Description

Business Overview

Mitek is a software development company focusing on two primary areas: mobile image capture and digital identity verification solutions.  The business is split roughly 60%/40%.  The company overall has grown revenue at an 18%/19%/22% CAGR over the last one, three, and five years, respectively, to ~$170m as of September 2023.  Over the same time period, the deposit business grew at an 18%/15%/20% CAGR, and the identity business grew at an 18%/27%/25% CAGR.  The business strategy has been relatively straightforward, recycling capital from the profitable/mature business in order to build the identity verification business.  The irony is that the mobile deposit business, aided by COVID, has grown at an almost equivalent rate such that the portfolio rebalancing has been limited in the last few years.

• Mitek's mobile image capture business focuses on providing solutions for the automatic capture and processing of images using mobile devices.  Mobile check deposit is the primary use case and driver of the business.  As many of you have likely used, the solution allows individuals and businesses to deposit checks remotely by simply capturing an image of the front and back of the check using the device's camera.  Mobile deposit products are sold through network processors NCR, FISV, FIS, Jack Henry who sell mobile deposits to banks/credit unions. As such, distribution costs are very low and gross margins are north of 90%.   The mobile deposit is sold in 1-3 year type of contracts that are fixed term limited use, time-bound, and typically include blocks/inventory of transactions.  In other words, financial institutions "batch" purchase a specific quantity of checks for future processing from Mitek.   Additional use cases/features of their technology include data extraction, streamlining the process of filling out forms and applications, and enhanced security.  

• Mitek's Identity business is focused on identity verification and document authentication.  The business was built through a combination of internal development and acquisition.   One of the original use cases for this product was to automatically prefill forms using pictures from the user’s ID, helping to reduce friction during account sign-up via mobile phone and improving conversion rates.  In May 2021 the company acquired ID R&D, a provider of voice biometrics and liveness detection.  In March 2022 the company acquired HooYu, a UK-based "Know Your Customer (KYC)" orchestration platform linking biometric verification with real-time data aggregation from different inputs.  Mitek has leveraged these acquisitions to build products/applications to meet specific customer use cases. Recent product launches include MiPass, which combines facial and voice biometric capabilities to defend against identity theft from digital attacks and deepfakes.   Another example is the Mitek Verified Identity Platform (MiVIP), which is an end-to-end platform designed to manage the entire KYC life cycle by integrating facial biometrics, liveness detection, ID document validation, database checks, geolocation, and digital footprint analysis.   

Outlook for the Deposit Business 

While the aggregate domestic usage of checks is in decline by a ~MSD% annually per the Federal Reserve data, the Deposit business has been able to grow through a combination of rising consumer adoption, low-single-digit pricing as customer contracts renew, and the development of new products.   Mobile check deposit adoption has steadily grown to an estimated 35%-40% per management's estimates.   TBD on what level of penetration mobile deposit can garner; however, industry participants believe >50% is not an unreasonable expectation.    Assuming that is the case and given where we stand today, the countervailing forces of check utilization against higher penetration should allow for a modestly growing/stable mobile deposit TAM over the next several years, before considering the benefit of pricing and contribution from new products.  

• Check Fraud Defender is a new product developed by Mitek that is in the process of scaling.   It is a cloud-hosted model leveraging a consortium of financial institutions to help reduce check fraud thereby saving its clients millions.  The product is designed to spot visual anomalies in checks across 18 different visual elements.  Management has not disclosed the exact revenue model for the product, but if they are successful in garnering participation in the savings for customers it could potentially be very lucrative.  Nonetheless, it should be a "material" contributor (i.e. $10+ million) to 2024 deposit revenue.  Not simply taking the word from Mitek management regarding the opportunity, below are selective quotes from the most recent Regions Financial quarterly results: 

"During the quarter, we continued to experience elevated levels of check-related fraud. Our third quarter results reflected an incremental $53 million in losses stemming from a second fraud scheme, which also began in the second quarter but was unknown to us at the time. This game manifested itself in delayed returns and as a result, has had a much longer tail. After adjusting our countermeasures to identify potential fraud instances more quickly, the volume of new fraud claims has slowed.

Although difficult to project based on what we know today, we expect quarterly fraud losses to come down significantly and to be approximately $25 million in the fourth quarter. Based upon the increases we are seeing in check fraud across the industry, in fact, based on data we have, we indicated losses were up about 40% year-over-year, we expect future fraud losses to normalize in the $25 million per quarter range in 2024

Fraud is increasing dramatically in the industry, and we seem to be the ones to call it out. It's hit us very hard. To your first question, this was a different scheme this time than what we reported on last quarter. And unfortunately, this scheme that they had, you don't know about until the banks on which the checks are written notify you that that's not a good item, and it takes about 50 to 60 days before you know that. We can look at when events occurred, and we can kind of see a pattern where we feel reasonably confident that we're not going to see that kind of increase going forward from the schemes that we've seen. And, of course, we are putting in new controls, we're putting in new technology, and it's very disappointing.

