“Ignoring technological change in a financial system based upon technology is like a mouse starving to death because someone moved their cheese.” – Chris Skinner
Last month wasn’t a great month for tech stocks; as flagged in The Lead-Lag Report, the sector was one of the chief laggards, alongside energy and communication services. In many ways, the correction was long overdue – and perhaps even healthy – given how overextended the tech sector had become. That said, as I mentioned recently in last week’s edition of The Lead-Lag Report, notwithstanding these bouts of short-term volatility, the prospect of a new stimulus package may continue to support the long-term uptrend for tech stocks.
From a style and market-cap perspective too, I’d shared with members of The Lead-Lag Report how the small-cap growth segment had been recently outperforming the large-cap growth segment. Thus, if you’re looking for a small-cap stock that has strong growth characteristics, and also one that belongs to the tech sector – a sector whose long-term uptrend appears intact – you may consider looking at Intelligent Systems Corporation (INS), a stock that fits this profile, although there are some risks to consider too.
INS operates via its wholly-owned sub – CoreCard Software, Inc., which is involved in the business of providing tech solutions and processing support to the FinTech Industry. CoreCard Software has over three decades of experience in providing card management and payment solutions to various parties, ranging from program managers, accounts receivable businesses, financial institutions, private-label businesses, retailers, and third-party processors. In essence, CoreCard helps manage their credit and debit cards, private label cards, prepaid cards, loyalty programs, loan transactions, and accounts receivables.
What’s to like about INS
Diverse revenue streams
The company has multiple revenue streams with various drivers (rather than any single driver) that bring a degree of resilience. For instance, the company generates software licensing fees that are dependent on the number of licensed users, the number of accounts on the system, and the number of software modules licensed. Then the company also derives monthly service revenue based on implementation, setup, customization, and annual maintenance & support services for their licensed software; this is based primarily on the number of accounts (with an average contract term of 3+ years). Consider the current environment where, on account of the weak discretionary spend environment, the company was not able to get any fresh license revenue in H1, but yet they were still able to get about $16m of servicing revenue that grew by 23% annually. The other thing to note is that their fees are not dependent on the volume of transactions at the customers’ end, but are rather dependent on the number of active accounts on file. So even if the level of transactions were to slow down on account of an adverse economic environment, it wouldn’t weigh heavily on their revenue.
Agile operator with great scope for penetration
CoreCard is what you’d call a small fish in a big pond as there are other larger payment software processing peers in this field who are not as nimble. INS believes the issuer solutions market is worth around $7bn (Source: INS Investor Presentation); with annual revenue of c.$35m, this would put their current market share at a paltry 0.5%. This also means that if they can continue to exert their influence in small niche pockets, their potential for deeper market penetration and strong growth looks attractive. I feel they have an edge, as relative to their larger peers, the company offers a much lower cost per account proposition. Also because of its smaller size, the company can offer greater system flexibility with greater customization effects for any particular client. Larger companies that operate at a larger scale don’t have this flexibility to finetune the end-product. In addition to this, what’s unique about CoreCard is that it offers its clients an option to license this software and bring it in-house if the client desires to become its own processor in the future.
INS has demonstrated an excellent growth track-record of the last 5 years. From 2015-2019, group revenue had grown at an impressive CAGR of 48%, whilst the group gross profit progression was even better, with a CAGR of 59%. On the operating income front, the company had been losing money in 2015 (operating loss of $-2.8m), but over the years, they’ve managed to turn that around and last year reported an operating income of $13.4m.
Not encumbered with debt
For a company with such strong growth credentials, it is rather uncommon to see it going about things without relying on any external debt. Most growth-oriented firms rely on external debt to keep up the pace of their growth but INS has been debt-free for most of its operating history. Companies in the tech space have to often spend a lot on R&D to deal with the fast pace of obsolescence, and if you don’t have the right balance sheet, this could hamper your prospects. INS self-finances its software development and R&D spend. For instance, recently in Q2, they spent about $5m to re-develop their processing infrastructure (investments were made in software licenses and data center hardware). They were able to do this comfortably on account of their solid cash reserves. (In H1, they had cash reserves of $32m, a 21% increase from its FY19 cash balance of $26m.)
Here are certain risks that investors should be mindful of.
As INS is still a small player, its roster of large clients is still quite limited. INS came into the limelight last year when Goldman Sachs (GS) selected it to help manage its credit-card partnership with Apple Inc. (NASDAQ:AAPL) for Apple Card. The effect of large clients definitely skews the revenue risk profile; last year c.60% of total group revenue came from this contract alone. As INS makes further inroads into the issuer solutions market, you would hope it would gain larger clients that would help bring more diversification, but for now, there is an element of “all eggs in one basket” at play, and this certainly brings risk to their revenue. Incidentally, INS also has sizeable exposure to Wirecard – the insolvent German processor; the company was their second-biggest client last year and currently is their 3rd or 4th largest customer (source: Q2 earnings call). Most of INS’s exposure is to Wirecard’s Asia Pac business. In the Q2 call, INS management mentioned that whilst they continue to offer their services to Wirecard, there is no guarantee they will get paid for their services.
No license revenue so far and tougher H2 comps
License revenue is not the dominant share of INS overall revenue, but in H1-20, the company was not able to generate any revenue from here as no customers were able to achieve new license tiers. Weakness in license revenue will likely be reflected in the Q3 quarter as well and will only pick up in Q4. In addition to that, INS itself had a strong overall H2 last year, so it will be challenging for the company to replicate the same performance in H2 this year.
Valuations are not cheap
As with most tech names, the INS stock is not particularly cheap. As per YCharts’ estimates, the stock currently trades at 31x forward P/E which is more than its 5-year average of 29x. I’ve also written previously about the stock’s strong growth profile, so it only seems fair to also measure it from a PEG (Price/Earnings-to-Growth) basis as it provides some color on whether the growth is justifiable at current price levels. Even here the stock feels steeply-priced, currently trading at a PEG ratio of 2.2x, well above the historical average of 0.5x.
Technicals and conclusion
Much of the movement in the INS stock has come from June 2018 onwards – since then, it has trended up, peaking in August at around the $52-50 levels and then resorting to a healthy pullback. In the middle of 2020, the stock completed 50% of its retracement and is now currently in the midst of forming a second leg-up with the intention of re-testing the previous August 2019 highs around the $50 levels. If this does not happen, we may see a second pullback before the stock resumes another move up.
I like the growth potential of INS and the ongoing opportunity to penetrate further by taking business off its largest peers. That said, current valuations are not cheap and the company will face tougher comps until the year-end, so upside triggers may not be significant in the near-term.
*Like this article? Don’t forget to hit the Follow button above!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This writing is for informational purposes only and Lead-Lag Publishing, LLC undertakes no obligation to update this article even if the opinions expressed change. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services in any jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Lead-Lag Publishing, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.