Description

NIC Inc (EGOV) $16.31

Summary

NIC Inc (EGOV) provides digital services and solutions to governments. NIC’s outsourced portal businesses enter into long-term contracts with governments to design and operate enterprise-wide online portals that allow businesses and citizens to access government information online. NIC’s business is entirely self-financing with minimal capital needs and carrying no debt and a significant cash balance.

Concerns over the loss of a large contract and slow growth have compressed the valuation even as the new tax bill should provide a 10% - 15% boost in free cash flow. Currently trading at its lowest valuation since 2008 at 11x TTM EV/EBIT, 14x 2019E EV/EBIT (likely ebb year), and 10x normalized EV/EBIT.

Either growth investments are successful and boost the valuation or growth investments are unsuccessful and the cost structure shrinks in response. Without the need for external financing, there is little reason why NIC should be a public company and I believe could likely attract interest from strategic and financial acquirers. Using conservative assumptions, my target price is $19 on normalized earnings and $22 if acquired.

Opportunity

NIC’s business model is like a private toll road. The government wants to provide a service to its constituents, but does not want exposure to the public appropriations process for funding. A compromise solution involves contracting with a private third party to underwrite the construction in exchange for the granting of a license to charge a toll to users. This is almost certainly not the optimal solution in a perfect world. Government, in theory, should be investing on a virtually infinite horizon and utilizing its scale and borrowing cost advantages to directly make infrastructure investments using today’s dollars that offer the highest benefit at the lowest societal cost over time. In practice, there are elections which effectively reduce the government planning horizon to 1 to 4 years – and create opportunities for firms like NIC. Until and unless the incentives change for elected officials, there will almost certainly be opportunities for firms like NIC.

NIC partners with primarily state and local governments to create websites that allow for individuals and businesses to get information and conduct business with government. NIC fully underwrites the cost of developing these websites and recoups its costs and earns a return by being able to charge a transactional fee to the constituents using the portals. The primary legacy business has been driver history records (DHR) which are purchased primarily by insurance companies to set premiums. NIC has an established history of then adding additional services to the relationship such as paying parking tickets, getting business licenses, vehicle registrations, etc. Currently, NIC has relationships with 27 states plus a small number of federal government contracts.

This is an amazingly high-quality business. It has been entirely self-funding since its IPO in 1999 and has never utilized any debt. Revenues have grown from $57MM in ’99 to $337MM in ’17, a 10% CAGR. The limited capital needs and strong cash flow have allowed the company to pay out dividends of $307MM from ’07 – ’17. Book value plus dividends has grown at 20% p.a. over the last decade, but has slowed to 10% p.a. over the last 3 years and 4% over the last year.

Invested capital is $189MM, but $162MM is cash. Excluding the 80% of cash balances that aren’t necessary to operate the business and invested capital is only $59MM for a business that generated $78MM in TTM EBIT.

Obviously, returns on capital are phenomenal. 5yr average EBIT/IC is 58% and EBIT(IC – 80% cash) is 172%.

Businesses like this are rarely inexpensively valued and NIC has been no exception. Over the last 12 years (’06 – ’17) EV/EBIT has mostly ranged in the high teens – low 20s and P/E excluding cash has rarely been under 25x.

Currently, NIC is trading at valuation multiples not seen since the end of 2008 because of growth concerns. I believe this presents an opportunity.

Growth has clearly slowed over the last few years. Few new states have been added and Texas recently shifted part of a contract away from NIC which sharply hit the stock in March when announced. However, I believe that lots of good things can happen when you have a good business, generating lots of free cash flow, a clean balance sheet and a reasonable valuation.

Frankly, I can’t make a good argument why a company like NIC needs to be public. It does not need external financing. More notably, my instinct is that there is an advantage to your customers not being able to see your financial statements. I suspect that NIC’s cost structure has bloated over the years because times were good (strong revenue growth, great cash flow) and the adverse incentive to running lean and letting your customers (and their constituents) see just how profitable your business franchise is. I suspect that there are significant costs that could be taken out of the business by a financial buyer if the company was no longer under public scrutiny and even more by a strategic buyer. One caveat is that NIC’s business strategy of setting up businesses in the state capitol of each partner state to deepen relationships is not a cost optimizing strategy, but one that may well need to be maintained to some degree for relationship management.

Consensus estimates for NIC decline for 2018 and 2019 on the loss of the Texas contract from $78MM EBIT in 2017A to $63MM in 2019E. I believe normalized EBIT is about $80-85MM.

Many levers exist to realize value here. NIC has been making investments in growth. If those are fruitful, revenue and earnings growth should follow, and the valuation should expand. If they are unsuccessful, NIC should flex down their cost structure to reflect their new low-growth reality and cash should be increasingly returned to shareholders. If NIC either fails to do this internally or if the valuation multiples remain muted, it is not unreasonable to think that the company could become a target either by management or a financial or strategic buyer.

I have included a few examples to illustrate the impact of NIC borrowing modestly for a leveraged share repurchase as well as an acquisition by a strategic buyer (Booz Allen – BAH) that has significant government consulting presence and could likely extract maximum costs in an acquisition. These demonstrate how value could be realized between $19 and $22 in a variety of scenarios.

Catalyst

Growth expenditures are successful and valuation expands.

Growth expenditures are not successful and costs are curtailed.

In absence of growth, if valuation compresses further, external agents (activists, financial or strategic buyers) may emerge.

Debt free, stable, high free cash flow business that would probably be better private or within a larger entity provide many ways to win.