Description

Pitch In A Sentence:

The market has overlooked the business transition and exceptional execution at i3 Verticals, allowing investors to purchase a secularly growing business with a management team with an enviable track record of value creation at a discount to similar businesses; furthermore, the fragmented space they operate in could support a long runway of inorganic growth – something the management team has successfully leveraged to create shareholder value.

Company Overview:

i3 Verticals (“i3” or “the Company”) is a vertical market software (which the Company calls “Software and Services”) and payments processing and other related solutions (which the Company refers to as “Merchant Services”) provider. As of the latest quarter, the Company generates 50% of its revenue from recurring software and services, 45% from payments processing, and 5% from other sources. In terms of end markets (“verticals”), the Company is primarily focused on providing solutions for the Public Sector (50% of Revenue) and Healthcare (20% of Revenue).

Their Public Sector solutions span a wide variety of solutions ranging from Judiciary and Court Management Software to Utility Billing to School Lunch Payments. i3 Verticals has historically focused on servicing smaller constituencies (~75,000 people) and k-12 programs; however, given recent progress in launching new products, unifying their product offerings, and coordinating more effectively across their organization, the Company has been increasingly competitive in larger, statewide RFP’s and university contracts.

Within the Healthcare vertical, the Company offers a wide variety of products ranging from Revenue Cycle Management Software to Medical Billing Software to Electronic Health Records Systems. The Company has only recently developed the product breadth and depth to warrant a product unification strategy; because this is currently underway, the fruits of this effort will likely pay off in the near to medium term.

History:

Understanding the history of the Company is a key part of understanding the current mispricing. At the Company’s IPO, the business was almost exclusively focused on providing payments solutions. The Company’s strategy was centered primarily around offering payments solutions first. This orientation is a function of Greg Daily’s experience as a renowned payments entrepreneur. Although they had realized the virtues of being a software-first business, payment processing related revenue sales comprised the vast majority of their revenues (>90%). Furthermore, the Company was relatively less concentrated in attractive verticals. However, over the last few years, the Company has quietly executed more than 30 tuck in acquisitions (~$2-5m in EBITDA, purchased at 6-10x). Through the combination of this inorganic strategy and internal development / integration, the Company has now successfully shifted its business into a primarily recurring revenue, software-first business.

Investment Theses:

Underappreciated Business Transition:

At its core, the mispricing is largely due to the market not fully appreciating the Company’s business shift. Over time, management has tactically used acquisitions and internal development to shift the balance of business not only towards more superior, recurring revenue streams, but also towards secularly growing, attractive verticals.

The benefits of recurring, high-margin software revenue streams are typically well appreciated. However, for i3 specifically, there are ancillary benefits. By offering software products, i3 can improve the margin in two ways:

1) Mix Shift: Because i3’s software business carries higher margin than their traditional, more commoditized payments processing business (~90% gross margin for software relative to 60% gross margin for payments processing), margins will expand as software grows as a percent of revenue.

2) Enhanced Value Proposition: By layering on payments after the initial software sale (cross selling the payments offering) or bundling the two together, i3 can charge more for its payments processing. Thus, these “integrated payments” are inherently higher margin. They are also less likely to be replaced or competed away as they are joined at the hip with a stickier, less commoditized software offering. This improves the performance of their payments business.  

The Company has also positioned itself to benefit more from fragmented industries that will benefit from secular tailwinds. At its IPO, the Company was somewhat oriented towards 3 verticals: Public Sector, Education (now incorporated into Public Sector), and Healthcare. However, the rest of the verticals that they served – Hospitality, Non-profits, B2B (SMBs), Retails – constituted a large portion of their end market exposure. Although the Company did not precisely disclose their vertical concentrations until 2020, we estimate that >50% of their business at IPO came from non-core verticals. Moreover, we estimate that <30% came from the Public Sector vertical. This is in stark contrast to today, where the business generates over half its revenue (and an even larger portion of its EBITDA) from the Public Sector; this is closely followed by the Healthcare vertical, which we estimate to be ~20-25% of revenue.

