Description

We have owned Q2 Holdings (NYSE: QTWO) in the past (sold way too early) and would like to own it at some point again under the right conditions and valuation.  As we will show below, the stock is currently priced for perfection despite several potential headwinds and risks. At this valuation, one basically has free optionality for (1) a recession in bank spending, which often happens after the yield curve inverts; (2) a temporary delay in decision making by banks ahead of the 2020 election due to fears of regulatory risk - this happened in 2016 after which the stock dropped 17% following 2Q's earnings; (3) increasing competitive intensity to impact win rates or sales cycles; (4) the current Q’s bookings not being as good as the prior quarter - On the last call management admitted that 1 of its 3 tier won wins was pulled forward from this Q; (5) management likely tempering expectations for 2020 margin expansion during Q3 and Q4 earnings.   Insiders have been selling aggressively and the company recently raised money at 23% lower than here, despite no clear use of proceeds. 

Business Overview

QTWO is a digital banking software company that provides cloud-based digital solutions to regional and community financial institutions in the United States.  Revenue from the Company's Digital Banking Platform represents over 90% of revenue, with their other two products, Q2 Open (Banking-as-a-Service, BaaS) and Lending Solutions less than 5% each.

Digital banking platform - provides customers a unified digital banking service across digital channels (e.g. cell phones, tablets, PCs, etc.).  QTWO's product has a single interface that connects to a bank's core software platform. While QTWO is most known on the retail banking side, they added corporate banking functionality in 2016.

Lending Solutions - acquired Cloud Lending in October 2018, whose product helps banks automate and digitize the lending process. 

Q2 Open - product helps Fintechs create bank-like deposit / products without the need for a bank charter.

 As of 12/31/18, QTWO had 401 banking customers and 13.6mm registered users as of 6/30/19, QTWO charges on a per registered user basis.  QTWO's main growth drivers are new bank customer wins (40/50 per year), increasing digital penetration at existing customers as not all customers have online / mobile accounts at banks, and product cross-sells.  Churn has averaged 5% a year, with 1/2 due to bank consolidation. 

Thesis

1.       Economic Sensitivity: we don't believe the market is putting enough weight on the economic sensitivity that QTWO faces through its customer base.  With the Fed reversing course and now cutting rates with the futures market forecasting another 100bps until the end of next year, QTWO's bank customer base is facing a much more challenging environment than the one QTWO had been selling into.  While Digital Banking is a high-priority for banks, QTWO's technology is a rip and replace of a pre-existing solution, does not have a clear ROI, risks disruption to the consumer experience, and has a long implementation cycle. As has been seen in the software space, in a stressed environment these four factors can cause customers to delay and extend sales cycles.  Consequently, we believe declining rates, along with other macroeconomic concerns (e.g. global trade climate, peak unemployment) could cause banks to delay decisions, deployments or go with lower-cost offerings from the core providers. Additionally, QTWO has benefitted from bank consolidation as their customers have more often been the acquirer vs the acquired. However, in this more challenged environment, we expect bank consolidation to slow as target banks become less willing to sell at depressed multiples and acquiring banks focus more on their balance sheet and have less profits to leverage.  For a corollary of what can happen to a SaaS company when they allude to a more challenging environment increasing deal cycles in this market environment, we'd point you to ZEN. ZEN, which is much cheaper on a growth adjusted basis than QTWO, has declined nearly 20% since it reported on July 30th and alluded to macro uncertainty creating softness in certain regions.

2.       Election Cycle Risk - during the last presidential election cycle in 2016, QTWO saw a slowdown as banks pushed-out decision making.  On their 2Q16 earnings call, after which the stock dropped 17%, QTWO called out uncertainties around the presidential election, along with other macro risks as driving the slowdown in momentum.  In that 2Q16 quarter, QTWO's billings declined 3.4% sequentially and billing's y/y growth rate slowed to 21% (after 5 straight quarters of 30%+ and an average of 41%). Given sentiment, bullish street estimates, and valuation, we believe any warning of or actual slowdown in numbers ahead of the election could lead to a material sell-off in the stock.  Regardless, we expect the share price to face pressure as the market becomes more cognizant of the election as it approaches. Below are some excerpts from the 2Q16 conference call:

