Jack Henry & Associates: Beware Multiple Contraction

Summary

• Jack Henry has provided shareholders with variable returns over the past six years.
• The variability in returns has been the result of considerable volatility in the share price from 2018 onwards.
• The biggest danger to Jack Henry's share price and, consequently, shareholder returns is a contraction of its P/E multiple from present levels.
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Jack Henry: Investment Thesis

Based on Seeking Alpha Premium analysts' estimates, Jack Henry & Associates, Inc. (NASDAQ:JKHY) is projected to grow EPS by an average of 10.79% per year for the five years 2019 to 2024 (I start with 2019 to eliminate COVID-19 distortions). The 10.79% forward estimate compares to a 3.72% average yearly EPS growth rate for the three years ended 2019. Table 1 below shows EPS declined from $4.43 for 2017 to $3.66 for 2019, contributing to the low historical growth rate through end of 2019, and the higher growth rate reflected in analysts forward estimates. A better measure of Jack Henry's longer term EPS growth is the actual and projected average yearly EPS growth rate of 8.1%, based on EPS of $3.28 for 2016, and analysts' consensus estimate of $6.11 EPS for 2024. That's quite a good EPS growth rate, but it has to be questioned if it justifies a P/E ratio in the mid-thirties and higher. If multiples remain around the historical average of 35.0 (see Table 3 below), double-digit returns are possible from buying and holding through end of 2024. The company, as a business, appears to be performing well, the dividend is safe, and the balance sheet strong with no debt. But, there appears to be a real danger to the share price from potential multiple contraction, leading to negative returns. A detailed analysis follows.

Looking for share market mispricing of stocks

What I'm primarily looking for here are instances of share market mispricing of stocks due to distortions to many of the usual statistics used for screening stocks for buy/hold/sell decisions. The usual metrics do not work when the "E" in P/E is distorted by the impact of COVID-19. And if the P/E ratio is suspect, so too, then, is the PEG ratio similarly affected. I believe the answer is to start with data at the end of 2019, early 2020, pre-COVID-19 and compare to projections out to the end of 2022 or later, when hopefully the impacts of COVID-19 will have largely dissipated. Summarized in Tables 1, 2, and 3 below are the results of compiling and analyzing the data on this basis.

Table 1 - Detailed Financial History And Projections

Table 1 documents historical data from 2016 to 2019, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. The table also includes estimates out to 2024 for share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates (note - while estimates are shown for analysts' EPS estimates out to 2023, 2024 and 2025 where available, estimates do tend to become less reliable, the further out the estimates go. These estimates are only considered sufficiently reliable if there are at least three analysts' contributing estimates for the year in question). Table 1 allows modeling for target total rates of return. In the case shown above, the target set for total rate of return is 7.5% per year through the end of 2024 (see line 12), based on buying at the Feb. 26, 2021, closing share price level. As noted above, estimates become less reliable in the later years. I have decided to input a target return based on 2024 year, which has EPS estimates from three analysts, because it allows the longest period for the impact of the projected EPS growth rates to be taken account of in the assessment of value of Jack Henry shares. The table shows to achieve the 7.5% return, the required average yearly share price growth rate from Feb. 26, 2021, through Dec. 31, 2024, is 6.48% (line 49). Dividends account for the balance of the target 7.5% total return. Table 2 below summarizes relevant data flowing from the assumption of a target 7.5% total return through end of 2024.

Targeting a 7.5% Return

Table 2 - Targeting a 7.5% return

Table 2 provides comparative data for Jack Henry, assuming share price grows at rates sufficient to provide total rate of return of 7.5%, from buying at closing share price on Feb. 24, 2021, and holding through end of 2024. All EPS estimates are based on analysts' consensus estimates per SA Premium.

Comments on Table 2 are as follows

Part 1 - Consensus EPS (Case 1.1) (lines 1 to 12)

Part 1 shows the amounts the share price would need to increase to achieve a 7.5% rate of return through end of 2024. The share price would need to increase by $18.22 from the present $148.44 to $166.66 at end of 2024, for the 7.5% rate of return to be achieved.

