Here's the Salomon Smith Barney report on CKFR....
OPINION
We are initiating coverage on Checkfree (CKFR) with a 2H rating and a 24
month price target of $41/share, representing a 20% annual rate of return.
Since the end of May, CKFR shares have risen over 35%. The company,s
fundamentals are strong and our 2H rating is based on valuation. We will
reevaluate our rating for a possible upgrade if the stock drops to the
mid-$20s or there is strong evidence of rapidly accelerating adoption of
electronic bill payment and bill presentment.
For 4Q98 we estimate that CKFR,s total revenues will be $64.3 million,
operating income will be $2.9 million and EPS will be $0.03/share. We
don,t expect an earnings surprise in the quarter. For 1Q99 our earnings
estimate is also $0.03/share on $60.9 million in revenue. The flat EPS
estimates reflect the fact that 4Q is generally the software unit,s
strongest quarter while 1Q is its weakest quarter.
For FY99, our EPS estimate is $0.32/share based on a top line of $279
million (up 19% year over year). Our FY2000 EPS estimate is $0.87/share.
We believe that over the next three to five years, CKFR,s EPS will grow at
a 45% CAGR.
*Description of Business*
CKFR has three business units. The electronic commerce division offers an
outsourcing service to large financial institutions which enables online
banking, bill payment and bill presentment. In FY98, which ended June 30,
the unit should generate an estimated $139.3 million in revenue and end the
year with operating income of $900,000. This compares with a FY97 top line
of $92 million and an operating loss of $31.6 million. 3Q97 was an
inflection point for the unit in which it achieved positive operating
results for the first time after 10 quarters of losses. For FY99, we
expect the unit to post $197.9 million in revenue and end the year with
operating income of $24.5 million.
The investment services business unit operates a portfolio accounting,
management and securities trading service bureau. The unit,s 215 clients
(CKFR claims over 95% client retention) manage over 500,000 portfolios with
more than $250 billion in assets. FY98 revenue will be $29.7 million and
operating income will be $5.8 million, more than doubling over FY97.
1998 has been a restructuring year for the software division. The company
has sold or has announced plans to sell non-strategic or under-performing
software business lines, including the cash management, wire transfer,
leasing, imaging, mortgage and safe box accounting applications. The total
value of the sales are expected to yield approximately $40 million. The
three software products lines to be retained by CKFR are reconciliation,
compliance and ACH payments. Together, sales of these applications are
forecast to be approximately $41.1 million in FY99 with operating income of
$15.4 million. Clearly, the company has kept the most attractive
properties.
*Brief Overview of Electronic Bill Payment and Bill Presentment (EBPP)*
While the investment services and software units are attractive businesses,
the real juice in CKFR is the electronic commerce division and at the heart
of the EC division are the electronic bill payment and bill presentment
services.
The electronic bill pay service enables a bank customer to visit a web site
with a stack of bills received in the mail in hand, enter payment
instructions (just as if s/he were writing checks and addressing envelopes)
and at the click of a button, CKFR takes care of everything else. The
customer can use the service to pay just about any type of bill. For the
customer, electronic bill payment is easy, quick, convenient, inexpensive
and facilitates personal financial management and record keeping.
Electronic bill presentment is often called the killer application of home
banking. Instead of getting bills in the mail, digital bills are delivered
directly at a designated web site. Digital bills look just like the paper
bills they replace. The customer logs into the web site, reviews the
digital bills, one at a time, and clicks a button to authorize payment.
There have been a wide variety of business models and payment processes
offered by a host of technology vendors and service organizations to enable
electronic bill payment and bill presentment. This is how we think it is
going to work:
Customers want to go to a single digital destination, log-in once, review
digital bills and authorize payment. Of course not every bill will be
digitally delivered and the customer wants to be able to pay paper bills at
the same time at the same site.
Paying bills frequently requires cash management gymnastics and
consequently the most logical place to pay bills is at the customer,s
bank web site where there is real time access to account balance
information and money transfer options. And it doesn,t hurt that
customers already have a trust relationship with their bank. Banks love
the idea of consumers paying bills at their web site because it enhances
the value of the banking relationship.
Billers see the tremendous potential in digital bills and they are eager to
move their customers to this payment option, but not at the expense of
losing control over the customer data or of the content of the digital
bill. Consequently, most billers will insist on either delivering the
bills themselves to their customers' computer screen or using a billing
outsourcer (that can be replaced by another, competing outsourcer) to
handle the mechanics.
