NIC (EGOV): A Far Above Average Business at an Utterly Average Price
NIC (EGOV) is a company that’s – as the ticker suggests – focused on eGovernment. In particular, NIC is focused on providing internet based interactions with state governments in the United States.
This is not a truly huge market. EGOV is by far the market leader and yet it only has $331 million in revenue, $78 million in pre-tax profit, and $59 million in after-tax free cash flow. The company is valued at $1 billion (the market cap is greater, but the company has net cash). To put this in perspective, EGOV has about half the addressable market for state government portals in the U.S. So, the stock market is saying that the entire potential state government portal industry – for all 50 states – is worth no more than $2 billion.
To me, that sounds a lot like a niche. And that’s what got me interested in EGOV. Actually, my co-founder, Andrew, got me interested in EGOV. But, I think my interest in the stock quickly outstripped his own.
In the U.S., government clients can be broken down into: 1) school districts, 2) cities / towns / municipalities, 3) counties, 4) states, and 5) the federal government (including military branches and various agencies). The biggest available government contracts are at the federal level. And the greatest number of available contracts are at the local level. For example, a Department of Defense contract would be a deal serving just one client, but the client would be very big. The Department of Defense has an annual budget of $534 billion. Meanwhile, the largest state government in the U.S. (California) only has an annual budget of $183 billion. Keep in mind, the median U.S. state by population (Louisiana) is about one-eighth the size of California. So, the average state’s budget might be 5% of the Department of Defense’s budget.
The biggest state with which NIC does business is Texas. It is the second most populous state in the U.S. (behind California) and yet we know that the revenues from providing eGovernment services through the Texas.org portal are only about $64 million a year (EGOV’s 10-K tells us that Texas is 20% of NIC’s total revenues and NIC’s total revenues were $318 million last year).
It may seem like I’m throwing a lot of numbers about market size at you here for no reason. But, I think there’s a very important reason that goes to the core of whether you should or shouldn’t invest in EGOV.
How niche is this business?
How competitive is this “industry” now?
And how competitive is it likely to get?
My guess – as long as EGOV stays in its niche of providing individual online portals for the 50 U.S. states – is that isn’t not very competitive now and it’s not likely to get much more competitive in the future. However, if EGOV strays from operating “dot gov” sites for the states into trying to win business with federal agencies, city governments, etc. (which it is already now doing a little of) I think competition could be a lot more intense.
So, how dominant is EGOV in its niche? And how competitive is that niche?
The U.S. consists of 50 states. There are also some state-like entities. Most importantly: the District of Columbia (a.k.a. “Washington D.C.”), Puerto Rico (a territory), and over 500 American Indian tribes (considered “domestic dependent nations”). Some of those entities are as big as the smallest U.S. states. However, their needs wouldn’t be exactly the same as states because of the division of power between the federal government and the state government in the U.S. Each of the 50 states can choose to put some things online – that is, use eGovernment or not use eGovernment – for all sorts of different needs. But, what each state does – either online or offline – is exactly the same for all 50 states. All 50 states have the power to grant the same licenses, collect the same records, etc. Basically, there’s a set customer group of 50 potential clients. That’s the addressable market here.
Right now, NIC operates a “dot gov” internet portal for 27 of the 50 states. So, NIC has roughly 54% of the addressable market.
How competitive is this market?
I will quote from EGOV’s 2016 10-K:
“Historically, we have not faced significant competition from companies vying to provide enterprise-wide outsourced portal services to governments; however, we face intense competition from companies providing solutions to individual government agencies…In most cases, the principal alternative for our enterprise-wide services is a government-designed and managed service that integrates multiple vendors’ technologies, products and services.”
The impression I get is that there is very little competition for outsourced portal services for state governments (the “dot gov” sites such as Texas.gov). This impression is backed up by several facts mentioned in EGOV’s 10-K.
One, in cases where EGOV wins a new government contract, that state has usually written a law (presumably at the request of lobbyists from NIC) to allow for outsourcing the state’s website and requesting proposals from private sector companies to run the site. In other words, EGOV is not taking business from competitors. Instead, it is getting U.S. states to switch from an in-house website to an outsourced website.
