Why are fintech valuations so gosh darn high? And why is Jack Henry's valuation at the top of the pack?
Over the past several years, investors have had a passionate love affair with companies within the fintech space. There are many reasons for that, although overall industry growth is really not amongst them. There are fintech companies such as PayPal (NASDAQ:PYPL) that are growing prodigiously. Most of the others have modest organic growth.
Jack Henry (NASDAQ:JKHY) is at the top of that pack. It has a sterling record within its primary space of selling to relatively small banks. It has one of the strongest organic growth rates in the cohort of companies that sell software to banks (and in this case, credit unions). But that certainly doesn't make it cheap. The share price appreciation of the company over the recent past has been more than prodigious - fill in your own word for something greater than extraordinary. The shares are up more than 6X since their trough at the market bottom in 2009. They have appreciated another 11% so far this year.
That said, in a normal world, most investors are unwilling to pay a 24X forward P/E for a company with less than 7% organic growth. Investors can readily find companies with a far more attractive relationship of top-line growth to price than most fintech names. Jack Henry's current valuation metrics are more expensive than the other fintech vendors. The company has an EV/S, which is 5.2X. The company generates reasonable amounts of cash. Its cash flow margin has been around 34%, and the margin has increased noticeably for several years. CapEx is relatively low for this company at only 17% of operating cash flow, and that number itself is an outlier. In 2014, the ratio was less than 10%. That provides an historical free cash flow yield of 4.6% based on 2015 results - not fantastic, perhaps, but certainly not particularly out of bounds either.
JKHY's chart resembles the charts of many other fintech vendors. The company's shares tracked the performance of the broad market with a peak just before the tech bubble broke in 2000 and then another peak just before the financial crisis of the last decade emerged in late 2007. And then, starting at the trough of the market in 2009, the shares have mainly been upward into the blue empyrean. That is, the shares have more than trebled the last five years and are up more than 6X since the market bottom of March 2009. EPS, well that has grown too, but only by 80% since 2011, although the EPS CAGR over the past five years has been close to 15%. Percentage growth in earnings is slowing significantly according to the consensus, to less than 13% this just passed fiscal year (ended 6/30/16) and to just 8% forecast by the consensus estimates of seven analysts for fiscal 2017. And cash flow growth has been somewhat more modest at about 50% over the past five years through fiscal '16.
My guess is that the outsized gains in fintech have come from a combination of consolidation potential in the industry of which there is plenty, low interest rates that have mainly gone lower through the years coupled with the factors of dependability, predictability and visibility. But there are elements of style in the sharp run-up and matters as well of competition between money managers to copy working asset allocation strategies. For some years now, the institutional case for fintech in general is that it afforded investors a taste of the higher growth rates seen in many other areas of tech coupled with stability and visibility.
Jack Henry probably has the highest organic growth of the group. So, 7% may not sound like much, but as Erasmus once wrote, "in the land of the blind, the one eyed man is king." The fact that JKHY has the highest organic growth in the fintech world is reasonably well known. Hence the higher valuation in a group that has been on fire for some years. As long as Jack Henry continues to enjoy organic growth greater than its peers, that kind of valuation premium is going to persist and may even be warranted - relative to its peers if not the overall market.
But does that justify the current valuation? Probably not. SA contributor Michael Boyd believes that the solid operational metrics of the company should allow it to surpass standard valuation metrics. But even Mr. Boyd suggests that the recent share price appreciation might give investors some pause. I think the pause has to be longer until there is a greater connection between earnings growth, the P/E and cash generation.
Not that it greatly matters to me, except as a data point, but that appears to be what the consensus is forecasting. The median price target of the consensus is $82.50, which doesn't exactly promote a healthy return for shares currently priced at $87. And that's reflected as well in analyst ratings, which have one strong buy, six holds and one underperform. Those metrics haven't changed in months while the shares have appreciated a further 11% thus far this year.
So is there an investment case that can be made for this mid-size, lesser-known, low-profile vendor of financial software? The balance of the article is going to look at items that do not relate to traditional analysis that may reach a different conclusion regarding the shares. Perhaps I lack imagination, and I would like to buy these shares for myself, but I was unable to find the combination of ingredients that would lead me to pull the trigger.
