Description

With an Enterprise Value of 259mm,net cash of 64mm, EBITDA of $50mm, minimal capex and a NOL of $144mm, S1 Corporation is valued as if the company is losing money or is showing big declines in revenue.  On the contrary, the company has grown revenues organically every quarter for the past 8 quarters and is positioned to do the same in 2010.  The company has also been regular buyers of its stock in the open market by reducing share count by about 30%.  Comparable companies trade with EBITDA multiples 7.5X and higher, while S1 is close to 5X.  Even with all this, the stock is down 24% this year, so it has hugely underperformed its peers.

We believe S1 is a company whose growth is being masked by the sunset of a large customer and over the next 12 months this growth will become more apparent.  We believe the core business is growing top line north of 10% and bottom line over 20% and is one of the few financial IT companies to grow of that magnitude in 2009.  The company's non-cash expenses make GAAP earnings look lower than cash earnings.

GENERAL OVERVIEW

S1 Corporation is a global provider of customer interaction software solutions for financial and payment services.  Customers include traditional financial services providers, such as banks, credit unions and insurance companies, as well as to transaction processors and retailers.  The company, founded in 1996, has nearly 1,600 employees and independent contractors worldwide and is headquartered in Atlanta, GA.  It serves over 3,000 customers in more than 50 countries and has 11 offices worldwide.

BUSINESSS DESCRIPTION

There are two primary solutions that S1 offers to clients:  Payments and Online Banking.

Payments

In the payments segment, S1 sells payment processing solutions and card management solutions to financial institutions, retailers, and transaction processors.  Card issuers from around the world (whether credit, debit, fuel, gift, prepaid etc.) use S1's solutions to develop, deploy and manage their card offerings for their customers.  ATM owners use S1 solutions to manage online connections to networks, card schemes, and host systems, and provides sophisticated performance monitoring, back office functionality and management information.  S1 assists retailers in offering their customers easier ways to pay by setting up debit and credit payment methods, has offers merchant acquiring solutions to merchant banks.

S1's customers process over 10 billion transactions annually from over 100,000 ATMs  and 750,000 POS terminals worldwide.  They serve 2 of the largest ATM network owners in the world, 25% of all off-premise ATMs in the US, and 25% of all ATMs in Australia.  They serve 9 of the top 10 banks in Africa, 8 out of the top 25 banks in the Middle East and the world's largest private card issuer.   In managing retail payments, their customers include the 2^nd largest petroleum company in the world, and 5 of the top 10 retailers in the UK.

The growth drivers in the payments business is simply that payments with debit, credit and stored value cards are growing at the expense of cash and checks.  This is particularly the case outside of the US where S1 has been growing and is seeing a lot of opportunity.

Online Banking

In this segment, S1 offers solutions which enable banks worldwide to better retain and offer customers better products and services.  S1 sells business banking solutions that banks offer to their corporate customers that allow the bank to offer customized service as well as allows the bank to offer more products to that customer.  These solutions include Cash Management, Trade Finance, Risk Management, Payments and Transactions.  The corporate customer is offered a sophisticated online dashboard that allows the customer to be serviced according to its needs.  S1 also offers its banking clients online solutions tailored for their consumer customers.  From everything from as simply as opening a new account to offering a new type of loan, S1 creates the online solution and allows the bank to make changes to the fly and their needs change.

The growth drivers in the online banking segment is that the interaction between consumers and/or companies and their banks is going more online and less via branch or call centers.  Furthermore, banks want to be able to offer more products and services to their existing customers and expanding their online presence does this.  The corporate customer is a valuable customer for a bank to have.  The bank holds checking accounts as well as offers loan products to the corporate customers.  Many times companies have multiple banking relationships because not one bank offers a one-stop-shop.  S1's solutions enable a bank to offer its corporate customers a "customer portal" which includes cash management, trade finance  etc.  Recently larger banks have been investing in their business banking portal to help retain customers.  In consumer banking, there is a trend for consumers to do more transactions over the internet with their bank and also integrate accounts from various institutions into one portal.  There is also a small albeit growing need for doing mobile banking transactions and even integrating PayPal with banking transactions. 