Two, in cases where EGOV loses an existing government contract, the company has usually chosen not to respond to a “request for proposal”. These seem to be money losing contracts. For example, NIC recently lost 3 state contracts and these 3 losses combined had no material impact on profit.
Three, although some states operate under agreements that they can terminate (without cause) on short notice – few do. When my Focused Compounding co-founder, Andrew, and I discussed EGOV the terms of these agreements were a major concern for him. For example, Texas is 20% of EGOV’s business and the state can simply terminate the deal and force NIC to hand the existing site over to a competitor. Texas does not need “cause” to do this. And Texas does not need to compensate NIC for the loss of the contract.
The idea that 20% of a company’s revenue – and even more of its earnings – could disappear overnight is a scary one for investors. But, this is not the part of EGOV’s business model I’m worried about.
Why not?
Sure, EGOV could lose state contracts. It has the contracts for about as many states (27) as it doesn’t have (23). So, EGOV can always lose an existing contract. But, it can also always win a contract it doesn’t yet have. I can’t say it won’t lose Texas. But, no one can say it won’t win California (a contract it doesn’t have) either.
As for having contracts the client can easily terminate…
First, many service businesses work this way. In my report on Omnicom, I showed that client retention at the world’s biggest ad agencies is often 95% to 99% even though clients could terminate these agreements without cause and hand over all the intellectual property the agency created for them to a competitor. Ad agencies don’t have contractual protections. However, they have historically done better at keeping clients than many business models that include a contractual lockup for the client.
Second, we can look at companies that are doing something different – like selling off the shelf hardware and software – but for similar clients. Tyler Technologies (TYL) serves mostly local governments. Here is what Tyler Technologies says about its retention rate:
“We have a large recurring revenue base from maintenance and support and subscription-based services, which generated…62% of total revenues, in 2016. We have historically experienced very low customer turnover (approximately 2% annually) and recurring revenues continue to grow as the installed customer base increases.”
While TYL’s recurring revenues are 62% of its business, EGOV’s recurring revenues are 90% of its total revenues (and 95% of “portal” revenue is recurring).
Finally, we can look at how many states have had NIC operating their “dot gov” portal for over 10 years (note that Tennessee is no longer a client):
26 years: Kansas
23 years: Nebraska and Indiana
21 years: Arkansas
19 years: Maine and Utah
18 years: Idaho, Hawaii, and Tennessee
17 years: Montana, Oklahoma, and Rhode Island
16 years: Alabama
15 years: Kentucky
13 years: South Carolina and Colorado
12 years: Vermont
It’s true that several large states – like Texas (9 years) and Pensylvannia (6 years) – haven’t been with EGOV for nearly as long as the states listed above. However, it’s worth stopping to think about just how long ago in the history of the internet some of these states were first signed up. Of state that still do business with the company, EGOV signed up a total of 6 states in the 1990s when the idea of doing much of anything through a statewide website was very new. Kansas, Nebraska, Indiana, Arkansas, Maine, and Utah were all signed up before the year 2000 and are all still with NIC.
If we look at old 10-Ks, we can see that some states used to be clients and are no longer clients. For example, by 2001, EGOV had signed up Georgia, Virginia, and Iowa. Iowa is a recent lost client for EGOV. None of these states are clients of EGOV anymore. Despite some states leaving EGOV, the total number of state portals operated by NIC rose from 17 of the 50 states (34%) in 2001 to 27 of the 50 states (54%) today.
The other issue to consider in terms of competition is scale. If EGOV has 54% of the state portals out there and the biggest other operator of state portals are the states themselves – there aren’t a lot of big state portal contracts available for a competitor to use as a steeping stone to bidding on more of this kind of business. EGOV mostly just operates state portals (that’s about 91% of their business) and yet they have 1 employee at headquarters for every 3 employees in the field. NIC is organized with 27 different state subsidiaries. These are like 27 field offices (one office in the capital of each state). If you read reviews of the company by employees and ex-employees, you get the general sense that working in these field offices – once EGOV has the master contract for the state portal – is not grueling work compared to life at most tech companies. Life is probably more hectic at headquarters. My point here is that even with half the addressable market – EGOV is carrying overhead of about 1 employee at the home office for every 3 employees in the field. Presumably, potential competitors would have much worse ratios of home office staff to field staff. The other issue for new entrants is scale at the state level. A new portal isn’t immediately profitable. And some of EGOV’s portals probably never become profitable. This has to due with the level of fixed expenses versus variable expenses and the ability to cross-sell other government services on the portal.