Can Jack Henry grow more than 7% organically? Does it even want to try?
Let's face it, the business of selling software and services solutions to the banking industry primarily in this country is not among the most exciting fields of endeavor in the US in 2016, or for that matter in the foreseeable future. Simply put, the applications that Jack Henry and its competitors sell are mission critical and that means they were adopted long ago. The number of banks is gradually declining because of consolidation. That presents a difficult environment in which to achieve growth. Last year, the number of banks in total declined 5% and the shrinkage was concentrated among the smaller institutions where the decline touched nearly 10%. What is of equal interest is that Jack Henry has grown its penetration of banks just up the food chain significantly over the last few years, and these wins are with institutions of a size that can afford to buy additional products.
So 7% is really not such a terrible number in this space. In point of fact, JKHY has enjoyed the highest revenue growth within its vertical. And the 7% projected this year includes a couple of significant boat anchors - they will reach anniversary results and cease to be a drag on reported numbers. Longer-term organic growth is probably more like 9% than 7%.
In the current quarter, the company felt the full impact on the merger between Susquehanna (NASDAQ:SUSQ) and BB&T (NYSE:BBT). BB&T had its own payment solution, and when it bought Susquehanna, the payments revenue from that client went away. In addition, the company lost a significant group of customers who decided they wanted to consolidate their system with their current POS vendor. Finally, there is an absence of what are called de-conversion fees that had arisen, as some users, whose banking solutions provider was consolidated, converted to JKHY and drove considerable revenues. Some analysts have opined that the loss of de-conversion fees might have cost the company 150 bps of growth in the March quarter. In aggregate, these headwinds ought to abate to a greater or lesser degree, which suggests that the organic growth rate projection could well rise.
There are a couple of steps that JKHY has taken to improve organic growth rates. It has migrated many of its current users and almost all of its new users to an outsource model. The outsource model is going to produce more revenue for Jack Henry because the company is essentially eliminating much of the customer's core IT function. The company has been introducing SilverLake Xperience, which is a core banking technology replacing some of the more antique systems that banks have used to operate their institutions. The company is introducing additional new products that are consistent with the technology capabilities of its customers. The company has had some success in signing up some new customers. In the last couple of months, the company signed up two new banks to multi-year agreements of some size, including a relatively major financial institution in upstate New York, and signed up 45 call center customers as well for its outsourced call center solution. As the company has about 11,000 customers overall, these kinds of success aren't going to have a huge impact on growth, but it is part of the foundation.
The company also is investing significantly in its Episys set of revolutionary products for its credit union customers. The company has an over 40% market share in the market space of $1 billion-plus credit unions and that market share has continued to grow in number and also with regard to ARPU. The overall number of credit unions is declining in terms of numbers, but at a slower pace than in the banking sector, and the number of mid-size credit unions has been at consistent levels. Overall, there were 969 deals signed in the credit union software vertical last year, and Jack Henry's Symitar/Episys product was the winning vendor in 35% of the total new engagements, beating the next closest vendor, which is called D+H/Ultradata by a factor of 2.7X. In addition, the company has been successful in its ability to unhook competitors with net takeaways of 49 institutions last year and of 41 YTD.
Last year, the company acquired a company called Banno so that it would be able to offer mobile/digital solutions. The solutions offered by Banno can be quite comprehensive and can include the customer's website. In the early part of the year, the company added 85 mobile clients. The company also started to offer hosted solutions to complement its outsourced offering and its on-premise products. Again, it is early days for the offering which has brought in contracts worth $4 million in ARR. For a company whose revenue expectation the current year is $1.4 billion, $4 million is trivial, but it is the first SaaS offering for the company, and given the success SaaS has had in other verticals, it might be reasonable to think of this as a growth driver going forward.
