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A Little Update on my Payment Processor Position

I’ve had family commitments the last couple of weeks and that has led to a longer than usual radio silence.  I am due for a portfolio update, and I plan to get to that next week.

In the mean time I wanted to talk about one change I’ve made to my portfolio since I last wrote a month ago.

While my rule is generally is to not add to positions until they show a profit, I paradoxically only seem to accumulate larger positions in the stocks that go down.   I guess that once I break the rule, I might as well go whole hog.  As much as I try to add to my stocks that are working, I rarely do it meaningfully.  As such, my biggest winners have always been the stocks that have gone down significantly after I bought.

It doesn’t always work.  One name that comes to mind is Bellatrix, which in 2014 I bought and bought and it fell and fell.  My timing was terrible, and whether I was right about the Spirit River potential at the time or not, it was irrelevant – any upside was lost in the commodity collapse.  I eventually gave up and sold the lot of it for a loss, wiping out much of the gains I had earlier in the year in the ethanol trade.

I mention this as a warning.  Just because I have decided to break my rule it does not mean I am right.  It just means that I have an unusual amount of conviction.

Intelligent Systems

I had that unusual amount of conviction in Intelligent Systems as I added to it a few weeks ago.  I mentioned the stock in my last update and at the time it was my usual starter size.  In late April, as it dipped to the low $30s and high $20s I decided to increase the position.

Since then the stock has done well.  It reached the mid-$40s before appearing to take a breather.  In full disclosure I did take a few shares off the table, but only because my position was getting a little bigger than I was comfortable with, and it remains a fair bit larger now than when I first talked about it last month.

This move is the latest in a number of “steps” that the stock has taken to higher levels over the past 6 months.  The chart of Intelligent Systems is not typical for one of my investments.  It is clearly up and to the right.  I usually find stocks that are either down and to the right or just plain down.  I enjoy misery.

The valuation of Intelligent Systems is not typical for me either.  The stock trades at 16x trailing price to sales.  Twelve month trailing earnings are 70c, which puts the stock at a rather nose-bleed trailing PE.

So this isn’t the usual “cheap” story that compels me to take a larger than usual position.  At least on the surface.

But this is a company that has had a big inflection point.  I suspect we are still fairly early on along that road.

The reason the stock ran so far in the early part of the year is because the company “won” business from Goldman Sachs to create their back-end processing software that will drive the new Apple Card.

Of course with such a ridiculous move higher, the bearish point to be made would be that this is more than priced in.

I’m not so sure about that.  As well, I think there are reasons to believe that wins with other names are imminent.

More on that in a bit, but first lets talk about Goldman Sachs/Apple.  The win is a licensing contact for the Intelligent Systems software.  Intelligent Systems is delivering the processing software that Goldman Sachs will use to be the processor of the new Apple Card.  Goldman Sachs will be the processor of that card.  Intelligent Systems will be paid with license revenue, professional services for the work they are completing on the software development (much of this has been recognized) and maintenance revenue that will be a function of the number of licenses.

What is that worth to Intelligent Systems?  Potentially quite a bit.  Intelligent Systems licenses their processing tools by the user.  So what matters is how many Apple customers apply for a card.  While few brokerages have provided their estimates (so far Apple hasn’t really given any guidance – at least none that I can see), one that has is HSBC.

If HSBC is correct, Apple will onboard 14.6 million users to their card each year beginning in 2020.

Corroboration that this estimate is in the ballpark comes from the Intelligent Systems first quarter conference call where they said:

We’re working and helping a licensee build a world-class processing environment. It’s one that will process 5 million, 10 million, 20 million or more accounts.

We don’t know for sure what Intelligent Systems gets on a per user basis for their licenses.  It’s a bit of a theme with the company – they are light on investor relations and therefore light on details.  We do know that the license revenue they charge varies based on the complexity of the card.  The Apple Card, a supposedly revolutionary card, is likely to be fairly complex.