Let’s start by discussing “start-up” costs and fixed expenses. EGOV has to start its “sales cycle” by lobbying the governor’s office and legislature (often two different houses) in a state capital. Once a bill is passed allowing the state portal to be outsourced and EGOV is chosen as the provider of that portal, it then needs to create a subsidiary in the state capital that does the decentralized work of providing a “dot gov” portal for that particular state.
EGOV’s business model is to have zero dollars allocated to it in the state budget. Normally, the state does not “pay” EGOV anything in that way (through legislatively appropriated funds). Instead, EGOV processes fees that would otherwise be collected by the state on the portal and a portion of these fees are used to compensate EGOV. So, if you sign up for a hunting license in the state of Oklahoma – you’re using an EGOV site to do that (Oklahoma.gov) and the state of Oklahoma is using the license fees collected from hunters to pay EGOV for providing eGovernment services on the portal such as issuing hunting licenses.
I gave an example that I thought would be clearer and easier for the folks reading this article to understand. Something like a hunting license is easy for a citizen to understand. In reality, EGOV gets about 72% of its revenue from businesses and only 28% from citizens. However, citizens sometimes generate the information source that EGOV sells to businesses. In fact, this is true of EGOV’s single largest source of revenue.
EGOV sells “driver history records” to insurers or re-sellers like LexisNexis. In fact, EGOV’s single biggest revenue source is payments from LexisNexis for driver history records which insurers then access via LexisNexis.
This is another example of revenue concentration that might worry some investors. About 20% of all payments to EGOV come from LexisNexis and about 20% of all revenue at EGOV comes from Texas. This means that EGOV could lose close to 40% of all revenue if just two parties – the State of Texas and LexisNexis – stopped doing business with EGOV.
How realistic a concern is this?
Texas could leave. But, LexisNexis wants to sell driver history records to car insurers – and in 27 of 50 states, you have to go through EGOV to get those driver history records.
EGOV’s business model is to get the master contract for operating the portal (which makes it little or no revenue and almost certainly loses money at first) and then quickly start selling driver history records. It then tries to get more and more “interactive government services” done through the website it operates.
The sales cycle takes years. Even after EGOV wins the contract for a portal, it’s unlikely to make any money within the first 18 months of the deal. And, as I said, in most cases there had to be lobbying ahead of time before a contract could be won.
My assumption is that large states that have had EGOV operating their portal for a long time and that have added more and more interactive government services through the portal over time are probably the biggest contributor to EGOV’s profits. Meanwhile, small states that are new contract wins for EGOV and which are reluctant to add more interactive government services to their portal (beyond driver history records) are less profitable or even unprofitable.
Yes, this would mean that the loss of a state like Texas would cost EGOV more than 20% of its profits even though it only accounts for 20% of revenue.
Keep in mind what I just said about adding services over time to the site as the years go by. It’s an important point. But, I want to first talk a little about fixed expenses and variable expenses. Again, I want to look at this more from the competitive (qualitative) side than from the operating leverage (quantitative side). Things like a small addressable market, a lot of already locked up customers, a long sales cycle, start-up losses, and high fixed expenses relative to variable expenses often mean you can expect few new entrants.
At the state level, fixed costs are 61% of EGOV’s costs. This is important because same-state revenue growth usually exceeds fixed cost growth while often growing no more than variable costs. For example, state level revenue grew about 9% in 2016 while state-level fixed costs grew 3% and state-level variable costs grew 15%. The easiest way for EGOV to grow returns for shareholders while making government clients feel they are getting at least as much for their money each year is to grow same-state revenue much faster than same-state fixed expenses.
