Description

Background

• Jack Henry was founded in 1976 as a provider of core processing software for banks. They now have 6,900 employees with their headquarters in Monett, Missouri and additional offices in 24 states.
• Management positions have generally been stable, but they recently hired a new CFO. The CEO and Chairman is David Foss, who began at Jack Henry in 1999 and became CEO in 2016. Mimi Carsely was name CFO in 2022 prior to which she held leadership positions at Blucora and LPL Financial and was CFO of Bluewater Global.
• Annual incentive compensation is based 75% on adjusted operating income and 25% on individual performance goals. Longer term compensation is based 60% on shareholder total returns relative to the S&P 1500 software and services index, 20% on organic revenue growth, and 20% on adjusted operating margins all measured on a 3 year basis. Management owns 0.63% of total shares. 
• Market cap of $12 B. 33 year history of dividend increases. Broad analyst coverage.

How do they make money?

Jack Henry provides technology solutions to financial institutions. In general, Jack Henry provides all the tools needed to run a bank. These services are hosted through their private/public cloud or customers on-premise cloud and are secured through contracts. Private cloud customers are typically on a 7 year contract, recurring electronic payment customers are on a 7 year contract and on-premise cloud customers are on a 1 year contract. On-premise customers license the software, which is paid upfront, then they are contracted for annual software maintenance (20% of original license fee).  They have made several bolt-on acquisitions over their history, but have primarily grown and developed products organically. 99% of revenue is generated in the U.S. They report three segments, which are based on the products that they offer. The core segment sells processing systems (the bank’s APX) that maintain customer information and processes, which includes posting deposits, withdrawals, loans and general ledger transactions; this system is extremely important to customers and has low turnover due to switching cost/risk. The payments segment provides processing tools and services for ATM, debit, credit, remote deposit and ACH. The complementary segment provides a wide range of additional software and services (100+) including, hosted processing platforms, call center support, fraud monitoring, and consulting. The complementary segment products can be used within their core system or independently. The complementary segment encompasses the majority of non-core customers.

Customers who use the core processing system are thought of as “core customers”, however these customers purchase services from a number of the segments. For example, 50% of “core customers” use the debit card processing product, which is included in the payments segment. Overall estimates suggest that core customers account for 65-70% of total revenue and non-core make up the additional percentage of 30-35%. Non-core customers on average use 3 different products.

In August of 2022, Jack Henry decided to refresh their corporate brand and bring all brands under the Jack Henry name in order to help customers understand the full list of products available under the company and unbundle some of those offerings. Jack Henry employs its own sales force, but also uses a variety of consultants and resellers to sell their solutions. The internal sales force is separated into 3 divisions. Those divisions are separated by, a division focused on new core customers, a salesforce that cross-sells solutions in the current core customer base, and a third that sells core agnostic solutions to customers outside of the core customer base.

Average contract is 7 years on the core side and if the company is acquired during the contract, then the contract has to be bought out. They call this “deconversion” revenue. This revenue can bolster financials at times, but is not a positive for the business long term, since they ultimately lose a customer.

Customers

Today, Jack Henry has 7,800 clients, which are made up of 1,650 core processing clients and 6,150 non-core clients that use one of Jack’s core-agnostic solutions. Banks and credit unions make up the majority of their customer base, but they also have a small presence outside of the financial industry. They focus on small to mid-sized banks and credit unions that have up to $50 million in assets. The FDIC states there are 4,790 of these commercial banks and savings institutions and Jack Henry’s core system is used by 950. The Credit Union National Associations states there are 5,000 domestic credit unions of which Jack Henry’s core system is used by 720.

Customer numbers have generally been in decline as the financial industry consolidates and the number of new bank charters has declined significantly. From 2016 to 2021, the number of commercial banks and savings institutions declined by 18% or 4% annualized, primarily due to mergers. Similarly, the number of credit unions declined at a 3% annualized rate. However, aggregated assets increased at an annualized rate of 9% over the same period. Overall, Jack Henry’s customer concentration is low, with no customer greater than 10% of revenue, so no one M&A event would be significantly damaging to the company. Also, contracts include “per account” fees for cloud and per computer fees for on-premise, which could insulate Jack Henry from the revenue impact of two customers merging.

Accounting Distinction

Since most of Jack Henry customers are under contracts and banking M&A is frequent, customers must pay a “deconversion” fee if they are acquired and migrate to a different system provider. Revenue from these fees create high margins, but are volatile from quarter to quarter. Since 2018, they have recognized $42 M of deconversion fees each year on average and estimates suggest this converted to $0.35 to EPS. Said another way, deconversion fees have made up 2% of revenue and 8% of EPS on average for each of the past 5 years.

Competition

There are a large number of small financial technology competitors in the market. However, for core processing, the top 3 companies (FIS, Fiserv, and Jack Henry) make up well over half of total U.S. market share. For the new market entrants, management believes that they have been more challenged in disrupting Jack Henry’s business due to the extensive regulation environment for financial services in the U.S., which requires products be approved by regulators.

Competitors can also be partners. For example, Jack Henry has outsourced their card processing to Fiserv. This partnership has allowed Jack Henry to growth their card processing services to non-core customers. Since the agreement was signed in 2017, Jack Henry has increased card customers by 10x from 111 to 1,100 Also, they have connections with over 950 different fintech providers that can integrate into Jack Henry’s core system.

