I bought the shares at 69.75 in July 2015 and sold it last week at 84.54 plus total collected dividend of 1.34. That’s 23% return in USD in 15 months. In SGD term, the return is 21% after adjusting for forex (USD-SGD), taxes on dividends, and trading fees.
Jack Henry & Associates, Inc (JHA) is a provider of technology solutions and payment processing services primarily for financial services organizations, such as banks and credit unions. Its solutions serve over 10,800 customers. A significant proportion of its revenue is derived from recurring outsourcing fees and electronic payment transaction processing fees that predominantly have contract terms of five years or greater at inception.
To over simplify for you, JHA earns some fees every time its banking clients process the debit or credit card payments, but that’s not the only thing that it does. JHA provides more than 300 products and services to financial institution clients. If you look at its website, you may be lost on the number of IT solutions they provide. To simply it, financial institutions use JHA’s services to process financial transactions, automate business processes and manage information.
This is the segment result for FY16. “Support and Service” generated 96% of revenue, while Licensing and Hardware generated the remaining 4%. In terms of client segment, 73.5% of revenue is generated from Banking clients and remaining 26.5% from Credit Union clients.
Source: Jack Henry’s FY16 Annual Report
Within “Support and Service”, this is the further breakdown. Payments (credit/debit card services, bill payment, processing) contributed 40%, OutLink (outsourcing service) contributed 23% and In-House (maintenance, support, etc) contributed 26%.
Source: Jack Henry’s FY16 Presentation
Look at its financial performance in the past 10 years. Revenue grew by 100% and net profit by 137%. Because JHA kept buying its own shares, EPS grew by 173%, much higher than net profit growth. Even during the worst financial crisis in 2008-2009, JHA maintained its revenue and profit. This demonstrated its very high stability in generating revenue and profit.
In terms of profitability, its gross margin is extremely stable around 41-43% over the past 10 years. Operating margin is actually rising from the already high level of 22% to 26%. Similarly, ROE rose from 17% to 25%.
This table shows the growth rate of the revenue, operating income, net profit and EPS. Revenue growth slowed down from teens in early 2000s to mid single digit now. Operating income growth averaged 10% CAGR in the past 5 years while net profit growth averaged 12%. EPS growth was higher at 14% CAGR due to shares buy-back.
There is no doubt about how wonderful the business is. I didn’t even go study its products and services, analyze its competitive advantage, or assess its management. The only question is really about paying the fair price for it (forget about paying a cheap price).
One thing I understand about IT system is that there is a high switching cost, meaning that there is high cost involved to switch from one IT system to another. A new IT system can take years to implement, and employees will need to be re-trained to use the new system. When I was doing IT projects last time, a big project could take 2-3 years to complete and require several years of continuous support and maintenance, providing steady maintenance fees to our company.
A complex IT system is also a barrier to entry for new competitors. A complex IT system takes a solid IT team years to build and enhance. New entrants will need to spend many millions to build such complex system and will have hard time to convince the banks to use their new systems. Banks also require the systems to be very “safe” and need good track record of the vendor.
Share Price Performance
Before going into the valuation, let’s look at its share price performance. All the outstanding financial performance above should translate to a similarly outstanding price performance, and it did. This may not be true for many other companies that were highly overpriced at IPO.
As mentioned in its Annual Report FY16, since its IPO in November 1985, its market capitalization as grown 32,537%, a CAGR of 20.9%. Total shareholder return (change in stock price + dividends paid) has grown 25,513% since IPO, a CAGR of 19.9%! That means 10k invested since IPO will turn to 2.55m (255x !!!)
For such a wonderful business, the valuation cannot be cheap. Its P/E ratio has grown from 21x in 2006 to 26.7x now. You can ignore the P/B ratio because for such IT companies, there is not much physical assets to invest in.
In unusual case, JHA’s Free Cash Flow (FCF) is actually higher than its Net Profit over the past several years. This is because JHA capitalized its software development costs and amortized them more aggressively over the years, resulting FCF > Net Profit. This is another plus point for JHA as it’s been conservative in reporting its financial statements. In our valuation, we assume FCF = Net Profit over time to be conservative.
How much are you willing to pay for such a company? Strong recurring and growing revenue (5-10% per year), expanding margin (latest: 26% operating margin), growing ROE (latest: 25%), in net cash position.
With a market cap of 6.35bn now, JHA is owned mostly by institution (91%) and followed closely by the market (analysts, fund managers, etc). Its share price tends to be quite efficient (reflecting all the information, potential growth, return, etc). After GFC in 2008-2009, its P/E ratio grew from 20x in 2010 to 26x now, while revenue grew at CAGR of ~7% and EPS at ~15%.
