|Shares Out. (in M):||66||P/E||0||0|
|Market Cap (in $M):||990||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
|Borrow Cost:||General Collateral|
NIC Inc (EGOV) write-up (Short) April 2018
Last print: $14.9 per share on 4/27/2018
Thesis (30-second elevator pitch)
NIC Inc is basically an outsourced website-designer for States with an archaic monetization model that does not fit well in the 21st Century and will struggle to continue its historical high-single-digit to low-double-digit organic growth as its profitable self-funded business model increasingly gets more push-back from its State customers. NIC has been losing contracts head over heels, and its most recent key loss (State of Texas @ 20% of its revenue just awarded its portal management contract to Deloitte after an extensive RFP process) is especially scary as TX’s decision sets a precedent for many other existing State customers who see TX as the pioneer/thought leader in this digital government initiative. In fact, there are multiple States that are already in process of evaluating whether to replace NIC with either a competitor or internal resources -- it wouldn’t surprise me if we see additional contract losses in the years to come. Meanwhile, same-customer organic growth metric is slowing down and SG&A investment cadence is accelerating hard as the company realizes it needs to invest more aggressively to remain relevant in the new world order. While the stock has fallen decently from the 2017 peak, NIC’s multiple has not actually compressed all that much given the abysmal direction of organic earning development (especially after NIC announced it lost the TX portal management contract). This stock is still egregiously priced at almost 25x run-rate earning power PF to TX’s contract loss with dubious growth visibility in the medium term. Once the investment community starts to perceive it as the melting ice cube that it really is, I believe the multiple will collapse further and the stock has another ~50% of downside from here.
**IMAGES AREN'T PASTING CORRECTLY, I WILL RETRY TOMORROW**
1. Company background and business overview
2. Revenue drivers
3. Discussion of value proposition to customers
4. Elaboration on key thesis points
5. Valuation, price target, and risk/reward
Company Background and Business Overview
NIC is an IT services contractor that partners with State gov’ts (and a few federal gov’t divisions) to help them establish their digital presence. Think about those State web portals like Utah.gov or Indiana.gov – NIC helps those States to design and maintain their web portals to improve citizens’ convenience. For example, you can probably renew your driver’s license on your State’s web portal, your neighbor may register for a hunting license through the State’s web portal, and your favorite local restaurant may apply for a liquor license through the web portal. Overall, this is not a complicated business – we are talking about making websites that process certain citizen/business requests.
When these interactions happen, the citizen or business may need to pay a “convenience fee” along with the typical license renewal/permit application fees, and the State would pass a portion of that convenience fee to NIC as compensation. NIC invented what’s called “self-funded” contract structure, where NIC pays for the initial web portal development expense of $500k to $1mm (without any State contribution) and reaps the financial benefit from these “transactional revenue” once citizens and businesses start using them. This revenue source is seen as a “recurring revenue stream” because these “transactions” happen years in and years out and the volume of transactions grows as more digital gov’t capabilities get enabled online.
· 5,500 federal, state, and local gov’t agency partners today with 27 enterprise-wide partner States and 2 government agency partner States
· NIC puts a local team in each capital city and aims to aggressively markets various digital gov’t services to help drive adoption
· Typical contract terms: initial terms of 5 years early-on, but increasingly seeing more 3-year terms with two 1-year extension options
o However, States have perpetual licenses to use the portal properties developed by NIC after expiration of contracts
Revenue Drivers (high-level)
While a small portion of the revenue base is made of fixed-fee contracts and time-and-material contracts, the vast majority of revenues are more recurring in nature and come from the following two sources:
o This is the single largest revenue in most States with typically low-single-digit growth as it grows along with population and occasional pricing increases that NIC tries to push through
· Most of the remaining revenues come from Interactive what’s called Interactive Government Services (IGS).
o IGS is the growth driver made up from hundreds of biz-to-government and citizen-to-government services, 75% of revenues are from business applications such as banking & legal, professional licenses usage. 25% from citizen services such as hunting/fishing licenses & car registration
· Given the DHR piece of recurring revenue will grow at very a slow pace, NIC aims to grow the IGS piece at 15%+ per year in order to achieve Same-State portal revenue growth goal of 8-10%
o 12-13% IGS growth is needed to push Same-State revenue growth above 8%
· Historically, NIC benefited from both robust Same-State revenue growth metrics and signing up new States. If you think about it like a restaurant concept, it was crushing it on both “same-store comps” and “new store roll-outs”. Going forward, the “comps” piece will slow down given law of large numbers and more importantly, there will be “store closures” (States leaving NIC).