"we did have an increase of push-outs in the bank space during the quarter.  I believe these push-outs reflect delayed decision-making as banks faced increased uncertainty in the second quarter…  There was comments from general negativity towards the economy, flat interest rates, continued energy pressure, BREXIT, the election and then it's Fourth of July weekend…  But if those push-outs continue, it could impact the back half of 2017. So it's really -- again, back to Matt's point of transparency and just making sure that you guys don't get out ahead of yourselves on your 2017 estimates." (2Q16 QTWO Earnings Call)

3.       Competition: Under new management from FIS, NCR Corp (NYSE: NCR) has turned around its Digital Banking team, has begun winning new customers again, and we believe will pressure QTWO's growth in the coming quarters.  As way of background, NCR acquired Digital Insight, a Digital Banking software company, in late 2013 for $1.65bn. At the time, Digital Insight was very similar in size to where QTWO is now:

o Digital Insight: annualized revenue of $300mm and 12mm online banking users

o QTWO: 2019 estimated revenue of $314mm and 13.6mm registered users as of 6/30/19. 

Previous NCR management mismanaged this business by implementing the wrong sales strategy where they replaced Digital Insight's specialized sales force with the general ATM sales team at NCR.  Given the specialized nature of the product, a focused sales team is needed to effectively sell the product. NCR's new management has restructured the sales team with software specialists and hired FIS' Head of Digital and Mobile this January (our checks on him have been very positive).  Additionally, from a product perspective NCR is investing more in R&D than QTWO and is advantaged due to greater scale and resources. Our checks imply that NCR's product is on par with QTWO and may have an edge on mobile functionality, where QTWO's shows better on PC. Given the future is with mobile, we believe this could be an important edge for NCR as they compete against QTWO.  NCR is also advantaged given their market leading ATM position, as NCR can integrate mobile functionality with their ATM hardware and software, for example allowing the customer to set-up an ATM transaction ahead of getting to the ATM so the customer only has to scan a QR code.

The turnaround effort at NCR has begun to bear fruit, with NCR winning 7 new customers in Q1 alone (including one in QTWO's backyard of Austin, TX), which is more than the past two years combined.  For context, we estimate QTWO has been adding 40-50 customers per year. According to QTWO, the pace of new customers to compete for has been stable around 80-100, with QTWO's win-rate relatively stable around 50%.  Consequently, NCR going from zero to 25-30 annualized (a pace that we think could accelerate) could have a significant impact to QTWO's business momentum, especially given the number of new deals to compete is not materially growing.  Furthermore, 90%+ of the customers selecting QTWO are switching from the core providers of FIS, FISV and JKHY. Given the growing importance of Digital Banking, the core providers are focusing more on maintaining that business, which could lower the pace of new deals to compete for each year.  QTWO claims that FISV and FIS are distracted by their recent acquisitions, but our checks indicate a significant pace of hiring for Digital Banking. For example, a search on FISV’s careers page yields a number of Digital Banking user experience and software development related openings (https://www.careers.fiserv.com/search-jobs/digital%20channels/1758/1?glat=38.9070014953613&glon=-77.0525970458984).

Finally, a bull case for QTWO is a push upmarket into the Tier 1 bank space.  In July of this year, NCR acquired D3, who caters to bigger banks. While D3 was a smaller player, this acquisition will strengthen NCR's offering to Tier 1s as QTWO looks to push into that space. 

4.       3Q Tier 1 Signing Risk - as just mentioned, one driver of QTWO's bull case is their moving upmarket into the Tier 1 bank space and a primary reason for the move up post 2Q earnings.  On the 2Q earnings call, the company mentioned a pull-in of a Tier 1 signing from Q3 to Q2 and alluded to a challenging 3Q for Tier 1 deals. Consequently, we believe that 3Q could disappoint from this perspective:

"We have a -- deals that are down the path. I think we borrowed a little bit from the Tier 1 space in Q2 from Q3. The team did a great job of pulling one of those deals in that I probably thought was going to land in Q3. So we've got our work cut out for us in Q3. But in the back half of the year, I think you'll see more Tier 1s coming in." (3Q19 QTWO Earnings Call)

5.       Tempering of 2020 Expectations - given macro headwinds, upcoming election cycle, and a more competitive NCR, we expect management will be conservative around 2020's growth expectations.  Additionally, we believe the street's margin expectations need to come down as the Company reinvests back into the business. For example, during Q2 earnings, QTWO increased their revenue guidance for 2019 but maintained their EBITDA guide.  Despite the Company alluding to reinvesting back in the business, the street is still estimating 29% incremental EBITDA margins in 2020 compared to low single digits this year and a cumulative 15% from 2016-2019. Based on conversations with QTWO, we expect the Company to qualitatively discuss 2020 during the Q3 call and to provide guidance with their Q4 results.