But again, the industry report we saw is up from $17 billion in 2022 to $25 billion of fraud in 2023, thus far"

Outlook for Identity

• While Mitek enjoys a virtual monopoly in the mobile deposit business, the market for identity is still characterized as early days, fragmented, and unsolved.   There are multiple factors driving market growth, including rising occurrences of identity theft, increasing risk of fraudulent access to business networks/applications, government regulations (e.g. KYC, anti-money laundering), and mandates concerning privacy.   Industry research provider Markets & Markets pegs the global identity verification market at $9.5 billion growing at a 15% CAGR to $18.6 billion by 2027.  While Mitek does not offer solutions for every aspect of the identity verification market, the recent acquisitions allow the company to offer a more comprehensive solution as opposed to a point solution.  As noted below, management will be under pressure to demonstrate success/growth from new product introductions prospectively to help justify the recent acquisitions.   Separately, Mitek has its own breakdown of the identity market opportunity here.  

• Despite the large and growing opportunity, more recently Mitek's Identity business has slowed compared to its historical growth rates.  The slowdown is attributable to the financial services exposure of many of the company's identity customers, which have been under pressure due to rising interest rates. Nonetheless, Mitek still grew revenue ~18% in fiscal 2023 including ~15% in fiscal Q4 (yet to be reported).  For 2024, management intimated that despite the more challenging macroeconomic conditions an upper teens growth rate is sustainable into 2024.

Idiosyncratic Issues

• Change of Auditor / Delayed Filings - the company changed auditors (to BDO from a smaller firm) in the middle of 2022.  The transition process was arduous, initially resulting in a delayed Form 10-K filing last September and then additional delays of the more recent Form 10-Q filings.  As a consequence, the company received a delisting notification from NASDAQ and was granted extensions to regain compliance.   With the most recent 10-Q filing on October 26th, the company is now current with its SEC filings, eliminating one overhang on the shares.  
• USAA Lawsuits - There is a LONG history here that is flagged for reference but importantly has not had an impact on the growth and development of the company's mobile deposit business.  Mitek and USAA collaborated in the early 2000s on remote deposit capture technology.  They had a falling out, sued each other, and subsequently launched similar mobile deposit capture products (Mitek in February 2008, USAA in August 2009).  After a series of legal battles over the rights and licensing of the technology, the companies settled in 2014, and both kept their patents.  Several years later, USAA pursued customers of Mitek (e.g. Wells Fargo, PNC, et al).  While Wells Fargo settled, PNC continued to fight.  Most recently, at the lobby of PNC, the US Patent Office’s Patent Trial and Appeal Board invalidated key USAA patents used to sue the company.   

 Management

• CEO - Max Carnecchia joined Mitek in late 2018.   Prior to Mitek, Max was CEO of Accelerys from 2009-2017.   Accelrys was a publicly listed company that was acquired by Dassault in 2014 after which he remained on as CEO.  Before Accelrys, he was CEO of Interwoven, a publicly traded content management solutions company, which was sold in 2009.

Valuation

• With a market cap and enterprise value of ~$485m, the stock is trading at ~2.9x trailing EV/Sales.  
• Gross margin is 87%, and adjusted operating margin is expected to be in the 30%-31% range.  Margins are notably obfuscated by the loss-making nature of the identity business, with disclosure here lacking.  Even still, the stock is trading for ~9x EV/EBIT.  In other words, the entire business looks like it is being priced for secular decline despite the deposit business growing 18% in fiscal 2023 and is expected to continue its growth trajectory into 2024.   
• LTM free cash flow was $38m, implying an EV/FCF multiple of 13.5x

Why Now

There are multiple, seemingly imminent paths to value creation here:   

• First, and simplest, is the removal of the overhang from being non-compliant with its listing requirements.  With the most recent filing of its 10-Q for the June quarter, the company has now regained compliance with NASDAQ.   The company is currently in its blackout period ahead of reporting September quarter results and thus restricted from repurchasing shares, however, prospectively the company will be able to repurchase shares and effectively stated their intention on the last quarterly conference call.   M&A is off the table, and as noted the identity business is progressing toward breakeven, which together will enhance the cash flow available to shareholders.   The company has $130m of cash on its balance sheet and no net debt as of the June quarter.   

"We do not need to do additional acquisitions to further penetrate the significant market opportunities we address.  Instead, we are focused on using our cash flow to drive shareholder value in other ways and we routinely assess all capital allocation alternatives, including opportunistic share repurchase programs."

• Second, management is under pressure from shareholders.   On October 10th, Hammana Partners issued a letter to Mitek's Board regarding the "urgent need to explore strategic alternatives."  Hammana argues the ID business is too undersized to be a public company, and further notes that if the public market is unwilling to give the deposit business a full multiple, "private market participants would cherish the asset."  Here it is also worth highlighting that a separate shareholder, Vector Capital Management, has taken a stake in the company this year and is indicative of potential private equity interest.   This wouldn't be the first time the company garnered private equity interest either, having previously received a takeover bid in 2018.   This combination along with a CEO who has a track record of selling small-cap companies is appealing.  Max is not a founder, and notably the company could not run an effective sales process without up-to-date, audited financial statements.  For context, on an EV/LTM Sales basis, the stock is trading at <60% of the multiple it was trading in 2018.  

Catalyst

• Large share repurchase authorization
• M&A