Value Investors Club / NIC Inc. (EGOV)

Description

THESIS

NIC Inc. (EGOV) is a wide-moat company with very high returns on capital, a great balance sheet, and 90%+ recurring revenue. My estimate of intrinsic value excluding new contracts is $6 per share, representing over 53% upside from the current share price of $3.92. In the near term (possibly 2009), the company could win two long-term contracts, worth a combined $3.80 per share. On top of that, there is an enormous opportunity for more contract wins down the road.

In addition to the two contracts, there is a third potential catalyst. Today (12/20) is the end of a lockup for pre-IPO investors who entered, in 1998, a Voting Trust, which dissolved this past June. These investors, who collectively own 1/3 of the shares, could reasonably be expected to reduce their stakes after 10 years. This selling might create a buying opportunity on Monday. Either way, the passing of the lockup could act as a catalyst by removing an overhang on the stock.

Stock price       $3.92
Diluted shares 63M
Market cap       $249M
Cash                $60M
Debt                 $0

BUSINESS DESCRIPTION
EGOV operates the official website portals for state government agencies in 21 US states, according to long-term contracts, which come up for rebid typically every 3-to-5 years. The company predominantly uses a so-called “self-funded” model, in which the state undertakes no expenditure, but rather shares revenue generated from transactions conducted through the portals by businesses and citizens.

The largest source of portal revenue is “DMV transactions”—purchases of driving records, mostly by resellers, whose customers are insurance companies. DMV transactions comprised 50% of EGOV’s 2008 revenue, and grow at 1-3% per year (along with the population), except when states occasionally implement price increases, which can add a few percentage points to the growth rate.

The economics of building a portal are extremely attractive. Because EGOV has years of experience, the company can be up and running in a new state quickly and inexpensively. EGOV invests $500K-1M upfront and commits a staff, initially consisting of a handful of people. DMV revenues are generated almost immediately and typically reach $0.50 per capita (nearly $2M on average) within a year. Early gross margins are about 40%, maturing to 45-50% within a couple years. The entire initial investment is recouped within 12 months.

Over time, EGOV develops relationships with other state agencies and builds out “applications” according to the customers’ goals: generally to efficiently and effectively inform, communicate with, and transact with businesses and citizens. In the 21 states in which it operates, EGOV serves over 2,800 agencies with a library of more than 3,900 applications. Of these, about 1,700 (45%) generate revenue. The most productive applications (other than DMV) include professional licenses and permits, court and criminal record searches, and corporate and tax filing (there is more detail in the 10K). Non-DMV revenue has grown at a consistently high rate, driven primarily by new applications. The table below shows the year-over-year growth rates of non-DMV transaction-based revenue, on a same-state basis (i.e., excluding the effect of new state contracts):

2003 2004 2005 2006 2007 1Q08 2Q08 3Q08
35% 39% 41% 27% 31% 38% 37% 26%

There remains an enormous growth runway for non-DMV transaction-based revenue, which was about $33M in 2008 (35% of total revenue), as EGOV’s network of agency relationships expands and new needs and opportunities are identified. (Note: The remaining 15% of revenue is not transaction based.)

For example, the company recently rolled out a website in Kansas for the Juvenile Justice Authority (http://www.kansas.gov/jja/). Although EGOV was not paid directly, the website paves the way for future revenue-generating applications for the JJA, such as paid record search. What might be surprising is that Kansas is EGOV’s oldest relationship—one that began in 1991. Another interesting statistic is that only about 1/3 of EGOV’s 21 states utilize all of the 30 most productive revenue generating applications. My research suggests that no states are approaching saturation of EGOV’s offerings.

Most transactions (both DMV and non-DMV) are mandatory and repeated annually. This implies that revenue growth for a particular application is more closely linked to population growth than to economic activity. For example, despite the recessionary environment in 2008 (and particular weakness in the auto industry), DMV revenue year-over-year growth on a same-state basis was 0%, 1%, and 2% in the first 3 quarters, respectively. The company classifies a mid-90% portion of revenue as recurring.

PROFITABILITY & GROWTH

EGOV’s 17% operating margin and high fixed asset turnover ($7M of PP&E sustains nearly $100M in revenue) support an ROIC of 35%. The company’s revenue grows organically at about 10-15%, driven mostly by the rollout of new applications. Selling and administrative expenses should grow at a significantly lower rate (I am modeling 3-4%), resulting in a high proportion of incremental gross margin dollars falling to the bottom line. Because of the business’s capital-light nature (including modestly negative working capital) and operating leverage, free cash flow can be expected to grow faster than revenue.

