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A Safer Play on the Banking Industry

Core processors are insulated from banks' woes.

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The term "business services" covers an array of companies serving different industries and having different dynamics. In this article, we'll focus on a relatively obscure but attractive area under this broad umbrella: core processors. These companies are also commonly referred to as bank technology companies. We cover three such firms:  Fiserv (FISV),  Fidelity National Information Services (FIS), and  Jack Henry (JKHY).

Before we go on to discuss the core processors' current situation and outlook, it would probably be helpful to describe their business and what is attractive about the industry. These companies serve banks and other financial institutions, such as credit unions. Core processing is the nuts-and-bolts system that banks need to maintain their deposit and loan accounts and to post daily transactions. Core processing is a very stable, almost annuitylike, business that churns out a reliable amount of free cash flow, and we think a moat surrounds these businesses due to the high switching costs involved. Given the integral nature of core processing to their operations, banks almost never switch systems. Besides the potential for interruptions, converting to a new system would require the banks to retrain employees. Customers typically sign multiyear contracts, and customer retention is about 99% annually, excluding customers lost because of acquisitions by another bank. Actual retention rates are typically only a few percentage points lower, depending on the level of M&A activity.

However, core processing typically accounts for only a portion of the revenue generated by core processors. These firms leverage their essentially captive relationships to cross-sell a variety of products to their bank customers, such as electronic bill payment, Internet banking, check processing, and remote deposit capture. Simply put, if a bank has a technology need related to its day-to-day operations, these companies have a product to address it. While they compete with each other, they also compete with in-house systems developed by the banks themselves. According to Automation in Banking 2009, 49% of financial institutions use an outsourced core processing system. The core processors' customer base skews heavily towards small and medium-sized banks, which usually lack the resources necessary to develop credible in-house solutions.

Core processors have two types of revenue streams: recurring fees under processing contracts and one-time license or event fees, with the former making up the bulk of revenue. Fiserv estimates it derives only about 5% of its revenue from license fees, while 8% of Jack Henry's revenue in fiscal 2009 was from license fees. Because the vast majority of revenue is recurring under long-term contracts and relates to systems that are necessary for the bank to remain in operation, the core processors have felt little impact from the unprecedented stress their bank customers have faced throughout the financial crisis. In 2009, both Fiserv's (stripping out a divestiture) and Jack Henry's revenue held basically flat (because FIS completed a large merger in 2009, its year-over-year growth was high, but its organic results were roughly in line with its peers). While the core processors may not have lost revenue, it's been difficult for them to grow, as struggling banks have been deferring new technology purchases while they attempt to put their own houses back in order.

Looking forward, we think it will take a while for this situation to improve. The big banks were hit hard at the front of the financial crisis due to their involvement in exotic asset-backed securities, while the small banks largely avoided this problem. The headlines currently focus on the rebound in the big banks' profitability, but the small banks are still struggling as the recession has led to higher charge-offs in their loan books, particularly due to small banks' concentration in commercial real estate loans. Fiserv noted in its fourth-quarter earnings call that there were 158 regulatory actions in 2009 and they expect this number to rise to a range of 200-250 in 2010. Given this, we expect a fairly flat year again in 2010 for the core processors but would expect FIS to see a top-line recovery first, due to its relatively high percentage of business with large banks, followed by Fiserv and then Jack Henry, which concentrates more heavily on the small bank and credit union space.

Over the longer term, though, we see some benefits for the core processors on the back end of the financial crisis. As banks stabilize and take a harder look at their cost structures, we think there could be an incremental increase in their willingness to outsource, both to reduce costs and to make their cost structures more flexible. Core processors typically tie their pricing to the size of the institution, so their growth over long periods tends to track the growth in bank deposits, which have grown at a 6% compound annual growth rate over the last fifteen years. We think this is the most realistic peg for industry growth over a long period, but we could see higher levels for a time when the financial crisis is fully resolved. An eventual bounceback in license fees would also be a positive. While these fees account for only a small portion of revenue, they drop almost completely to the bottom line, so they can affect profitability materially.

Right now, we don't see any great bargains in the space. Fiserv looks somewhat undervalued to us, but the margin of safety isn't large enough for us to recommend the stock. Still, we think these companies are worth keeping on your radar as they could be a relatively safe way to play any further uncertainty in the banking industry.

Brett Horn does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.