48: 1/26/22 Watchlist Update; Adding Jack Henry (JKHY)
170 feet below a mountain in Missouri lies a fiercely guarded treasure. Bank data.
Below you’ll find an updated Watchlist and excerpts from the full 21-page analysis of Jack Henry that went out to paid subscribers last week.
Here’s the latest watchlist (click to see Google Sheet):
As of January 17, 2022
Jack Henry & Associates
Deep below a mountain in Branson, Missouri, 170-feet under solid rock, lies a fiercely guarded treasure. This treasure isn’t gold or another precious metal, but data. Bank data. Unlike gold, this precious commodity must be guarded against physical attacks and electronic breaches.
Jack Henry & Associates competes for the hearts and minds of bankers – almost literally.
At the heart of every bank is its core. This is the engine that powers the bank, holding and processing transaction data on everything from deposit accounts to loans, and integrating a host of ancillary software to make a bank run seamlessly. It’s not exaggerating to say changing a bank core is like changing one’s heart. It comes at a great cost in terms of dollars, a lot of risk, as well as long days (and sleepless nights) for almost everyone within the organization.
My time in commercial banking showed me how disruptive changing a bank core can be. It also left me with a good idea of just how high the switching costs are. The bank at which I worked switched to what turned out to be a subpar core (it wasn’t JKHY or any of the majors). Yet there was no discussion of changing again. The organization was exhausted from the tedious work that went into moving systems. No one wanted to do that again. Never mind the contractual obligation keeping us locked in.
Jack Henry is the smallest of the three leading bank core software providers in the United States. Its business has expanded into ancillary banking services over the years into payments and other bank and financial-related software. It’s a mature business earning good returns on capital, but without outsize growth prospects. Consequently, the company pays out most of its earnings as dividends and buybacks.
I readily admit upfront that this Deep Dive took me to the edge of my circle of competence. I feel I have a pretty good understanding of JKHY but not enough to have great certainty into what the landscape for its non-core business will look like in ten years.
INDUSTRY OVERVIEW:
JKHY competes almost exclusively in the United States (99% of revenues), and that is the market I’ll focus on.
To talk about bank software necessitates a discussion of the US banking industry. In a word, it’s consolidating. That has implications for bank software providers, but not all negative. Over the last two decades the number of commercial banks declined at a rate of 3% annually. At the same time bank assets increased at almost 6% per year. (See chart below).
KEY VARIABLES & METRICS:
The industry analysis above painted a clear picture of steadily declining US banks, the result of industry consolidation. But what really matters to industry players is the underlying size of the banks its serves. That’s because pricing is based on number of accounts and on transaction counts[1]. Precise data are hard to come by but we can get roughly there by looking at market share in the bank core space, processing volume, and profit margins.
Key metric #1: What is the company’s market share in bank core software?
We can see the remarkable consistency JKHY has in commercial bank core software. Over the past decade it has remained at 22% of the market. In credit unions the company has increased its share by four percentage points over ten years. Note that this table and the industry tables above don’t reconcile perfectly because the slides JKHY presents focus on the $1bn+ market.
We can use share of the number of banks and credit unions as a key indicator with one important caveat: The company must not be going down market. In other words, if JKHY maintains market share but only by focusing on smaller banks which are losing assets to the larger banks, its business is going to suffer. In fact that’s the opposite of JKHY’s strategy of focusing on larger banks, but it’s important to understand that stable or even increasing market share doesn’t automatically equal good results.
Key metric #2: What is the aggregate size of the underlying financial institution customer base?
This metric gets to the missing information above. It’s imperfect but shows how JKHY is increasing the number of financial institutions it works with (not all core customers) and the underlying asset base of the institutions served.
Key metric #3: What are profit margins?
Company-wide profit margins paint a good picture of the trend and consistency of a company. JKHY’s pre-tax (EBIT) margins have remained steadily in a range of between 22% and 25% over the past decade.
Such consistency is not guaranteed, however, even with a triopoly in bank core software. JKHY management has noted the increased presence of consultants in their core renewal deals. Here’s CEO, David Foss, discussing the dynamics (Q4 2021 earnings call; emphasis mine):
For core renewals, what -- we've talked about this in the past. Consultants are now engaged every time there's a renewal. So 10 years ago, it was rare to have a consultant involved in a renewal. Today, every single one of them has a consultant, and that's not just Jack Henry, it's in the industry. And how does the consultant justify their role? It's by ensuring that it's a very competitive process. So that's been going on. It started before the pandemic. It is definitely in place today, where every single renewal for all of us, there is a consultant engaged. They're encouraging diligent review of pricing and all that kind of stuff. And so we know how to operate in that model, and we're comfortable with what's happening.
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Stay rational! —Adam
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