Relative to the non-core verticals, the Public Sector and Healthcare verticals are more attractive because they are more fragmented, benefiting from secular tailwinds, and less exposed to cyclical pressures.

The Public Sector Software landscape is extremely fragmented and outdated. In 2019, Bloomberg wrote an article titled “America’s Cities Are Running on Software From the 80’s,” detailing the decrepit state of most government systems. Current industry reports estimate that roughly 67% of current deployments are legacy software (developed 20+ years ago); this belies the opportunity set for i3, as the percentage for smaller municipalities is likely higher (we estimate ~80%) given less sophisticated procurement. Governments are currently served by small, local operators who do not have the scale or desire to improve their offerings. Because the software is deeply embedded into the relevant authorities’ workflow and retraining could slow down already painfully slow government workers, governments at all levels are reluctant to change providers. However, this has recently been changing. Due to increased pressure from constituents for efficient and modern systems coupled with increased stimulus for smaller governments (like the $350 billion granted under the American Rescue Plans’ Coronavirus State and Local Fiscal Recovery Funds), municipalities have begun the undertaking of upgrading their systems [Example of this happening with a i3 Verticals customer: 054 GC Agenda 041223.pdf (nh.gov) ].  Most of the Company’s acquisitions in the Public Sector verticals are benefiting from these tailwinds, growing organically at low double digits on a standalone basis. Additionally, governments, unlike Retail or Hospitality, are not subject to the same cycle-driven cost pressures. This means that even in recessions, spending on critical systems like the ones i3 provides remains intact. Finally, the Public Sector is also uniquely attractive because they are far less price sensitive once a product is installed. Because governments prefer continuity and stability over the most cutting-edge technology, they are unlikely to switch their software provider unless there is a serious problem. For the clearest evidence of this, we can look to i3’s larger peer, Tyler Technologies, who has been able to consistently raise prices at rates close to 3% over the last decade.

Healthcare is also similarly fragmented. Most hospitals rely on outdated, sometimes homegrown software services. For example, the Revenue Cycle Management is a relatively fragmented subvertical. Today, most revenue cycle management services are carried out by hospitals themselves; only ~1/3 of the estimated $120 billion market is outsourced, with the largest player only having ~$2.5 billion in revenue. As providers are forced to become more efficient to deal with rising labor costs and declining reimbursement, the trend of outsourcing and increased spend on improved Healthcare IT provides a robust tailwind. This trend, coupled with the CMS’ expected 5-6% growth in healthcare expenditures, is expected to result in the TAM for i3’s Healthcare products growing at 11-12%. Like governments, healthcare tends to be relatively acyclical, making this vertical far more attractive than i3’s non-core verticals.    

In summary, i3 Verticals has shifted from a non-recurring, relatively commoditized payments processor serving unattractive, cyclical end market to a primarily recurring revenue, higher margin software and integrated payments provider exposed to secularly growing, acyclical end markets.

Although we are often hesitant to underwrite any multiple expansion in our investments, we believe that this material change in the business warrants at least a modicum of multiple expansion. As the market becomes more familiar with the current business mix and appreciates the improvement in business quality, we believe i3 Verticals will re-rate closer to its current peer set. Currently, i3 Verticals is valued ~11.5x LTM Adjusted EBITDA; this is close to the multiple paid for payments-oriented comps (RPAY, FOUR, WEX, etc.).  However, software companies focused on Government and Healthcare verticals (TYL, RCM, ASX:TNE, etc.) trade at closer to 20x. While it would be highly unlikely (and unwarranted) for the Company to trade in-line with the latter comps, the Company should approach those valuations. In our base case, we underwrite a single turn of multiple expansion from 11.5x to 12.5x, which contributes ~10% of the overall return (~2% IRR). Even without any multiple expansion, i3 Verticals presents an interesting investment opportunity.  

