Description

Jack Henry & Associates, Inc. (JKHY) is a capital compounder that will benefit from tightening oligopoly nature of the industry and shift from in-source to outsourced/cloud customers with lengthy contracts.  Owners’ earnings are far higher than GAAP net income and growing at a faster clip (?).  

Positives

• Industry surveys indicating a potential ramp in future tech spending

• Transition from short-term to long-term contracts

• Ability to launch new products into existing customer base

• Management has shown strong track record of capital allocation

• Named executives have half their comp solely from Total Shareholder Return relative to peers

• Former CEO and Board Chair owns~$30 million of shares and CEO owns $9 million

• High margin (low- to mid-30% EBITDA margins), high ROIC business (>20%)

• Consultants becoming middleman should strengthen incumbents' market share positions

Negatives

• Valuation

• VC/startups with monoline products constantly seeking to enter space

• Relatively mature banking services market

• Fiserv acquisition of First Data - unclear how longer-term partnership plays out longer-term

Jack Henry provides information management, transaction processing, automation solutions, and other back office functionality for financial institutions, particularly midsized banks (those with less than $50 billion in assets) and credit unions. This technology infrastructure allows financial institutions to comply with the complex regulatory environment and compete with larger banking institutions. Solutions range from customer-facing such as web and mobile applications, to in-house functions such as automated loan underwriting, data-driven credit loss provisioning, network security, and asset-liability management. The company provides its technology through three branded segments. Jack Henry Banking serves commercial banks and savings institutions. Symitar serves the credit unions. ProfitStars provides technology applications for a variety of financial entities and is structured to work with non-Jack Henry core systems.

The company has about 1,900 core clients and more than 9,000 non-core customers. For the twelve months ending March 31, 2019, Jack Henry generated $290 million in net income and $410 million of operating cash flow on $1.60 billion in revenues. The company has $35 million of revolving credit facility debt and 77 million shares outstanding. Its fiscal year ends June 30.

At first glance, the industry dynamics appear unattractive. Mega banks such as J.P. Morgan and Bank of America budget for billions of dollars in spending on internally-developed new technology according to their public disclosures. At the other end of the spectrum, the number of small and midsized banking institutions – those with less than $50 billion in assets – has declined due to mergers and closures. For example, from 2013 through Q1 2019, domestic commercial banks and savings institutions fell by 21%, from 6,800 to 5,300. 

Data source: FDIC

However, according to FDIC data, the number of banking institutions with greater than $500 million in assets is growing at a healthy clip.

Data source: FDIC

Today, three back office technology vendors – Fiserv, Fidelity National Information Services (FIS) and Jack Henry – divvy up amongst themselves most of the market. A few smaller players have nibbled on the edges. For example, specific to the credit union space, Corelation, through its Keystone platform, served 50 credit unions in 2016 and 57 as of 2019. This compares with over 630 credit unions for Jack Henry (through its Symitar Episys platform) and over 770 for Fiserv (through 6 different platforms).

There has been a change in the vendor procurement process that favors incumbents even more than in the past. Banks, by their very nature, are risk averse. The business model is to generate a few percentage points of return on assets, through lending operations, and financing those operations using significant leverage through low-cost funding (zero interest checking accounts, savings accounts and CDs are paltry rates). Consultants are risk-averse too. The cliché “Nobody gets fired for buying IBM” comes to mind.  They don’t get paid for taking longshots. And it is consultants who have increasingly become the gatekeepers between technology vendors and their bank and credit union customers, further entrenching incumbent operators like Jack Henry.

Some recent excerpts from JKHY personnel:

• 5/6/19 JKHY Analyst Day -- Steve Zengel, President of the Jack Henry Banking division: “Probably the biggest thing that I would see in contract negotiations is consultants are in about every deal, and banks used to just run their own contract negotiations … So instead of working with customers all the time, we work with consultants, and the terms become a little bit more standard. We know what to expect with each consultant more or less on what their hot buttons are.” 

• 5/7/18 JKHY Analyst Conference -- President of Symitar Teddy Bilke: “It's pretty limited. There's only about 4 of them that are in probably 95% of the deals” 

• 5/7/18 JKHY Analyst Conference -- Jack Henry CFO Kevin Williams: “Consultants like to have 3 players out there so there's some competition”.  

Overlay the above gatekeeper dynamic with the sticky nature of back office systems, banks’ (and their retail customers’) aversion to learning new systems, and the lengthening of industry contract terms (more on that later) and you end up with a recipe for an industry that should show remarkably consistent market share for incumbents year after year. And indeed it has.