On one call the CEO of Intelligent Systems, Leyland Strange, gave a theoretical example that used a $1/license number.  So perhaps that is a good place to start.  There is some scuttle that has an existing licensing company with a very simple platform being charged in this range.

So if the Apple Card is more complicated maybe it would be a bit higher.  The number seems likely to be somewhere between $1-$2.  That would mean anywhere from $15 million to $30 million of annual revenue from licenses, at least over the next few years, if HSBC is correct.

Could I be wrong?  For sure.  The only other reference to what the Apple Card uptake might be is from this article, which suggests that Goldman is expecting 21 million accounts in 2020.  This is quite a bit higher than HSBC.  I don’t have access to Goldman research however, so I can’t verify the number directly.

On the calls the Intelligent Systems management, in particular Strange, has stated that license revenue is essentially 100% gross margin.  It is technically true, though they do a ton of professional services work upfront to develop the software, customize to the clients specifications, etc.  But that work is at its own profit and already done it is independent of license revenue, which means the important thing for investors is that the license revenue does fall in whole to the bottom-line.

On top of license revenue Intelligent Systems will continue to generate maintenance revenue and professional services revenue from Goldman Sachs.

The professional services revenue will come as Goldman or Apple ask for tweaks, new functionality or an expansion of what the software does.

On the last call management clarified that the maintenance revenue piece was tiered and based on the number of licenses.  While again I do not have enough information to equate a hard number to maintenance revenue, it seems that it will increase as Apple Card licenses are on-boarded.  Overall it is safe to assume there will be material recurring revenue from the relationship separate from the one-time license revenue.

While I don’t believe that it has ever been stated by anyone, I also think it is quite likely that the relationship between Intelligent Systems and Goldman is about more than just the Apple Card.  It seems likely that it began as work on Goldman’s new consumer platform called Marcus.

Goldman launched Marcus a couple of years ago.  It started off as a consumer digital deposit platform in the United States and last year expanded into loans.  They launched a similar digital deposit platform in the United Kingdom in September.  That platform in the UK has taken in $5 billion of deposits since then.  In the US and UK combined Marcus has taken $46 billion of deposits.

Consumer deposits and unsecured loans were just the first step of Goldman’s vision with Marcus.  The following is from a presentation Goldman gave in early-2018:

The credit card piece has perhaps been clarified with the Apple Card.

Here is what Goldman has said about the Marcus platform.  This is from their second quarter conference call:

Importantly, I want to turn your attention to the key elements of this project as they represent the same drivers that underscore a range of major strategic growth initiatives underway at the firm. These elements include: re-imagined projects that address pain points for corporations, institutions and consumers; new technology unburdened by legacy systems that often slow down innovation; digital delivery mechanisms that produce scale and efficiency; and access to large customer populations. These elements are critical to our key growth platforms, including: Marcus and mass affluent wealth, where we will pursue partnerships to access large numbers of consumers; Marquee, our digital institutional platform with the ability to innovate can help us engage its other institutional client base; and corporate cash management, where we can serve existing clients for the firm and offer differentiated products on a digital platform.

In my opinion, the key points as they might relate to Intelligent Systems role, is the excerpt I highlighted.  It gives an idea of what Intelligent Systems is delivering.

But this is just me guessing.  I don’t know what role Intelligent Systems has in Marcus.  I assume that Marcus is the engine driving the Apple Card processing.  I also assume that Goldman’s vision with Marcus is not going to stop with Apple.  On Intelligent Systems first quarter call, in a comment where he was referring to their “world-class licensee”, Leyland Strange said that Intelligent Systems was a “key contributor to the main system of record that requires a highly scalable and high availability infrastructure”.

With all that in mind, it is important to note that on completion of the Goldman platform Intelligent Systems will retain the IP.

It surprises me a little that Goldman is so willing to let the IP of one of their next, big growth engines to remain in a relatively small company in Atlanta.  But maybe I don’t understand the risks and they are less than I think.

