Jack Henry & Associates, Inc. (JKHY) Earnings Call Transcript & Summary

All right. Good afternoon, everyone. I am Rayna Kumar, and I lead U.S. payment processors and IT services. And today, I'm very fortunate to have CFO of Jack Henry, Mimi Carsley [indiscernible] for the first time.

So Mimi, just to start out with, in the fourth fiscal quarter, Jack Henry booked 16 competitive core takeaways, making it 47 for the fiscal year. What's fueling the strength? Has the competitive dynamics changed? And more importantly, are you seeing any residual effects from one of your competitors which is currently struggling?

Thanks. So yes, we just closed out a strong FY '23. We are a June 30 filer, so we just finished our year-end and kicking off FY '24. So historically, on average, we close about 50 new core wins. Now when we say core wins, we mean completely new logos to us. So this isn't a switcher, this is a completely new core win. So on average, we like to say it's like one per week. It's certainly not as even as that, but on average, about 50 to 55 in a given year. And we've been doing that pace for a number of years. So I think the dynamics that have been driving demand are certainly still there very much before. And so we support community and regional banks. We intentionally don't aim to target the smallest institutions in America. And we don't target the Tier 1s, the 2s and the [ wealth ] and the super high. So within that space, most of our customers have [ IT needs ] and the demand is really robust. In fact, we've just -- even after a record Q4 and a record FY '23, our pipeline going into FY '24 is the lowest we've ever had. And one would expect you to kind of drain the pond, if you will, starting off the year. But we've actually walked into the new year with the strongest pipeline we've ever had. So I think that you mentioned competitors. I'm not going to talk about competitors specifically. But the challenge would think like, "Oh, gosh, there's other people struggling. Can you go and do more?" The challenge, as in any given year, there's only so many people up for renewal on the core side. These are long-term contracts, on average, 7-year length. It's an incredibly strenuous effort to change out your core system. You're talking about the heart and lungs of a financial organization. The ERP touches like every process, every employee within a bank or a credit union. So you don't take this decision lately. And even with that, we still get 50 new wins a year. But most, if you think about maybe 200, 250 institutions across the U.S., thinking about a renewal or a change, only about half of those or even less actually make a decision. Most decision is a no decision of just keep with their current provider. So of that 100 that actually make a change in a given year, we win about 50 to 55. So we're winning a really nice margin percentage of those. But most still, it's a really big undertaking. What drives most of them to make the change, and you mentioned competitors, is that either they're having really weak customer service where they're at or they're not getting innovation. And so Jack Henry has one core system on the credit union side and one flagship on the bank side. We have two other for smaller institutions and kind of a legacy perspective, but our SilverLake product on our banking side and our Symitar product on our credit union side. But if you're at [indiscernible] may not. They have 10 to 20 sometimes core systems. And you're not clear what is the go-forward core and you may not be getting that innovation. And so while it's an incredibly strenuous effort from a bank or credit union to make that core decision, sometimes that's the only way you're going to get innovation and that's also the only way you're going to be able to get things like ancillary products that are so critical to their systems like digital banking.

So just to be clear, are you running three core systems? Is that...

So we have one on the credit union side and we have three on the banking side, but one is our flagship go-forward core, which is SilverLake.

Got it. Okay, that makes a lot of sense. And then I know that you're not going after a Bank of America or a [ Chase ]. But are you trying to have conversations with larger banks, maybe more of the regionals there?

Yes. The largest customer today is around a $30 billion institution. They have aspiration to be a $75 billion institution. And technologically today, we support up to a $100 billion institution. So we are getting inbound inquiries. Interestingly enough, we've been talking about our tech modernization strategy for a little over 1.5 years now. And it's really interesting because we've been getting an incredible amount of inbound calls from these larger institutions that are really crazy about technologically where we're going and our approach. So part of our tech modernization strategy is around decoupling the core. So the core system has maybe 30 bps of functionality that a bank from kind of end-to-end, open accounts, take deposits and record mortgages. That's kind of what's the heart of a core system. And so by decoupling those elements, it derisks that huge, big bang conversion that would normally go [indiscernible]. So that's really appealing to a lot of large institutions.