There are many billers that wish to present bills digitally and many banks
that wish to host bill payment services. But try to imagine every bank
electronically connected to every merchant. It would be chaos. Someone
has to sit between the banks and the billers and direct traffic.
The traffic controller, CKFR,s role, manages the bill pay and bill
presentment process and assumes responsibility for customer care. The
controller maintains security; guarantees privacy; manages registration,
delivery and payment; and maintains an audit trail and real-time account
status.
The key to customer and biller (the two endpoints of a bill) satisfaction
is automation. The greater the automation, the less likely errors will be
to occur. Errors result in exceptions which must be handled by people.
Exceptions are expensive and CKFR,s scale has enabled it to confidently
invest in state-of the art systems which minimize the number of exceptions.
Smaller electronic bill payment and bill presentment traffic controllers
don,t have the scale to justify the investment.
*Large Market Opportunity in EBPP*
What,s the potential for electronic bill payment and bill presentment?
Assume 1) that there are 110 million households in the U.S. each receiving
12 bills/month (mortgage, car lease, credit cards, electric, gas,
telephone, cable, student loan, insurance, rent, etc.) and 2) it costs
$0.40 per bill to pay for the entire process (includes creation of the
digital bill, presentation and delivery of the bill, transferring funds,
posting remittance information to the biller,s accounts receivable system
and customer services). 16 billion bills at $0.40/bill yields annual
revenue potential of $6.4 billion. If 33% of households pay their bills
online, the market size is $2.1 billion. Include small business bill
payment in the calculation and the market doubles to over $4 billion per
year.
CKFR is the dominant EBPP processor. It has contracts with 23 of the 25
largest banks, 24 of the top 100 billers and has made significant
investment in scale, connectivity, and process and customer service
automation. In a scale business, CKFR is easily the low cost vendor. We
believe that long-term CKFR should be able to maintain at least a third of
the market -- between $700 million and $1.4 billion -- and most likely will
do considerably better than that. (As a point of reference, First Data
Corp, has a 40% share of the credit card payments processing business.)
*Excellent Management with Skin in the Game*
So how does CKFR capture the opportunity? We think it,s down to blocking
and tackling and the key there is management. We think that CKFR,s
management is terrific. The team is young, focused and heavily invested in
the company. Together the board of directors and senior management own
19.3% of the common shares outstanding and, in addition, each member of
senior management has a material number of stock options.
Peter Kight, CEO, founded CKFR in 1981. He has been involved since the
inception of the on-line banking, bill payment and bill presentment
industries. The remaining members of the management team have been
assembled to provide the blend of skills and experience required to operate
a company driving rapidly toward internally generated sales of $500 million
per year.
*Market Position*
Obviously, CKFR is not the only vendor to recognize the opportunity in
EBPP. Two mighty competitors, Intuit and Visa, have already tried and
failed to make the business work. But as the market has continued to
evolve, a new significant competitor has entered the stage. MSFDC is a
50/50 joint venture between Microsoft and First Data Corp (FDC).
Originally focused on just the bill presentment opportunity with a thick
consolidator business model (see our forthcoming report for a complete
description), MSFDC has recently acknowledged that it will have to offer
"pay anyone" bill payment services and permit merchants to maintain control
over creation and delivery of the digital bill. Slowly MSFDC is moving
toward the CKFR model.
Large banks don,t mind buying software from Microsoft, but they don,t
seem to like it playing in the payments area. As long as MSFDC threatens
to be a success, banks will bristle every time the "M" word is mentioned.
As a result, we think that it is possible that at some point Microsoft will
decide to pull back from the MSFDC venture and concentrate on selling the
banks software. However, it hasn,t made any sign of pulling back. In
fact, in our discussion with MSFT management they reiterated their
commitment to the venture.
The banks do not appear overly fond of FDC either. However, as the largest
credit card processor, EBPP is a natural extension of FDC,s business and
the company will likely feel the need to be a player in this market, with
or without Microsoft.
Given the talent and resources at its disposal, we expect that MSFDC will
ultimately prevail over the initial resistance of the banks and
successfully establish itself as an EBPP processor. The open question is
how long will it take.
