The Long Case for Yucheng Technologies

| About: Yucheng Technologies (YTEC)

Yucheng Technologies (NASDAQ:YTEC) is a little known Chinese IT provider for the growing Chinese banking industry. The company was officially formed in November 2006 as a result of a 3-way merger between China Unistone Acquisition Corporation, Beijing Sihitech Technology Co., Ltd., and Beijing e-Channels Century Technology Co.

The company focuses on financial software development, internet banking, call center installation & support, risk management solutions, information technology consulting, and system integration for the banking industry.

It has also recently expanded into merchant acquiring & Point of Sale [POS] business.

The field of financial services in China is a nascent and growing field; there are more than 40000 financial institutions in China, of which a majority is state owned. However there has been strong growth of late in the private banking sector. The Chinese banking sector is undergoing a radical transformation, as many of China's leading banks have already undertook initial public offerings (raising billions of dollars in the process), while others are in preparations for such listings or in search for strategic investors as the industry consolidates and modernizes in order to better serve their customers and compete in a growing economy. It is worth noting that China continues to update its banking regulations to comply with the agreement signed with the World Trade Organization in November, 2001.

Two major restrictions have been removed on foreign banks as of December 2006:

  1. Ability to take Renminbi deposits.
  2. Ability to broaden their Chinese banking network.

The gradual removal of restrictions will enhance competition in the sector and force more Chinese banks to upgrade their IT infrastructure and broaden their financial offerings. The Chinese banking sector has a long way to go to reach the same level of service and offerings as its international banking rivals. For example, China's largest bank, China Construction Bank, has 200 million accounts served by 1200 call center seats, against 21 million accounts for Bank of America (NYSE:BAC) served by 12,000 call center seats. While 71% of Bank of America customers use some form of e-banking, only 7.5% of China Construction Bank customers use such services.

In order to profit from the strong growth in its industry segment, Yucheng Technologies is planning to build a financial services powerhouse, driven both by organic and none-organic growth; in fulfillment of that promise, the company completed the following acquisitions in the last 12 months:

  • January, 2007: Accretive acquisition of Sunrisk Information Technology, a company founded in 2004 by David Wang, a former vice president at JP Morgan. Sunrisk offers a highly complimentary product to Yucheng in the area of risk management. This is a key area for growth as Chinese banks must be Basel II compliant by 2010, Sunrisk solutions helps provide that compliance.
  • July, 2007: Accretive acquisition of 75% of Easycon, an IT services provider for small and medium size Chinese banks, a market Yucheng has not penetrated in the past. This acquisition has already netted benefits as evident by the company's 3rd quarter results published on November 7th, with the company already winning contracts with Hangzhou City Commercial Bank, Huishang Bank, and Bank of Beijing.
  • October, 2007: Accretive acquisition of Recency Technology, a provider of business intelligence and risk management software. This acquisition is complimentary to the Sunrisk acquisition done in January, and better position Yucheng in the high growth area of financial risk management solutions. Furthermore, the company has mentioned in the last conference call that it is still looking for further accretive acquisitions throughout its spectrum of businesses.

Financials

To better understand Yucheng financials, it is worth highlighting that the company historically has been a low margin system integrator rather then a high value/high margin financial software and service provider. However the company has indicated since early 2006 that it will be expanding further into the none-system integration segment. This focus seems to be finally baring fruits as evident by the company financial results for the last two quarters:

Gross Margins Q207

  • Gross Margins: 36% compared to 32% Q2/06
  • Q3/07 Gross Margins: 39% compared to 29%
  • Q3/06, with higher margin revenues presenting over 60% of overall revenues, exceeding for the first time the system integration revenue for a given quarter.

Most importantly, the company expects higher margin revenues to exceed low margin system integration revenues for the year 2008, which will further solidify Yucheng's move from a system integrator to a high margin software and banking solutions provider.

Revenues

Yucheng's revenues have been steadily growing driven by strong industry demand and added acquisition revenues:

  • Q1/07 Revenues: 39% increase over 2006, for a total of $9.3 million dollars.
  • Q2/07 Revenues: 32% increase over 2006, for a total of $10.2 million dollars.
  • Q3/07 Revenues: 20% increase over 2006, for a total of $15 million dollars.

Operating income

  • Q1/07: 34% increase over 2006, for a total of $1 million dollars.
  • Q2/07: 50% increase over 2006, for a total of $2.1 million dollars.
  • Q3/07: 51% increase over 2006, for a total of $2.9 million dollars.

In regard to the company's estimated results for full 2007; they are expected to be in the range of 50m to 52m in revenues, with an operating income above $9.3 million.

What is interesting about Yucheng's results in the last quarter is the increased operating leverage in the business model, as the company shifts from low-margin system integration business to the high-margin banking software and support business. Operating results have grown 56% and 255% faster than revenue growth in Q2 & Q3 respectively. The reason EPS was not shown in the financials is due to the significant share dilution caused by the exercise of the 9 million warrants in Q2, which netted the company over $34 million dollars in income - an income that is being used currently to fuel the company growth and finance the announced acquisitions.