Yes. And just sticking with the tech modernization strategy, I feel like there's -- you get tons of questions on this, so there's some confusion as to what Jack Henry is doing there. But could you talk about -- like help us better understand how unbundling services can help the customer and generate a longer-term sustainable revenue stream for the company?

Yes. So taking that, let's call it, that 30 core pieces of functionality and saying, "Yes, most likely, people are going to have a bundle or suite that kind of looks like a core does today." But if they want to, they can do it piecemeal and take a la carte services, what do I want to do, which allow a larger-sized institution to say, "Oh, I'll do deposits first or maybe I'll do commercial loans first or just my account opening first." And so it allows them to step into, over time, that process of a core conversion. It also allows us to, what I call, write once, use often, which is how do we take carts of functionality and then add that innovation to Symitar or SilverLake today? So over time, in the long term, I think you'll see what is a core for a credit union and what is a core system for a bank more similar to where there's going to be more of a commonality in the functionality and then maybe some modules of differences.

Got it. That makes sense. Are you starting to see interest from your customers for being in a public cloud environment?

Yes. So we have today parts that are public cloud-native today. Our payments through Payrailz. Anything we're producing in the last 3 years has been really cloud-native. So our LoanVantage product, our Financial Crimes Defender that's coming out this year, all of our other work. And now there's other work, Banno, for example, digital cloud-native. And for Banno, our digital [indiscernible] It's just where PII sit. So even though people are very comfortable with Banno being in the public cloud, it's really the regulators who are not comfortable with the PII being in the public cloud. So there are very few banks in the U.S. today that have their core system in the public cloud. Now I think it's going that way certainly. And we're doing our part to help the regulators on their education and figure out how to test in that environment. But I think what we've been thinking about from a development road map time frame is somewhere probably 3 to 5 years, where you see a full end-to-end core in the public cloud.

Understood, okay. Looking across your segments, core revenue growth has accelerated in the last few quarters. What's driving the strength? And which components do you expect to be durable into FY '24?

Yes. So we report in three public segments. Our core business, that is where you get new core sales wins. Now that takes about 12 to 18 months for any new sales online from [indiscernible] that revenue stream. Now that timing is less about us helping them on the readiness and more from the financial institution. Because that core, they're changing workflow, every training, it's a lot of work from the financial institution to get ready for that one operation. So any sales you see today might be 12 to 15 to even 18 months on, on the late side of that. But you're also getting organic growth from our clients growing. So even though the number of institutions in the U.S. is shrinking, the size of those institutions are growing. And so as a reminder, we get paid mostly for our cloud-hosted business that's on a per account or a per member basis on the core. And on a host on the on-premise, when they have the license on their premises, it is on [indiscernible]. So as they grow, we're going to get that [indiscernible] sales growth. And then we have sometimes implementation revenue. When they are doing an acquisition, we help them with that. So that's the drivers we see behind the core segment. And I would say in any 1 quarter, it's really about who's coming off the backlog and who's coming online. And so there might be fluctuations in a quarter. But we really don't have seasonality in our business. I would really recommend you look at it on an annual basis. So that's our core segment.

Makes a lot of sense. Regarding your progress with FedNow, [indiscernible] is one of the protectors of FedNow. What type of revenue model does [indiscernible]

So we've been working with the Fed for a number of years in readying. We've had a number of our clients into beta. We have 15 clients live today, probably about another 150, 160 signed. We're quite excited. We're hearing a lot of enthusiasm from our customers. A couple of reasons, they like the neutrality of it. Rather than having some of the other rails owned by a consortium of [ other bankers ], they like the neutrality of it being the Fed. And most have an account with the Fed already, so there's a trusted relationship there. I think the adoption curve is going to take some time as with other RTPs. But I think it has an opportunity to accelerate from a [indiscernible] perspective of that adoption relative to others. If you think about the number of payments that the U.S. government and the Treasury control, now the Fed can't mandate that, so they can certainly work with their partners at the Treasury. But if you think about it, if they said, "The only way you're getting your IRS rebates is through FedNow or your VA [indiscernible] or your [indiscernible] payments," that's a lot of payments that the Fed controls through the Treasury. And so what we've [indiscernible] ready to be turned on receipt. We think it will take some time before you see sending volume large, but I think receiving volume will start at a healthy clip.

