Intelligent Systems (INS) – “Small and Focused Wins”

Sector:      Technology – Internet Services and Infrastructure

Price/Market Cap:   $40.71 / $362M

Target Price/Implied Upside: $92 / 125%

Thesis

Intelligent Systems (INS) has established itself as the go-to payments-processing software provider specializing in complex credit. Previously under the radar, the company is attracting attention after being tapped by Goldman Sachs and Apple to support the new Apple Card.  The announcement was a whale for the company and, if the partnership is successful, could set Intelligent Systems on a path to multiply in size while attracting other large clients seeking highly flexible and customizable software to manage authorizations, fraud identity, interest and rewards calculations, and other merchant processing functions. Intelligent Systems’ CoreCard software was purposely built to uniquely address the rapidly evolving merchant processing market with solutions that other large software providers are not built to handle.  They have made investments in their software technology that create a barrier to entry for competitors.

Catalysts

  • INS doubled its revenue in 2018 and transitioned from loss making to profit generating
  • Selection to provide payment processing software for Apple Card raises the company profile and will attract other customer seeking highly flexible solutions to compete for credit customers.
  • Our conversations (and site visits) with management revealed a strong corporate culture, a customer-centric focus, a vision for the future, and a healthy pipeline feeding the company all the business they can handle. 
  • This is a counter cyclical business. In an economic downturn, it is likely that more consumers will sign up for new credit cards and increase use of their existing cards.

History

Headquartered just outside of Atlanta in Norcross, Georgia, Intelligent Systems (INS) has its roots as an early pioneer in the microcomputer hardware industry.  Through its association with Gwinnet Innovation Park in 1990, INS evolved into a technology incubator. The consistent theme has always been creating shareholder value by nurturing the growth of promising companies developing emerging technologies that address attractive B2B markets. INS has been involved with technologies from color computer terminals to hard drives to memory cards to accounting software.  The most successful of these companies were eventually sold off to strategic buyers.  Their largest sale was Quadram, a pioneer in the enhancement products industry which was sold to National Semiconductor. And possibly their most important sale was in 2001, when INS sold PaySys International to First Data Corporation while retaining the emerging technology group that is now CoreCard Software.  This CoreCard product is the foundation of the modern Intelligent Systems.

Finally, with the 2015 sale of ChemFree Corporation, a washing solutions system for industrial and commercial applications, INS is now singularly focused on the Fintech industry through CoreCard[1]

Company

Intelligent Systems provides technology solutions and processing services to the broader FinTech industry. The company’s primary product is their CoreCard Software which they have spent over $50M developing. CoreCard is a flexible and highly customizable software solution for banks, retailers and processors to manage their credit, debit, prepaid, private label, and fleet cards, as well as loyalty programs, accounts receivable, and small loan transactions.

The solution is highly customizable to address the unique requirements of customers and program managers that issue or process credit cards.  INS clients are banks and processors. However, the CoreCard software can create specific customizations that are highly attractive to the end customer, the retail consumer. The key differentiator is the purpose-built flexibility of the software which allows customization for numerous complex applications. 

CoreCard provides customers the flexibility to offer a spectrum of tools for their products.  These tools include the ability to set up and maintain account data, to record advances and payments, to assess fees, interest and other charges, to resolve disputes and chargebacks, to manage collections of accounts receivable, to generate reports and to settle transactions with financial institutions and network associations. As the solutions get more complex, INS begins to rise above industry peers.

As an example, consider a customer purchasing a new kitchen appliance from a hardware store.  The hardware store offers the customer special financing with options for a 6, 12, or 18 months loan at 15%, 17%, or 19% APR with no interest due for the first 6 months. The customer makes their selections and purchases the appliance using their store branded credit card.  The customer then returns to the same store 3 weeks later to purchase a riding lawnmower.  For the lawnmower, the store is offering 12, 18, or 24 months financing at 12%, 15%, or 17% APR.  The CoreCard software can automatically aggregate the two purchases into a single bill and accurately calculate the amount due and make adjustments for late payments and overpayments while applying the extra payment to reduce the debt most beneficial to the customer. The software determines where to apply interest, fees, and principal, and in what amounts to each loan plan.  CoreCard can also automatically handle product returns and add a standard revolving account to the loan account.