Jack Henry offers a set of solutions that it calls ProfitStars. The ProfitStars solutions tend to be somewhat more sophisticated and revenue driven than the other offerings from this company. Some of the products are sold to the JHA Banking and Symitar base, but more than 50% of sales are to clients with competitive banking platforms. The company continues to offer a minimal amount of hardware and an even smaller amount of licenses. Hardware is down to 4% of revenue and continues to shrink. License is essentially a rounding error.
Overall, the company projects 7% revenue growth as its business model. Of that 7%, outsourcing growth is 2%, growth in payments/mobile is 2%, add-on business is 1% and new products is 1%. Is the company trying to improve its organic growth performance - I think that is an objective, but not a primary objective? Is it likely to achieve organic growth beyond 7%? I doubt it. I think it would be unwise to think that the organic growth potential for Jack Henry is greater than 7%.
This is an older company and still capitalizes software. It is a hoary old practice that FASB should eliminate. I suppose that it is supposed to be similar to the oil depletion allowance in the energy vertical, but really at some point, a company should amortize as much software as it capitalizes.
The company is expending 6% of its revenues on R&D, consistent with prior years. Capitalized software would add 60% to the R&D spend on a net basis. In fact, this company spends about 10% of its revenues on R&D. For that spend level, the company ought to be seeing more and more significant new products than is currently the case. The increase in capitalized software added about 15% to reported operating income for the first nine months of fiscal 2016. If the company's R&D efforts were either better focused or if the new products that emanate from that effort met user requirements better, the it should achieve far more revenue growth coming from the new product bucket than is currently the case.
Historically, one of the major growth drivers for this company has been in M&A. The company has enjoyed quite a bit of success with some of the businesses it has acquired and is benefiting significantly at this point from the acquisition of Banno.
On the latest conference call, the CEO and the CFO both mentioned that while they were in the frame of mind to do an acquisition, they hadn't seen any that made sense. Either the valuation was excessive or the focus didn't fit the market that this company plays to or the companies that had been offered for sale were in the broken category. This company has acquired 15 vendors of various sizes and various levels of importance since 2005. As mentioned earlier, the Banno acquisition allowed this company into a highly strategic part of the market. The acquisition of ProfitStars was basically the foundation for the company's third leg of its stool. Jack Henry has acquired just two vendors since 2010 and that's a very significant issue in terms of reported growth. It is great to see that the company has remained disciplined, but at some point, exogenous factors are going to put pressure on the strategy. In the meantime, the company is ramping R&D spending, mostly seen on the capitalized software line, to accelerate the flow of new products which is part of the life blood of products in the fintech sector.
If the growth isn't really worth the valuation, are recurring revenues and the transition to outsourcing reasons for investors to consider the shares?
Investors, or at least some investors, are perfectly happy to pay what some believe to be sky-high multiples to buy shares in companies with recurring revenue models. Salesforce (NYSE:CRM), Workday (NYSE:WDAY) and ServiceNow (NYSE:NOW) are just a few examples. But those companies are enjoying growth in the 25-35% range, not 8-9%. For what it's worth, JKHY is just starting down the path of offering its users what are basically SaaS banking solutions and it has seen some early adoption.
I have tried above to consider in some detail all the potential growth drivers in this market. The biggest issue of all is that the market, particularly in the kind of banks and credit unions that Jack Henry sells to, is shrinking, mainly through acquisitions and mergers. The accretion that banks can obtain through buying each other is better and more certain than any other growth source. And so, the smaller banks and credit unions on which Jack Henry has focused and will almost certainly continue to focus have diminished and will continue to diminish in number. The company has made a move upstream toward selling to slightly larger banks and has had some success in doing so.
JKHY has done more than a little to ameliorate that issue. It has urgently moved to outsourcing and that is the source for 48% of its revenues. It has signed multi-year agreements with its clients, essentially doing away with license revenues in the process. It has tried to sell its customer base new products with some success. And where it is possible, it has been able to acquire some new customers. And that still is 9% organic growth.