As you talk to these banks about FedNow, what do you think are the main use cases?

Yes. I think today, it's a lot of commercial. But I think in talking to [indiscernible], they're really excited about the business. So it will be interesting to see the ramification for [indiscernible] of does this become some of the rails that [indiscernible]. For our clients, they're excited about not only the neutrality of it being the Fed, but they're excited about this being a revenue opportunity. Today, they don't make money on Zelle, for example, and yet they have Zelle progress. And we don't make money because they don't make money on that. But for FedNow, originally the thought it would be somewhere between a wire and an ACH. And it looks like they're pricing it closer to an ACH. So I think that will be another thing that's going to spur adoption. And that's good for our customers to be able to make money on that and then our turn to be able to make money on this transaction.

So I've also heard the big use case for FedNow is [indiscernible]. Are you also hearing use cases from consumer [indiscernible] P2P?

I think it's going to start to develop. I think you're going to see most in the government sending to consumer and B2B before I think you see a P2P. But I think it's going to be there.

Got it, okay. Let's move on to operating margins. So in your last earnings call, you guided for 20, 25 basis points of non-GAAP operating margin expense in FY '24. Can you talk about the different puts and takes of this target, including maybe [indiscernible] Payrailz mechanics?

Sure. So first and foremost, margin expansion on a consistent basis is super important to us. We know it's a primary tenet in investment thesis for Jack Henry, and we are determined to deliver it. So I am also personally [ goal ] on it, just FYI in all transparency. So we know that it is important. And we believe that the business model inherently is a margin expansion story. If you think about some of the tailwinds, we have the continuation from on-premise to private cloud. And that's where our clients host the software themselves to where Jack Henry hosts the software. And you may say like, "Well, what is the difference?" Well, when we hosted it, it's almost 2x the revenue. And you may ask, "Well, why are they making it 2x revenue?" Well, now the FI doesn't have to have a CTO and worry about disaster recovery and their own cyber insurance and hardware equipment go several hundreds of thousands to millions of dollars. And so that trend, we're about 70% hosted today on our private cloud. I think you're going to cap out somewhere in the 90s. So there's a nice 7-year runway. We win about 50 of those conversion deals a year. I think you have a long runway for that. And then you'll go to the private, from private cloud to public cloud. I think that's another margin expansion opportunity between [indiscernible], the security environment, just lower dev cost environment, I think that's a margin expansion story. So I think those are some longer-term tenets. To your question specifically for FY '24 and the guide of 20 to 25 basis points, I think there's three main drivers I would kind of point to. One, in FY '23, we did not meet our internal financial goals. We have a very wide bonus program for our associates. And because we didn't meet our internal numbers in Q4 of FY '24, you'll see that accruing and, hopefully we're going to meet all our goals, paying at 100%. That's about a $6 million headwind year-over-year. The second thing I would point to is with almost -- with over 7,000 employees, [indiscernible]. And while we've seen a tempering in the [indiscernible] wage and we've seen [indiscernible] there's still people, other people-related costs, like medical benefits, for example, still in teens year-on-year from an inflationary perspective. [indiscernible] travel costs, et cetera, are still out there. So I think that is probably another year until that inflationary pressure kind of tempers itself. That's been a headwind to margin expansion. And the third one is because of the amount of internal development we've done over the last 3 years and this year having a roster of super exciting new products, like Banno Business and Defender, once those products go GA, we start to expense that amortization. And so out of the gate typically, you'll start to see revenue build. But that expense comes front and center of day 1 of GA as you start to have to amortize that. So that's the other third headwind that's creating for FY '24 the pressure to keep the margin expansion a little lower than our longer multiyear trajectory.

Given some of the headwinds you just talked about, would you characterize your guidance as being conservative?

I think there's probably a little bit of conservatism in there for sure. But it's really important to me, I'm about a year in the chair, integrity is really important to me. And second, we talk about doing what you say you're going to do. And so it was really important that we could come up with a number that I can sleep at night comfort [indiscernible] delivers. Short of a major macro event, we are going to hit that number. And as a management team, we are fully committed to [indiscernible] on delivering that.

