Tuesday, October 31, 2017

A current AIM Program Small Cap Equity Holding: NIC, Inc. (EGOV) by Alex Czachor. "Time to move on"

NIC, Inc. (EGOV, $17.25): “Looming Uncertainty not Received NICely”
By: Alex Czachor, AIM Student at Marquette University

Disclosure: The AIM Equity Fund currently holds this position. This article was written by myself, and it expresses my own opinions. I am not receiving compensation for it and I have no business relationship with any company whose stock is mentioned in this article.


NIC, Inc. (NASDAQ: EGOV) Provides digital government services that helps governments use technology to provide services to businesses and citizens.

• NIC currently holds 27 contracts, including multiple state governments.  One of their largest contacts - Texas - is up for re-bid this fall and if the company is unable to renew this contract it would have a material impact on NIC’s earnings.

• Competition represents a long term concern.  Currently this is not a concern as the company is facing little competition from big companies such as IBM, MSFT, or ORCL.  The lack of interest may possibly be due to the specialized and small industry in which the company is in, as it may not be profitable enough for the bigger players to pursue.  If the market grows, bigger players may enter in resulting in the loss of market share for the company.      

• The company currently does not have a contract with at least a third of the states, potentially creating an opportunity for growth.  

• In FY’17 the company won a contract with the state of Illinois, which will add up to $3 million in revenue represented as a one-time spike in operating profit for the upcoming year.

Key points: With uncertainty looming around the company in regards to the renewal of the Texas contract, the company was still able to provide some good news to investors in FY’17.  The new contract with the state of Illinois represents a six-year contract with an additional four one-year renewal periods extended through 2027.  As soon as NIC is able to deliver the initial phase of the permitting  and licensing systems to Illinois the company will then receive $2.4 mil, with an additional $600k sometime in the 1H’18 when the remainder of the platform is delivered.  This can be seen as a positive as it will create a one-time spike in operating profits, followed by additional maintenance fees throughout the duration of the contract.

However, as of late the company’s share price has experienced a bit of pressure due to the increase in uncertainty surrounding the expiration of their contract with Texas.  The Texas.gov contract represents approx. 20% of NIC’s revenue and added an estimated 30% of operating profit as of FY’16, making Texas one of their largest contracts.  Management believes that they will not be able to win the same contract they had with Texas prior as Texas is looking to diversify its portfolio of vendors.  It is possible the company will be able to save some pieces of the contract, but in the end will most likely experience a decline in revenue contribution from the state. 

Along with the loss of one of their biggest clients, the company is also facing potential risk due to their niche industry.  With more resources and firepower why is it that companies like IBM, MSFT, ACN, or ORCL do not enter into this industry and compete with NIC.  Due to their specific niche industry, its business is extremely specialized and small and it wouldn’t be worth it for large companies to enter into the market due to the lack of profitability.  Moving forward if the company continues to grow earnings, it is possible that one of these larger companies do look to compete within this industry and with large R&D teams it would be relatively easy to enter into the space and erode market share.

While the addition of the Illinois contract can be seen as a positive, there still remains an overhang in the stock until the Texas contract has been renegotiated.  Further, it is likely that NIC will be unsuccessful in retaining the total pie from Texas and because of this will lose some share in the upcoming year.  With the recent wave of uncertainty looming around the company, NIC’s stock has sold off 25.8% YTD.        
What has the stock done lately?

Since the company’s Q2 earnings report the share price has declined approx. ~12.2%.  Even though top line came in above consensus estimates, higher spending levels caused the company’s margins and profits to dip.  Resulting in the decline of operating margins by 200 bps as well as a slight decline in both net income and EPS.  The inability to sustain margins accompanied with the looming uncertainty surrounding the Texas.gov contract resulted in the selloff following the Q2 report.        

Past Year Performance: Year-to-date NIC’s stock has declined 25.8% to its current price of $17.25.  During the year the company reached a 52-week high of $25.90 and a low of $15.45.  Investor uncertainty has clearly been reflected in the company’s share price and with near term headwinds it is unlikely that there will be any strong growth in the stock into the foreseeable future.    

Source: FactSet

My Takeaway

While the addition of a new contract with the state of Illinois will benefit NIC, ultimately the outcome of the renewal process with Texas.gov will dictate whether this stock will prosper in the upcoming FY’18.  Texas.gov is said to be making a decision by the end of FY’17, and is unlikely to fully renew their prior contract with NIC.  As Texas is looking to diversify and add new vendors, NIC’s top line will be negatively impacted due to the large exposure the company had to the state ~Texas made up approx. a quarter of the company’s FY’16 revenue~.  Due to the strong likelihood that Texas.gov diversifies and lessens its exposure to NIC coupled with the continued uncertainty surrounding the stock as well as the lack of strong near term growth opportunity’s it is recommended that the AIM small cap equity fund should sell NIC (ticker: EGOV).