The other primary competitor for Jack Henry is in-house software deployment. In-house core systems are primarily used by larger institutions due to the opportunity for operation leverage. However, other software services may be created in house.

Jack Henry has the leading share in ACH processing and bill pay in the U.S. for banks.

Growth

There is an interesting dichotomy for this company on growth. On one hand, the number of customers is declining as the financial sector continues to consolidate. On the other hand, technology spending for the financial industry is growing at 5-10% per year and continues to gain importance with their customers.

Jack Henry adds about 40 new core customers per year. These customers are the most important to growth in that, as management suggests, they end up purchasing much more than the core processing system due to cross selling of additional services. A number of these new customers have come from market share growth in that they are competitive takeaways. New customers also come from new banks, where management has suggested that recently have had a 55% win rate.   

The addition of additional services and capabilities from cross selling and offerings to customers that do not currently use their core system has been an area of growth. Management suggests that they spend at least 14% of sales on R&D each year, but this number includes their capitalized software spending which accounts for ~7-8% of revenue.  

Moving customers to the private cloud is a current driver of revenue. Management suggests that moving a customer from an on-premise/in-house model to private cloud/outsourced model could increase revenue from that customer by 2 times. Also, it increases the contract length to 7 years.

Sell side analysis suggests that financial institutions can save 5-10% on a per account basis by moving their system from on-premise to a private cloud system through Jack Henry.

On a longer term basis, public cloud is likely to be the next level of client conversion that will drive growth. As a part of their unbundling effort, Jack Henry has begun to move all of their services to the public cloud. Today, Jack Henry offers a number of services through the public cloud, like their digital banking platform, Banno. However, there is no demand for a core system on the public cloud because the regulators require the ability to do a full exam and they are not ready for that on the public cloud. The core system conversion will likely be slow in part due to the massive nature of changing a banks core system, but also the build out will take time as everything needs to be rewritten and the modules being rolled out are relatively small. They have continued to add public cloud partners to be the base operator of this public cloud system and were told they are currently the largest financial player in the Microsoft cloud environment today. This will be a new leg of “replacement” growth for core customers when it is built out and accepted by regulators.

Financial Strength

Overall, financial strength is very solid from a balance sheet and operational standpoint. Historically Jack Henry has carried low to no debt on their balance sheet. However, their recent all cash acquisition of Payrailz for $230 M has led to an increase in debt. Their high number of reoccurring revenue and provisions that protect revenue in the case of an acquisition creates a solid base for their operations.

• Jack Henry has $275 M of debt and $48 M of leases. They also have cash of $26 M.
  • Debt is made up of a credit facility with $600 M of total availability ($325 M currently available) and a maturity of August 2027. The interest rate if SOFR + 1%. 
  • Covenants are interest coverage > 3.5x (current = 83x), and leverage < 3.25x (current = 0.6x)
• Additional obligations:
  • Contractual obligation totaling $980 M with First Data/Fiserv to process credit and debit card transactions through January 2036.
  • Contractual obligation totaling $225 M with Google to provide their cloud platform to Jack Henry.

On capital allocation, they seem focused on returning cash to shareholders, and making tuck in acquisitions. If valuations improved/declined they may increase the number of acquisitions they make, but the CEO stated on a recent conference call that they “are NOT looking for a transformative acquisition”. Jack Henry has made 50 acquisitions since its inception, but acquisitions have slowed in recent years. They acquired Payrailz for $230 M in September of 2022, but that has been the only notable acquisition over the past 5 years relative to their ~$12 B Market cap. Management believes they have built out a full offering and do not have any “holes to plug”.

Risks

• Decline in customer base starts to impact growth. Death of local or regional banks? 
• Cyclicality due to IT spending budgets (though this has historically been somewhat resilient).
• Renewed focus from large competitors on the core processing segment or competition from a large number of providers who could find an edge as technology is continually evolving. There are about 80 different core platform providers.
• Cyber security risk or other brand damaging risks.

Valuation

Using a free cash flow based DCF I arrive at a value of $145 ; using a discount rate of 9%, a terminal growth rate after 5 years of 5% and a free cash flow margin of 17% (I include the capitalized software expense in my CAPEX number). This valuation is very similar to the current stock price.

Jack Henry’s forward P/E has ranged from 41 to 28 over the past 5 years. They currently trade at a 30x. If we used the middle of the historical range (34.5), that would led to a valuation of $175 using consensus EPS of $5.08.  

While the valuation may not be extremely attractive, I feel it is worth initiating a position in this high quality company at the current valuation.

Final Thoughts

Jack Henry is a focused provider of ESSENTIAL services to financial institutions. Despite the decline in their customer base, they have a track record of increasing revenue through growing technology spending by customers and market share growth. High switching costs and stringent financial regulations provide Jack Henry with a moat. Financial strength is solid from a balance sheet and operational standpoint with low debt and high reoccurring revenue. Profitability and returns on are attractive.

Catalyst

Move upmarket to larger banks driven by expansion of technology offerings and cloud. End of the banking crisis or belief that regional banks will live.