Several large banks also pose a credible threat to CKFR. Citicorp
processes its own electronic bill payments and even provides outsourcing
services for Fleet. Bank of America processes electronic bills within its
home state. We wouldn,t be surprised to see either of these firms take a
run at the business.
Travelers Express is the only credible vendor that currently offers a
competitive product and they haven,t made the investment necessary to
compete on cost. Their target market tends to be small and medium sized
financial institutions, a market segment CKFR is not focused on.
CKFR currently enjoys a 75%+ market share and its electronic bill payment
contracts typically are for a period of 3 to 5 years. Over the next 24
months, it is hard to imagine a new competitor springing up and taking a
significant chunk of the market.
*Strategic Relationships*
As we mentioned in the Market Position section, Visa and Intuit have both
tried to sink roots in the EBPP business. Neither was successful and CKFR,
ever opportunistic, escorted both institutions out of the business by
buying their operations and making them partners. Intuit owns 10.6 million
shares or 19.1% of CKFR and Visa has agreed to form a joint venture with
CKFR which will facilitate remittance processing.
Another important partner and CKFR owner (3 million shares plus 7 million
warrants) is Integrion, the bank owned for-profit association, formed to
establish, maintain and operate an online home banking utility.
Significantly, Integrion has designated CKFR as the preferred EBPP
processor for its member banks.
In addition to these three strategic relationships, CKFR maintains
relationships with a number of strategic partners which extends the
company,s marketing reach, limits opportunities of potential competitors,
and furthers its agenda in establishing industry standards.
*Investment Concerns*
Other than the competitive threats discussed in the Market Position
section, there are three significant investment concerns. The first issue
is consumer adoption. Will customers go to a bank web site to pay their
bills? The second issue is distribution. Will banks, billers and vendors
organize themselves to ensure that digital bills can be delivered from any
biller to any customer over the Internet? The third issue is the potential
for technical obsolescence. Will a new bill payment technology surface
that is more convenient, offers greater consumer control or is less
expensive?
One other issue of note: The Internet stocks have been hot recently and
CKFR has enjoyed some lift from the heat. If the Internet sector cools,
CKFR shares would likely also loose some air.
Adoption: If the banks offer EBPP, will consumers come? Consumers already
are signing up (CKFR currently has 2.5 million subscribers) and our bet is
that adoption will accelerate. Online banking and bill payment is
convenient, private, safe, and cheap. Where,s the downside?
Adoption is still significantly below 5% of U.S. households because the
infrastructure hasn,t been in place to support mass adoption and
consequently banks have not marketed the service. We think that as more
and more consumers gain access to the Internet and large banks bring full
service, scalable and secure web sites online, they will market the service
aggressively and adoption rates will jump. The Online Banking Report, even
in its low-end forecast, estimates that 13% of all households will be
banking online by 2000. The Jupiter Communications home banking forecast
projects the same level of household penetration in 2000.
Distribution: Digital bill distribution is tricky. It is widely assumed
that bill presentment does not become compelling until a consumer can log
onto a single site and be presented with at least 3 or 4 bills. Given the
lack of end-to-end standards, it could be some time before bill presentment
reaches critical mass. It's anybody,s guess as to when things will sort
themselves out, however, given everything that is to be gained (except by
MSFDC which doesn,t yet have a deliverable solution) we bet that over the
next 12 months a viable distribution process will emerge. In the meantime,
our CKFR model does not assume a significant revenue contribution from bill
presentment activity.
Technological Obsolescence: Almost weekly a new billing scheme is proposed
by a vendor in search of a market. The EBPP model as outlined in the
Overview section was designed to address the needs of all parties whose
cooperation is necessary for the industry to be successful. In the name of
efficiency, cost savings or consumer preference, new proposals have tended
to upset the balance by excluding a party, deemphasizing its role or
offering a chicken and the egg model where success of the proposal requires
investments in new business processes that no one is willing to make unless
the model is already successful.
*Valuation*
So, what,s the company worth? Our FY2000 price target is $41/share. We
get there by adding up the pieces.
*$5.38/share* for the software unit (30x FY2000 earnings of $10.9 million)
*$3.22/share* for the investment services unit (30x FY2000 earnings of $6.6
million)
*$32.88/share* for the electronic commerce unit (50x FY2000 earnings of
$40.3 million)
-kalpesh |