Discussion of Value Proposition to Customers
So what did the States like about NIC and what led almost 30 of them to contract with NIC over time? It boils down to the following:
· NIC pursued what’s called the “self-funded”/transaction-based model where States didn’t have to appropriate funds to build these portals. On top of that, NIC is financially incentivized to help States/Counties grow E-Government presence given “it eats what it kills”
· NIC gives States ability to use State-level master-contract to accelerate portal roll-out at the agency level so each agency doesn’t have to get bogged down by its own separate RFP process
· NIC offered end-to-end payment processing capability, allowing it to become merchant of record for States in processing these transactions and taking care of payment-related compliance
Elaboration on Key Thesis Points
The short thesis is that the dynamics between NIC and its State customers are quickly changing as the customers are increasingly pushing back on NIC’s monetization model.
· States’ CIO offices are getting increasingly sophisticated and as a result they are scrutinizing the economics they are giving away to NIC
o Many States, especially the larger ones that receive a decent chunk of transactional revenues from these online citizen/business services, are starting to ask the question: “why do we have to keep giving this variable economics to NIC perpetually? After all, don’t we already own the codes underneath our web portals?”
o Many States are doing cost/benefit analysis and there have been some that realize they can bring this in-house to realize savings
o State CIOs are also increasingly monitoring the gross margin/bottom-line that EGOV is earning from them
o The cut that NIC receives per transaction is very significant, sometimes easily 50%+ of the convenience fee charged to the end-users, and there is a real risk that these economics splits can be renegotiated down in the future if States push for them
o For example, States like Indiana have become concerned enough to switch to a hybrid model (partly transaction-based and partly fixed cost) to “control NIC’s margins”
· Several States finally bid farewell to NIC after years of partnership, with the recent Texas loss being the most damaging (NIC just lost almost a quarter of its EBIT)
o Starting in 2014, a few smaller States realized NIC is not working out and terminated the partnership after contract expiry. Arizona’s contract expired in March 2014 and Delaware’s contract expired in March 2015, Oklahoma was on the verge of leaving NIC but ultimately changed contract structure from self-funded to just a fixed portal management fee. Iowa also decided to ditch NIC and go for a time-and-material model because it better aligns with the objective of the State. Iowa ultimately hired a contractor that delivered similar quality of work while achieving material savings.
o Then the bigger States started waking up: long-term customer Tennessee put out an RFP in 2016 and instructed contractors to either bid all-inclusive or carve out specific functions to bid on. NIC went for the all-inclusive solution, Adobe went for just the portal, while some other competitors went for certain other application pieces. Ultimately, Tennessee decided to insource it all as it had a fairly progressive CIO who was focused on building internal capabilities. Tennessee was a fairly devastating loss for NIC given the size.
o Then the tornado event, Texas (20% of NIC’s revenue and ~33% of EBIT), came along: NIC acquired the Texas portal/payment contract from Bearing Point when it filed for bankruptcy and after years of extending renewal options, Texas finally put out an RFP in 2017 one year ahead of the contract expiry, as it wanted to see if it can find better bang for its bucks.
o As it turns out, Texas wasn’t so happy about NIC’s monetization model and wanted to 1) pursue more transparent fixed-cost model, and 2) split the contract into two pieces, a portal management piece and a payment processing piece.
o After a lengthy RFP process, NIC informed the investment community that it indeed lost the portal management contract (containing most of the economics of the legacy contract) while retaining the payment processing contract (low net margin business as it collects a thin spread on the transaction volume). While NIC didn’t lose 1/3 of its earning power (that would have been the worst case), it did lose about ~23% of its 2017 EBIT due to the Deloitte portal management contract win, and there is no SG&A offset (thus the flow-through to EBIT is painful).
· Many NIC States view TX as thought leaders and are now exploring their own options given the direction Texas took (shifting to fixed cost contract model or moving towards in-sourcing), and this is very scary for NIC because between ~22% and ~38% of revenues (2012-2017 average) are tied to contracts that expire in any given year, exposing NIC to significant contract non-renewal risk
o There are evidences that Colorado and Oklahoma along with a few other States are interested in adopting the new Texas model and shift material amount of work in-house by the time their contracts expire with NIC (2019/2020)
o Executive Director of Statewide Internet Portal Authority of Colorado has confirmed that Colorado is certainly going to explore the Texas model and has in fact sent one member of its team to Texas to discuss the specific details with TX Department of Information Resources
o Colorado is also hoping to see more competition and alternatives by the time its contract with NIC expires in 2019, and it is getting a lot of interests from other vendors. This is very different from the environment when Colorado last renewed with NIC – NIC was the only bidder back in 2009.
o As another example, Oklahoma is likely in-source significant amount of work that is currently being done by NIC. Oklahoma has been working on constructing its own web portal and its representative believes the majority of the work will be done in-house post the NIC contract expiry (2020).
o In addition, multiple states are actively looking at adjusting the revenue sharing agreements with NIC – to reduce the % of cut NIC receives.
