Description

Thesis:

Goldleaf Financial Solutions (GFSI) is a recently restructured financial technology company which provides a suite of software products to small and mid-sized community banks.  After years of declining profitability due to poor management decisions and a bad capital structure, GFSI underwent a major transformation in 2006 and has positioned the company to return to positive and growing profitability in 2007 and beyond.  Over the last year, the company has acquired a superb technology platform (more on that later) through a series of three acquisitions, replaced its senior management team, and completely recapitalized the organization with a $63 million gross equity raise (11.5 million shares at $5.50).  Now that GFSI has completely paid off its long-term debt and its burdensome preferred stock, the balance sheet is pristine and the company’s earnings will flow to the common shareholders instead of the holders of its debt and preferred stock.  More importantly, we believe that revenue and cash flow are about to grow substantially from current levels.

 

GFSI’s share price has declined from an all-time high of $190 per share in the height of Internet craze in 1999 to its current price of $6 following the recapitalization of the company.  The chart alone is enough to scare most investors away from the name, while the market cap of $100 million keeps GFSI off of most professional investors’ radar screens.  However, as Revenue and EBITDA accelerates, Goldleaf will look excessively cheap compared to its peers.  At its current price, GFSI trades at about 1.7x its annualized 3Q06 revenue of $58M (EV = $98M) and 10.6x its annualized 3Q06 EBITDA.  This is already below the trading multiples of its larger peers and well below the acquisition prices paid for recent financial technology deals.  We believe Goldleaf’s revenue will grow from the current run rate of $60M per year to $90-$100M per year within 3-4 years, while its EBITDA should grow from $9M a year to $20M-$25M per year over the same time period.  GFSI is a technology leader in the fast growing remote deposit capture and ACH arena, has put together an experienced sales force, and already has established relationships with over 2,500 financial institutions.  Revenue is not only growing quickly from a modest base level, but the incremental contribution margin of new business is also over 60%.  As EBITDA grows to the $20M to $25M per year level, we believe GFSI will be a $12 to $15 stock.

 

Background:

Prior to 2006, the company was called Private Business, Inc. (PBIZ) and provided a niche set of software products for accounts receivable financing and retail inventory management services.  After revenue growth stalled in 2000 at the $56 million level, the board replaced the CEO in early 2001.  The company’s headcount was reduced by 20% (461 FTEs at the peak to 372 FTEs in March 2002), capital expenditures declined, and not enough money was invested back into the business.  While earnings and cash flow temporarily improved, the ongoing business suffered and revenue began to decline.  Furthermore, the capital structure was heavily diluted by preferred stock issuance and increasing levels of bank debt, and less and less cash flow was flowing through to the common shareholders.

 

The Transformation:

Beginning in December 2005, Private Business/Goldleaf made a series of strategic actions that will significantly improve the value of the company.  On December 9, 2005, PBIZ acquired Captiva Solutions, which added core data processing as well as image and item processing.  At the same time, Lynn Boggs (former President of InterCept) was installed as the new CEO of the company.  In January 2006, PBIZ acquired Goldleaf Technologies, Inc. and P.T.C Banking Systems.  These two transactions added Automated Clearing House (ACH) processing, remote deposit capture technology, and teller automation systems to the company’s suite of products.  This new product set enables the company to participate in a major current trend in banking as banks begin to take advantage of “Check 21” which was enacted by Congress in late 2004.  The company also officially changed its name to Goldleaf Financial Solutions in May 2006 to reflect the new focus and direction of the company.

 

The last major step for GFSI was the recapitalization of the company.  In October, 2006, Goldleaf completed an 11.5M share offering at $5.50 per share, raising $57 million of net proceeds.  Management used the funds to retire $37 million of preferred stock and repay $18M of outstanding debt.

 

The Check 21 Opportunity:

The Check Clearing for the 21^st Century Act (Check 21) was signed into law on October 28, 2003, and took effect on October 28, 2004.  The new law enables checks to be truncated and cleared electronically, eliminating the need for businesses to physically deliver checks to their bank.  One result of Check 21 is the rapid adoption of remote deposit capture technology by banks and their customers.  Under the new rules, a business like a supermarket can make its daily deposit by running checks through a desktop scanner and electronically submitting the deposit to the bank.  Banks across the country are tripping over themselves to adopt the technology as it eliminates the need for expensive courier services and they can effectively serve more customers outside of their geographic branch footprint.