Part 2 - Required change in P/E ratio to achieve target 7.5% return (lines 21 to 23)

Part 2 shows the amount the P/E ratio would need to increase or decrease by, from buy date to end of 2024, to achieve the share price level at the end of 2024 necessary to achieve the targeted 7.5% return. For Jack Henry, the P/E ratio at buy date can decrease by (19.0)% from the present 38.16, to 30.92 at the end of 2024 and the 7.5% return would still be achieved. Being able to achieve a targeted return with a decrease in the P/E ratio would normally be regarded as a positive. However, due to the distortions of earnings and sentiment owing to the COVID-19 pandemic, it's difficult to judge whether the change in P/E ratio is a positive or the result of a distorted starting point. To overcome this difficulty, in Part 3, I review the necessary change in P/E ratio from a different, pre-COVID-19 starting point.

Part 3 - Projected change in P/E ratios from 2019 to 2022 (lines 31 to 46)

In Part 3, I start with the share price at Dec. 31, 2019, before the impact of the COVID-19 pandemic on earnings and market sentiment. The end point is projected share price at end of 2024, when it's assumed the market and earnings are no longer materially impacted by the pandemic, and EPS growth has brought the P/E ratio back closer to historical levels. For Jack Henry, the share price needs to increase by $39.40 from $149.54 at Dec. 31, 2019, to $188.94 at end of 2024, and as detailed in Part 1, at $188.94, the targeted 7.5% rate of return would be achieved. For Jack Henry, there are a number of givens in our assumptions. Using these givens, the change in the share price from Dec. 31, 2019, to end of 2024, can be expressed as mathematical formulae as follows:

(A) Change in share price due to effect of EPS growth rate, equals share price at beginning multiplied by (1 plus average yearly Consensus EPS growth rate) to the power of number of years invested.

= $149.54*(1+10.8%)^5 = $249.63 (that would be the result if the share price grew in line with EPS growth, and the P/E multiple remained constant)

(B) Change in share price due to change in P/E ratio equals share price adjusted for EPS growth rate multiplied by (1 plus/minus percentage change in P/E ratio).

= $249.63*(1-24.3%%) = $188.94 (price required at end of 2024 to provide 7.5% total return, buying at current share price)

The increase of $100.09 ($249.63 minus $149.54) due to the average yearly EPS growth rate is cumulative, and share price will continue to increase the longer the shares are held and the growth rate continues. The decrease of $60.69 due to a change in the P/E ratio ($249.63 minus $188.94) has a one-off effect. A continuing high or low P/E ratio has no impact on future share price growth, only a change in P/E ratio affects share price, not the level of P/E ratio.

Next, rather than targeting a specific rate of return, I look at historical P/E ratios to see the potential impact on returns of a reversion to these levels of P/E ratio. First of all, I should explain a little about the Dividend Growth Income+ Club approach to financial analysis of stocks.

Understanding The Dividend Growth Income+ Club Approach

Dividend Growth Income+ Club logo Copyright: Robert Honeywill 2020

Total Return, Dividends, Share Price

The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price. It follows what really matters in share value assessment is the expected price at which a buyer will be able to exit shares, and expected cash flow from dividends.

Changes in Share Price

Changes in share price are driven by increases or decreases in EPS and changes in P/E ratio. Changes in P/E ratio are driven by investor sentiment toward the stock. Investor sentiment can be influenced by many factors, not necessarily stock-specific.

"Equity Bucket"

Earnings are tipped into the "Equity Bucket" for the benefit of shareholders. It's prudent to check whether distributions out of and other reductions in the "Equity Bucket" balance are benefiting shareholders.

Jack Henry's Projected Returns Based On Selected Historical P/E Ratios Through End Of 2024

Table 3 below provides additional scenarios projecting potential returns based on selected historical P/E ratios and analysts' consensus, low, and high EPS estimates per Seeking Alpha Premium through end of 2024.