Makes sense. Okay. I know beyond '24, you've highlighted normalized margin expense in that 20 to 40 basis point range. Can you talk about what would get you closer to 20 versus the 40?

Yes. I mean, I think the 20 guide is probably a little bit of conservatism there. The 40, I feel good about the nature of the business model. And normally as we sign on more clients, particularly as we sign up larger tier clients, like it's not a ton of extra cost in the model. And so inherently, once we get over this rise from an amortization expense perspective, we're going to see the margins increase. Now there's always -- I call us a SaaS business, but we're a fortified SaaS business. So we are -- there's other SaaS businesses with margins of Salesforce or Adobe. Nobody is going to hack a Adobe system to get your demo or your document or your contract. When you support over 8,000 of the U.S. financial institutions, you have a fortified data center. And so there are costs around cyber that we will always spend to make sure that our environment is secure. Over time, as we get more and more efficiency, we're always looking to see how we drive cost [indiscernible] our business, we're going to see margin expansion.

Makes a lot of sense. Just going back to the tech transformation for a second, are you seeing any of your competitors do anything like Jack Henry is doing in the sense of unbundling and shifting over to a public cloud environment?

Yes. I mean, I think there's definitely a push for public cloud interest in that for all the [indiscernible] that you get like DevOps tools. Typically, in our space, you get innovation once a year, maybe at least twice year and big drops of product refreshes. By having it in the public cloud, it's like, I mean, Banno do many updates a month. Just as soon as we have encoded functionality, we can now leave it [indiscernible] So that development philosophy of innovation within the cloud [indiscernible] capabilities. So [indiscernible] it's night, every night, every month, every quarter, every year-end from major capacity needs. Well, in the public cloud, capacity is limitless and cheaper than making that [ peak level ] in a private cloud environment. Security, we offer an incredibly durable, secure environment. But Google is our major public cloud provider. We work with AWS and we work with Microsoft. But Google is our go-forward strategic partner, has even better security environment than ours to maintain. So all of those, I think, from a perspective, are part of our tech modernization and are reasons why people are excited about public cloud. I think part of the decoupling or the modulation, there's a couple of startups there in that direction. I think I would point to the difference from a Jack Henry perspective. Our clients still want 90-plus percent functionality out of the box. When you're a regional or a community bank, you don't have the army of tech talent to customize a complete front end. So there's a number of [indiscernible] alternatives out there. Some are what we would call headless [indiscernible]. Among others, still require some servers. If you look at the architecture, I would say that's not a public cloud-native architecture. And others are just really long to implement because it speaks so much to that customized development. So I think we're really at the forefront alone in terms of our approach to the [indiscernible].

Got it. And while we stay at the competitive environment, outside of your two largest competitors, are you seeing any other new entries? Do you start out your international [indiscernible]

Yes, I mean, there's a couple of startups up there. I was -- without going into too much names, I would say [indiscernible] from a technology approach to it. Now I would say theirs requires more of that customization. But in general, the beauty of Jack Henry is you get the innovation, but you also get the operational know-how. So it's a lot different to solve a mechanical computing challenge than it is to actually operate in a highly regulated environment. And a lot of these donuts don't know how to support their customers in that with the regulators. So for our customers, they're getting the best of both.

Understood. Of all the moving pieces in macro right now, what's your view on bank IT spending for the next 6 to 12 months?

What we're hearing from our customers is they don't have their head in the sand. They're watching delinquencies. They're watching real estate. They're watching auto, used auto prices and the like. But by and by, they're feeling pretty healthy. And the reality is there isn't a challenge that they face right now, the technology is not self-sufficient or the primary [indiscernible] of the solution. So [indiscernible] if it's broad mitigation, if it's driving efficiency in the business, its compliance, technology is a solution for them. So I don't see where, in particular, our kind [indiscernible] foot off the gas and remain competitive. I think maybe impacts the super Tier 1 space, where more they're [indiscernible] more back-end loaded versus front-end client-facing needs. They could maybe slow down if they chose to. But our clients is really around a digital front door. It's around innovation that's going to help them remain competitive.

