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NIC: Supreme Business, but Large Contract Renewals Warrant Caution

- By New Moon

NIC Inc. (EGOV) provides digital government services. It typically offers services to state governments under master contracts that allow it to build portals that cover all parts of state governments' services. NIC runs a "self-funded" business model, where it invests about $1 million to build the portal and then collect online transaction fees from the ender users of the state's databases. Usually, NIC gets its investment back in a year. Around 95% of its revenue is transaction-based recurring revenues, 75% is from businesses and 25% from citizens. Revenue sources are motor vehicle driver history record retrieval, motor vehicle registrations, tax returns, permit applications and requests for government-gathered information. Of these sources, motor vehicle driver history is the largest one that accounts for a bit over one-third of total revenue.


The company's services save money for state governments, who used to manually process the requests for government-gathered information. State governments usually have understaffed IT departments that cannot satisfy its own technology needs. State governments like NIC's self-funded solution because they do not need to go through the complicated budget discussion and do not need to put up initial investments. The company owns the intellectual properties of the portals, but a government partner typically receives a perpetual, royalty-free license to use the software only in its own portal. If the contract was terminated, the government would be entitled to take over the portal in place, and NIC would have no future revenue from its former government partner.

NIC currently serves 27 states. Texas is the largest contract, accounting for 22% of the total revenue. The contract ends in August 2018. The contract renewal is undergoing negotiations. The contract was first initiated in 2009 and was renewed once in 2016.

The company was founded in 1992 to provide Telnet access to the state of Kansas. The company is led by Harry Herington, chairman and CEO since 2008. Herington used to be a police officer.

Brown Capital Management owns 13% of NIC, Blackrock owns 9.1%, Vanguard owns 7.2% and Jackson Square Partners owns 6.8%.

Financial profile

NIC has been growing its revenue very nicely. Initially, it was able to sign new contracts each year, which drives revenue growth. More recently, new contracts are harder to gain. It is true that its portal solution may be more suitable for smaller states that are more resource constrained. However, winning the Texas contract in 2009 proved NIC could serve the largest states as well. The company has also been able to grow revenue in each state as it provided more and more transaction-based services to the governments. The company's long-term target for same-state revenue growth is 8% to 10%.

Although growth may have slowed, the profitability and return profile of NIC has been without a doubt superb. Its return on invested capital has been over 200%, most recently over 300%. The business itself does not take much capital. The company did not acquire any companies in the past. It pays out the majority of its earnings as dividends.

The company has almost no competition on what they do for the state government. Large vendors such as Accenture (ACN) simply are not focused in the small space. Small vendors tend to focus on fixed-fee projects and usually are not willing to invest the initial $1 million start-up expense. Small vendors also cannot compete with NIC in similar projects due to short track records and government bureaucracy.

NIC has a net cash balance sheet. The business is stable but the company does not want to lever up because it has to maintain a strong balance sheet as a vendor to the state to avoid political scrutiny.

Risks

The biggest risk for NIC is contract renewal. As we have seen from the table above, the company did start to lose contracts. At the time of contract expiration, the government would have all IPs of the portal. It takes time for the portal to become obsolete, just as any software we use could last a number of years without real need for updates. But as time passes by, the need for software upgrades and higher cybersecurity becomes more urgent.

Do the state governments have enough internal resources to satisfy such need? Do they outsource the task to vendors? What are the implicit and explicit costs associated with the options? Whether the state chooses to maintain the portal internally or outsource to outside vendors, they would need to have a budget for it, while with NIC, the government does not have to have a budget for the services provided. In addition, since the majority of the states are not allowed to charge online transaction fees by law, governments cannot make the online transaction fees a revenue source either. Therefore, the decision to terminate contracts with NIC is likely to be non-economical and political and, as a result, unpredicable. We think losing contracts posts a downside risk, but such risk is manageable and is balanced by the upside risk of gaining more states.

Currently, the Texas contract, expiring August 2018, is up for renewal. Accounting for 22% of its revenue, Texas is the largest contract for NIC. Without knowing the result of the Texas contract, given it is still at a high valuation, it is too risky to take a position in NIC. On the positive side, the company could also continue to win business from states that have not used its services. Those states tend to be larger in size and therefore could bring more revenue down the road. There is also the big space of federal government contracts to explore, although those would be much harder for NIC given the high level of competition.

The longer-term risk is whether or not driverless cars would make one-third of NIC's revenue from driver history go away. Although we think the process will be slow, the threat is real.

Valuation

NIC has always been expensive due to its strong, consistent growth over the years with extremely high ROIC.

The valuation against peers seems reasonable. It looks attractive compared to Tyler Technologies (TYL), who serves governments. Indeed, the whole market is at a very high level right now. NIC has been relatively derated in the last couple of years. We think the reason for this is because it started to lose contracts in 2013. Relative to the market and sector, NIC looks attractively valued. But the Texas contract is too large to take a risk at this point, in our opinion. With the Texas overhang, a 20 times price-earnings (P/E) or $15 stock price is more warranted than a 31 times P/E or $22 stock price.

Disclosure: We have no position in EGOV.

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