Improved Growth Outlook:

            The market is not only underappreciating the quality of this business, but also fundamentally mismodelling the growth of this business going forward. Consensus estimates for this company believe that the Company will grow 7-8% over the next few years. Part of this sentiment is driven by skepticism around the Company’s ability to execute organic growth initiatives. However, evidence suggests that this skepticism is highly misplaced.

            Firstly, the Company has a strong track record of mostly low double digit organic growth. However, we project that recent changes in the Company are likely to accelerate this growth – at least in their key verticals.

            The Unified Product Offering and centralized RFP process are material changes to the business. Whereas the Company was previously more of an amalgamation of loosely connected businesses, these initiatives have centralized many functions. This has allowed the Company to address larger, statewide RFP’s and better allocate salesforce resources. Our analysis indicates that this has resulted in an increase in the Company’s win rate. By searching the names of i3’s subsidiaries in procurement portals across the country (typically in the format “i3-BIS,” “i3-Imagesoft,” or “i3-Milestone”) we can see a marked improvement in the Company’s new contract wins – in frequency, scope, and contract value. This has partially become visible in the financial statements and earnings calls (where management has started calling out larger installations with greater frequency); however, we believe that there is a significant portion of contracts that are likely to flow through the financials over the next few years, supporting a higher organic growth rate (in our research, we have uncovered contracts that would imply ~$50m in incremental annual revenue that will come online in the next 5 years; extrapolating to geographies with lower visibility, we believe that this alone supports 6% growth in Public Sector revenue). Greg Daily alluded to this dynamic when asked about 2024 guidance on the Q4’23 earnings call:

“We're being careful with the guide, but it -- I feel very comfortable with what I'm seeing the pipeline, the deals that we've already signed, we just haven't installed yet, so I'm optimistic about our guide.”

Given that the TAM is expected to grow at ~8-9%, we believe that i3’s Public Sector can organically grow at 12-13% for the next few years. This growth above TAM growth will be driven primarily by 1) increased win-rates leading to market share capture (~100 bps), 2) layering on payments to existing contracts / growing payments volumes (~150 bps), and 3) successfully cross-selling different services to existing government customers (~50 bps).

            The Company has recently undertaken the task of integrating the Healthcare Vertical, which should result in similar benefits. However, since the project is still underway, we do not underwrite any improvement to the business. We believe that the Healthcare business will grow at 8%, slightly below the growth of its addressable TAM. This difference is primarily to reflect our conservatism on the segment until management can prove that they can replicate the success of the Public Sector vertical.

A secondary impact of the Unified Product Offering is an increase in margin; in the latest guidance, the Company guided margins to improve by ~150 bps by next year. They attributed a lot of this expansion to the success of the integration plans. We believe that over the next 5 years, the operating leverage inherent to this business and the improvement in product mix (collectively contributing ~90 bps of expansion each year) and continued benefits of the ongoing integration (~25 bps of expansion each year) will lift margins more than the market expects.

We also believe that the Company has an additional under-tapped growth lever. The public sector business is one that really lends itself to pricing increases. As mentioned above, customers are very reluctant to switch providers and are often amenable to price increases upon renewal (within reason, of course). Many larger competitors consistently take pricing and are already priced significantly above i3 Verticals; although this difference is partially attributable to the fact that the customers of larger customers are themselves larger, we believe that the dynamics driving customer inertia remain the same even at smaller governments. In their Q3’23 Earnings the CFO had the following to say regarding taking pricing:

“Our style has never been to raise prices. And so in some cases, when we do, we haven't raised in 10 years and our customers understand. So we do have the ability and the resolve to pass through cost increases.”

            So while we do not underwrite any benefit of this latent pricing power, we believe that it offers some margin of safety around our growth estimates. If the Company becomes more aggressive on pricing it’s products, it would likely be able to deliver modest organic growth through margin-accretive pricing increases. We believe that they could raise prices on existing customers at an average rate of ~100-150 basis points a year.