However as of today there are no more warrants overhang and the share count is expected to be stable going forward at the 16.3m shares, except for shares issued for management compensation.

Yucheng wild card: POS

Despite all that has been mentioned above regarding the strong growth in the company financial software and support business and the resulting strong increase in revenues and profits, the real hidden added value in Yucheng is its expansion into the Point of Purchase [POS] merchant acquiring business.

Let me explain.Point of Purchase is the point where a client pays for his or her purchase. In the case of Yucheng, it is the point where the clients pays for the purchase with a credit or a debit card, a Point of Purchase being any business that accepts a credit card: a restaurant, supermarket, hotel, bar, car rental .. etc,. So how does Yucheng profit from this business? Yucheng provides its partner banks the following service; I will use this paragraph from the company April 11th press release to better define the business:

Yucheng's POS merchant-acquiring outsourced services provide Chinesebanks with a total outsourced solution for merchants in China, including POS machines and maintenance, merchant acquisition, authorization and capture of transactions, clearing and settlement of transactions, information reporting services related to transactions, merchant billing services and merchant training. Revenues from merchant acquiring services derive primarily from a percentage share of the transaction value for processing electronic payments, including credit, debit, and prepaid cards.

Now lets put this business in prospective; the use of credit cards remains very limited in China, as of the end of 2005, under 5% of the retail business was conducted by credit card with only 810,000 installed credit card machines, compared to over 40% of retail business conducted by credit card in the developed world. The growth in this business is projected to be exponential, driven by wider adoptions of credit cards as a means of payment in China for obvious reasons, such as convenience & security, leading to a higher transaction volume, as well as higher transaction value as China's population grows wealthier.

Additionally Chinese banks continue to promote the growth of credit cards as a new and stable source of revenues. Yucheng is working to help Chinese banks expand their merchant network quickly and efficiently, by helping them sign thousands of new business in order to expand and enhance their merchant payment network, in return the company get a cut from the transaction revenue; POS revenues are extremely valuable for any bank due to its recurring and stable nature, the growth of this business in China today is at the "land grab" stage, as banks scramble to expand their payment network.

Yucheng has partnered with China Merchants Bank, the leading dual-currency card issuer in China with 34% market share. Yucheng has been very successful so far; they have signed over 5000 merchants for the bank since their official entry into the business in April 2007. The company has ambitious goals of reaching 7000 merchants by the end of 2007, 20000 by the end of 2008 and over 50000 by the end of 2009.Additionally, the company is in discussion with several other banks who would like to benefit from its merchant acquiring business. According to the CEO Mr. Weidong Hong in the latest conference call, a mutual agreement has been reached with new local banks and an official announcement should come shortly. Yucheng continues to invest heavily in its POS merchant acquiring business. The company has POS offices in 9 cities, and is expanding rapidly. This expansion is cutting into the company profits, and this division is not expected to breakeven before the end of 2008. However if the company plans in POS work out, this business can be a formidable source of recurring revenues and profits, and is well worth the investment. Finally the company expressed its wish to acquire businesses in this domain to further accelerate the growth of this division.

POS Revenue projections

The company mentioned in an investor presentation in February 2007 that the average business processed on a POS machine in China is 200,000 USD. (This number is likely to rise as more people start paying with a credit card.) Assuming an average transaction cost of 1.5% charged by the bank, the average revenue per machine will be $3000, and if we assume that Yucheng is awarded a 3rd of the transaction cost, this would net the company $1000 in transaction revenue per year. Thus, based on the company's expected rate of merchant sign up, the company could generate as much as $50 million dollar in recurring transaction revenue by the end of 2009 as they sign up over 50000 merchants on their network. This is as much as the company's expected revenue from all divisions for 2007. The company should provide better clarity about the progress in this business by Q1/2008 as it starts reporting POS results under a separate segment on the income statement.

Valuations

Despite the strong run up in the stock price since the company NASDAQ listing this summer, the company remains attractively valued on absolute bases and relative to its competitors, with a stock price of $12.79 as of November 9th, 2007, the company valuation is as follows:

  • Market cap = 208 million dollars
  • P/S = 4.6
  • P/E = 27
  • Trailing 12 months revenues: $46 million Trailing 12 months
  • EPS: $0.46

One of the company major competitors is LongTop Financials (NYSE:LFT), a company that was brought public recently by Goldman Sachs, and it trades as follows:

  • Market cap = 1.2 billion
  • P/S = 24
  • P/E = 71
  • Trailing 12 months revenues: $50.15 million.
  • Trailing 12 months EPS: $0.31

While Longtop may deserve a premium valuation due to its higher operating margins resulting from its none-exposure to the system integration business, the premium does seem excessive in relation to Yucheng. Since both companies seem to enjoy a similar growth rate, and in light of Yucheng's further expansion into Longtop's turf and its expansion into the POS business, this extreme discount is unwarranted. It is likely that Yucheng's stock will remain volatile, due to the small float and investors excitement about China related companies, but if you are willing to hold for the long term and wait for the company to execute on its plans, an investment today could bring significant returns over the next 12 to 24 months.

Disclosure: The author is holding YTEC stock at the time of the writing.