Table 3 - Summary of relevant projections Jack Henry

Table 3 provides comparative data for buying at closing share price on Feb. 26, 2021 and holding through the end of 2024 (or longer if sufficient analysts' estimates are available). There's a total of nine valuation scenarios for each year, comprised of three EPS estimates (SA Premium analysts' consensus, low and high) across three different P/E ratio estimates, based on historical data, and alternative Cases A and B (see below). Jack Henry's P/E ratio is presently 38.16. This is considered distorted by the impact of COVID-19, and it's assumed in due course the P/E ratio will revert to historical levels, or lower, per Table 3 above. This analysis, from hereon, assumes an investor buying Jack Henry shares today would be prepared to hold through 2024, if necessary, to achieve their return objectives. Comments on contents of Table 3, for the period to 2024 follow.

Consensus, low and high EPS estimates

All EPS estimates are based on analysts' consensus, low and high estimates per SA Premium. This is designed to provide a range of valuation estimates ranging from low to most likely, to high based on analysts' assessments. I could generate my own estimates, but these would likely fall within the same range and would not add to the value of the exercise. This is particularly so in respect of well-established businesses such as Jack Henry. I believe the "low" estimates should be considered important. It's prudent to manage risk by knowing the potential worst-case scenarios from whatever cause.

Alternative P/E ratios utilized in scenarios

1. The actual P/E ratios at share buy date based on actual non-GAAP EPS for Oct. 31, 2020, TTM.
2. A modified average P/E ratio based on 18 quarter-end P/E ratios from Q4 2016 to Q4 2020 plus current P/E ratio in Q1 2021. The average of these P/E ratios has been modified to exclude the three highest and three lowest P/E ratios to remove outliers that might otherwise distort the result.
3. I would normally use a median P/E ratio here, calculated using the same data set used for calculating the modified average P/E ratio. Of course, the median is the same whether or not the three highest and lowest P/E ratios are excluded. In Jack Henry's case I am concerned historical P/E ratios are overly high. I have swapped out the historical median P/E ratio of 37.22 with a lower Case A estimate of 30.0.
4. The actual P/E ratio at Feb. 21, 2020, share price, based on 2019 non-GAAP EPS. The logic here is the market peaked around Feb. 21, 2020, before any significant impact from COVID-19 became apparent. This makes the P/E ratios at Feb. 21, 2020, reflective of most recent data before distortion of P/E ratios by the impact of the coronavirus pandemic. As for the median P/E ratio, I have swapped out the Feb. 21, 2020 P/E ratio of 46.72 with a lower Case B estimate of 25.0.

Reliability of EPS estimates (line 17)

Line 17 shows the range between high and low EPS estimates. The wider the range, the greater disagreement there is between the most optimistic and the most pessimistic analysts, which tends to suggest greater uncertainty in the estimates. There are three analysts covering Jack Henry through end of 2024. In my experience, a range of 5.0 percentage points difference in EPS growth estimates among analysts is on the high side, suggesting a degree of uncertainty, and thus lesser reliability.

Projected Returns (lines 18 to 39)

Lines 25, 32 and 39 show, at the range of historical P/E ratio levels adopted, Jack Henry is conservatively indicated to return between negative (0.8)% and positive 4.7% average per year through the end of 2024. The negative (0.8)% return is based on analysts' low EPS estimates and the positive 4.7% on their high EPS estimates, with a positive 2.1% return based on consensus estimates. Those are the lowest of the returns under the consensus, low and high EPS scenarios, based on Case B P/E ratio of 25.0. A P/E ratio of 25.0 is well below historical levels for Jack Henry, but acknowledges the potential for multiple contraction. At the high end of the projected returns for Jack Henry, the indicative returns range from 7.6% to 13.6%, with consensus 10.8%. But those higher returns require the 2016 to 2020 historical P/E ratio of 38.16 to be maintained through end of 2024. That's a very high P/E ratio, even for a company with a projected EPS growth rate of 10.8% (line 24 Table 1). Also consider the projected EPS growth rate of 10.8% is well above the 2016 to 2020 historical EPS growth rate of 3.72% (line 24 Table 1).

