The banking sector over the past 10 years has one that has been perpetually characterized by spats of optimism followed by poor execution. Time and time again, investors have expected the banking sector to be on the cusp of recovery. "This time will be different!" they say. Thus far (outside of a few exceptions), that recovery has never materialized.
Jack Henry & Associates (NASDAQ:JKHY), while relying on the banking industry for its revenues, has been the furthest thing from dead money. Since 2009, the company has done nothing but trend upward, rarely trending to the downside before resuming its steady march upward. What is it that makes the company such a great generator of shareholder value, and is the company set up to continue to do so in the future?
Insulated, Protected Business Model
Jack Henry provides data processing systems to banks and credit unions below $30B in assets. Segment sales are broken up by counterparty (roughly 75% of 2015 sales to banks, 25% to credit unions). At under $30B in assets, these banks are far too small to warrant building and maintaining in-house data processing systems themselves and hiring costly IT staff to manage and service those systems. This is even more the case today in the current low interest rate banking environment than it was 10 years ago. Bank management is intensely focused on costs and trimming expenses, and outsourcing these initiatives spares banks from massive upfront capex with no guarantee of success. It is simply easier to contract out to a known quality product in order to free up management time to address the real issues impacting banks today (regulation, growing AUM).
Systems provided cover the gambit from balance sheet management systems (deposit, loan, and general ledger management), customer information storage, and much more. The company has made dozens of acquisitions over the last 20 years in order to plug the holes in its portfolio suite. Basically, if there is a data system needed to properly run a bank, Jack Henry offers that product.
Generally, most of these sales are done on a licensing schedule, which provides steady, recurring revenue for Jack Henry. In most cases, Jack Henry is also paid by banks for installation, implementation, annual software support, and training. Overall, the company has stated more than 90% of revenue is classified as recurring in nature. These recurring revenues have proven to be incredibly sticky. While there are competing products in this space, switching products entails the move of a massive amount of data to a new system, along with retraining what could potentially be thousands of bank employees. The risk in such a move is massive, and it simply isn't worth undertaking in many situations for what is likely marginal savings.
Of course, that works both ways. Competitive takeaways are difficult in the banking space; the company has been averaging a couple dozen per year. Considering Jack Henry currently supports 1,200 banks, growth from takeaways in this manner makes up just a fractional portion of organic growth, and is offset to some degree by the steady consolidation that is taking place within the industry. As reported by the FDIC, there were just 1,689 banks with assets under $99M operating in 2015, down from 1,872 in 2014. While these are likely the lowest revenue sources (Jack Henry benefits from higher volumes, often getting paid on a per transaction basis on some of its software offerings), it is nonetheless a headwind. Even if the two banks engaged in a merger are both Jack Henry customers, total revenue would be higher from two separate institutions than one. Obviously though, merger consolidation is much better than the alternative that the company faced in 2008-2010 (bank failures).
Despite this, the banking segment has been growing at a 7-8% annual clip of late, bolstered by growth in electronic payment services revenue from transaction processing (e.g., higher volumes), outsourcing growth (larger business commitment other than software leasing, i.e., security monitoring and network infrastructure management), and cross-selling (selling more product offerings to existing customers).
The result has been steady revenue growth (7.2% CAGR since 2012) and margin growth (both gross and operating margins). Software development costs are minimal ($77M of $145M in capex in 2015), so free cash flow here is high. Conservatively (deducting all of 2015 capex), free cash flow is in the neighborhood of $229M; more realistically, closer to $275M figuring maintenance capex. Free cash flow yield as a result is in the neighborhood of 3.5-4%.
This is far from cheap - but the quality of the company is what is driving these results. The opportunity to buy a company with no meaningful long-term debt (the company occasionally taps its revolver to fund working capital), highly stable recurring revenues, a wide moat, and high-single-digit annual growth for cheap rarely comes around. The opportunity the market gave investors in this company in 2012 (7.5% free cash flow yield, 18x forward earnings) due to fears regarding bank consolidation that proved unfounded is unlikely to repeat itself any time soon.
Is it worth paying 27x fiscal 2017 earnings? Given that the forward multiple is at a five-year high, it is tough to justify. However, the company does belong on a watch list in case the company does experience a sell-off. At a price nearer to $70/share, I'd gladly be willing to own the equity here.
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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.