            In summary, we are more constructive on the organic growth outlook for the Company. Given the growth expectations highlighted for the Public Sector and Healthcare in addition to the Company’s historical 8-9% growth in the other segments, our base case is that topline growth over the next 5 years will be ~10%. Additionally, we believe that Adjusted EBITDA margins are set to expand by ~575 bps by year 5.

M&A Upside:

            While not in our base case, we believe that M&A could be a meaningful driver of value well into the future. Particularly in the Public Sector vertical, the market remains quite fragmented. Furthermore, these smaller acquisitions typically provide i3 with a beachhead from which they can land and expand. Traditionally, the Company has focused on layering payments services over the software services that they acquire. However, with their increased portfolio breadth, they can likely cross-sell governments with a wider variety of services over time.

            However, even if the opportunity exists, it is important that the management team is able and willing to seize the opportunity. We believe that i3 Verticals’ management team is uniquely qualified to do just that.

            Greg Daily, i3’s CEO, is a serial entrepreneur with a track record of enormous success. He is highly regarded in the payments industry for his previous ventures. His first large success was PMT, a payments processor focused on small businesses. His thesis was that these customers had been neglected by larger companies and that by consolidating providers, he could benefit from economies of scale. Greg co-founded the company with $2,000 in 1984 and eventually sold it to NOVA corporation for $1.3 billion. While he generated enormous wealth for himself, he also generated enormous wealth for shareholders when the company was public. Between when PMT IPO’d in 1994 and when NOVA acquired the company in 1998, shareholders grew their investment almost 20 times.

            Greg would then parlay his success into his second venture: iPayments. iPayments would IPO in 2003 and would public for a short time. Greg Daily, unhappy with the market’s lack of appreciation for the company’s potential, would buyout the company. For the period the company was public, shareholders who invested at the IPO would have generated a 33% IRR (~2.6x MOIC) when Greg carried out his buyout. Although Greg would subsequently lose control of the company due to an unfortunate run in with an opportunistic, litigious “potential” investor, the company would be sold to PaySafe (a wildly successful Blackstone and CVC portfolio company).  

            In his past ventures, Greg Daily has clearly demonstrated that he is an adroit capital allocator with a knack for value creations through M&A. But, Greg is not the only star player on the management team. Former C-level executive of the Company stated that Greg “brought the band back together” to start i3 Verticals. An integral part of that team was Clay Whitson, i3 Verticals’ CFO.

            Clay Whitson was part of the amazing success stories of PMT and iPayment. However, he remained at iPayment even after Greg left. One notable aspect of Clay’s work experience is his ability to handle and navigate leverage prudently. With the MBO of iPayment in 2006, the company’s leverage reached 7.4x. During the next few years, Clay was able to manage the capital structure and ensure that the company did not trip a single covenant – even through the 2008 crisis – and delever to 4.8x when he left the company in 2010. This illustrates that Clay is not only comfortable with leverage but also able to manage it even in uncertain macroeconomic conditions. This gives us comfort, especially knowing that i3’s leverage is significantly lower than 7.8x and the business is inherently more predictable than iPayment.

            Clay also has CFO experience at The Corporate Executive Board, where the company grew in market cap 3.2x over his 4-year tenure. He also worked at Edo Interactive, a smaller, growthier venture. In summary, Clay has a broad set of experiences and has proven to be capable at employing leverage to create value.

