The shares of Intelligent Systems (INS) have increased over 350% in a year, is it too late to step into this growing and profitable company? We don't think so; there is more to come.
Intelligent Systems receives basically all its revenues from daughter company CoreCard, a card management, payment, and transaction processing products company.
Its processing software is very versatile. It can be used for basically anything: credit cards, debit cards, virtual cards, prepaid cards, loyalty cards, loans, stock trading, insurance, etc.
Here is a remarkable acceleration in revenues and also considerable operational improvements (the increase in net revenue only looks less impressive because of the scaling of the graph):
It should be no surprise that the acceleration in the share price is even more dizzying:
The shares are up over 350% in 12 months; clearly the company is doing something right. But what? The company generates revenues from software and hardware. From the 10-Q:
Our service revenue consists of fees for software maintenance and support for licensed software products, fees for processing services that we provide to companies that outsource their financial transaction processing functions to us, and professional services primarily for software customizations provided to both license and processing customers. We derive our product revenue from licensing our comprehensive suite of financial transaction management software to accounts receivable businesses, financial institutions, retailers and processors to manage their credit and debit cards, prepaid cards, private label cards, fleet cards, loyalty programs, and accounts receivable and small loan transactions.
The biggest part of revenues comes from license income and clients licensing their processing software.
- New licenses (the product line in the accounts)
- Upgrade (adding more users to existing accounts, also in the product line)
Management argued that there were no new license sales. 65% of the revenues came from services, consisting of:
- Maintenance and support (generating recurring revenues for the duration of the contract).
- Professional services, involving training, customization and the like. These are revenues that tend to be high in the beginning, but taper off with time.
There is something investors need to understand (Q3CC):
Remember, our customers are usually processing for their customers. And after a year or so, a pattern gets established and we can usually budget the amount as regularly or recurring revenue so we know - because we come to know what they're going to need on an ongoing basis. So all the recurring revenue that comes from a licensed customer comes from the utilization of our personnel.
That is, it's not a pure software model which is mostly fixed cost. There are variable (personnel) costs involved with scaling. On the other hand, license revenue doesn't really have cost against it; that's almost pure profit.
The other 33% of revenues came from hosting processing, which generates recurring revenues (it also includes some professional services revenue and even some "ghosting" pass-through revenue).
The main reason Q3 produced such sterling results was that the company managed to gain a really big customer in October 2018. From the 10-Q:
Indeed, during the Q3CC, management even admitted that it had some initial reservations about taking on a customer of that size:
We, normally - you've heard me say, we normally would not take on a customer that we felt it was too big, because we wanted to do this brick-by-brick, step-by-step. And, there was presented to us an opportunity that we had to do a lot of soul searching to determine whether we'd be able to successfully implement for this customer, given their demands.
It even had to temporarily postpone some work for other customers to be able to deal with this one, but shareholders should be glad it did (Q3CC):
Well, I'm going to say, one has been very large. And we have other large customers standing in the wings... As with a lot of companies, you have to kind of get through certain levels to get the confidence of the next - next level sized customer.
Not only does the company gain confidence, but it can also even go to the next level, and it will have gained credibility with potential clients, so this is a positive development all around and is likely to spur more adoption.
How good where the results? Well, here is the 10-Q:
Not only did revenues explode, but the company also enjoyed a substantial operational leverage, making it quite profitable already.
Both GAAP gross margins and operating margins are at record levels and the company has amazing operational leverage. This is mostly because it spends next to nothing on marketing, and the R&D expenses have actually gone down in dollar terms (see the operations table from the 10-Q above).
Operating profit increased from $1.2M in Q2 to $1.7M in Q3, which is quite a sequential bump.
Much of the leverage exists in the Processing Services business, so it's good to read that this is actually growing faster than licenses (10-Q):
As we continue to grow our Processing Services business, we continue to gain economies of scale on the investments we have made in the infrastructure, resources, processes and software features developed over the past number of years to support this growing side of our business. We are adding new processing customers at a faster pace than we are adding new license customers, resulting in steady growth in the processing revenue stream with the third quarter of 2018 growing 16 percent and 22 percent, respectively, over the second quarter and first quarter of 2018. The infrastructure of our multi customer environment is scalable for the future.
Processing Services are recurring revenues, so this is another benefit.
The turn in cash flow is almost as dramatic as the turn in the share price, and given that the figure shows the moving 12-month periods, and the big customer only entered in the last quarter, cash flow is likely to remain positive.
We don't have to worry much about an overload of stock-based compensation. This is next to nothing, hence there is very little dilution:
What's more, the company has no debt and substantial amounts of cash ($17.35M), and now that it is generating more cash, it is going to give back some to shareholders.
The board authorized a $5M buyback program. With a rapid rising market cap ($157.5M at the moment of writing), this isn't going to make too much of a difference, but who knows what kind of cash flow the company can generate if more big customers join the club.
The first nine months of 2018 delivered a little over $14M in revenues with management arguing the revenue for 2018 will arrive at between $19M and $20M. That is, Q4 revenues will come in at $5-6M, similar to that in Q3 ($5.4M).
That $14M in the first nine months of last year was more than double that of the first nine months of 2017 ($6.6M), but management tempered the expectations (Q3CC):
But please don't make the assumption that it will be our run rate, because I seriously doubt our first nine months of 2019 will be doubled this year's first nine months.
However, it also said this (Q3CC):
I have reasons to believe that the 2019 year can be substantially better on both the revenues and operating profits, if we get the license revenues we're anticipating. Now I'm not going you give any further guidance at this point, but this is what I know and this is what I believe at this point.
And the company expects new license revenue in H1 2019 (Q3CC):
And if our customers do what their plans project they will do, we should get another license revenue pop another - again, that pop is not a good accounting term, but we should get another license revenue pop in the first or second quarter.
This is excellent in two ways. Not only does it increase its user base, but also license revenue has very little or no cost against it, so it almost entirely goes straight to the bottom line.
It won't be a surprise that the big rally in the shares have pushed up valuations quite a bit. The sales multiple is already in SaaS territory, but the 22 cent in quarterly profit suggests that the company's 12-month EPS run rate is close to a dollar.
That actually makes the shares still very reasonably priced, especially if you take management at its word arguing that 2019 revenues and operating profits will be substantially better.
At first sight, the shares look like a no brainer, with explosive growth, amazing operational leverage, cash generation and profitability and still very reasonable valuations.
But there are some things one has to consider as well:
- The big jump was almost entirely the result of one big customer. Now, we tend to argue that when there is one big customer taking the leap, and this becomes a success, getting the next big customer becomes easier, and that's clearly what management also suggested.
- Not all revenues are recurring like the license sales or upgrades, which are one-offs. The professional services help customers set the system up, customize it, familiarize them with the possibilities, etc. and tend to decline over time.
- However, its processing business is growing faster than its licensing business, and this has the double advantage that these are recurring revenues which generate considerable leverage over existing infrastructure.
- Selling more licenses does have the double benefit of increasing its base of users and it involves very little additional cost, almost all of it goes straight to the bottom line (the license income itself, not the servicing).
So we think this is still a good buy.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in INS over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.