Cass Information Systems: A Dividend Growth Investing Hidden Gem

Summary

• Cass Information Systems processes complex bills for big corporations. It has established itself as a leader in that niche. It's a "digital resources" investment play.
• Cass has an impressive track record of profitable growth with demonstrated resilience during crises, which enables it to consistently raise dividends.
• Cass qualifies as a target for dividend growth investing due to its capital efficiency, growth prospect, and dividend policy.
• For a wide-moat multi-year compounder, Cass is currently undervalued relative to its 'digital resources' peers.
• I do much more than just articles at The Natural Resources Hub: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

In this article, I'd like to discuss Cass Information Systems (NASDAQ:CASS) as a potential target for dividend growth investors.

A bank or a business service firm?

Cass has a 115-year-old history in banking. Today, it still wholly owns a subsidiary, i.e., Cass Commercial Bank. However, Cass also has another business segment - payment services, which nowadays overshadows the banking subsidiary. The payment services contributed some 67.7% of the total revenue in 2019, while commercial banking generated 32.3% (Table 1). As of February 19, 2020, the payment services hired 821 full-time and 246 part-time employees, while the commercial bank subsidiary only had 54 full-time employees and one part-time (see here).

Table 1. Selected financial information for each of the five years ended December 31, 2015-2019, modified from this source.

Core competency

For large corporations, paying their complex bills is an onerous task to be outsourced. For Cass, utilizing the latest technologies to process those bills for customers is its core business.

In fact, Cass is the leading provider of payment services to large U.S. corporations for their utility, telecom, financial, and transportation needs (see here). It provides payment and information processing services to large manufacturing, distribution, and retail enterprises. It provides a B2B payment platform for clients that require an agile fintech partner. It also uses an online platform to provide generosity services for faith-based and non-profit organizations for its faith-based customers.

Cass primarily focuses on processing payables and payables-related transactions, with four core competencies:

• Data acquisition, i.e., the gathering of data elements from diverse, heterogeneous sources, and the building of complete databases for customers. Cass gathers vital data from complex and diverse input documents, electronic media, proprietary databases, and data feeds, including data acquired from vendor invoices as well as customer procurement and sales systems. Cass then assembles these vital data into centralized data management systems and warehouses, thus producing an engine to create the power of information for managing critical corporate functions and processing systems.
• Data management. Once data is assembled, Cass utilizes the derived information to produce significant savings and benefits for its clients. This information is integrated into customers’ unique financial and accounting systems, eliminating the need for internal accounting processing, and providing internal and external support for these critical systems. Information also is used to produce management and exception reporting for operational control, feedback, planning assistance, and performance measurement.
• Business Intelligence. Cass’ information delivery solutions provide reports, digital images, data files, and retrieval capabilities through the Internet or directly into customer internal systems, using its proprietary internet management delivery system. Transaction, operational, control, status, and processing exception information are all delivered through this system, thus creating an efficient, accessible, and highly reliable asset for customers.
• Financial exchange. Thanks to its unique advantage of owning a commercial bank, Cass is able to manage the movement of funds from its customers to their suppliers. Cass provides immediate, accurate, controlled, and protected funds management and transfer system capabilities for all of its customers, replacing costly check processing with efficient electronic cash management and funds transfer systems. (In addition to supporting the company’s payment operations, Cass Commercial Bank provides banking services to its target markets, which include privately-owned businesses and faith-based ministries).

These four core competencies allow Cass to perform the highest volumes of transaction processing in an integrated, efficient, and systematic approach, while in the meantime it collects the data defining the transaction and effectuates the financial payment governing its terms.

A "digital resources" play

I believe some of the key characteristics of Cass can be better understood in the context of what I call the "digital resources" investment space at the Natural Resources Hub (Table 2). This is a group of businesses from various industries, which in a nutshell share the following features:

• A unique value proposition. By accumulating and processing big data, or enabling data-intensive operations, these B2B companies generate recurring, subscription-based revenue from business or government customers.
• Wide moat. They command a monopolistic or oligarchic position in their niche, protected by enormous barriers to entry, some network effects, and switching costs, which gives them a sustainable competitive advantage over the fellow industry participants they serve. They tend to show resilience during industry crises.
• Dominance in native industry. They are deeply entrenched in their respective native industries. Some of them were even bankrolled at their birth by home industry advocacy groups. They then expand into adjacent industries in pursuit of economies of scope.
• Aggressive acquisitions. In an expansion of their service into adjacent verticals, they usually face a fragmented competitive landscape, fertile for M&A, which further fuels rapid growth.
• Capital and operational efficiency. They develop scalable solutions that are built once and installable or sellable countless times. So, they are capital-light and can operate very efficiently. They typically generate superior profitability and deliver a high rate of return on invested capital.

Table 2. The competitive landscape of the digital resources space. Source: Laurentian Research.

Although it does own a commercial banking subsidiary and process bills for business customers, Cass shares most, if not all, of the characteristics of the verified members of the "digital resources" space. Prima facie, it's a wide moat prospect and worth a deeper examination.