At any rate that IP will be a key to future growth at Intelligent Systems as it will be the basis of their own processing business.  On the last conference call:

The fact is that we cannot take on a new 5 million account client in our own infrastructure and environment at this point in time.  So it’s better for we ourselves to say not ready rather than customer due diligence come back with, you’re not ready…

We’re working and helping a licensee build a world-class processing environment. It’s one that will process 5 million, 10 million, 20 million or more accounts. We’re the key contributors to the main system of record that requires a highly scalable and high availability infrastructure.

 We will then add the elements that we have brought to them as well as lessons learned from their smart people to our own environment and have a good, valid reason to then claim we are a world-class processor. I hope we do it by the end of this year. It could drag on if we are tied up with them a whole lot longer.

Intelligent Systems has a processing business already, but not one of the scale they are describing above (processing and maintenance revenue was about $1.8 million last quarter).

Where are these (large) processing clients going to come from?  There is reason to believe that Intelligent Systems is working with a few large operators already.

The one that is likely closest to launch is Sallie Mae.

No one has said that Intelligent Systems is working with Sallie Mae.  Yet I think they are.  Here is my reasoning.  We know that Sallie Mae is working with a company called Deserve on the new credit card they are about to launch.  Sallie Mae has mentioned Deserve by name on a number of their conference calls.  This reference is from their third quarter call (SLM CEO Raymond Quinlan talking):

Deserve is a west coast, very modern, integrated native app purveyor of credit cards. And when we looked at our entry into the card business, several things guided us: One is that the card business is filled with very capable competitors, many of whom have excess capacity, while we’re sitting here; two is that we did not want to build an infrastructure that had high fixed costs associated with it; three is that we wanted to be modern and we thought that we would have an advantage over existing players who frequently are bound by their old unintegrated and not fair consumer-friendly systems. And so as we surveyed who would be a potential partner, we looked at multiple potential capabilities. We hit upon the Deserve folks because they are modern, they are dedicated to us and — but they are a relatively new company, and so we made a small investment in them.

A little bit of digging turns up that the Deserve platform is powered by Corecard, which is the brand that Intelligent Systems markets their processing solution under.  From the Deserve Privacy Policy (a h/t to Hiddensmallcaps for finding this link):

There are a few other indications of the Sallie Mae connection that I’ve discovered but won’t get into here.

What is the Sallie Mae business worth?  Well first of all, this is a different model than what Intelligent Systems is delivering to Goldman/Apple.  Sallie Mae (if I am right and it is indeed them that Intelligent Systems is working with) is almost certainly the processing client that was delayed last year and it now being ramped up.  This is something Intelligent Systems has discussed a number of times on the last few calls.

As a processing customer, the revenue model is more traditionally recurring.  Intelligent Systems will generate revenue on a monthly basis as a function of the number of accounts processed for the card holders.  So again it’s a function of accounts – but this time it is not a one-time fee and maintenance.

How much is that fee?  I can only make an intelligent guess.  I dug up some information from First Data that is very old (2003) that suggested at the time they generated $4/year/card holder on processing.  I can also infer from 3Pea International disclosures (they are now called Paysign) that they generate $8/year/card holder for their processing platform, though they also provide a more end-to-end solution than Intelligent Systems.

How many users will take up a Sallie Mae card?  Again, tough to say with any certainty.  Sallie Mae has over 1 million customers and originated almost $6 billion in loans last year (I had previously written 25 million customers but I didn’t realize that came from a disclosure before the spin-off of Navient).  How many of those customers take a card?  Your guess is as good as mine here.

Now again, nothing has been officially announced with Sallie Mae. This is my speculation based on the information I have dug up.

What lies beyond Goldman and Sallie Mae?  Another big question. We know there are two processing customers they are working with.  We have talked about the first likely being Sallie Mae.

I can’t say for sure who the second is.  My only guess is that it may be Greensky.  Greensky partners with merchants to provide point of sale credit.  They primarily derive their business from home improvement stores (Home Depot makes up 5% of sales while Renewel by Anderson is a sponsor for another 19%).