Historically, EGOV has had a very impressive rate of same-state revenue growth. And in the company’s last 10-K it included an aggressive goal:
“Our long-term goal is to grow same state revenues at our historical average of approximately 8-10% per year. Same state portal revenues grew 9% in 2016 compared to 8% in 2015. Revenues from interactive government services…primarily consist of transaction fees generated by means other than from providing electronic access to motor vehicle driver history records…As (interactive government services) revenues continue to become a larger component of overall portal revenues, our growth in same state (interactive government services) revenues becomes more important to our overall growth as a company. Same state (interactive government services) revenues grew 12% in 2016 compared to 11% in 2015. “
My personal long-term concern with EGOV is that this goal might not be achievable. The company can’t realistically grow same-state revenue for driver history records very fast. This past year, it grew 1%. And I expect 0% to 3% to be the norm going forward (that’s without considering the long-term impact of driverless cars). EGOV can mostly just implement pricing increases on those. Growth in drivers is no greater than population growth these days. So, the eventual long-term growth in driver history records would at best be inflation plus 1% and due to factors like low population growth and the possibility of driverless cars – it’s likely to be lower than that.
Now, interactive government services revenue can grow a lot faster. States still do a tremendous amount of things offline. But, if we look at states where we have some hints of revenue levels – we see that same-state interactive government services growth is very fast in early years and then slows as more and more services are already done via the website. In other words, a new state contract might be able to grow at 20% a year in its fist 3 years. But, by it 8th, 9th, and 10th year it might be growing more like 5% a year. We don’t have exact numbers on this. But the broad strokes of what I just laid out there are consistent with the disclosures on a state like Texas.
Here is what EGOV said in its most recent earnings release:
“Quarterly portal revenues were $76.4 million, a 2 percent increase over the third quarter of 2016. On a same-state basis, portal revenues were $76.4 million in the current quarter, a 5 percent increase over the third quarter of 2016. Same-state, transaction-based revenues from Interactive Government Services (IGS) rose 10 percent over the third quarter of 2016, due primarily to higher volumes from a variety of services including motor vehicle registrations and business registration filings, among others. Same-state, transaction-based revenues from Driver History Records (DHR) were up 1 percent…”
This is actually very impressive compared to what I would expect in the long-term. Think about it: same-state interactive government services are rising 10% a year at a time when nominal GDP in these states likely rose about 5% or less. In the last 10-K, a goal of 8% to 10% was mentioned. These are aggressive targets. If the company achieves them going out 5, 10, or 15 years, it’s going to make today’s buy and hold shareholders in the stock very rich. I’m not sure the targets are achievable though – at least not for that long.
If EGOV’s only business was driver history records, I don’t think the company would grow revenue by more than about inflation each year.
However, the same-state growth in interactive government services has always been strong and it continues to be strong this year.
Obviously, if EGOV really can deliver 8% to 10% truly long-term same-state revenue growth in its interactive government services while keeping fixed cost growth closer to half that level – it’s a dirt cheap buy and hold forever stock even right now (when the P/E is 21).
If the stock can grow at nominal GDP type rates, it’s a good stock to buy and hold even now when this stock – and the overall market – has a pretty high P/E.
What if it only grows at about the rate of inflation plus population growth?
Well, even then, I’d expect EGOV – if you really bought it today and held it forever – to outperform the overall market. This isn’t obvious right now because EGOV is operating in a low inflation environment – as are all U.S. stocks.
EGOV could do well in high inflation environments because it has:
- Almost no tangible capital invested in the business
- Revenue sources that are completely non-discretionary
Now, it is true that the state governments have to approve increases in the fees EGOV collects. So, there’s no guarantee that revenue won’t lag in a high inflation environment. But, I promise you that EGOV’s growth looks pretty high right now instead of exceptionally high mostly because inflation is low. This is the kind of company that would have good EPS growth compared to more asset heavy businesses in a high inflation environment. It should be possible for EGOV to have earnings grow faster than sales and sales to grow faster than invested capital. That’s a recipe for success during times of inflation. And most times have higher inflation than the recent past we’re using as “normal” here.
How cheap is EGOV now?
A little cheap.