Financial performance

Revenue growth

From 2004 through 2019, Cass was able to grow total revenue - including the fees generated by the payment services and interest income earned from commercial banking - from $64.78 million to $162.68 million, at a CAGR of 6.33% (Fig. 1). That is substantially faster than the GDP growth (at a CAGR of 2.14%) of or inflation (averaging 2.04%) in the U.S.

Fig. 1. The revenue, gross profit, operating income, and net income of Cass, from TIKR.

• The payment services segment reported consistent revenue expansion at a CAGR of 8.36% in 2004-2019, while the commercial banking segment posted anemic net interest income growth (Fig. 2).

Fig. 2. Revenue from the payment services (in black) in comparison with interest income from commercial banking for Cass, from TIKR.

Margins

The changes in the operating margin seem to coincide with the rise of the payment services relative to commercial banking; the operating margin gradually decreased from >30% prior to 2011 to the mid-20s in percentage thereafter.

• Cass Commercial Bank has been extremely profitable. Its net interest margin (aka, NIM) was 3.38%, 3.32%, 3.34%, 3.32%, and 3.36% in each of the five years between 2015 and 2019, substantially higher than the NIM attained by major banks in 2019, e.g., 2.88% for JPMorgan Chase (JPM), 2.73% for Wells Fargo (WFC), and 0.50% for Goldman Sachs (GS).

Apparently, the slow growth of the high-margin commercial banking segment hurt the operating margin. However, Cass maintained the net margin at the high levels of 18.2 +/- 2.2% in these 16 years (Fig. 3).

Fig. 3. The operating and net margins of Cass, from TIKR.

Profits and cash flow

Thanks to the relatively stable net margin, Cass generated net income growth at a CAGR of 6.54% since 2009.

The business of Cass is extremely capital light. For a business pulling in $64.78-162.68 million per year, Cass only averages $3.1 million in annual capex from 2004 to 2019, as a matter of fact, its annual capex never exceeded $6.3 million during that time. As cash from operations expanded from $10.8 million to $42.1 million, Cass threw off an increasing amount of free cash, with free cash flow growing at a CAGR of 10.02% in those 16 years.

Cass was able to convert on average 116.62% of net income into free cash flow, suggesting its reported earnings are of high quality (Fig. 4).

Fig. 4. Free cash flow and the conversion of net income into free cash flow. Source: Laurentian Research based on Cass financial reports.

Share buybacks, dividends

Cass repurchased 128,779 shares in the 1Q2020 before it temporarily suspended the stock buyback program on March 16, 2020. On October 20, 2020, the board of directors restored the stock buyback program which authorizes the company to repurchase up to 500,000 shares, out of the approximately 14.55 million diluted shares outstanding. Cass had repurchased on average 0.97% of shares per year between 2014 and 2019. Share buyback led to the earnings per share growing at a CAGR of 7.81% from 2004 and 2019.

Cass has been consistently raising quarterly dividends, from $0.006987 to $0.27 per share on a split-adjusted basis, which implies a CAGR of 16.45% (see here). Since 2011, the company has been on average raising dividends by 11.06% per year, at a pace slower than in the earlier years but still faster than both the earnings per share (3.94%) and free cash flow (6.56%). Dividend payout relative to EPS, consequently, has risen from 28% to 51%, and that relative to FCF has risen from 26% to 38%. The payout ratios are still at comfortably secure levels (Fig. 5).

Fig. 5. The earnings per share, dividends per share, and dividend payout over EPS, and dividend payout over FCF of Cass, with adjustment for splits. Source: Laurentian Research based on Cass financial reports.

Dividend growth investing

Cass yields 2.71% as of early January 2021. Although such dividends cannot be called high yield at this time, my proposition is Cass qualifies as a dividend growth investing (aka, DGI) play. Even if the EPS and FCF remain at the same level as in 2019 going forward, dividends that grow at 11.06% per year can still be fully covered by the EPS until 2026 and by the FCF until 2028. If we suppose the EPS and FCF continue to grow at the CAGRs as in 2011-2019, dividends that grow at 11.06% per year will still be fully covered by the EPS until 2030 and by the FCF until 2042. Therefore, there's a lot of headroom for Cass to continue raising dividends for many years.

For a buyer of Cass on January 8, 2021, they will be enjoying a "yield to cost" of 8.58% by 2031, and 24.50% by 2041, if Cass keeps the 11.06% dividend growth CAGR, which is not impossible (Fig. 6).

Fig. 6. Projected dividends per share and yield to cost. Source: Laurentian Research.

The presence of a wide moat

One of the best metrics to measure an economic moat is to compare the rate of return achieved by a company with its weighted average cost of capital (or WACC). The ultimate litmus test of an alleged wide moat is to see how the business performed during a crisis.

Capital efficiency

Although the commercial banking subsidiary of Cass contributes only about 1/3 of the total revenue, it does hold a lot of financial instruments, which leads to huge total assets. As a result, asset turnover appears minuscule, while the leverage (total assets/equity) seems high (Table 3).