Why Greensky?  Well its more of a stretch than Sallie Mae so take this with a grain of salt: First and circumstantially Leyland Strange has made point-of-sale credit comments on the conference calls a couple of times (there is a long example of POS credit scenario at Bass Pro Shops that he says only Intelligent Systems could handle on the fourth quarter call).  Second, there is a striking similarity between the credit card service portal of Final, which is a Corecard client, and Greensky (though I have to say I am comparing the screens second hand as my IP is in Canada and I am blocked when I try to access this Greensky portal – a h/t again to @hiddensmallcaps here).  Third, if you do a Google search with the terms ‘ corecard’, oddly this is the only result that appears.

So those are my guesses at the immediate two processors that are in the wings.  There is reason to believe that they have another large processing customer that is still a year or more away.  There is scuttle on this that truly is scuttle and so I’m not going to speculate on who.  There was mention of this on the last call, though Strange was quick to say that this customer is not in any “pipeline” – so take that for what its worth.  Either its not a done deal or Strange is being his usual understated self.

More broadly, I believe that Intelligent Systems had a unique processing platform and through Goldman/Apple has been paid to develop an even better one.  I suspect the platform is geared towards real-time processing, which from what I gather from listening to panel discussions and the calls of larger processing players, is really the shift that is beginning to take place – replacing ACH batch processing with immediate transfers has many use cases.  Real-time processing offers speed, transparency and 24/7/365 capabilities that give it advantages to merchants and consumers.

It is my sense that the processing industry is quite a hodge-podge of solutions.  Companies like Fiserv, Total System Services and First Data have a number of different brands and versions of payment solutions that they have acquired over the years and from what I can tell they are all quite distinct from one another and are difficult to combine.  Case and point is that as Fiserv has made a bid to acquire First Data, they listed a host of synergies between the two companies but were clear that the product lines would see limited or no integration.

It’s an industry that is ripe for disruption.

So that’s story and why I was willing to add to the stock as it dipped, rather than following my usual strategy where I do not add until I see begin to see a profit.

Going forward I think the stock can move higher, but the time frame is less certain.  This company does very little to promote itself (there is no corporate presentation and no IR to speak of), so there almost assuredly will be no press releases between now and the second quarter results.  Those second quarter results might be a catalyst; there may be an uptick in license revenue from Apple/Goldman – but there also may not.  I can only guess when the licenses will begin to be recognized or how fast it will be recognized.  The Apple Card is not launching until the summer.

The two processing customers will begin to generate revenue in the second half of the year.  But this will likely be a small base at the beginning.

Could the company be taken over?  I think that is a possibility.  On more than one occasion Leyland Strange has said that they are a “very opportunistic” company.  He said this specifically in response to questions about being acquired.  He is also 76 years old and owns over 25% of the company (two holders, Strange and Weitz Investment Management, own over 50%).

As well, Goldman themselves said on their own third quarter call that while they did not plan to make any large acquisitions, they were looking at ways to “consolidate their technology”, particularly on the consumer (Marcus) platform.  They said that such acquisitions would be small for Goldman and not require share issuance.

The short interest in the stock has risen, which is interesting.  I imagine there is a simple thesis around valuation.  On a trailing basis the company looks very expensive.  I also wonder whether the inclusion on the board of a prominent executive that has been in the cross-hairs of short sellers (I will not mention his name because I have no interest in this blog being listed in Google searches with respect to this individual – I have come to dislike publicity in general and specifically of this nature!) who you can look up easily enough in their filings.  My thoughts on this board member are – it is what it is.  He’s been there forever, there is a relationship there and if you want to make something of it that is yours to do.  I have seen no reason to myself.

That short interest could be negative but could also be positive.  The float is actually quite small here as between Strange, Weitz and a few other individuals and funds own over 60% of the shares.

Either way I don’t care much about that.  I plan to stick with this name as long as it continues to execute.  I’m hoping that, barring a takeover, that will be a very long time.