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Stock Strategist

Banking on Stability

Wide-moat Jack Henry's future is bright, if not quite as bright as the recent past.

 Jack Henry's (JKHY) fiscal 2015 first-quarter results contained no major surprises. Revenue increased 8% year over year. While the growth figure was helped slightly by fairly strong license sales, which can be lumpy quarter to quarter, this level was in line with recent results and the growth rate we expect going forward. Electronic payments remained a key pillar, with the company seeing a 9% growth rate in this area. Jack Henry is on track to achieve our full-year expectations, and we are maintaining our $48 fair value estimate and wide Morningstar Economic Moat Rating.

While Jack Henry retained its top-line traction in the quarter, margin expansion stalled, with operating margins coming in at 25.9% compared with 26.2% last year. Management had said it expected margins to hold flat in fiscal 2015 as the company is making some investments to support future growth, and it reiterated this guidance on the call. We have always believed that the rate of margin expansion the company achieved in recent years was unsustainable, so it does not surprise us to see a pause on this front. Still, we think the company can achieve some modest margin expansion longer term due to the scalability of the business.

During the quarter, the company remained aggressive in repurchasing stock, given the dearth of attractive acquisition targets, buying back about 1 million shares at a total cost of $60 million. While we appreciate management's diligence in returning capital to shareholders, given recent trading levels we are skeptical that these repurchases created value.

Adept Competitor in Variety of Environments
As banks have progressed past the financial crisis, bank technology providers have seen growth pick up a bit. Jack Henry has come off the mark much faster than its larger peers, and we expect that to continue in the near term. But we believe the gap will narrow in the coming years.

Jack Henry has been performing very well recently, achieving both strong sales growth and significant margin improvement. On the sales side, we believe the company's small-bank focus is paying dividends in the current environment, as small banks are relatively late adopters of new products and Jack Henry is in something of a sweet spot on the adoption curve. For instance, Jack Henry is seeing double-digit growth in products like electronic bill payments, a product that has already matured for its larger peers. The company is also shifting away from license sales and toward support and service revenue, a trend we believe will continue and which we view positively, as support and service revenue is both recurring and sticky. The downside is that license sales carry much higher margins, but the company has been able to offset this by scaling its support and service operations. Still, we believe the recent pace of margin improvement in this area is unsustainable, as it is above the level the company has historically been able to achieve, and even management expects the improvement to slow. This was borne out in the latest quarter's results.

The sale of Open Solutions and its DNA core processing platform to Fiserv might also make for an incrementally tougher competitive environment. We believe Open Solutions was hampered by its high leverage, which made banks somewhat reluctant to commit to the company, and relatively small product portfolio, which limited cross-selling opportunities, but both of these issues will become moot under Fiserv's roof. Jack Henry has proved itself an adept competitor in a variety of environments, and we believe its future is still bright, although its performance is likely to slow a bit in the coming years.

High Switching Costs Are Biggest Advantage
Jack Henry's wide moat is based primarily on the high switching costs for its core processing services. Financial institutions very rarely switch core processing providers because a conversion introduces the unacceptable danger of potentially losing critical data or disrupting operations and requires retraining employees. Switching benefits are tenuous at best as there is very little savings to be had from moving to a competitors' product, in relation to the financial institution's total costs. Recent replacement rates imply that the average bank maintains its core processing system for more than 30 years. The biggest competitive threat is from in-house solutions, but Jack Henry's client base is made up of small and midsize institutions that, for the most part, lack the scale to make in-house solutions viable.

Jack Henry sells a number of services outside of core processing. While these other services might be no-moat or narrow-moat products on a stand-alone basis, we believe significant synergies are involved in cross-selling a full suite of services to Jack Henry's essentially captive core processing customers, and we don't see this evolution as necessarily dilutive to the company's moat.

Bank Health, Regulation Could Have Effect
We would generally view acquisitions by a wide-moat company negatively, as they might dilute the moat. But Jack Henry's small size relative to peers makes acquisitions somewhat necessary, and the ability to cross-sell acquired products provides a strategic rationale. Further, history suggests management will pull back when appropriate.

Another banking crisis could lead Jack Henry's customers to defer purchases, and banks could also fail in large numbers. Government intervention in the banking system could lead to a shift in the structure of the industry, and if this were to occur, the effect on Jack Henry's business would be difficult to predict. Any shift in deposits from small and midsize banks to large banks would hurt the company. Finally, Jack Henry processes sensitive information, and any breach of its systems could damage its reputation and lead to lawsuits.

Stable Management, Stable Business
We think Jack Henry's managers have been good operators, and we don't have any major issues with their capital-allocation decisions. Historically, the firm has been fairly consistent in its uses of free cash flow. Acquisitions have been the main use, accounting for almost half of free cash flow over the past 10 years. The money paid for acquisitions can vary wildly year to year, and the acquisition of iPay in 2010 may have marked a shift toward larger targets. However, management's desire for balance has been demonstrated by a relative lack of activity since.

Dividends are the second main use of free cash flow, eating up about 20% of free cash flow over the past 10 years, and management consistently raises the dividend to maintain the payout ratio. The company's use of stock repurchases has been spotty, with buybacks typically employed only if acquisition targets are scarce.

We do believe that management is too conservative in its approach to its capital structure, and an increase in leverage to a point in line with its peers would enhance shareholder returns without creating much risk. Still, management has done very well by shareholders over time, and we like that it has remained focused on expanding the company's position in a fundamentally attractive business. The stability in the management team corresponds nicely with the stability of the business, and we think the company is run frugally, as befits a company founded using a borrowed computer in the back of an engine-repair shop.

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