Review Of Historical Performance For Jack Henry

Jack Henry : Historical Shareholder Returns

In Table 4 below, I provide details of actual rates of return for Jack Henry.

Table 4

For many stocks where I create a table similar to Table 4 above, I find a wide range of returns indicating a degree of volatility and risk. Table 4 above shows the results for Jack Henry were double-digit returns, ranging from 13.6% to 16.8%, for three of eight different investors, each investing $3,000 over the last six years and holding to the present. A further four investors achieved low to mid single-digit returns ranging from 0.6% to 6.8%. The remaining investor had a negative return of (20.8)%. These rates of return are not just hypothetical results. They are very real results for anyone who purchased shares on the various dates and held through to Feb. 26, 2020. In the above examples, the assumed share sale price is the same for all investors, illustrating the impact on returns of the price at which an investor buys shares.

Checking Jack Henry's "Equity Bucket"

Table 5.1 Jack Henry Balance Sheet - Summary Format

Table 5.1 shows an increase of $513 million in shareholders' equity, which was used to fund an increase of $430 million in net operating assets, and a increase of $83 million in cash net of debt, over the 3.5 years June 30, 2017, to Dec. 31, 2020. The company has no debt. Outstanding shares decreased by 1.3 million from 77.4 million to 76.1 million, over the period, due to share repurchases offset by shares issued for stock compensation. The $513 million increase in shareholders' equity over the 3.5 years is analyzed in Table 5.2 below.

Table 5.2 Jack Henry Balance Sheet - Equity Section

I often find companies report earnings that should flow into and increase shareholders' equity. But often the increase in shareholders' equity does not materialize. Also, there can be distributions out of equity that do not benefit shareholders. Hence, the term "leaky equity bucket." I find this happening to some extent with Jack Henry.

Explanatory comments on Table 5.2 for the period April 30, 2017, to Oct. 31, 2020:

• Reported net income (non-GAAP) over the 3.5-year period totals to $3,055 million, equivalent to diluted net income per share of $6.34.
• Net income growth was flat for FYE Apr. 2020, but appears to have picked up in first half of Jack Henry's fiscal 2021, which ends on April 30, 2021.
• Over the 3.75-year period, the non-GAAP net income excludes $112 million (EPS effect $0.23) of items regarded as unusual or of a non-recurring nature in order to better show the underlying profitability of Jack Henry.
• Other comprehensive income includes such things as foreign exchange translation adjustments in respect to buildings, plant, and other facilities located overseas and changes in valuation of assets in the pension fund - these are not passed through net income as they fluctuate without affecting operations and can easily reverse in a following period. Nevertheless, they do impact on the value of shareholders' equity at any point in time. For Jack Henry, these items were $80 million (EPS effect $0.17) over the 3.5-year period.
• There were share issues to employees, and these were a significant expense item. The amounts recorded in the income statement and in shareholders' equity, for equity awards to staff, totaled $46 million credit ($0.10 EPS effect) over the 3.5-year period. The market value of these shares is estimated to be $155 million ($0.32 EPS effect). The understatement of expense by $201 million is material in the context of non-GAAP earnings total of $3,055 million over the 3.5 year period, and of some concern from a "leaky equity bucket" aspect.
• By the time we take the above mentioned items into account, we find, over the 3.5-year period, the reported non-GAAP EPS of $6.34 ($3,055 million) has decreased to $5.52 ($2,662 million), added to funds from operations available for distribution to shareholders.
• Dividends of $1,575 million, and share repurchases of $209 million were adequately covered by the $2,662 million generated from operations, leaving a balance of $878 million added to equity. Shares to staff at market value of $155 million further increased this $878 million to $1,033 million added to shareholders' equity per Table 5.1 above

Jack Henry: Summary and Conclusions

I can only repeat, the company, as a business, appears to be performing well, the dividend is safe, and the balance sheet strong with no debt. There appears to be a real danger to the share price from potential multiple contraction, leading to negative returns.