RISKS/WHY IS IT CHEAP

The 5 Big reasons behind the valuation discount:

1)      State Farm....In 2008 it was announced that S1's largest customer, State Farm is going away in 2011.  In 2009, it will do approximately $37mm in revenue with State Farm down from $48mm in 2006, and $42mm in 2008.  In 2010, it will only generate about $25mm from State Farm, and half of that in 2011.  S1 provides professional services to State Farm which include project management, implementation and integration.  They have been doing work for State Farm for nearly 10 years and the work is highly specialized.  While margin contribution is not specifically broken out from this customer, it carries lower contribution margin than its faster growing license and subscription sales.  In 2009, sales to State Farm will drop 12% and represent about 15% of total sales while EBITDA for the entire company will increase by about 12%.  It is my estimation that the State Farm business does anywhere from a 25% to 30% EBITDA margin.  If you exclude State Farm, it is my calculation that S1's core business grew 9-10% in revenue and 23% in EBITDA.

2)      History...S1 came from a background of being a mix of poorly timed, valued and executed acquisitions.  The company was had poor operational performance and customer satisfaction.  In 2006, an activist shareholder (Ramius) got involved and insisted strategic alternatives.  The company went through a sale process and did not consummate a transaction, however, the results of the strategic review was a tender offer for 15% of the company. 

3)      Banking Industry Malaise...It is no secret that banks in the US are running into some major issues and have curtailed spending.  Furthermore, banks are simply going away.  This is a difficult end market environment, but S1 has clearly been able to grow through out it which speaks to their ability to grow when and if the market environment gets better. 

4)      Dubai...The latest headline to hit the stock is the Dubai banking situation.  S1 maintains an office in Dubai to focus on the Middle East market.  Some of its customers are Dubai Banks.  While the percentage of revenue to Dubai Banks is minimal, and there is no recurring revenue coming out of Dubai banks, the headlines have hit the stock

5)      High Receivables Balance last Quarter...S1 performs services for its clients when it installs its software.  The company is undergoing a large implementation for a major international customer (not a Dubai Bank if you were wondering) where they are performing work but there is a lag to when they actually bill the customer.  This high receivable balance should fix itself within a quarter or two according to management.

COMPETITION

In addition to S1 competing with its customers creating solutions in-house, S1's competition varies depending on the end market solution.  Some competitors overlap in some areas while others do not.  In the payment processing and card management space, S1 competes with ACI Worldwide (ACIW), Fidelity National Information Services (FIS) and First Data.  In internet banking they compete with Intuit(INTU), Fiserv(FISV), Fundtech (FNDT) and Jack Henry and Associate (JKHY).

POTENTIAL ASSET

Ownership in Yodlee-Another Source of Hidden Value

S1 owns about 14% of a company called Yodlee which provides the backbone for consumers to aggregate their financial accounts into one website.  Customers include B of A, JP Morgan and Fidelity.  Yodlee works with six of the top 10 U.S. banks and many leading portal sites to deliver tools that empower consumers to track - and manage - their holistic financial affairs, from budgeting to account balancing, funds transfer, and bill payment.  Yodlee powers innovative solutions for more than 155 global financial institutions and 20M+ consumers. More than $3 Trillion in financial assets are currently tracked through Yodlee-powered services.  Yodlee has raised over well over $100mm in venture money over the years.  Recently, a company that used Yodlee's backbone was acquired by Intuit (Mint.com) for $170mm.  While guessing the value of Yodlee is anyone's guess, but it carries zero value on S1's balance sheet.

GROWTH PROSPECTS

Management has stated in the most recent conference call in November that their pipeline of sales opportunities is up over $250mm.  While they didn't elaborate on what the base of this is off, it is quite a large number increase for a small company.  They have upgraded their online management product over the past year and will be introducing it to new clients.  We believe the addressable market for S1 is well into the billions.