· As States leave NIC, there is little offset as new State wins have been slow/marginal with few active RFP in the pipeline – reflecting a severe lack of growth runway
o There hasn’t been any new State RFP opportunity in 3 years, South Dakota issued an RFP for self-funded eGovernment service in 2014 but no deal was ever signed with NIC
o Analysts inquire NIC management about “active RFP opportunity” on almost every quarterly earning call, and CEO always replies with “there are opportunities out there, we are in constant conversations with several different states and some that I am extremely excited about. But there is not an opportunity out there that we have responded to at this point.”
o The last “new” State with self-funded model that NIC brought on-board is Louisiana. Louisiana converted from a pilot program signed in Q3 2014, converting into a 4-year agreement in 2016
o Recent contract with Illinois addressed a narrower statewide permitting and licensing vertical and is not a traditional self-funded contract – doesn’t give NIC the upside to “variable volume”
· I don’t believe NIC can continue to deliver its 8-10% Same State revenue growth target given law of large numbers
o NIC got a lot of SS revenue growth traction initially as it was launching a bunch of new transactional functions but most of the “easy levers” have been pulled and most functions implemented at this point
o Another reason that explains NIC’s historically solid SS revenue growth is that as NIC brings on new States (that start from zero base), it makes for an “easier” previous comparable base. However, if NIC can’t keep adding new State customers, SS revenue growth on the existing pool will naturally slow down
o It is already decelerating -- especially on a two-year stacked basis.
· Pursuit of Federal contracts has yielded very marginal success despite recent years of investments, as competition is intense there
o NIC has been wanting to tap into the Federal contracting business for a long time but there is a lot of competition on that side, not to mention that Federal agencies are more focused on time & material contracts compared to the self-funded contract structure
o NIC is structurally disadvantaged on that front given its lack of track record and relationship
o Results from all the years of Federal pursuit: $14mm of revenues in 2016 (13mm/11mm in 2015/2104) out of the ~320mm revenue pool was from Federal contract
o Essentially all of it is from a contract with Federal Motor Carrier Safety Administration (FMCSA) to develop and manage its pre-employment screening program for motor carriers nationwide, using a transaction-based biz model
· Frankly, NIC is significantly over-earning on its only successful Federal contract (FMCSA) and it is expiring in the next few months -- there is potential for pricing to come down
o NIC gets $10 every time a trucking company wants to check a government-run database and NIC management has admitted that this contract earns materially higher margin than the corporate average
o The contract expires this Summer and this is the first time where FMCSA will put out a new RFP, so we could see competition from other vendors
o In fact, the Trucking Alliance has been complaining about the high fee and this is what it wrote in a letter to Elaine Chao of Department of Transportation
· To make this all worse, NIC’s human capital is stale and increasingly un-competitive among the IT vendor ecosystem
o The CEO is very old school and resistant to changes, has a lot of his friends on the Board. Ex-employees at NIC have commented that talent pool there is not best-of-breed, culture is stifling, and moving up the organization “is more about how close you are to ‘Harry [CEO], the Board, and his friends.’”
o Multiple former employees acknowledged NIC is incredibly risk-averse and scared to make refreshing long-term strategic decisions
o A lot of States are furious with NIC as it had made promises but couldn’t deliver because it failed to hire people of domain expertise
o As Scott Stringer (NYC Comptroller) put it: “NIC is old, male, and stale”
Discussion on earning power and valuation
If you parse through all the disclosures around the Texas contract loss (NIC held a conference call in early March to update its guidance post contract loss), you will realize that NIC will lose roughly ~$45mm of annualized run-rate revenue from the lost TX contract at a ~40% decremental margin. Not only is there no SG&A offset, NIC is actually planning to ramp up SG&A/investment spend because it is absolutely desperate to grow its topline. All of this will put tremendous pressure on earning power and sell-side is materially over-estimating NIC’s 2019E EPS because it doesn’t have the correct understanding of quarterly cadence.
· The TX contract doesn’t expire until the middle of Q3, and the Q4-implied (first clean quarter post TX) run-rate annualized EPS is 60 cents per share
· Consensus is at 75 cents of EPS for 2019, I don’t see how NIC gets to 75 cents in 2019 from an exit-run-rate of 60 cents at Q4 2018
· To top of off, my 60 cents base case “normalized EPS” estimate assumes no further State contract loss and successful renewal of the FMCSA contract at existing terms
· The reality is NIC will continue to lose customers in the medium term or renew at lower contract economics – its earning power will continue to get pressured. You can easily get to bear case EPS of closer to ~40 cents as more States terminate the partnership.
· What multiple should one pay for a business with dubious terminal value? I think even 10x is generous. I am truly unsure if NIC will exist in its current form 5-6 years from now.
· At current price, it is trading at ~25x my normalized EPS estimate – the bulls will wake up sooner or later
o Even after excluding net cash per share, it is still trading at ~21x that normalized EPS estimate
· Price target: 60 cents of normalized EPS capitalized at 10x P/E, and add back about $2.5 of net cash per share, that’s $8.5, or close to 45% downside. If more States start walking, the market cap will keep on melting
More State losses
2019 earning miss