The software can handle multiple layers of additional increasing complexity. This differentiates Intelligent Systems and management does not believe anyone else can handle the complexities that CoreCard can. And competitors who are willing to create this flexibility can’t get new programs up to speed as quickly.

INS has established a niche in “complex credit.” They are not as interested in markets such as pre-paid card processing, which is a low-margin business where processors compete on price and there is little room to differentiate.

The company has three lines of business: licensing, processing, and services; but they have five true sources of revenue:  

  • Licenses – The company charges a license fee for banks to use their software.  This revenue is high margin with minimal additional input necessary from INS. The license fee is tiered based on the number of end user accounts (10k, 50K, 1M, 2M, 3M, etc.) and is charged as a one-time fee each time a new customer tier is achieved.
  • Maintenance and Support – This is a recurring revenue stream based on the amount of the current licensing fee tier and is charged as long as the customer continues to use the software. 
  • Professional Services – This fee is charged for customizing CoreCard software to meet customer needs. This revenue is not typically recurring and is higher up front and then declines over time. This revenue stream follows the same cycle for each new bank customer on the platform.  Almost all licensed customers end up leveraging INS resources for customization as flexibility and customization are why customers seek out INS in the first place.
  • Hosting Processing – This is traditionally referred to as “processing,” and this fee is charged per account per month. 
  • Managed Services – The company occasionally monitors and manages a client’s credit card program and operations. 

Corporate culture is customer centric and driven by the Chairman, President and CEO, Leland Strange. He was previously the founder of Quadram Corporation and became CEO after Intelligent Systems and Quadram merged in 1983. Leland has been described by peers as creative, entrepreneurial and opportunistic.  Our view is that he is authentic and a straight-shooter, an excellent capital allocator and long-term focused.  He owns 23% of outstanding shares which aligns his interests with shareholders. Management has made clear that they are fully vested in Fintech and their CoreCard strategy. There are no plans to spin off CoreCard, but M&A, acquisitions or a sale, are never out of the question:

We are unapologetically opportunistic, meaning the company or any part of it is always for sale, if it is in the best interest of shareholders and employees. On the other hand, we will always manage, operate and invest as if the company is privately owned and going to be around forever. We’ll always try to build the company, but we’ll also always evaluate any offer in light of the risks and opportunities at every moment in time.” – Leland Strange

Intelligent Systems has grown to over 500 employees, with the majority compromised of software development teams in two office locations in India.  There are fewer than 50 employees at the Norcross headquarters, but these employees are long tenured and committed to the company’s long-term growth strategy.

Customers

The customer conversation revolves around their newest customer Apple (Goldman Sachs) for the new Apple Card. As Apple was considering the infrastructure for their new product, they came across another INS customer licensing CoreCard software and, as they began to understand the flexibility, they asked INS to compete for the business. As Apple reviewed proposals, the larger competitors were able to do what INS offered, but they could not come close to meeting Apple’s proposed launch schedule. INS was confident they could meet the timeline, as their infrastructure (Microsoft stack and Dell servers vs COBOL residing on mainframes) was designed to get customers launched quickly.  After selection and diligence, the Apple Card was launched within a year.

Image result for apple card

This was no small task as launching a new credit card requires the coordination of numerous entities. Visa, MasterCard and many others. The Apple Card itself is unique in that no product like it existed previously. There had never been a card that resides solely on your phone but can also have a physical form if desired. The process required the ramping, coordination and integration of 10 to 15 total vendors.

