Description

Summary

ACI Worldwide (ACIW) is a software company with a “last-man-standing” position in its core market that offers four bagger potential with little downside risk.  This market position and appreciation potential was recently confirmed by a five year warrant agreement with IBM that, if exercised, will put IBM’s total cost at $41.92 per share (3x the stock’s current price).  Over the last 18 months, management has made a series of decisions that led to a large drop in GAAP results in 2007 and will continue to create a headwind over the next 4-6 quarters.  Over the medium to long term, however, these actions will significantly increase the company’s revenue and profitability.  This progress can presently be observed in deferred revenue and 60 month backlog which have both shown encouraging growth.

 

It should be noted that ACIW was formerly know as Transaction Systems Architects (Ticker: TSAI), and that their FYE has historically been September 30.  The three months ended December 31, 2008 will form a transition period after which the company’s FYE will become December 31.  Management has been providing guidance in calendar terms for 2007. 

 

Background

ACIW makes software that large banks, retailers, and payment processors use to facilitate electronic payments.  Approximately 60% of ACIW’s business comes from software used to facilitate retail payments—the credit, debit, and ATM transactions that most people initiate on a weekly, if not daily basis.  The balance comes from retail-related software (i.e. fraud detection) and software used to facilitate wholesale payments—the  large transfers that occur among banks and enterprises. 

 

Retail Payment Engines

Small and medium size banks and retailers usually outsource payment processing to third party processors such as First Data.  The scale and complexity of large banks, however, means that they can realized significant control and cost benefits by performing these functions in-house.  A large bank, for example, would have to pay a third-party processor $0.02-$0.05 per transaction.  Using software like ACIW’s, this cost falls to $0.0001 to $0.001 per transaction.  I estimate that ACIW’s average customer in this division processed roughly 160MM transactions in FY06, and this figure is expected to continue growing 7-12% per year for the foreseeable future.  (This implies an average savings of 3MM to 8MM per year, which will grow at a 7-12% annual rate.)

 

ACIW’s retail payments software facilitates all of the underlying steps involved in processing credit and debit card payments, including (but not limited to):

 

• Channel Management & Enterprise Access:  This involves routing the information along the relevant networks, which depends on the type of transaction (ATM, credit, or debit), where the transaction is occurring and where the card holder’s bank is located.
• Authentication: This involves determining whether the POS terminal, network, card, cardholder, and bank are all legitimate.
• Authorization: In this step, the software addresses questions such as: Does this PIN match this card?  Does this cardholder have enough cash in his account?  Has this cardholder tried to withdraw $10,000 at 10 ATM’s in the last 30 minutes (i.e. fraud prevention and card limits)? 

There are more steps than I’ve outlined above, and they vary significantly by the transaction’s origin, which payment networks are used to communicate the information, and which financial institutions are involved.  In some cases, multiple entities (i.e. the retailer or ATM owner, network operator, and bank) could each be using ACIW software to handle their part of the transaction. 

 

Large retailers use ACIW’s software for a number of functions such as aggregating their electronic transactions.  Third party processors use ACIW’s software to process payments for smaller banks and retailers who lack the scale to operate this type of software in-house.  This means that ACIW is a supplier to the processors who are in some cases ACIW’s competitors.  In such cases, ACIW will still benefit some because its contracts include a volumetric component.

 

In the retail payments area, ACIW has a “last man standing” position among the vendors who are capable of serving Tier 1 banks on a global basis.  When I first spoke to the company over three years ago, they listed three companies as competitors: Mosaic, S2, and eFunds. 

 

Mosaic was a South African company with a product on a Windows platform that competed with ACIW in mid-sized banks.  Mosaic struggled to compete with ACIW among large banks, however, because Windows wasn’t perceived as robust enough for datacenters.  S1 acquired Mosaic in late 2004, intending to sell Mosaic’s mid-sized software to large banks, but this strategy proved unsuccessful.  S2 used to be one of ACIW’s strongest competitors, but ACIW bought them out in mid-2005.  eFunds has a division that competed with ACIW for decades, but this division eventually morphed towards a processor type business model and lost its way.  Today, that unit has 50MM of revenue (out of eFund’s 400MM of total revenue) and installations at 30 of the world’s top 500 global banks (vs. 120 for ACIW).  Fidelity National recently acquired eFunds and has announced their intent to reduce costs by 60MM, which happens to be the amount eFunds was spending on the unprofitable division that competes with ACIW. 