Table 3. DuPont analysis of Cass, 2004-2020 (trailing 12 months). Source: Laurentian Research based on Cass financial reports.

Cass could have achieved a higher return on equity (or ROE) if it had leveraged up the non-banking part of the balance sheet with debt. In reality, Cass did not carry any long-term debt since 2009. That may be partly to blame for the relatively high WACC from 2013 to 2017. Overall, Cass was able to achieve excess return over the WACC, which implies capital efficiency (Fig. 7).

Fig. 7. A comparison of ROE and WACC for Cass, modified from this source.

The COVID-19 crisis

The COVID-19 outbreak and responding measures implemented by governments around the world have had an adverse impact on the financial results of Cass since 1Q2020:

• The Fed lowered the Federal Funds rate, which has adversely affected interest income and therefore, the company’s results of operations and financial condition. The Fed has continued its commitment to this approach, indicating that the target Federal Funds rate would remain at current levels until the economy has recovered. Compared with the same quarter one year ago, the net interest income dropped by 2.02%, 7.16%, and 11.90% in the 1Q, 2Q, and 3Q2020, respectively.
• For payment processing services, business closures, including constrictions in the manufacturing sector, have led to a decline in customers’ business activity and a decrease in the number of transactions and dollars processed. The decrease in demand for oil and the ensuing drop in oil prices has had (and may continue to have) a negative effect on both the number of freight transactions processed and the dollar amount of invoices processed. A compared with the same quarter one year ago, the payment service revenue dropped by 3.61%, 15.61%, and 12.13% in the 1Q, 2Q, and 3Q2020, respectively.
• On a consolidated basis, the net income decreased by 7.57%, 29.22%, and 29.38% in the 1Q, 2Q, and 3Q2020, respectively, because the costs could not be cut at the same pace as the weakening revenue.

Yet the operations of Cass have shown exceptional resilience during the public health crisis. This is seen not only in its remaining to be profitable in the past three quarters but also in the sequential improvements in sales and earnings since the 3Q2020. From the 1Q to 2Q2020, the payment service revenue dropped by 11.14%, the net interest income decreased by a moderate 1.86%, and net income declined by 27.91%. However, from the 2Q to 3Q2020, although the net interest income still decreased by another 3.11%, the payment service revenue managed to increase by 7.57%, while net income rose by 6.29%. Business is already on a rebound (Table 4).

Table 4. Quarterly income statement for 1Q, 2Q, and 3Q 2020, as compared with the same quarter in the previous year, sourced from here, here, and here.

Given its track record of long-term profitable growth (Fig. 4), high margins (Fig. 3), capital efficiency (Fig. 7), and resilience during the 2007–2008 global financial crisis and the Covid-19 pandemic (Fig. 4; Table 4), I'm of the opinion that Cass does command a sustainable competitive advantage. In other words, it is a wide-moat multi-year compounder.

Valuation and risks

For a wide-moat compounder with a P/E multiple of 23.19X and a P/FCF multiple of 14.9X, Cass seems to be undervalued relative to its better-known "digital resources" peers such as:

• Verisk (VRSK)(P/E, 49.73; P/FCF, 43.94),
• Moody's (MCO)(29.16; 28.34),
• S&P Global (SPGI)(32.73; 23.73),
• Equifax (EFX)(51.82; 47.92),
• Intercontinental Exchange (ICE)(32.4; 29.33).

Historically, Cass traded between a P/E multiple of 12.84-34.25X and a P/FCF multiple of 10.81-32.92X; so, Cass has some headroom for re-rating, although it may never reach the level of valuation as seen in its "digital resources" peers due to its commercial banking subsidiary. However, that is acceptable to me because the chief focus for a DGI play should be on (1) whether there exists a wide moat that protects the business, (2) if the business has the prospect of profitable growth in the long run, and (3) the dividend coverage by earnings or FCF and the security of dividends (see here).

Going forward, the main risk, as I see it, is Cass may end up being acquired, thus having its dividend growth trajectory truncated. The "digital resources" space is a fertile ground for M&A due to the fragmented competitive landscape, a company that is not aggressively pursuing acquisitions may become an acquisition target sooner or later. To prevent that from happening, Cass should accelerate its pace of expansion. Chairman, President, and CEO Eric H. Brunngraber has done a fine job in managing Cass with financial conservatism since he became president in 2006 and CEO in 2008, although I do hope he devotes more attention to M&A and organic growth, e.g., through international expansion.

Investor takeaways

Cass is an ideal DGI play for those who are still decades away from retirement. It is a multi-year compounder that is protected by a wide moat. It has been delivering profitable growth for decades and is poised to continue to grow as its customers expand.

The stock is currently undervalued relative to its 'digital resources' peers, thanks to the decline of share price in the wake of the Covid-19 outbreak (Fig. 8).

Fig. 8. Stock chart of Cass, dividends back-adjusted, from this source.

Disclosure: I am/we are long CASS. 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.