The fact that INS was able to land the Apple business under reasonable terms (not a margin drag) speaks to the uniqueness of their offering and the attractiveness of INS speed to market proposition. However, landing Apple created the champagne problem of significant customer concentration[2] which creates lumpiness in revenue and customer concentration risk.  However, customers in the payments processing business are sticky.  Customers often have to invest their own money and resources to get a new product up and running and there are then switching costs after the vendor coalition is created.  Switching is not impossible, but not easy.  Most customers who leave, leave for a very specific reason such as they are acquired by a larger company using an alternate vendor or the customer decides to bring the technology in house. 

Management keeps their client list close to the vest. However, we are confident that both SallieMae and Kabbage are also clients.

Emerging Opportunities

Intelligent Systems is just getting started with applications for their flexible software. Their success with Apple will open doors.  Management sees emerging opportunities in the area of digital payments as well as in food delivery where drivers actually pay restaurants for the food at pickup and they are not reimbursed until you, the customer, receive your delivery. In between, there is a 15 to 30-minute window where the driver is floating the charge and so there are unique credit opportunities within this space.

Currently, Apple Card is purely a domestic product. But Apple has obvious aspirations to launch internationally and provide Apple Cards to iPhone users worldwide.  This creates a whole new set of hurdles.  Apple would need an international bank which could also be Goldman.  Chances are high that if Apple and Goldman pursue the international opportunity, INS will be in a prime position to provide the payments processing software.

With solid execution, the market opportunities are countless.   

Competition

The payments and processing marketplace is crowded with giants.  Direct competitors include major behemoths, Global Payments (GPN), TSYS (TSS), Fiserve (FISV), Fidelity National (FIS), etc.  Each easily 100x the size of INS.  And then all of the tech titans (Apple, Amazon, Google, Facebook, Uber) are eager to make their mark on the Fintech landscape.  The blaring question is easily, how does INS not get run over by the largest incumbents?  The answer is that INS has created a niche where there is significant room for unimpeded growth.  Customers choose INS because they want to bulletproof the future as fintech opportunities evolve. Solving complex credit problems and addressing solutions much faster and with more flexibility than the competition gives them plenty of runway.  There is ample room for the company to compound over time before anyone perceives them as a true threat. 

Financials and Valuation

INS is unique in that their expense structure differs from their peers and most major businesses. Customers seek out INS for their unique ability to solve complex problems and their speed to market. The customers come knocking and INS incurs almost zero marketing expense and have no sales staff.

If you can’t find us, you’re probably not a good prospect, and we don’t need to be knocking on your doors.” – Leland Strange

And because their pipeline is already full with as many customers as they can handle, they see no need to ramp up sales in the near future.  At some point, they will reach a level where they will need to develop a sales and marketing arm, but they don’t see it in the immediate future as they have all the inbound interest they can handle.  With these inbound customers, their engineers act as de facto sales staff. Customers prefer this as they know that engineers typically know what they can develop and won’t promise features that they cannot implement. 

The company often receives compensation for their R&D.  INS does not (currently) attempt to develop new products that their customers might want.  Instead, banks ask for new features and they are willing to pay for INS to develop them.  The customer will then receive the added functionality while INS retains the right to use the new features and technology for future customers, and expensing the development payments (Professional Services revenue) as R&D.  

Without having insights into specific customer product ramps, it is challenging to accurately model the business. Revenue is lumpy. Large customers take 6-9 months to onboard and start generating revenue. And once ramped up, INS has no control over the rate that the end credit card customers scale.  All INS can do is support the banks issuing the cards. 

But modeling isn’t the point. 

The point is this is a very experienced management team with a history of excellent capital allocation that has shed its past as an incubator to focus on a single product to address an endless TAM that is the Fintech services market.  They have more inbound business than they can handle, and management forecasts 25%+ growth for multiple years ahead.  As the business scales, more cashflow drops to the bottom line. Management is long term focused and aspires to be a world-class payments processor.

