Description

Computer Services Inc. (CSVI - $620mn cap) - “Dividend aristocrat” that has grown EPS for 20 consecutive years trading for 15x CY18E EPS

Investment Thesis:

High quality business (>90% recurring revenue w/ ~100% customer retention) at a relative bargain (11x EBIT). CSI is a good business that should benefit as banks spend more on IT systems, compliance, and cyber security. I am betting that the stock will move higher as (1) the valuation gap between CSI and peers narrows back towards historical levels, and (2) historical EPS growth (9% CAGR over the past 10 years) continues (and accelerates in CY18 with tax reform).

Despite (1) an attractive organic growth profile (~5% organic revenue growth historically) and (2) accomplished management team (especially for a company of this size), the stock trades at 9x TTM EBITDA vs. peers at 19x. I believe this mis-pricing exists because (1) the stock trades OTC and doesn’t have ample liquidity for most institutions (avg. trading value of ~$150k), and (2) has insufficient data on some common platforms (like CapIQ). There is no sell side coverage, management rarely attends conferences, etc...

Business:

Small company in Paducah Kentucky is in rarified air with regards to its track record of growth, execution, and capital returns. CSI has grown revenue for 17 consecutive years and EBIT for 20 consecutive years, and has averaged a 22% return on equity since 2007. It has grown its dividend (currently 2.7% yield) for 45 consecutive years. This company has a pretty incredible track record...

I view CSI as a mini Fiserv or Jack Henry, providing IT solutions for banks. CSI’s customer skew is to community/regional banks in the Midwest and South (it customer base is in less than 50% of US states). They derive revenues from 2 segments:

• Processing services (63% of revenue). As explained by Jim211’s FISV writeup, “Core processing would include processing of banks' customer deposit and loan accounts. These solutions are offered on an outsourced basis or licensed in-house system. Mostly they are done on an outsourced basis, helping the banks avoid spending large sums on capex and their own in-house IT groups. These services are billed mostly per account on a monthly basis (in the case of customer accounts) or on a per transaction basis (in case of check clearing or lending solutions).” As seen below, CSI is the 4th largest player with 6.6% share:

• Integrated banking solutions (37% of sales). This segment is a catch-all of ancillary services including check imaging, cash management, branch and merchant capture, mobile and Internet banking, teller services, card service/support, compliance software, risk assessment, and security/fraud protection.

Valuation & Price Target:

My 1YR PT is ~$60 (36% upside) is based on 11x CY19E EBITDA (~20x EPS). As illustrated below, I believe the near-term risk/reward is favorably skewed.

*Calendar year

While I can envision greater upside in a bull case (primarily by using higher multiples or in a scenario where CSI puts its balance sheet to work), I am particularly attracted to the seemingly limited downside, which is cushioned by CSI’s balance sheet and the quality and resiliency of the business. Note, this company grew income >10% in both 2008 and 2009. Note, I am still assuming CSVI trades at a significant discount to peers.

As seen below, this type of valuation gap has not always existed (at least not to the current extent). In 2012, these stocks all traded at ~10x EBITDA. Peers have re-rated significantly over the past ~2-3 years while CSVI (orange line) has languished below 10x EBITDA.

Investment Positives:

(+) Good business characterized by long-term contracts and high switching costs. CSI’s data processing contracts are three to ten years in length and switching costs are high. As a result, CSI’s customer retention (excluding banks getting acquired) is often ~100%. According to an EVP at CSI’s competitor, “core conversion is a lot of work...we’ve called it open heart surgery without anesthesia. It is a grueling effort that requires a lot of attention. People don’t want to go through it very often.” The attractiveness of the industry is evident in the stock prices of the big 3, whose stock prices have compounded nicely over the long term. Since 2004, FISV +720%, JKHY +580%, and FIS +200% (vs. S&P up 150%).

(+) Capital allocation is solid. In addition to 45 consecutive years of dividend increases (currently 2.8% yield), the share count has declined at a 1.6% CAGR over the past 10 years.

(+) Historically a full taxpayer, CSI will benefit from tax reform. CSI has a 38-39% tax rate. Assuming it pays closer to a 25% rate with tax reform it would be ~20% accretive to EPS. I have assumed a 25% tax rate in my CY18 estimate of ~$3 in EPS.

(+) Under-leveraged balance sheet. Attractive PE target. The company has $35mn in cash with no debt. There is significant dry powder for either (1) an acquisition (which have been good historically due to cross-selling), and (2) a levered recap (unlikely). Given stability of cash flows, it appears that CSI could be a very attractive PE target (Vista equity partners bought D+H and Misys to form Finastra). Note, Vista paid 2.7x revenue and ~14.7x EBITDA for DH.

Investment Risks:

(-) Largest competitors are taking share from smaller players.  In an industry where three players (FIS, FISV, and Jack Henry) control >85% of the market for banking systems, CSI is the 4th/5th largest player. According to industry consultant, “there is a second tier of vendors that is shrinking every year...once there were 117 companies in this market and now I’m lucky if I can come up with 20...in a herd-like industry where bankers follow the leaders, the little guys are in tough shape...no respectable bank is going to put all their eggs in the basket of one tiny company and risk their future success.”

(-) Trends towards vendor consolidation and bank consolidation is bad for CSI. Bank consolidation has been one of the largest headwinds to CSI’s growth, as the acquired bank often breaks its contract with CSI to change with the systems of its acquirer. This has been a headwind over the past few years (the extent of which is outlined below), which is why revenue growth has decelerated in recent years, but I don’t foresee it intensifying.

• Note, despite a light F3Q (Nov end), there has been no slowdown from recent trends in FY18 to date (revenue +7% and EPS +9%)

(-) Minimal disclosure. As a result, I don’t feel like I have enough information to make a whole hog financial model with thoughtful revenue drivers.

Historical Financials (FY end Feb 28th):

Catalyst

Be patient?