            This proven management team has also shown that they will remain disciplined on acquisitions. They are also quite incentivized to create shareholder value. Greg Daily owns a significant portion of the equity in the company; as of the last proxy, Greg Daily beneficially held approximately 24% of the shares outstanding. In May 2023, he also made open market purchases of ~$1m with a $21.56 cost basis. Clay Whitson and other named executives and directors hold an additional ~6%. Moreover, Clay Whitson and Rick Stanford (President of the Company who spearheads M&A) have significant incentive to increase shareholder value due to the options that they have received. Most of the options that have vested / will vest over the next few years have strike prices that are 35-50% above today’s share price. Insider ownership and alignment with shareholders should provide investors with comfort that this management team will create value, as they have done in the past. While many teams give lip service to sticking to a clearly articulated strategy, the i3 Verticals team is shown that they are truly selective and disciplined with their acquisitions.

Firstly, the Company follows a strict policy around how much management is willing to pay for acquisitions. In the past, management has paid between 6 and 10x EBITDA for smaller companies. Management never paid past 10x for their acquisitions. With interest rates rising and uncertainty on the horizon, management has pulled back from acquisitions and has lowered their maximum willingness to pay to 8x EBITDA. The Company has also remained relatively consistent with the size of their acquisitions, with most acquisitions falling between $2 and $5 million in EBITDA.

Secondly, management has developed a robust pipeline of “proprietary” deal flow. Although this word is often used superficially by large private equity firms, i3 Verticals’ deal flow is truly differentiated. The Company eschews banked processes and will often walk away if a company has been given an inflated valuation by a financial advisor. Instead, the Company primarily relies upon referrals from CEO’s of companies that they have acquired or been in contact with through past ventures. These CEO’s have networks of like-minded entrepreneurs in the same verticals, enabling i3 to connect with these business owners. Though some of these owners are not looking to sell at the time, i3 has shown that it can not only provide exit liquidity, but also grow these businesses and do right by customers / employees. In many cases, i3 can also help smaller ventures to scale and get access to more geographies and resources. Ultimately, this process of circumventing highly competitive processes and solely-financially-minded sellers has enabled the Company to consistently pay a lower price than peers. Furthermore, as the Company grows, they are likely to continue compounding this “network” of potential sellers.

Finally, the Company has not strayed from the strategic rationale behind its acquisition strategy. The Company has shown that it will not engage in empire building by diluting business quality. Rather, the Company has leveraged its acquisitions to enhance fundamental business quality, expand geographically, and/or develop product breadth. The industrial logic has remained consistent, enabling shareholders to be confident that management will not squander money on bad acquisitions.

In summary, i3 Verticals has a dynamic management team that has proven their “M&A chops” in other businesses. And, more importantly, they have shown that they are selective with their acquisitions; they will utilize proprietary deal flow, strict price restrictions, and strategic logic to prevent engaging in negative NPV acquisitions. This should provide investors confidence that the management team will be able to execute against the opportunity set ahead of them and create value for shareholders.

Valuation:

As detailed above, our base case projects revenue to grow organically at an 11% CAGR over the next 5 years. Over the same period, we underwrite that margins will expand ~575 bps to ~33% from ~27%. This shift will be in part due to the benefits of integration and operating leverage (~125 bps). We project that software and services revenue (~35% higher margin than merchant services) will grow to ~60% of revenue (still below managements long term aspirations of 65%) from ~50% today, driving the remaining portion of the overall margin expansion (~450 bps).

Underwriting Adj. EBITDA to Free Cash Flow Conversion of ~65% (in-line with management guidance and historical capital intensity), we believe the Company can generate ~$570m in Free Cash Flow. In our base case, we underwrite that management allocates this fully to debt repayment and that the excess free cash flow would be used to partially offset dilution from Stock Based Compensation and Earn Outs (we have projected that SBC will remain in line with historical trends, but that Earn Outs will taper off given no acquisitions in our base case).

With a 12.5x LTM EV/EBITDA multiple on year 5 EBITDA of $205m, we get an enterprise value of ~2.6b. With all debt being paid down and shares outstanding rising 35% (net of repurchases), we estimate a 5-year target share price of $55 / share. This reflects a ~24% IRR and ~3.0x MOIC. The largest driver of return will be revenue growth (44% of return), followed by debt paydown (~28% of return). Multiple expansion only contributes 10% of the return.