Okay. I'll pause here and we can take any questions in the audience. We have a mic that will go around. Feel free to raise your hand if you have anything for Mimi. And if not, I will continue with my questions. I have plenty. So for Mimi, so for FY '24, you expect free cash flow to be 60%. How should we think of our free cash flow conversion over the medium term as you transition from a license and maintenance business model more to SaaS?

Yes. So we're going to continue to target that 80% to 100% free cash flow conversion as our target. There certainly were some things driving FY '23 that are continuing to be headwinds in FY '24, prominently the change in Section 174, which is the legislation around the deductibility in development-related expenses. And that hit a lot of software vendors. For tax purposes, you used to be able to deduct all of your development-related expenses for tax purposes. And now you can't. And so it restarts that clock. If you're domestic, it restarts that clock for a 5-year amortization. And if you're international, it then restarts that clock for 15%. But last year in FY '23, that led to an extra incremental $80 million in cash taxes. Well, that's a big hit to free cash flow. And on top of that, we had roughly about another $14 million in COVID-related tax repayment. So that certainly, the COVID-related tax is certainly 1 year. But if you look at the free cash flow conversion and you neutralize that impact for the taxes, you're in the 70% to 80% range. So unclear if post the election, you'll see a reverse of legislation or not. But if not, it still mitigates this year the impact with the largest impact being FY '23 and FY '24.

So without that, should we think of the medium term as a 70% to 80% conversion?

Yes, we're around that for sure.

Okay, great. Just any update on your capital allocation priority here? You've been in the seat for roughly 1 year. And maybe just your acquisition pipeline, what types of assets [indiscernible] and what criteria are you seeing those acquisitions?

I think more will stay the same in terms of allocation philosophies. We're a very conservative company. We're really about shareholder value creation. So first and foremost, we spend about 14% to 15% of revenue on R&D. We believe in organic redevelopment and spending from that perspective on organic growth, driving future organic growth. The second is we are a long-standing [indiscernible] to our dividend policy and growing that. We've grown our dividend over 35 -- I think this year, it's 35 years. Vance will correct me if I'm wrong. And certainly, right now, with the current interest rate environment, paying down debt. We have a small amount of debt on our books. And the last is opportunistically repurchasing our shares. Should we not see any M&A that interests us, we'll return any excess capital back to shareholders that way. In terms of M&A, I was really hoping that would be a better pipeline here right now than we're seeing right now. I think small companies have yet to capitulate on valuations and larger companies are well capitalized still. And it seems that they're going to bounce back from the current stock environment that they're in. So there is not a lot about there. Now the positive is we don't have a lot of gaps. So our 7% to 8% revenue growth, now that revenue growth targets don't imply any need for external acquisitions. So we have the ability as we've done the last number of years to just head down and develop it ourselves if we're not seeing anything that interests us. And from an acquisition perspective, it would need to be digital cloud-native. It would need to be a cultural fit. It would need to be clearly additive, either a migration of an existing product or something that would be a need to our niche market. We like serving domestic financial institutions. So there aren't that many things out there that we're seeing right now. But we're always looking. We're an experienced acquirer, so we're always looking.

And you only want to be a core [indiscernible] unlike your [indiscernible]

We have a whole -- well, we specifically didn't get into merchant acquiring for a reason. And I think even though people gave Dave a lot of grief on that when he chose not to go in that direction, I think today, that decision is looking [indiscernible]. But no, we like serving directly to the financial institutions. So we have a portfolio of over 200 solutions beyond core and a sales force that knows how to sell outside our core base. So if there is a good piece of technology that we think will serve our financial institutions, we certainly know and have great experience in knowing how to integrate that and [indiscernible]

I'm going to sneak a question about gen AI, which everyone wants to know the impact of gen AI on all the companies I cover. So what do you think is the impact, potential impact on the cost side and maybe on the revenue side as well for Jack Henry?

Yes. So as it relates to AI/machine learning, not gen AI but machine learning, Jack Henry has been using it for quite some time. So call center, thinking about what the next question might be [indiscernible] in our fraud solutions, using machine learning in our fraud solutions engines. So we've been using that for quite some time. Now gen AI, we, like a lot of folks, are trying to figure out what to do. Obviously, it would need to be a walled garden experience. We have a lot of PII that we're not going to be putting up on ChatGPT. And so we're trying to figure out where that is within our organization. But we've already been doing a lot of work within the team.

