Flow, MRQ=Most Recent Quarter

We had two takeaways from this data:

  • NIC’s primary governmental portal competitor, CGI Group, is more of a traditional IT consultancy, with governmental portal/outsourcing working being just one of the many services it can deliver. NIC is exclusively focused on governmental portals, and its higher valuation reflects its higher growth and well-defined market opportunity.
  • Ancestry.com looks like a bargain compared with its peers in general and NIC in particular. But consider that Ancestry.com’s growth is slowing rapidly, and it’s not clear that its business model is ready for what comes next. Whereas NIC’s long-term business model is established and ready for taking on more and larger state clients.

Conclusion (Buy, Sell or Neutral?):

NIC has a superior business model. It offers state governments a hard-to-believe value proposition: Hire NIC and spend less. NIC would seem to be well positioned, with most state governments strapped for cash for the foreseeable future. Moreover, NIC’s own high-quality efforts, and ever-larger portfolio of applications have created a formidable moat against competitors. And the company’s modest profit margins aren’t attracting the wrong kind of attention for a government vendor.

The wheels of government turn slowly, which will prevent NIC from accelerating its own growth much. But even with half the U. S. states under contract, recent “same-store” growth rates in the mid-teens seem sustainable. And potential “new-store” business is substantial, as noted by the many large states (e.g. California, New York) yet to sign contracts with NIC.

Previously, when NIC has won a large state portal, the stock has often pulled back on the news, because the only immediate financial impact is negative, as NIC and the appropriate state subsidiary have to ramp up spending well in advance of revenue. This happened two years ago when NIC took the Texas portal business away from Bearingpoint in mid-contract, shortly thereafter winning a fresh bid for the business.

But there’s no need to wait for a pullback: NIC can begin generating alpha for investors right now. We believe you need to Buy/go Long shares of NIC Inc.



Disclosure: I am long ARBA, EGOV, IBM.

Additional disclosure: I am long ARBA, EGOV and IBM in the Separately Managed Account product for which I am the portfolio manager and in which I am an investor.

Source: NIC Inc.: A Dominant Player In Government e-Services