Cloud transition creates near-term revenue headwinds

Within Jack Henry’s customer base, there is a transition away from in-house solutions – those where the banks and credit unions license Jack Henry technology and run applications on their own servers and networks – to an outsourced or cloud model. The contracts are lengthier, with terms of at least 5 years. Eight years is not unusual. This compares with the legacy in-house model where a one-year service contract is the only commitment. In the past, the company would recognize “Implementation Services” and “Hardware” revenues as part of the upfront installation process for an in-house customer. With cloud customers, revenues are recognized over the term of the contract. Consider the following:

• Hardware sales represented 4% of company revenues in 2015, 4% in 2016 and 3% in 2017. In fiscal 2018, Jack Henry stopped reporting hardware sales data due to immateriality.

• In addition, as part of connecting an in-house customer Jack Henry would realize “Implementation” revenues. The company does not break out explicitly, but we can back into revenue figures from disclosed year-over-year percentage and dollar change figures provided in 10-Ks. Implementation revenues represented 6% of company revenues in 2015, 4.6% in 2016 (after falling 15% YoY), and 3.8% in 2017 (after falling 14% YoY).

• Collectively from the above, 10% of the company’s 2015 revenues have been in a relatively rapid and perpetual state of decline. At the same time, connecting cloud customers is recognized ratably over the life of the contract, a period of 5 years or longer. Jack Henry is losing the benefit of showing legacy business model revenues and not immediately gaining the benefit in early periods of cloud model customers during this transition.

ASC 606 Further reduces run-rate revenues

As evidence of this, Jack Henry filed an 8-K in November 2018 that restated fiscal 2017 and 2018 to show ASC 606 effects. Reported revenues were 3% lower in 2017 and 4.5% lower in 2018 versus GAAP results under the prior standard (ASC Topic 985).  https://www.sec.gov/Archives/edgar/data/779152/000077915218000093/0000779152-18-000093-index.htm

The company’s fiscal 2019 10-Q filings show the recasted balance sheet under ASC 606.  For example, page 13 of fiscal Q1 2019 10-Q shows a bump to retained earnings of $56 million reflecting the booking of cumulative net profit on previously deferred revenues.  Non-current deferred revenues were reduced by $75 million in the same exhibit. https://www.sec.gov/Archives/edgar/data/779152/000077915218000101/0000779152-18-000101-index.htm

Jack Henry is growing share

Data source: FDIC, CUNA, Jack Henry 10-Ks

Within its customer base, JKHY is growing the number of solutions per customer for those customers

And growing revenue/customer ...

While its cloud/outsourced offering is now growing with some of its larger, higher spending customers:

Source: Analyst day presentation page 84

Capital Allocation Track Record

Over the 10 year period ending June 30, 2018, Jack Henry generated $3.1 billion total in operating cash flow. A third of that was reinvested into the business through capital expenditures (including capitalized software development costs). The remaining $2 billion was split amongst Acquisitions, Dividends, and Share Repurchases. Slightly more than a third went to share repurchases and slightly less than a third to acquisitions. 

Management’s reinvestment into the business via capital expenditures and acquisitions totaled $1.6 billion over the past 10 years. In addition to yet-to-be-realized growth, that investment spending has boosted annual operating cash flow from $180 million in fiscal 2008 to $410 million for fiscal 2018. Some of the $1.6 billion in reinvestment was needed to maintain the current steam of operating cash flow, in addition to the $90 million (and growing) annual R&D investment which is expensed as incurred. However, if we assume 100% of that spending yielded the increase in cash flow over the decade (implying the business needs zero capital investment to maintain existing operating cash flow), that 10-year investment yielded a 14% perpetuity-like return. More realistically, if we assume some level of annual reinvestment, such as $50 million per year, was required to maintain operating cash flow (of $180 million per year), then growth investments over the 10-year period totaled $1.1 billion and yielded a 20% return stream.  These figures are consistent with more traditional ways to measure corporate returns such as Return on Equity and Return on Capital Employed.

Valuation

We underwrite 9%/yr revenue growth and ~400-500 bps of margin expansion over the next 5 year period ending 2024.

Fiscal 2024 ending 6/30/24

Revenue: $2,389 (CAGR of 9% vs fiscal 2019 consensus)

Cost of revenues: $1,290 (54% of revenues, 300 bps expansion vs. as reported 2018)

SG&A: $263 (11% of revenues)

R&D: $143 (6% of revenues)

Pretax: $693

Normalized Tax Rate: 25%

Net Income $520

EBITDA: $932 (D&A unchanged at 10% of revenues)

Share Price IRR at EBITDA multiples:

16x ($193): 6.6%

18x ($217): 9.2%

20x ($241): 11.5%

Plus 0.4%-0.7% from buybacks (assumes circa $50MM/yr to $90MM of annual spend, 300,000-500,000 shares/yr, at avg price of $175) and 1 to 1.2%/yr from dividends, gets total IRR in range of 8% to 13.4% for an unlevered, growing, high quality, entrenched, stable, and recurring business.

Catalyst

• Continued growth in existing customer base
• penetration/wins into new customers