 

Internationally, ACIW competes with various regional players, but a global support infrastructure is proving increasingly important in serving global banks.  ACIW’s global support network took years to build and thus serves as a competitive advantage.  In addition, ACIW is offers the most comprehensive solution in the industry.  It’s competitors, by contrast, only provide pieces of the overall solution. 

 

Other Retail Products and Wholesale Payment Engines

Roughly 20% of ACIW’s revenue come from products that either compliment its payment engines or facilitate other back office activities.  These include fraud detection and anti-money laundering products, products to manage smart cards, and products that allow heterogeneous legacy computer systems interact with other systems.

 

Roughly 20% of revenues come from software that facilitates wholesale electronic payments.  This includes software for handling very large wires and transfers between banks as well as software used by enterprises’ finance departments to manage cash balances, initiate wires, and similar activities.  One of ACIW’s competitors in this space is FundTech, though FundTech tends to focus on the middle-market.

 

ACIW has traditionally had a less complete product offering in the wholesale payments area than in its core retail payments division.  Over the last couple of years, management has worked to fill out this product line, primarily through acquisitions. 

 

Market Opportunity

While ACIW has historically had some third party competitors in the retail payment space, its real competition has been the homegrown systems that banks built decades ago.  The newest of these systems is 15 years old, and ACIW believes that such systems represent at least 34% of the market among large banks.  The main sources of stress on these systems comes from rising payment volumes and new regulatory mandates from bodies such as Visa, MasterCard, and the Office of the Comptroller of Currency.  These mandates usually change how transactions have to be processed or encrypted and thus require updating the software. 

 

Coming into Y2K, many banks considered upgrading to a third-party solution, but companies like ACIW had limited conversion resources which forced these banks to instead heavily remediate their homegrown systems.  This remediation left these homegrown systems well prepared for the higher volumes and mandates they would face during the early 2000’s.  It was analogous to sinking a lot of money into jalopies to get them ready for a big state inspection.  Such efforts extended the lives of these beaters, but they’ve put on a lot of miles over the last eight years, and the engines are starting to come under strain again.  This has been especially pronounced in Europe where there have been far more regulatory mandates.

 

ACIW’s flagship retail payment engine, BASE24 was developed decades ago to run on the HP Non-Stop hardware platform, which was the leading edge hardware for such applications at the time.  BASE24 eventually became the industry’s gold standard, but HP Non-Stop gave way to mainframes and servers.  This was problematic for ACIW since the need to buy Non-Stop hardware became a “Non-Starter” for many prospective customers.  Many banks appreciated the quality of ACIW’s products and staff, but were simply unwilling to buy a Non-Stop machine just so they could run BASE24.  Doing so would have created an island in their IT departments which were already built around other hardware platforms like mainframes.

 

To address this limitation, ACIW introduced an open version of BASE24 in 2002 called BASE24es (now called BASE24eps) that would run on mainframes and other hardware platforms.  The ability to address mainframes alone doubled or tripled the addressable market.  The first four years, however, were slow because it was difficult to recruit launch customers for such a mission-critical application, especially since the entire market had so recently overhauled their legacy systems.  In addition, the few customers ACIW did attract tended to be very large and complex, which led to lengthy implementations (12-24 months).  These factors meant that the product got off to a very slow start and took four years to build a set of referencable accounts—a key step in selling mission-critical software.  

 

By March 2006, BASE24eps had 22 customers.  Five of these were “live” on four different hardware platforms in four different countries.  One particularly high profile installation was VISA Europe’s network switch which demonstrated the tremendous scalability of the product.  By late 2007, BASE24eps had signed over 60 customers, 31 of which had gone live.  This progress suggests that the product has crossed the “chasm” and gained industry acceptance.  This acceptance may have been helped by IBM’s publication of two “Red Books” which are highly detailed technical manuals that discuss the finer points of implementing and operating the software on IBM hardware.  As part of this collaboration, ACIW began to fine-tune BASE24eps for running on the IBM Z-Series (i.e. mainframes).  This collaboration recently grew into formal agreement which is encouraging because IBM is the leading IT supplier to financial institutions.  (ACIW’s CEO, Phil Heasley, appears to have been instrumental in repairing and cultivating the company’s relationship with IBM which had been adversarial at times in the past.)

 

What Phil Has Done

The management team in place during the late 1990’s had hoped to spin off two of ACIW’s three divisions during the tech boom.  Even though these bubble burst before these units could be spun out, they had still been maintained in their full glory, with separate CFO’s, etc.  In addition to being expensive, this led to an uncoordinated sales effort as these three divisions each called on the same prospects separately.  Lastly, it underutilized the strength of the company’s ACI Worldwide brand since this was only used by the retail payments division.  Phil Heasley joined the company as CEO in 2006 and proceeded to restructure the firm into a single company, operating under the ACI Worldwide brand.  This has resulted in more coordinated sales efforts, more effective cross selling, and better positioning for the smaller two divisions.

 

Under Phil’s leadership, the company has also made a number of acquisitions which have filled out the company’s product line and improved its distribution and support network internationally.

 

Phil’s most consequential (and painful) decision, however, was changing the sales forces’ incentives and how the company goes to market.  ACIW’s products have three dimensions to their price.  Customers pay based on:

2) The breadth of the solution they are buying (i.e. the number of modules)

3) The number of transactions they are allowed to process

 

This creates recurring revenue because the licenses must be renewed every five years.  A second recurring element is that customers must periodically buy “capacity upgrades” that give them the right to process more transactions.  (It is analogous to how people with prepaid phones are required to periodically purchase more minutes.)

 

This business model brings tremendous financial stability, especially since ACIW’s renewal rates are 98%.  Installing this software is similar to getting a heart transplant.  You could theoretically switch to another transplant, but virtually no one is willing to accept that much risk and pain.  The switching costs are evident in the fact that many of ACIW’s customers are in their fifth five year term extension.

 

This financial model, however, created two problems.  The first is that it discouraged the company from selling new products.  Renewing a legacy BASE24 contract allowed the company to start recognizing license revenue immediately because the software was already running and installed.  In the short term, this was far more lucrative than selling a BASE24eps contract since the BASE24eps implementation would take at least 6-9 months, delaying revenue recognition for that amount of time.  (This timetable can elongate to as much as 24 months if ACIW is selling multiple products to a completely new customer.)  Over the last few years, ACIW’s European staff rose to the occasion and seized on the flurry of European mandates (i.e. SEPA, Faster Payments, etc.) to persuade new customers to sign up for BASE24eps and associated products.  Their American counterparts, however, had evolved into relationship managers who just renewed existing contracts.  (Management has turned over most of the American sales organization.)

 

The second shortcoming of this financial model is that it presents the opportunity to pull revenue forward in order to meet quarterly numbers.  If software is already installed and running, high margin renewal revenue can be recognized immediately if the customer pays up front.  (If the customer pays on a monthly basis, revenue is recognized monthly.)  In some cases, ACIW was proactively approaching customers three years into their five year agreements and offering them large discounts (as high as 40%) if they would renew early and pay up front.  Customers eventually became conditioned to this and realized that they could wring large discounts out of ACIW if the company was trying to meet its quarterly numbers.  When Phil discovered this activity, he labeled it “puffing” and quickly recognized how much long-term value was being left on the table. 

 

In late FY06, Phil changed the sales forces’ incentives to redirect them to:

1) Sell new products instead of renewing old products.  A basic new product would involve a sales cycle, followed by a 9-12 month implementation period.  Revenue recognition under this scenario occurs much slower than if an existing license is renewed and paid up front (immediate recognition) or paid monthly (monthly recognition that starts immediately).

 

2) Sell multiple products instead of individual products.  This elongates the implementation cycle by another 6-12 months, pushing revenue recognition even further out. 

 

3) Stop offering discounts to customers who were willing to renew licenses or buy capacity upgrades early.  This activity was more or less banned, and created a two year hiatus in this revenue since it would take 8-10 quarters for the existing licenses to start expiring under their original contracts.   

Any one of these headwinds would have been manageable in isolation, but taken together, they created a “hole” in organic revenue in FY07, especially for license revenue which, of course, carries the highest margins. 

 

During this period, ACIW became mired in a voluntary review of its historical stock option practices, and combed through every option granted since 1995.  While this study exculpated current management, it found that backdating was common under the management team in place in the early 2000’s (three CEO’s ago and two CFO’s ago).  This wasn’t surprising since that CEO and CFO had been forced to leave, the auditors had found material weaknesses in the accounting, and the results from that period had been restated twice.  The practical impact, however, was that ACIW’s executives were distracted by an internal investigation and financial restatement for about a year.  Shortly before this investigation, ACIW had made a large acquisition of a company in the wholesale payments area, and the investigations delayed its integration (and expected synergies) by about a year.

 

I think few managements have the backbone to do what Phil and his team have done to maximize the long-term value of this business, and I am thankful for the changes they have made.  The near term consequence, however, is that GAAP revenue has fallen short of expectations, and given the fixed cost nature of the business, EPS has been crushed.

 

Why I Think ACIW Is Going to Work

While the GAAP results have been poor, I derive enormous comfort from the progress ACIW is showing in the marketplace as evidenced by the huge increase in BASE24eps signings and start ups in 2007.  Because ACIW sells five year licenses, they have visibility into revenues that will occur contractually over the next 60 months.  The trends in this backlog and the company’s deferred revenue also attest to their success in the marketplace as shown below (in $MM’s):

 

			2Q06	3Q06	4Q06	1Q07	2Q07	3Q07	4Q07
60 Mo. Organic Backlog			1,031	1,050	1,072	1,055	1,072	1,095	1,144
% Change (Yr./Yr.)							4.0%	4.3%	6.7%
Tot. Organic Def. Rev.			101	95	95	n.a.	110	110	116
% Change (Yr./Yr.)							9.8%	15.9%	21.8%

 

Most encouraging, however, is a recent agreement with IBM that extends their relationship and dramatically improves ACIW’s ability to execute on its goals.  While much could be said about the relationship, the highlights are that:

1) IBM paid $33.3MM for warrants to buy 2.854MM ACIW shares during the next five years at an average price of $30.25 per share.  (ACIW ended FY07 with about 35.7MM Diluted Shares Out.)  If exercised, this means that IBM will have paid an effective price of $41.92 per share.  The effective price would be $53.59 per share if you include an additional $33.3MM that IBM will pay ACIW for meeting certain objectives by March 31, 2008 that management thinks will be easy to achieve.

 

2) ACIW will further optimize BASE24eps to run on the Z-series, along with several other products that have yet to be optimized for this platform.  This will create an integrated product line that has been optimized on the most popular banking hardware platform.  It will also move ACIW closer to realizing its vision of “convergence.”  Banks currently use different engines to process the various types of payments (credit, debit, ATM, wire, ACH, etc.).  These processes vary some, but often share similar steps, and ACIW believes there is the opportunity to develop “payment hubs” that use common components to handle every type of payment.  This would yield tremendous operating and security improvements at the banks.  Since ACIW’s engines handle retail and wholesale payments—the most difficult types—management believes that ACIW is well positioned to develop this next generation of technology.  ACIW also employs the largest number of experts in this field, which contributes to its position.  Payment hubs would result in larger sales since the solution would be more comprehensive. 

 

3) ACIW and IBM will form a joint sales force to sell ACIW’s products on the Z-Series.  ACIW will realize the same margins under this arrangement as it would have on a stand alone basis, but I think IBM’s endorsement and a coordinated sales effort will dramatically improve ACIW’s ability to sell to Z-Series users.

 

4) IBM will create a “Migration Factory” to help customers switch from legacy systems to BASE24eps on the Z-Series.  Because ACIW had been renewing customers on the same product for 25 years, they have little migration experience, and some of the migrations undertaken to date have been inefficient and expensive.  This part of the agreement removes an significant source of execution risk and will allow ACIW to sunset its legacy products much sooner, improving operating efficiency.  IBM will benefit by being well positioned to capture ACIW’s 460 legacy customers that currently run on HP Non-Stop.

I believe that IBM entered into this relationship because they recognized the enormous market opportunity that ACIW has been talking about since they launched BASE24eps in 2002.  The existing set of systems that process payments are archaic, ranging from 15 to over 30 years old, and these systems are starting to wear past their overhauls of the late 1990’s.  In addition, M&A has left many banks with redundant payment systems.  Merging banks often choose to maintain both of their legacy systems since neither system was robust enough to handle the combined volumes from both banks.  Citigroup, for example, has 17 retail payment engines, three of which are homegrown.  This is very inefficient since it requires far more IT resources to continually remediate these three homegrown systems and update the 14 third party systems.  Using disparate systems also complicates risk management and fraud detection. 

 

ACIW appears to be the only company of size that can address these needs, and its next generation product has now been thoroughly tested and proven in the marketplace.  2009 is expected to be the beginning of a growth period for the company.  This will be driven by: 

1) The resumption of the natural renewal cycle for term extensions and capacity upgrades.  This two year revenue “hole” will get filled sometime between 1Q09 and 3Q09.

 

2) Revenue beginning to be recognized from lengthy implementations currently underway.  While poor from a GAAP perspective, 2007 was a successful year for signings.  Translating one year’s signings into another year’s revenues oversimplifies the situation because the company is a few years into signing larger contracts with various implementation timetables.  Still, management seems to have begun placing more focus on multi-product deals in late 2006, so a 18-24 month implementation cycle would imply that revenue would begin to improve in 2009.  

 

3) The initial fruits of the IBM agreement. 

The number of BASE24eps implementations has been building for some time, and it’s possible that some of these will begin to convert to revenue in 2008.  The street is not anticipating much revenue improvement in 2008, so such a development would be a plus. 

 

Financial Projections & Valuations

The timing and trajectory of ACIW’s revenue ramp is difficult to predict.  What we do know is that ACIW has a dominant position, a proven product that is well matched to an emerging industry need, and 460 customers that will be forced to migrate away from its legacy products in the coming years.  Pinning down the cadence of EPS over this period is tough, but I think that EPS will be in the range of $1.90 to $2.10 around 2010 and $3.10 to $3.50 by 2013.  Applying a 15x multiple to these would imply a stock price of $30.00 by 2010 and $52.00 by 2013.  The price that IBM paid for its warrants suggests that they are looking at numbers as good or better than these. 

 

Another way to look at the valuation is to look at ACIW’s earned before management created a “crater” in FY07 and FY08’s revenues.  In FY09, this crater will naturally fill and the growth trajectory will resume.  In the figures below, I have taken the normalized Net Income and FCF for FY04 through FY06 and divided by the current diluted share count.  I have used the current share count because management repurchased 6% of the diluted shares in FY07.  (Management has been buying stock for their personal accounts since this summer.  The CEO has bought over $1MM.)

 

			FY04	FY05	FY06
EPS			$1.01	$1.23	$1.36
Multiple at $13.70			13.6	11.1	10.0
FCF			$1.38	$1.21	$1.30
Multiple at $13.70			9.9	11.4	10.6

 

For those of you who think about P/S, I’d point out that ACIW is trading at 1.26x CY07 sales.  This compares to an industry norm of around 3-5x.

 

As a practical matter, I think the stock will be back into the low $20’s within 12-18 months as the natural license renewal cycle and the associated high margin revenues resume.  (That’s over a 30% annualized return from today’s price and the reason I'm recommending the stock today, even though the catalysts are as far as 18 months away.)  Investors’ confidence will also probably start to improve as they get more visibility into the IBM relationship and get closer to its initial contributions in 2009. 

 

I think that the downside risk is very limited.  After the initial 33.3MM from IBM, ACIW probably has about 99MM in cash and 75MM of debt, leaving them with a net cash position of 24MM.  Over half of the company's revenues come from recurring sources such as maintenance and monthly license revenues.  Even more of the revenue would be recurring if you factored in the 98% retention rate and five year terms of their contracts.  Lastly, the capital requirements are low and the business has traditionally been a strong FCF generator.  Beginning in FY07, FCF has become significantly higher than NI because FY06’s acquisitions added significant Intangibles Amortization.

Catalyst

Filing of ACIW's 10K later this week and thus becoming current with the SEC. Better visibility into the new relationship with IBM. Resumption of high margin "capacity upgrade" revenue and license renewal revenue sometime between 1Q09 and 3Q09.