The company has a very stable revenue base. Small banks really can't afford transition expenses and given the nature of what the company sells - well, the name says core and the solutions are at the core of the operations of the smallest banks. In some ways, what JKHY sells to banks is more important for them than keeping the lights on and operating the vault door. And again, because the solutions are core, the idea of switching those solutions at the most makes no sense to smaller financial institutions and could actually be a factor in terms of survival. Almost all of the company's revenues are ratable, and ratable revenues should be worth more than the revenues of companies that have to sell lots of perpetual licenses every quarter.
Compare the stability of this company's business to what SAP (NYSE:SAP) or Oracle (NYSE:ORCL) are going through. And the company is gaining rather than losing market share. It can, does and should sell for significantly higher multiples than companies like Oracle and SAP. Oracle has a P/E of just less than 15X, and SAP has a P/E of 18X. And they are cheaper as well on all other standard valuation metrics.
Jack Henry has developed a great franchise in its target market. But the number of entities in its target market is shrinking. The company has adopted a number of appropriate strategies to keep growth at reasonable levels. But that still leaves the shares expensive. The shares have had periods of contraction. They fell by 6% in the first week of February during the tech panic. There will be better times to buy these shares.
Competition at the moat
There are literally dozens of competitors that provide some or all of the same services in the banking field that Jack Henry offers. Many of them are best-of-breed point providers. Novantas, for example, is the leader in analytic advisory services for banks. But very few of Jack Henry's customers would be able to use the analytics that Novantas can produce. The most direct competitor of Jack Henry is ACI (NASDAQ:ACIW). In terms of revenue, ACI is about 25% smaller. ACI is going through lots of turmoil these days and can't really be thought of as a competitor. It has most recently sold its Community Financial Services assets to Fiserv (NASDAQ:FISV). Fiserv is everyone's competitor in the banking software space. Depending on who is doing the counting and the definitions used, FISV is perhaps the world's leading provider of banking software. It is in many ways an admirable company. If the specific space in which JKHY operates didn't have the defensive qualities that it does, Fiserv would be a significant competitive threat. The company is a behemoth, and has 700 solutions at the moment, and it actually competes in what is described in this industry as the denovo space (Denovo in this industry means banks that are newly started and which need a whole suite of new products).
Fiserv and Jack Henry have coexisted together for many, many years. Jack Henry is far more focused. Fiserv has far more solutions. Jack Henry has what appears to be an unassailable market share within the credit union space. JKHY has a large market share in the smaller banking institutions that are the preponderance of its customers. Fiserv covers the waterfront.
At this point, there really isn't anyone who is directly attempting to unhook JKHY's users. There is a lot of competition for whatever new customers are available. There is even more competition to sell installed customers add-on products to supplement core banking solutions. But those users that have outsourced their entire IT function to Jack Henry - and that is 48% of revenue and rising - there is very little competition, and those revenues are as assured as the health of the financial institutions that have contracted for the service. The preponderance of the balance of the revenues may be on-premise, but that really doesn't make them more accessible to competitors. Almost all of these revenues are coming from multi-year services agreements, most of which have been in place for many years. A forklift replace would be close to impossible and would be highly risky for a customer in the very regulated banking field. Despite the fragmented nature of the space, Jack Henry really has little to worry about from competitors trying to target its installed base.
Overall, the lack of competition in terms of revenue opportunities is a significant factor supporting the current valuation. Given just how much revenue is pre-committed at the start of a quarter, visibility is excellent as well.
- JKHY is one of the leading providers of software to smaller banks and most credit unions.
- The company's shares have been on a multi-year tear and have left valuations stretched.
- It has grown significantly through strategic acquisitions. Management says that comparable acquisitions are hard to find.
- Jack Henry appears to have a long-term organic growth rate of 7-9%.
- The company has been taking significant steps in order to both solidify and grow its base.
- Most of the company's revenues are recurring and highly predictable. 48% of revenues come from the company's outsourcing effort. It has begun to offer SaaS solutions to its potential customers.
- While competition in the fintech space is quite severe, the company's outsourcing and multi-year agreements has built it a very strong competitive moat.
- Given the stretched nature of the current valuation, a strategy of watchful waiting seems an appropriate strategy to be recommended at this time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.