MOAT

EGOV has a wide moat, which I expect to get stronger over time. The company invented the self-funded model in 1991, and in the ensuing years won 20 additional states. Of the 29 states that do not use EGOV, only 1 outsources its portal—Texas to BearingPoint. Therefore, EGOV is for all intents and purposes the only company with vast experience doing what it does. The company has never lost a rebid, and Texas is the only instance in which it has ever lost new business to a competitor. Since then (2000), BearingPoint has bid on new states (how many is not public information, but my research suggests at least 5), and lost them all to EGOV.

The company’s moat rests on 3 competitive advantages:

· Economies of scale: EGOV’s vast experience creating state government portals and applications allows it to operate far more efficiently and effectively than a competitor could. Other than EGOV and BearingPoint, the only company to have operated in this space is IBM. IBM developed 49 applications for Arizona, before EGOV unseated it in 2007. BearingPoint has developed 852 for Texas. This of course compares with EGOV’s 3,900 applications. For a competitor to start a portal from scratch it likely would require 10x the investment that EGOV makes, or more. Management estimates BearingPoint’s cost to build TexasOnline to be in the neighborhood of $10-20M.

· Barriers to entry: In addition to a cost disadvantage, competitors face a significant reputational disadvantage when competing with EGOV. State decision-makers are highly risk averse and would be very reluctant to use an unproven vendor when there is a clear alternative choice.

· Customer captivity: Once EGOV is in a state, it becomes extremely risky, complex, and costly for the state to switch vendors. Stickiness increases over time, as EGOV builds out its agency relationships and establishes itself in more portals.

VALUATION

Below is what my numbers look like assuming no new contracts. My model is extremely conservative relative to the growth rates described above. 2009 could be a very tough year, and DMV revenue (half of the total) could be down. I still view 3% overall growth as achievable, especially if a few states decide to raise DMV prices in view of their strained budgets. In any case, it would be extremely surprising if revenue did not reach $113M by 2011.

2008 2009 2010 2011

($ millions)
Revenue 97 101 107 113
Y/y growth 13% 3% 6% 6%

EBIT 17 18 19 21

Free cash flow* 13 13 14 15

Maintenance FCF** 14 14 15 16

* Free cash flow is operating cash flow less capex, excluding contributions from negative working capital and interest income.

** Maintenance FCF (MFCF), which I use for valuation, is FCF plus an estimated $1.4M after tax that EGOV invests in marketing efforts for new contracts. This investment began in 2007 and will stop if it does not bear fruit in the next few years. In the EV calculation I capitalize the $1.4M at 5x and treat it as debt (“PV of growth investment”).

The stock’s current EV/MFCF multiple is12x my 2009 number. Based on the company’s sustainable moat, rapid organic growth, large revenue opportunity, capital-light business model, and operating leverage, I believe an EV/MFCF multiple of 21x 2009 MFCF (17x 2011 MFCF) is reasonable. This implies $6 per share, yielding 53% upside from the current share price. Note that this excludes new contracts.

2009 2011

($ millions except per share)
Stock price                               $6.00               $6.00
Market cap                               381                  381
Less: Cash                               84                    113
Plus: PV of growth investment   7                      7
EV                                           328                  274
EV / MFCF                              21x                  17x

I do not expect the stock to fetch the multiple it deserves anytime soon. But if it gets to $6 in 2 years, at which point it would be trading at 17x forward numbers, you get 25% annualized. On this basis alone, I think EGOV makes a good investment. While it is possible to argue that even 25% annualized is not exciting in today’s world of dirt cheap stocks, we should not ignore the opportunity EGOV has with the other 29 states, two of which might be near-term events.

NEW JERSEY CONTRACT

EGOV submitted a bid for NJ’s contract in September 2008. The state has not disclosed a timeline for its decision, and such processes are unpredictable. The good news is that NJ specifically tailored its RFP to request EGOV’s self-funded model. Moreover, the company believes there are no other “significant” competitors (e.g., BearingPoint or IBM) in the running. With a population of 9M, NJ would be EGOV’s largest state.

My rough estimate of the NJ contract’s value is $52M, equal to $0.80 per share. I start with a simple DCF with the following assumptions:

Population 8.7M growing at 2% annually

Per-capita revenue       $0.50 in year-1 ramping to $1.25 by year-7*
Gross margin %            40% in year-1 ramping to 45% in year-6
Discount rate               10%

* EGOV’s average company-wide revenue per capita is $1.25 and the population-weighted average contract life is 7 years.