Understood. How has the progress been in trying to sell Banno to non-core customers? And do you think that could be material to your revenue and earnings?

So we made the strategic decision last year. We had been ready to sell Banno outside the core base. And we were excited about it. And we actually temporarily paused that because what we were hearing from competitors [indiscernible] people is, "Please bring Banno to us." And then we said, "We're not really in the job to make other people's core systems better." And so right now, you can still only buy Banno if you're a Jack Henry core customer. Now over time, we will cherrypick and think very thoughtfully about which other core systems, competitive core systems we will work and sell. But we won't do like a mass opening for all. It's going to be a targeted approach, where we're winning and having the most traction from a sales perspective against those other weaker cores. Today, any new core customer is buying Banno as part of that. And we have over 10 million users on the Banno platform.

Got it. Okay, that's great. Can you talk a little bit about the progress you're making on your credit card processing business? And when do you think that will become a larger piece? And can you just help us better understand the dynamics you have with First Data and how long that contract is?

Yes. So Jack Henry has long been a debit card issuer and processor on behalf of RFIs. Most banks, you open a bank account, they give you a debit card. And so we have over 1,000 customers using our debit platform. A couple of years ago, we entered into the credit space as a way to support our customers [indiscernible]. Customers tend to want their debit and credit at the same place. And so we wanted to ensure that we were continuing to win in the debit space but also as a way for RFIs to diversify their revenue sources and potentially enter into credit. So we have two ways for them to use credit. We have a traditional offering that we do. But we also have a partnership with TIB, where they can do a complete white glove. So if someone doesn't have the resources within their financial institution to do credit, they can have an outsourced program. And a lot of the regional and community financial institutions, they were leery about credit because of fraud. Well, fraud -- JPM fraud costs are extremely expensive relative to their business. It's not debilitating. For a small or a smaller institution, that can be big dollars relative to their book. So a lot of the reentry into credit was really the modernization of the management tools around that program, around managing that risk, managing fraud. And so we're really excited about where that's going from a direction of helping our customers in mitigating it. But it will be some time, and I don't think you'll ever see credit being like this huge portion of our business, in part because whenever we win a credit customer, we're winning a debit customer. So from a ratio perspective, that's going to be a hard one to drive. But we have about 50 customers on credit and about 1,000 on debit.

And any progress on the [indiscernible] with First Data contract, how long that is?

Yes. So we have a partnership, it's not direct with Fiserv but through PSCU. So that's where our relationship is.

Okay, understood. Okay. I know we're running out of time, so I just have one final question. Well, it's actually two parts. What are you most excited about for Jack Henry's future? And what do you [indiscernible]

I'll deal with, well, what's exciting. So much is exciting. This year, I mean, FY '24, just the amount of new products coming out. And we've been talking about them internally since I joined. But now to be able to see and talk to customers who are starting to use them, it's really exciting. One of the things that brought me to Jack Henry is this really rare opportunity, where you have a 46-year-old, now 47-year-old company of operational execution, maturity and know-how mixed with innovation and this drive for growth. And so to me, that's really like a wonderful blend. I think I'm really excited about our tech modernization. I think where it can unlock and just the business models it can unlock and how we can help support what will be the next [ 10-plus-year ] approach to banking, I think, is really an exciting time. So that excites me. What keeps me up at night? Not much. I have a fantastic team, the best IR guy in the world. I would say if anything, what keeps me up is a bit of -- I mean, listen, there's always fraud and there's cyber risk in our industry. But I feel, knock on some sort of wood, like we're pretty fortified in that. But that's a constant struggle. I mean, there's bad actors out there and that's a constant struggle to stay ahead. But I feel like we're doing a great job there. If anything, I think continuing to how we get our message out, I think there's some misnomers about us. There's misnomer that we only play in the itty-bitty banking space. This year has been a challenge to be anything associated with banks. Our correlation with the CREs hurt us and [indiscernible]. And I think [indiscernible] technology firm. And so I'm quite excited about that. And I think it's doing pretty well.

Great. Well, Mimi, it was wonderful having you. Thank you so much for your time. This was great.

Thank you for having me. Thank you, everybody.