This is the current state of the business:

Current Financials. Q4 and FY 2019, RCG Estimates

We created an estimated valuation with the following assumptions:

  • 10-15% attach rate for maintenance and support
  • Processing and Unit economics – $0.50 – $1.00 per account per month for credit.
  • Roughly a 25% annual growth rate through the period.

From this, we see 125% upside to current valuation.

Risks

  • Lawsuits – There is ongoing litigation from a short report issued early in 2019.  30 separate lawsuits gained class action status.  Management views this as ambulance chasing and they don’t plan to pay anything to settle the suits and they estimate that legal fees will be less than $500k.
  • Customer concentration – This is counterbalanced by the stickiness of their business model.
  • There is reputational risk for INS if there is a blackout in their software. Any problems of this sort with their largest customer would be catastrophic.  Management is confident in their software.

[1] INS still has some remaining investments outstanding, but their future is in Fintech. All future investments will be directly related to CoreCard. 

[2] 58% for the first 9 months of 2019 and 70% for Q3 2019.

7 comments

  1. Good analysis. With the latest Q42019 result, what will be your revised valuation on INS?
    I see that with the Goldman Sachs target 21 mils issued Apple Card, assuming 5 mils has been issued in 2019, 15 mils Apple Card to be issued this year is highly as achievable. This will be on top of increasing revenue from professionals services, maintenance & support services, etc.

    1. Hi Christopher. Thank you for reading and commenting. We have made some updated assumptions given recent earnings. They incorporate the increased investment in people (INS views 2020 as an “investment year” and 2021 as a year focused on ramping up cc processing) contrasted against the GS Apple Card growth outlook. Balancing these two (and making some additional model refinements), we actually have a target in the $85-$90 range. Not too far from our original target. We continually refine our assumptions and targets as new information becomes available. However, we reserve these updated insights for clients. We post our preliminary work on the blog to spark discussion as well as highlight our investment process.

      1. Hi Khadir,
        Thanks for your sharing again.

        I would also like to highlight a few points which readers can be aware and we all can learn together:

        1. INS management shared before during last year quarterly report that the growth of the company will be about 25% for the next 2 years. However, the real growth for 2019 had far exceed the management’s guide. Revenue growth is 70% year on year, profit is > 100% year on year.

        2. What if the one time license revenue is more than $1 per active card? Forecasted 16 mils Apple card growth for 2020 to reach 21 mils would means the revenue would easily be >50% year on year again, including the rest of the professional services, maintenance support, etc.

        Let me know if any my points is too optimistic.

        Thanks!

  2. So we would agree with point 1. Given the tremendous growth in 2019, 2020 will be nowhere near as exciting. We expect growth to resume in 2020. Management also indicated they will be investing in personnel and so operating margins will likely decline. I would also expect to see capex grow a bit as well. Leland has frequently commented that their business is very challenging to model internally and so almost impossible for external analysts to model “we are an analysts’ model nightmare.” (August 2019 Earnings call). On your second point, the license revenue is charged on a sliding scale depending on which tier(# of cards) the customer has reached. Matt has indicated that he has provided enough information for analysts to back into what they charge fortheir tier levels (1K, 10K, 50K…..1M, 2M, 3M, etc). We have some thoughts on this, but we do not yet have a high level of confidence that we have all of the numbers correct. The $0.50 – $1.00 per account per month was for credit card processing. Apple/Goldman is not currently a processing customer. Only perpetual license.

  3. Hi,

    Do you think normalized 60% FCF/Sales margins achievable in the next 1-2 years? INS had about 40% FCF/Sales for 2020, though they did spent some on growth capex.
    Thanks.

    1. Thank you for reading, Raheel. I am unsure if FCF margins with reach the 60% level. Annual FCF is trending in the right direction (28%, 25%, 40%) and we expect the second half of 2021 to be quite robust. However, a 60% FCF margin is not vital for our investment thesis.

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