Description

Overview

In today’s expensive market we are generally looking for better than average businesses that are priced for relatively limited downside with decent prospects for an above-market return. We think SS&C Technologies (SSNC) fits that bill.

SSNC’s recurring revenue software and outsourced services business catering to financial services and healthcare customers boasts 95%+ retention mainly due to high switching costs. The business generates close to 40% EBITDA margins on essentially no net tangible capital. SSNC is led by founder, Chairman and CEO Bill Stone, who owns over $2 billion worth of stock. Stone has overseen huge value creation over many years primarily through a well-honed M&A strategy premised on buying targets with sticky revenue and bloated cost structures using leverage. Management then cuts costs and cross-sells other products to generate earnings growth while rapidly paying down debt. The company has high market shares and generally competes with large custodian banks and smaller independent players. Organic growth typically runs in the low- to mid-single digits. Taking it all together, management at SSNC has grown EPS at close to 25% annually since coming public in 2010. Despite the stability of earnings, compounding potential from a proven M&A capability, and oversight from a well-aligned and thoughtful steward and capital allocator, the stock trades for under 17x estimated 2021 earnings. We think this is too cheap in today’s market and gives investors the opportunity for a double-digit annual return over the medium-term.

Note that throughout this write-up we have removed amortization of intangibles from the income statement (though we include amortization of capitalized software). Our figures also include stock comp as an expense.

Business

SSNC provides software for the financial services and healthcare industries. Its biggest businesses include fund administration services for alternative and traditional asset managers and portfolio accounting. The company also provides portfolio management, trading, banking/lending and other software to asset managers, banks and financial advisors, as well as a virtual data room business and a healthcare administration business. SSNC owns and operates the full technology stack across securities accounting, front-to-back-office operations, performance and risk analytics, regulatory reporting and healthcare information processes. Financial services clients are diverse: hedge funds, mutual funds, private equity, fund of funds, RIAs, wealth managers, family offices, endowment/pension funds, banks, brokerage firms, real estate, insurance companies, managed accounts and asset managers.

The business is really a combination of software-enabled outsourced services (like fund admin), subscription-based cloud solutions managed and hosted at SSNC’s facilities (multi-tenant or dedicated), and specialized software products deployed at clients’ facilities (on-prem, which is only about 6% of revenue and is often large clients that need on-prem for cybersecurity reasons). Software-enabled services, which are 83% of LTM revenue, are typically provided under 1- to 5-year evergreen contracts with monthly or quarterly payments (fee-based or transaction-based). Generally, prices for alternative asset managers scale with client AUM, complexity and transaction volume. Pricing for mutual funds and brokerage is based more on the number of accounts and transactions. Maintenance services and term licenses make up the bulk of the rest of revenue (14% LTM), with professional services and perpetual licenses rounding out the remainder.

The healthcare business sells services to insurance companies, individual and government sponsored health plans, healthcare providers and benefits administrators. Healthcare services include pharmacy, healthcare administration and health outcomes optimization solutions, including claims adjudication, benefit management, care management and business intelligence services. SSNC acquired this business as part of the DST acquisition in 2018. It is currently less than 10% of total revenue. We suspect they will either acquire around it to build it into another growth platform or will look to sell it.

Investment Positives

Here is what we like about SSNC:

-          Strong insider ownership and oversight

-          Proven M&A playbook

-          Highly recurring revenues

-          Leading market positions

-          Excellent financial profile

-          Good valuation

Chairman and CEO Bill Stone founded the business in 1986, took it public in 1996, took it private in an LBO with Carlyle in 2005 and took it public again in 2010 at a split-adjusted $7.50 per share. SSNC is Stone’s baby, and he has well over $2B personally invested in the common stock. His ownership makes it less likely that management will flame capital and more likely they will continue to allocate intelligently and compound EPS for shareholders. He has tried to push equity compensation deep into the organization to create an ownership mentality.