Risks and Mitigants:

1. Increasing Competition from Upstream Players: One large risk, especially in the Public Sector vertical, is that large incumbents like Tyler Technologies and CentralSquare Technologies – who have historically targeted areas with >350,000 populations – begin to move downstream. Our thought process around this risk is as follows:

a. Tyler Technologies is primarily focused on growing with their existing customers. A J.P. Morgan report on Tyler states that the CFO foresees revenue growth to come from “up to 4% growth of revenue in a given year typically comes from price increases on recurring top line, up to 3% is derived from new logos, while another 2%-3% is from up-sell of additional modules.” This clearly shows that growing with existing customers through pricing and upsell is a larger growth lever for the company than stretching downwards and chasing smaller contracts. The company has also recently made a large push into penetrating their existing customer bases’ payments needs; this is a large, under tapped proposition (which i3 has already been executing on), and it will likely be prioritized over competing for smaller contracts that do not move the needle as much on a $1.9 billion revenue base.

b. Although CentralSquare Technologies’ strategy is less publicly available, we take some solace in the fact that this is a highly levered private company. In the midst of the pandemic, the company received a credit downgrade from S&P and Moody’s, who cited an eye popping “11x debt-to-EBITDA ratio.” As the company deals with looming debt maturities and is eventually cleaned up for the next round of PE hot potato (the company was formed through a merger orchestrated by Vista and Bain in 2018), we think it is unlikely that they will be allocating the requisite resources to compete with i3 Verticals in smaller markets.

c. Another nuance is that smaller municipalities are often cognizant that the support that Tyler / CentralSquare provides them will not be as good as the support that i3 provides. A large reason for this is that smaller municipalities are not big customers of these larger companies and often are deprioritized. Hence, i3 is able to offer superior service than their larger peers.

2. M&A Related Risks: Management’s comfort with a rapid pace of acquisition does warrant some concern. The two main risks we foresee on this front: management becomes undisciplined – paying too high a price or acquiring for the sake of acquiring –and integration challenges. Our thought process around this risk is as follows:

a. As discussed above, management is not new to inorganic growth. Management has a stellar track record of value creation through acquisition. They have been extremely disciplined on both price and size. They have a clearly articulated strategy with strong industrial logic. We are relatively confident that this is unlikely to change.

b. The successful development of a Unified Product Offering in the Public Sector Vertical and its observable impact on the business give us confidence that management has the requisite expertise in integrating acquisitions.

3. Leverage Profile: To fund their acquisitions, the Company has primarily used their credit facilities. This has left the company with a reasonable debt load. Some investors are concerned that this leverage is not sustainable and a potential risk. While we do see the potential for the debt to create problems, our thought process around this risk is as follows:

a. As it relates to M&A, the company has recently stated that they internally generate sufficient cash flows to fund most of their acquisition strategy. This should enable the company to grow without the need for more capital and pave the way for the company to de-lever their balance sheet over time.

b. The Company currently sports a 4.0x leverage ratio; under their credit documents, they must stay below 5.0x. We believe that 4.0x is sustainable given the stable end markets (admittedly, these are the famous last words of many levered roll-up companies).

Catalyst

1. Continued Success in Acquisition Strategy – this should make the business mix more attractive, warranting a re-rate

2. Large Contract Wins Flow Through the Financials – the Company has recently won several larger, state-wide contracts. Should they continue to demonstrate their competitiveness in similarly sized processes, it is likely to warrant a re-evaluation of the business

3. Completion of the Healthcare Unified Product Offering – once the Unified Product Offering in the Healthcare unit is completed, the Company should be well positioned to see an improvement in business momentum like the one that they saw in the Public Sector vertical

4. Continued Strong Execution – the Company’s valuation is likely to change as the market comes around to management’s ability to successfully execute the strategy that they have laid out