6.       Insider Selling and Secondary Offering - in early June, QTWO launched a secondary offering at $69.50 per share, 23% below today's price, in addition to a convert.  The company had not identified any specific uses to the capital, saying they thought, "market conditions to be favorable for a deal."  We believe the Company sees growing competition and increased macro and regulatory uncertainty going into 2020 and decided to take advantage of the very high current valuation.  Additionally, insiders have been selling shares at an accelerating pace. For example, insiders have sold $97mm shares YTD compared to $39mm over the same time period last year, an increase of over 50%.  As mentioned earlier, we think management is smart and know their business and the environment well. Consequently, we view their actions as a helpful barometer for intrinsic value and thus believe accelerated selling a strong negative read for the current share price. 

7. Convert - The company has over $500mm of convertible debt outstanding.  We don’t believe the sell-side is properly accounting for the potential dilution, which could limit upside and add another 6/7% to the share count over time.

8.       Stock Based Compensation - Currently, SBC is running at ~12.4% of sales, up 41% y/y and up from 11.5% of sales in 2019.  While profitable on an adjusted EBITDA basis, given elevated SBC we don’t expect QTWO to be profitable when including SBC until 2021, with SBC significantly diluting shareholder returns in the coming years.

Valuation

While some sell-side analysts point to TEV / Revenue for QTWO, QTWO's gross margins are substantially below the rest of the SaaS universe (55% vs mid-70's) given heavier implementation burdens and a lower margin transaction segment.  Therefore, we believe a TEV / Gross Profit is a better metric to evaluate QTWO. On TEV / Gross Profit, QTWO is materially more expensive at a 5x higher multiple than the average of a universe of SaaS companies. For example, on consensus numbers both QTWO and SMAR trade at 21x TEV / 2020 GP, but with SMAR expected to grow gross profit in 2020 at nearly 2x the rate of QTWO (51% vs 27%) - we also believe SMAR is much more likely to beat consensus numbers based on the magnitude of recent beats and cohort analysis.

Further, QTWO laid out long-term targets at their Investor Day of 20%+ revenue growth and an adjusted EBITDA margin of 20-25%.  Even a very bullish scenario where QTWO grows at 25% (5% above its LT guidance) from 2020-2025, reaches the top of the EBITDA guidance with a 25% EBITDA margin, and using a terminal multiple of 35x EPS (26x EBITDA exc SBC) would yield a share price of $88, still implying downside to today's price (10% discount rate).  Of note, this scenario would also imply an acceleration of organic growth after 24% in 2018 and an implied 24% in 2019 based on commentary around the contribution of their acquisitions of Gro (1% of revenue) and Cloud Lending ($14-15mm) for 2019. 

On what we believe to be more reasonable assumptions of moderately decelerating revenue growth, though still staying above the 20%+ guidance, and significantly expanding margins towards the high-end of the 20-25% EBITDA range, we see over 30% downside.  We also see a bearish case with more significant downside, where the incremental competition from NCR and the core providers discussed above pushes growth below 20% and limits margin expansion as the Company decreases pricing and / or continues reinvestment to stay competitive.

Finally, given the run-up in the share price, we believe the stock is at risk of valuation downgrades from the sell-side with the average consensus target price at today's price of $90 and 75% of analysts having a buy rating on the stock. 

In summary, as mentioned above, the stock is currently priced for perfection despite several potential near and long term headwinds and risks. 

Catalysts

·         NCR competing away wins from QTWO pressuring bookings and growth trajectory

·         Core providers competing more aggressively to keep / win back the digital banking side

·         A slowdown in IT spending by banks given fragile macro environment and lower interest rates

·         Upcoming election catalyzing banks to push out decisions, with the potential of a democratic victory making some push-outs more permanent in nature

·         Tempering of 2020 expectations during Q3 and Q4 earnings calls

·         Light Q3 Tier 1 customer wins

·         Further acceleration in insider sales

·         Sell-side downgrades

 Risks

·         New products and growing product penetration expand revenue per customer offsetting slowing registered user growth. 

·         Core providers effort to refocus on digital banking fails to mitigate their loss of customers to providers like QTWO.

·         NCR suffers a misstep around efforts to turnaround their Digital Banking product.

Catalyst

See above