 

Goldleaf Technologies was one of the first vendors to tap the remote deposit capture market.  A study done by the Copper River Group in the fall of 2005 showed that Goldleaf held a 25% market share, as measured by number of bank customers.  So far, Goldleaf has signed up 135 banks which have purchased 4,100 scanners (2,600 were active as of 9/30/06).  We believe there is much more room for growth given that there are 8,000 banks in the US and roughly 6 million small businesses.  While the larger technology vendors like Fiserv, Fideltiy, and Metavante can and probably will capture the largest share in the space over time, GFSI has a defensible niche strategy by providing a high level of service to the underserved smaller banks.  Many of the small banks we have spoken to have identified this as the precise problem when dealing with large vendors – slow response times and a poor level of service.

 

The potential revenue stream from remote capture is strong and largely recurring.  GFSI sells a 5-year up-front software license to a bank for $22,000 and clips a 15% profit margin on each $600 scanner they sell.  Once a bank has implemented the technology, GFSI earns three sources of recurring revenue: 1) $3,000-$4,000 of annual maintenance fees per bank, 2) $480 per year per installed scanner, and 3) $0.06 per transaction (scanned check).  For example, if GFSI signs up 500 banks with 40 merchant customers each (20,000 scanners) Goldleaf will earn $13 million of fees up-front and approximately $15 million of recurring revenue per year (assuming each merchant scans 50 checks per week).  Goldleaf’s revenue from remote capture is currently only about $10M a year, but it clearly has the opportunity to double or triple from current levels.  More importantly, the incremental gross margins of remote capture once a bank is signed up for a 5-year contract approach 100%.

 

Other Revenue Opportunities:

Conceptually, GFSI is comprised of two parts: 1) its legacy businesses (inventory management software and accounts receivable financing software) and 2) its growth businesses (remote capture, ACH, core processing and other banking software.  With regard to its legacy businesses, the new management team has refocused its sales force and eliminated some of the unprofitable business lines.  We don’t expect miracles here, but management has set a very achievable goal of 1-3% growth from its legacy businesses.  We have already seen the legacy revenue stabilize and start to grow from trough levels.

 

With regard to its newer suite of software products, GFSI has significant growth prospects.  Lynn Boggs, the new CEO, was at the helm of InterCept (ICPT) when it was sold to Fidelity (FIS) for $447 million in 2004, for about 14x its expected EBITDA.  InterCept was one of the largest financial technology companies at the time with over $260 million in annual revenue and a large, elite client list of 425 community banks.  Boggs is working to re-establish many of these relationships with his experienced sales force, as many banks are frustrated by the service they get from the large technology vendors.  Goldleaf has already signed up 17 banks on its core processing platform (averaging about $125,000 of annual fees) and has a pipeline of 15-20 more.  We expect GFSI to have significant traction in this arena, as banks begin to implement some of Goldleaf’s technology solutions (from teller systems to core processing to internet banking).

 

Note:  InterCept was quite a turbulent story as those of you who are familiar with the space may know.  ICPT made an ill-advised acquisition of a company called “iBill” in 2002 (before the arrival of Boggs) and subsequently wrote off the majority of the investment.  ICPT was also involved in a proxy battle with JANA Partners who argued for the sale of the company.  Our recommendation of GFSI rests on two keys premises: 1) the core business of ICPT was excellent and its inherent value was validated in the sale to FIS and 2) Boggs was part of the solution at the company, helping the company get back on track after the iBill transaction and facilitate a sale to FIS.

Catalyst

* The increasing adoption of remote capture and ACH technology by small- and mid-sized banks will accelerate revenue and EBITDA growth for GFSI.
* The recapitalization of the company in October 2006 will allow cash flow to benefit common shareholders instead of preferred stock and debt holders. This benefit will be more obvious when 4Q06 and 1Q07 earnings are released.
* GFSI already trades a discount to its financial technology peers at 9x estimated 2007 EBITDA versus other financial processing companies at 10-11x. While we believe that EBITDA will more than double in the next 3-4 years, we also believe that the valuation gap will close in a much shorter time period.