So, EGOV trades at about a 5% earnings yield using last year’s after-tax EPS. EPS always understates free cash flow at a business like this. And then the corporate tax rate has been reduced from 35% to 21% in the U.S. EGOV is the kind of business that should benefit tremendously from this sort of tax break. It does business 100% within the U.S. and in fact must pay pretty high taxes every year. Before last year, EGOV had a tax rate in the high 30s to low 40s just about every year. This is not surprising for a business that is so decentralized it has 27 different state subsidiaries. A business like this can avoid neither state nor federal taxes.
The savings from the federal tax cut are unlikely to get “bargained away” by the parties on the other side of EGOV’s negotiations. The state governments mostly set fees on citizens and businesses. State governments could negotiate down EGOV’s take – but state governments aren’t for profit businesses. So, it’s less likely than in tough negotiations between suppliers and retailers or something like that. EGOV’s bargaining position for keeping the tax cut to itself is stronger than it is at most public companies.
I expect EGOV to benefit a lot from the tax cut. It should be one of the biggest beneficiaries of the corporate tax reduction.
As a result, we should probably immediately assume that EGOV has a P/E of something closer to 18 than 21. On top of this, free cash flow is actually higher than EPS. So, we should assume that as of this moment – EGOV has a price-to-owner earnings of less than 18. The true economic P/E is under 18. That’s cheap compared to the market.
EGOV is also a much higher quality business than most stocks in the S&P 500. For example, the business uses almost no capital. Joel Greenblatt would calculate the ROIC of EGOV as being way into the triple digits. It’s effectively infinite. More importantly, EGOV doesn’t use its free cash flow to make expensive acquisitions. Instead, it basically keeps share count constant and pays a dividend.
That dividend is one of two possible catalysts for EGOV.
Assume EGOV’s actual business doesn’t change much this year. Could the stock price rise for non-business reasons?
Yes.
One, the company just switched from declaring a special dividend each year to now declaring a regular dividend. Given EGOV’s high free cash flow relative to EPS and its high historical growth rate in EPS (18% over the last ten and five years and then 8% over the last year), it would be very easy for EGOV to start with a low dividend yield like 2% and then raise that dividend per share at a double-digit percent rate for a very long time. As I write this (with the stock at $17.45 a share) the dividend yield is 1.83%.
I don’t know if EGOV’s plan really is to raise that dividend by 10% or so annually. But, I do know that EGOV is pretty much the perfect stereotype of what a consistent dividend increasing company looks like before it gets noticed as a consistent dividend grower. The payout ratio is low. The company doesn’t buy back stock, it doesn’t make acquisitions, it doesn’t use capital in the business as it grows, and it does get almost all its earnings from recurring revenues. This is a dividend grower in the making.
The other catalyst is the tax cut. EGOV’s earnings per share could grow 10% to 15% next year simply as a result of the tax cut. This is a one-time boost. But, remember: the stock fell about 30% in price last year. I’d estimate that 30% decline in the stock’s price was accompanied by probably a 20% increase in the stock’s after-tax earning power.
Think about that. EGOV’s price went down 30% over the last year while it’s value went up about 20% last year. That’s the kind of year that gets a value investor’s attention.
So, am I buying EGOV today?
No.
Is it near the very top of the stock I’m considering buying list?
Yes.
Will I write about it again?
Probably.
I’m going to do some more research on this company. And I’d love to get emails – or comments (below) – from Focused Compounding members interested in this stock.
EGOV isn’t a clear “value” stock yet. But it’s a “quality” stock that is no longer trading at a premium to the market. In fact, EGOV is now quite cheap compared to the average P/E it used to trade at.
I know some people prefer a stock like Tyler Technologies (TYL) which I mentioned above. Tyler is not really a competitor. It is a fast-growing stock and I have nothing bad to say about Tyler except that it’s priced at almost 3 times EGOV’s price and yet it doesn’t have better returns on capital, better financial strength, etc. What it has is a higher growth rate and a much higher price. Both companies are impeccable according to most quality metrics – growth, return on capital, predictability, financial strength, etc. Tyler is a faster grower. But, it’s priced like a much, much faster grower.
From a pure handicapping perspective: I’m a lot more comfortable digging deeper into EGOV than digging deeper into Tyler Technologies.
So, that’s what I’ll be doing this week – digging deeper into EGOV.
I suggest you guys do the same.