Analyst’s 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.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.

Comments

[diamondjimbob]

Your "multiple contraction" concern also occurred to me during 2020. I've held JKHY for more than 20 years and felt that it was getting exceedingly expensive last year as the PE climbed above 40. I decided to set a limit order to sell a portion of my holdings if the stock ever hit $200. Bingo! Aug 18th at a PE of about 51, the order triggered. Call it luck. I did something similar with JKHY in December 2017 when I thought it was too rich and sold some at a PE of 35 and a price of $118. That was also the right choice for me at the time even though it continued to go higher afterwards.

For me, buying anything at astronomical PE ratios is nearly impossible, but astronomical PE ratios make the selling decision much easier.

[Robert Honeywill]

@diamondjimbob Thank you for your contribution to the discussion.

[eatonbiz]

@Robert Honeywill, very interesting and thorough analysis. Makes me rethink my current limit order on JKHY. I particularly appreciate the “leaky equity bucket” insight. Thanks for the education.

[Robert Honeywill]

@eatonbiz You are very welcome, and thanks for the kind words.

[WSLegend]

What is their business?
Did I miss a summary of what they do?

[Robert Honeywill]

@WSLegend Thanks for the question. Here is a summary from their latest SEC 10-K filing -

ITEM 1. BUSINESS
Jack Henry & Associates, Inc. ("JHA") was founded in 1976 as a provider of core information processing solutions for banks. Today, the Company’s extensive array of products and services includes processing transactions, automating business processes, and managing information for nearly 8,700 financial institutions and diverse corporate entities.
JHA provides its products and services through three primary business brands:
•Jack Henry Banking is a leading provider of integrated data processing systems to approximately 1,000 banks ranging from community banks to multi-billion-dollar institutions with assets of up to $50 billion. The number of banks we serve has decreased in the last year due to acquisitions and mergers within the banking industry, which are discussed further under the heading "Industry Background" in this Item 1. Our banking solutions support both in-house and outsourced operating environments with three functionally distinct core processing platforms and more than 140 integrated complementary solutions.
•Symitar is a leading provider of core data processing solutions for credit unions of all sizes, with nearly 840 credit union customers. Symitar markets two functionally distinct core processing platforms and more than 100 integrated complementary solutions that support both in-house and outsourced operating environments.
•ProfitStars is a leading provider of highly specialized core agnostic products and services to financial institutions that are primarily not core customers of the Company. ProfitStars' more than 100 integrated complementary solutions offer highly specialized financial performance, imaging and payments processing, information security and risk management, retail delivery, and online and mobile solutions. ProfitStars’ products and services enhance the performance of traditional financial services organizations of all asset sizes and charters, and non-traditional diverse corporate entities with over 8,600 customers, including over 6,800 non-core customers.
Our products and services provide our customers solutions that can be tailored to support their unique growth, service, operational, and performance goals. Our solutions also enable financial institutions to offer the high-demand products and services required by their customers to compete more successfully, and to capitalize on evolving trends shaping the financial services industry.
We are committed to exceeding our customers’ service-related expectations. We measure and monitor customer satisfaction using formal annual surveys and online surveys initiated each day randomly by routine support requests. We believe the results of this extensive survey process confirm that our service consistently exceeds our customers’ expectations and generates excellent customer retention rates.
We also focus on establishing long-term customer relationships, continually expanding and strengthening those relationships with cross sales of additional products and services, earning new traditional and nontraditional clients, and ensuring each product offering is highly competitive.
The majority of our revenue is derived from support and services provided to our in-house customers that are typically on a one-year contract, outsourcing services for our hosted customers that are typically on a five-year or greater contract, and recurring electronic payment solutions that are also generally on a contract term of five years or greater. Less predictable software license fees, paid by customers implementing our software solutions in-house, and hardware sales, including all non-software products that we re-market in order to support our software systems, complement our primary revenue sources. Information regarding the classification of our business into four separate segments is set forth in Note 14 to the consolidated financial statements (see Item 8).
www.sec.gov/...