15% growth in earnings is considered a growth stock. If you follow Peter Lynch’s method of pricing a growth stock, using PEG ratio (P/E-to-growth ratio), then JHA’s PEG ratio will be 26/15 = 1.73x, which is no buy. A PEG ratio below 1 is potential to buy. In fact, if we use PEG ratio to assess JHA, we will never get the chance to buy it any time in the past 10 years because JHA’s P/E has been near or above 20x most of the time (except during the extreme bear period in late 2008 to early 2009), while earnings growth is between 10% and 15% most of the time. Therefore, using PEG will miss out JHA entirely, which returned more than 270% in the past 10 years.
Joel Greenblatt, a legendary investor with strong investment track record, started buying JHA in mid 2011 at the price of 28-34 per share. Over the time, he added his position, reduced it, sold out and bought back again, added and reduced position again. He sold out in early 2016 at the price 74-86 per share. He would have done better if he held the position throughout the time from 2011 to 2016 and never sold a single share until today. Why didn’t he hold the shares throughout?
I believe part of the reason is that the valuation has gotten more expensive over time. JHA’s P/E ratio rose from 20x in 2011 to 26.7x now, indicating that price has risen faster than earnings. For a company with earnings growth of 12-15%, P/E of 27x looks high.
Using DCF is tricky when you are projecting some growth (> 10%) and using a low discount rate.
JHA’s revenue growth is around 5 – 10%, but earnings growth is higher because of expanding margin and share buyback. Currently high operating margin of 26% could normalize to 22-23% in future when growth slows down and costs catch up. When that happens, earnings growth will be inline with revenue growth of 5-10% assuming stable margin. If the company fails to meet the growth expectation, the valuation can substantially drop.
For discount rate, some analysts will use discount rate of 10-12% for JHA, but I think that penalizes the company and does not reflect JHA’s business model and competitive advantage. A significant portion of JHA’s revenue is recurring in nature. Its revenue stability during GFC 2008-2009 demonstrated that. I will assign discount rate of 7-8% for JHA. The problem when using low discount rate is any small change can have big impact to valuation. If we assume terminal growth rate of 3.5%, then using discount rate of 7% will yield P/E multiple of 28.5x for terminal value. If we use 8% discount rate, then P/E multiple drops to 22.2x. That’s 22.2x vs 28.5x, a 28% difference in valuation multiple just because of 1% point change in discount rate.
JHA’s business is not without risk. There is a constant consolidation of banks and credit unions in US over the time. This will eventually cause JHA to lose some clients. US experienced a steady economic recovery and falling unemployment rate after GFC. In next downturn, banks are likely to cut their IT spending budget, resulting slower growth for JHA.
At the moment, JHA’s business risks have lower probability and it’s the valuation that we need to pay attention to. A change in market expectation can cause P/E to drop from 28x to 20x, which remains high for a good business, but that’s 28.5% loss for the investors.
When I bought the shares in July 2015 at 69.75 (record high), I estimated the FY15 earnings to be around 2.5, yielding P/E of 27.9 at that time. My quick estimate of the valuation (bull case scenario) is between 65 and 73. So, I consider my purchase price of 69.75 to be slightly overpriced, but I bought it because of its track record and after considering that a 10% earnings growth in the following year will make my entry price to be less expensive.
As luck was on my side, its EPS grew from 2.59 in FY15 to 3.12 in FY16, a 20% growth. 19.5m of the profit came from the disposal of a business. At effective tax rate of 30% for FY16, that’s nearly 0.17 per share. Removing this one-off gain, the adjusted EPS for FY16 is 2.95, which is still 14% higher than FY15 EPS. Following this solid performance, the share price rose steadily to 89 before tapering off a bit to 84. I attribute most of the return in this case to luck.
In my bull case scenario, the value of JHA could be worth 80 to 95 now. I decided to take profit 84.54 last week. I wasn’t expecting 20% return in 15 months. I was expecting something closer to 10% and fully aware that if market re-rate it lower, I could potentially face 20% loss in short term despite holding a wonderful business.
Part of the reasons why I sold is because other solid IT service providers also experienced fall in share price and valuation multiple. Fiserv is another IT service provider to financial institutions, handling payment processing. It’s 3.5x bigger than JHA. Fiserv’s P/E has dropped to 25x now, from last year’s 30x. JHA’s current adjusted P/E is 28.6x, which is nearly 15% higher than Fiserv. I’ll be equally happy to hold Fiserv as JHA. Cognizant Technology Solutions Corp is another provider of IT, consulting and business process services. Its valuation multiple has dropped from 26x in 2013 to 23x in 2015 to 20x now, while its earnings grew steadily. Accenture, a market leader in consulting, technology and outsourcing services, has P/E of 20x while growing its revenue and earnings steadily.
After considering that I can get similarly wonderful business like JHA at a lower price (lower valuation multiples), I decided to sell out my stake in JHA. I hope there is re-rating for JHA to be valued lower (closer to 20x P/E). This is a stock that you can hold for a long time, but it should be done at a fair price.