Stone is a commercial animal with a winning mentality. His skills are most apparent in the company’s M&A strategy, which he has proven many times over the past several decades. Stone has a knack for using borrowed money to acquire businesses with sticky clients where SSNC can squeeze out costs to dramatically improve margins and cross sell other products. They typically find margin improvement from operational efficiency, facility consolidation, vendor contract negotiation and reduction and productivity. As they expand the margins and grow top line, they rapidly deleverage. The big DST and Advent deals are good examples of this playbook in action at scale. This chart from an early 2019 Needham conference shows their track record:

SSNC has highly recurring revenues, with high retention rates that hold strong even in severe downturns like 2008-2009, when retention bottomed at 91%. In normal times it runs around 95%. This dynamic results from high switching costs due to complex, highly configured, deeply imbedded, mission-critical systems. Customers are unlikely to gamble on an unproven entity for this critical software. SSNC has a long operating history as trusted experts in accounting and compliance.

SSNC is the leader in many of its markets, including alternative fund administration (they have over $2 trillion in assets as of Q1 2021), mutual fund administration, portfolio management and accounting, and virtual data rooms. Many of their competitors are either large custodian banks (State Street, BONY Mellon, Northern Trust), smaller independent specialized administration providers, or other financial firms that provide these services in combination with prime brokerage. SSNC competes mainly with State Street in its GlobeOp alternatives administration business, though Citco and BONY Mellon are also big players. In its DST mutual fund transfer agent and broker sub-accounting business, SSNC competes in a quasi-duopoly with BONY Mellon, with specialized technology companies like StatPro and Empower nipping around the edges. In its Advent Geneva portfolio management and accounting business, SSNC competes primarily against Sungard, which is owned by FIS, Clearwater, and overseas with Simcorp. In its Eze order and execution management, SSNC competes with Charles River (which was acquired by State Street) and a handful of smaller players. Unlike SSNC, some competitors do not sell their own software. For instance, BONY Mellon uses Sungard’s software for mutual fund admin and SSNC’s for hedge fund admin. On the flipside, many of the software competitors do not offer fund admin or other outsourcing services. By owning its own source code, SSNC can be nimbler in responding to customer needs or evolving trends in the marketplace, rather than having to rely on a software provider to make those changes. This is particularly important given the need to keep up with regulatory changes.

SSNC produces high and stable margins. EBITDA margins are generally in the 38-40% range with very little variability. In 2018 they produced a 34.6% EBITDA margin, their worst margin since at least 2007. However, this result was mainly due to mixing in the DST acquisition. There is essentially no tangible capital in the business, and ROE is currently in the high teens. Their “acquire and improve” strategy has driven phenomenal growth in Stone’s three primary metrics for shareholder value: EPS, cash flow and revenue. Since coming public in 2010 SSNC has grown revenue and EBITDA at a 30% CAGR and EPS at a 24% CAGR. Even without M&A, management targets 50-75 bps of margin improvement each year through productivity, technology and other cost reductions.

SSNC’s stock sits at an attractive price today, especially considering alternative investment options in the market. The stock trades at 14.4x trailing EBITDA, 15.7x EBITA and 19.0x earnings. It pays a 0.9% dividend yield. Using the mid-case of management’s 2021 guidance and adjusting to reduce earnings for our estimate of stock-based comp, it trades at 16.8x forward earnings, or a 6% earnings yield. This strikes us as too low for a high-quality company with the potential to compound EPS at a high single-digit rate without M&A and a double-digit rate if management can continue to execute its M&A strategy at anything close to historical levels. We pencil a low- to mid-teens type of IRR over the medium term assuming no multiple expansion.

Risks

The main concerns leveled at SSNC include:

-          Tepid organic growth

-          Reliance on M&A to drive earnings

-          Exposure to financial markets

-          Leverage

While admittedly not gangbusters, SSNC has generally achieved organic growth in the low- to mid-single digits (including 2.9% in Q1 2021) and management expects to generate mid-single digit organic revenue growth in normal times. Growth in general is driven by increased outsourcing of back-office functionality to scale players with software-enabled services. Complexity from regulatory burdens, globalization and digitalization are driving these trends. Fee pressure on asset managers could also lead to more outsourcing. In addition, SSNC can grow with their existing clients as client AUM grows (the equivalent of a price increase), and through cross-selling other products into the installed base. Their Black Diamond RIA business is growing quickly, as is their private equity business (though they are a weaker player on the PE side). Their best businesses (fund administration outsourcing and the accounting software businesses) are higher growth – probably in the 6-7% range – and Eze and Intralinks should also grow mid-single digits as they broaden the customer base beyond hedge funds for Eze and M&A for Intralinks. These businesses are around 60-65% of the total, with DST making up the balance. DST is a slower grower, slightly negative since the acquisition and probably closer to 0-3% going forward. That said, DST presents a major revenue opportunity. Over the last few years management put a ton of effort into changing the sales culture at DST to transform it from bureaucratic to commercial. That effort is just beginning to pay off. DST had struggled historically with retention, and as a result had to give away pricing concessions. Under SSNC ownership, they have already seen retention rates move up to SSNC levels as they’ve improved customer service and introduced new technology. They are no longer giving away price, and they’ve beefed up sales and marketing (which had been 2% of revenue, vs. 4% for SSNC’s outsourcing businesses and closer to 8-9% for the overall company). The healthcare business has struggled the last few years as they lost several accounts that were known at the time of the DST deal, as well as during Covid with lower utilization. As they get past that attrition and the Covid impacts in 2021, the healthcare business should grow mid-single digits, in line with underlying growth in Medicaid and Medicare. Margins are similar across SSNC’s businesses, so there is not a mix issue if one grows faster than another. Expanding internationally is another revenue opportunity for the company, as the U.S. is currently 73% of revenue. Their recent acquisition of Capita in Ireland and their current efforts to acquire Mainstream in Australia are examples of this strategy.

In terms of M&A, it is true that the outsized EPS potential comes in large part from a hoped-for continuation of the successful acquisition strategy. However, we would argue that at current prices we are not paying for this upside. If all SNCC can deliver is predictable high single digit EPS growth year after year from mid-single digit organic growth, improving margins, debt paydown and stock buybacks, investors will still do okay with relatively limited downside risk. That said, we expect Stone to continue to do deals. The target profile seems to be shifting towards faster-growing companies, which will mean they have to pay higher prices. There is some risk around that, but we think that given his skin in the game and proven skills, Stone can still be a big money maker with “growthier” M&A. There is no shortage of undermanaged targets in this huge market (Stone talks about their financial services TAM being a $100 billion domestic market and a $100 billion international market, plus healthcare at another $100+ billion).

Some investors worry about SSNC’s exposure to price declines in the equity and other financial markets. While the stock typically does trade down during major drawdown periods in the equity market, the reality is that SSNC’s clients run the gamut in terms of types of financial firms, asset and market exposures and strategies, such that declines in the markets do not generally lead to much impact on the business. For instance, credit, equity, derivatives/vol, macro, private equity, interest rates, FX, HF, FOF, etc. all march to somewhat different beats. This was evident in 2020 as Covid hit the markets (AUA dropped only $20 million in Q1 2020), as well as in 2008/2009 and other periods of volatility. SSNC’s business has proven resilient. This is also in part due to fixed fees, minimum thresholds, and other non-asset-related revenue drivers. This chart from the 2018 investor day is illustrative:

Organic revenue declined only 0.5% in 2020 and was down 7.0% in 2009 (following 12% growth in 2008). EBITDA dropped only 2.4% in 2009 while EPS was up. Both measures grew in 2020. Furthermore, management says that most of their expenses are variable (primarily direct labor, with 60% of the cost structure going to employee compensation).

The leverage profile is also not especially concerning. Net debt to EBITDA foots to around 3.5x while net debt to EBITA is an even more comfortable 3.8x, a function of the low capital needs of the business. They have one financial covenant (secured leverage ratio) which only applies when they have drawn on the revolver, plus they have lots of cushion in the calculation. There are no near-term maturities. Given the stability of the revenue and earnings, this capital structure seems appropriate.

In sum, the risks are manageable, the business is stable and high-quality, the growth profile is somewhere between fine and good, management is strong, and the price is attractive. It’s a good combination in today’s heady market.

Disclosures

The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved.  All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis.  The user of the information assumes the entire risk of any use it may make or permit to be made of the information.

Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.

The adviser, through a partnership that it advises, holds an investment in the issuer's securities.

Catalyst

- Improved organic revenue growth

- Additional acquisitions