INTERNATIONAL EXPOSURE IN GROWTH MARKETS

S1 has pretty good global exposure for such a small company.  International represents about 30% of total revenues with sales in the Asia Pacific, Middle East, India and Europe.

MANAGEMENT

While S1 has had its share of poor management decisions over the years, when current CEO Johann Dreyer took over at the end of 2006, the company made a notable turnaround.  Mr. Dreyer focused on the product development, customer satisfaction and general execution.  They recently hired a new CFO in January from a competitor who is much more polished than their previous CFO who left in 2008 for personal reasons.  So management has upgraded over the last few years.  Management has also been quiet on the investor relations front but that is set to increase in 2010 as the new CFO gets settled.  They are looking at holding an investor conference for the first time and we expect additional coverage on the stock.

RECURRING REVENUES

Over 50% of S1's revenues (excluding-State Farm) are recurring in nature.  They include subscription license revenue, support and maintenance and data center revenue.  The contracts are long term in nature and have high renewal rates.  In addition, the company regularly gets professional services work from its existing customers for various projects.  While professional services does carry a lower gross margin, if you include this $20-30mm of professional services that is also recurring in nature, almost 70% of the business has good visibility.  Currently the company is working through moving data center revenues to higher margin Subscription Licenses which is why Data Center Revenues are declining.

EARNINGS MODEL

What you will notice in 2009 and 2008 for that matter is that margins are increasing despite a decline in revenues from State Farm.  Organic revenue is growing double digit and we believe bottomline is growing about 23% excluding State Farm's profits.  The company has been growing Gross Margin as well as Operating Margin without skimping on product development.  You will see that there are non-cash expenses that run through the income statement that far exceed capital expenditiures.  Under GAAP, the company accrues for Stock Appreciation Rights which is a non cash charge and depends on where the stock is trading. In addition, the company essentially pays zero income taxes in the US and will do so for years due its NOL.  They are currently accruing at a low tax rate but this may increase if the reverse the valuation allowance on their NOL, but they will still be paying very little in taxes.  Therefore, for adjusted EBIT and EBITDA, I add back the stock appreciation rights to give a more accurate earnings picture.  The company presents it in the same format.

VALUATION

S1 is trading at an EV/EBITDA of 5.2 on 2009 EBITDA and 4.8X on 2010 EBITDA.  On an FCF/EV, it is trading at a 13.9% yield on 2009, and 14.7% on 2010.  However, since State Farm is going away in 2 years, it is important to analyze earnings ex-State Farm.  While the company doesn't do this explicitly, it is my estimate that State Farm is a 30% EBITDA margin as explained above.  This would bring 2009 EBITDA ex-State Farm to $39mm, and 2010 EBITDA to 47mm.  At these levels, the company is trading at 6.6X and 5.5X respectively for 2009 and 2010 excluding State Farm.

The comparable companies it its space trade at the following EBITDA multiples:

Of all the comparable companies, S1 is the only company who showed material organic top and bottom line growth in 2009 in an extremely difficult environment.  S1 will grow revenues organically 11% in 2009.  By my calculations it will grow EBITDA by over 23% in 2009 Excluding State Farm.  No other company has weathered the downturn as well.  S1 also has greater exposure to high growth regions such as the Far East, Middle East and India than its comparable companies.  Furthermore, S1 carries a $143mm NOL which represents over 1/2 of its enterpise value and should be taken into consideration.  For these reasons, S1 should trade at a premium to the group.  My target on S1 is $9.00/share which represents a 9% free cash flow yield on 2010 free cash flow, and an EV/EBITDA multiple of 7.7X on 2010 EBITDA (which represents 8.8X for the business Excluding State Farm).  I am assigning no value to the ownership in Yodlee.  We believe that S1 represents an attractive acquisition opportunity for a larger financial IT firm in which are looking to expand their product offerings and expand geographically.

Catalyst

Gradual realization of value by the investment community

Further stock buybacks

Getting acquired

Greater coverage by analysts.