Here is another way to estimate the value. NJ would add 9M to EGOV’s current population served of 70M, a 12% increase. The increase in intrinsic value can be thought of as 12% adjusted by 2 multipliers. The first multiplier accounts for the fact that NJ’s initial per capita revenue would be about 40% of the company average ($0.50 versus $1.25) but would ramp to 100% of the company average over time. We can split the difference between 40% and 100% and set the multiplier at 70%. The second adjustment accounts for the difference between the contribution margin percentage of incremental revenue (40-45%) and the company’s operating margin (17%), implying a multiplier of 2.5.

The percentage change in intrinsic value should be equal to the percentage change in population after applying the two multipliers: 12% * 70% * 2.5 = 21%. The $52M value estimate of the NJ contract is equal to 16% (reasonably close to 21%) of $328M, which is the EV implied by the intrinsic value estimate of $6 per share from above. Each method is rough, but using both has the virtue of tying the contract DCF value to the company intrinsic value.

I believe it likely that EGOV wins NJ. Timing, however, is difficult to predict because the contracts are often delayed. I think the probability of EGOV winning NJ in 2009 is at least 1/3.

TEXAS CONTRACT

EGOV’s bid for TX is due on January 6, 2009 and the decision is slated for June 1, 2009. As discussed above, TX is the only non-EGOV state that outsources its portal, currently to BearingPoint (which is in bankruptcy). With a population of over 23M, TX would increase EGOV’s population served by nearly 1/3. My DCF model is similar to that for NJ, except that the initial per-capita revenue is $1, because TX already generates a significant amount of revenue through its portal. The DCF value is 196M, equal to $3 per share. $196M / $328M = 60%. The multiplier method reconciles nicely: 33% * 80% * 2.5 = 66% (80% is used instead of 70% because of the higher initial per-capita revenue).

Although the timing of TX is more visible than it is for NJ, EGOV’s chance of winning is less clear, because there is an incumbent. I think there is at least a 25% chance that EGOV wins TX in 2009.

Because the outcome of each contract is independent of the other, my probabilities imply that the chance of EGOV winning at least one of them in 2009 is at least 40%. Therefore, I attribute $1.25 of intrinsic value to these opportunities, bringing EGOV’s intrinsic value to $7.25 (representing 85% upside to the current share price).

OTHER CONTRACTS

In theory, the other 27 states—all of which in-source their portals—could be EGOV partners. There is a view that large states like CA and NY are unlikely partners because they have greater internal capabilities. It is also possible to argue that EGOV has picked the low hanging fruit, and future wins will be more difficult. On the other hand, EGOV is certainly more proficient and has stronger competitive advantages now than it has in the past. Moreover, the company expanded its dedicated new-contract sales force from 5 to 12-14 people in 2007 (part of the $1.4M growth investment mentioned above), and management claims the larger team is getting exciting traction (although there is no concrete evidence of this). I am inclined to believe that EGOV’s historical win rate of 0.85 contracts per year is more likely to increase than to decrease.

A logical question to ask is why states do not try to capture EGOV’s economics for themselves. The answer is that those economics are not available to them because of EGOV’s economies of scale. Like BearingPoint in Texas, a state would have to invest millions to replicate what EGOV brings to the table. That is why there is a view that state budget constraints should catalyze the adoption of self-funded portals: they are a source of revenue that does not require a new budget item.

The 27 states in question have a population of about 200M, implying a 285% increase in population served were EGOV to win them all. Using the multiplier method: 285% * 70% * 2.5 = 500%. This implies more than $20 per share in value from the remaining states, though I am not claiming that will ever happen. If we assume EGOV eventually captures 1/3 of this opportunity ($7 of future value), we might attribute $3.50 of present value, bringing EGOV’s intrinsic value to $10.75 (175% upside).

VOTING TRUST & SPECIAL DIVIDEND / BUYBACK

As mentioned above, EGOV’s Voting Trust, formed in 1998 by the pre-IPO investors, dissolved in June, and investors were locked up through December 20. The Trust held 21M shares (1/3 of the float), of which 10M are owned by the current CEO and COO, and another 3M by 3 current directors. Owners of the 8M remaining “non-affiliate” shares could reasonably be expected to reduce their stakes after having been locked up for 10 years. This could create a buying opportunity starting on Monday. Either way, the passing of the lockup could act as a catalyst by removing an overhang on the stock.

EGOV has a history of returning excess cash via special dividends ($47M in February 2007 and $16M in February 2008), and could well continue the pattern next February. I believe that management is considering a buyback instead, because of where the stock is trading.

Catalyst

Company wins TX contract
Company wins NJ contract
Passing of Voting Trust lockup removes overhang
Results demonstrate economic resilience of business

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			2008	2009
Price:	3.92	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	249	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT