Some six weeks ago, NIC Inc. (EGOV, Financial) lost a major client, the state of Texas, and one analyst says that client represented 20% of the company's 2016 revenue. Analyst Peter Heckman of D.A. Davidson Cos. also said five other states had made "major changes" in contracts with NIC in the past five years. What does all this mean for the future of the company?
The company calls itself America's largest provider of digital government services, sites and secure payment processing. If you have done anything online with a government agency, there is a good chance NIC facilitated it. For example, it helps citizens renew drivers' licenses, get information about services and access state construction registries. One of its competitive advantages is the ability to pay the upfront costs of a government portal and then share in the revenue generated. The model is especially popular among cash-starved jurisdictions.
In an earlier article, I compared NIC’s business model with that of Gillette razors; more than a century ago, King Gillette disrupted the razor market by selling razors at a loss but making a fortune selling disposable razor blades. That’s the legend at least—it’s now disputed at several levels—but the model of giving away the razor and selling the blades remains strong today. Something you’ve no doubt considered when you bought cartridges for your inkjet printer.
NIC the stock surfaced through an application of the Macpherson model, a set of criteria designed to quantify what Warren Buffett (Trades, Portfolio) called great companies at great prices. Thomas Macpherson argues that a first screen of just four common criteria will bring up companies with good fundamentals, while discounted cash flow provides an initial screen for great prices.
Those four criteria are:
- No debt.
- Return on assets: at least 15% per year, averaged over the past 10 years.
- Return on equity: an average of at least 15% per year over 10 years.
- Return on capital: again, an average of at least 15% over 10 years.
All four of those criteria are met by NIC, and this excerpt from the GuruFocus dashboard shows why:
Also note in the top right corner of the dashboard, the bar graph results for the two DCF results. The vertical dotted line represents the current price and the right edges of the bars represent intrinsic value. In both cases, they show that NIC is undervalued when compared to intrinsic values.
As noted above, there is a reason for the undervaluation, and it is not just the Texas contract. CSIMarket reports NIC's fourth-quarter and year-over-year results for 2017 showed it lagged its competitors on revenue growth, profitability (net margin) and on earnings per share growth:
This 10-year free cash flow chart shows another concern:
Total free cash flow (what’s available for reinvestment) has slipped from $72.9 million for calendar 2016 to $56.5 million for calendar 2017. That means $16.4 million less for reinvestment.
Of the $56.5 million remaining free cash flow, $5.32 million will be paid out in dividends, assuming the company maintains its eight-cent dividend throughout 2018, and $25 million will go to share buybacks, again assuming the full amount will be spent in 2018 (and perhaps a good idea while the share price is depressed). That leaves $26.2 million available for reinvestment and growth, approximately 7.8% of revenue.
On that note, how solid is NIC’s competitive advantage, or moat? Based on its return on capital, that seems very strong. In 2017, it recorded an ROC of 719%, significantly higher than 459.3% of 2016.
Going back to its funds available for reinvestment, note in this dashboard graphic how little capital it needs to generate increased returns:
So while NIC appears to have short-term difficulties, the longer-term perspective seems more bullish. But, what do expert investors and analysts think?
Four of the gurus followed by GuruFocus had holdings in NIC at the end of 2017; they were Joel Greenblatt (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Pioneer Investments (Trades, Portfolio) and Hotchkis & Wiley. Greenblatt has the largest holding with 421,570 shares.
During the fourth quarter, Jones reduced his holding, Pioneer and Greenblatt made initial buys, while Chuck Royce (Trades, Portfolio) and Jim Simons (Trades, Portfolio) sold out completely.
At NASDAQ.com, the firm is followed by analysts at four firms, and they have a lukewarm perspective:
Their 12-month consensus price target is $15, which would be a 7.3% gain over the March 20 closing price of $13.90. Not much for a high-flying tech stock, but respectable by the standards of the whole market.
In an article dated Nov. 10, 2017, Zacks took a positive stance on NIC. It summarized its perspective this way: “NIC Inc. is an inspired choice for value investors, as it is hard to beat its incredible lineup of statistics on this front. Furthermore, a strong industry rank (among Top 36% of more than 250 industries) boosts investor confidence. However, over the past two years, the broader industry has clearly underperformed the market at large.”
In the 2017 Annual Report, CEO and Chairman Harry H. Herington said, “Make no mistake, our business continues to grow. We launched hundreds of new services in 2017 from an enterprise-wide, entirely mobile brand inspection platform in Nebraska that will process millions of cattle inspections annually, to a new comprehensive campground reservation system in New Jersey.... We will continue to focus on the right allocation of capital to best return value to stockholders.”
Conclusion
There are varied opinions on the future of NIC. Those opinions vary from favorable to modestly pessimistic. It is a debate over how fast and how effectively the company will grow in coming years.
For 2018, we would expect prices to be muted, but over five years, the company should be able to become a solid growth holding once again. It has capital available, it still has management that made it a leader in the past and it stands to gain as its government clients try to keep up with the ever-increasing demands of their citizens.
The current uncertainty means it is underpriced, while remaining a quality company, and well worth further attention by value investors.
Disclosure: I do not own shares in any of the companies listed, and do not expect to buy any in the next 72 hours.
