Expert Insights from Aaron Silva, President & CEO of Paladin fs
Moderated by Timothy Chiodo, Payments, Processors, & FinTech Analyst at Credit Suisse
The following is a republication of a report by Credit Suisse.
Insights & Discussion with Core Banking Expert
We [Credit Suisse] hosted an expert call with the President & CEO of Paladin fs, a national research & consultancy firm that specializes in bank & credit union contracting for core banking & ancillary technology services via the likes of FIS, Fiserv, Jack Henry, etc. (with this expense often the second largest cost for many banks behind payroll). Our expert started the firm in 2007, and began negotiating fees on behalf of banking customers in 2009, with an emphasis on financial institutions under $25b in assets. Paladin fs is approaching ~200 transactions and has assessed hundreds of additional US financial institutions. Our expert also founded the Golden Contract Coalition with an aim toward organizing hundreds of institutions & ~$1b in core IT contract revenue.
General Tone is Cautious Near-Term, More Balanced Medium-Term
Our expert was cautious over the near-term for the core banking providers given the current environment (expectations for a pull-back/delay of portions of incremental or discretionary technology spend previously planned for 2020, potential for “extend and blend” re-negotiations to provide a degree of near-term relief for banks, potential for contracted recurring revenue streams to be pressured by account & transaction growth, asset declines, etc.) although more balanced over the medium-term (benefiting from contract extensions, added product commitments, opportunities to upsell & cross-sell, and a need [enhanced by COVID-19] for banks to invest behind digital & omnichannel services, albeit with the potential for third-party FinTechs in ancillary services to be a larger part of the conversation once spending returns).
Bank IT Spend in 2020
Our expert speaker believes that a portion of banks may forgo plans they may have had for incremental discretionary technology spend (e.g., addition of a new ancillary service, improvement or upgrade to existing services). For context, we consider bank technology provider revenue growth to be sourced largely from four buckets: 1) account & transaction growth (number of checking accounts, debit cards, transactions processed); 2) incremental add-on product sales (e.g., bill-pay, Zelle, RTP, online banking, etc. sold by core providers and integrated into the core system) including upgrades to more dated versions; 3) CPI-based escalators (which only work to the upside); and 4) new client additions, term fees, & other (e.g., asset size noted as an approach employed more by JKHY) – the expert believes incremental portions of category number two are most at risk, while the transactional portions of category one will also be pressured near-term (per FIS COVID-19 Q1 2020 update, which called out headwinds in issuer processing & account transaction volumes within Banking Solutions). The expert suggested that a sub-set of banks may look to expand spending in digital products (particularly in light of COVID-19), which he believes would be tilted omnichannel offerings (online accounting opening, loan originations, mobile, etc.) and shifted into the later part of 2020 – banks may also increasingly consider third-party FinTechs (outside their core provider), weighing the potential for improved consumer experiences vs. additional costs and/or integration hurdles.
“Extend & Blend” to Support Banks Near-Term, Benefits FIS & FISV Medium-Term
Further, the expert believes that banks may look to re-open contract negotiations with core providers ahead of schedule, attempting to trade near-term and/or blended discounts for a deepening of the relationship (e.g., contract extension by ~2-3 years, commitment to add incremental ancillary services over time). Banks taking this approach are coming to the table with a more data-driven approach (i.e., market intelligence, pricing data), but also with a willingness to extend terms and add new services to the overall relationship. The banks & credit unions benefit in the near-term by reducing their expenses during a challenging year, while FIS, FISV, JKHY, etc., stand to benefit medium-longer term via expanded customer relationships (including the opportunity to continue to upsell & cross-sell over time).
Finxact, Neocova, Nymbus, & Emerging Core Providers
While our expert was positive on the prospects for Finxact, Neocova, Nymbus, etc. over a ~3-5 year time period, he did not expect their progress to hinder the trajectory for the legacy platforms over the medium-term. Finxact was highlighted as a platform being well received by the marketplace, with its Core-as-a-Service & Open Core API approach resonating. We note that Finxact recently announced that it now has 14 US contracted customers, including soon to be announced $20b & $90b regional banks the will run new digital bank offerings on Finxact. The company counts both Accenture and Deloitte as SI partners to aid in the implementation of these projects. Finxact investors include SunTrust Banks (now Truist), Live Oak Ventures, American Bankers Association (ABA), Accenture Ventures, First Data (now Fiserv), and others. Neocova was also mentioned as a new, emerging platform. We note that in January 2020, Neocova raised $9.5mm in a Series A round (link) made up of several community banks, all of which intend to be clients on the platform (Coastal Community Bank, First Financial Bank, Kearny Bank, and others).
Billing Differences Amongst Providers
According to the speaker, all three of the large providers bill based on a combination of factors that range from AOF (number of accounts on file) & transactions (usage) to other factors such as assets (size of bank). Further, there can be minimum amounts attached to certain services, along with a degree of bundling. All three providers tend to employ (although we gather these can be negotiated at times) CPI-based pricing escalators as part of their contracts. While Fiserv and FIS tend to skew more toward AOF & transactions (which generally come with reduced unit pricing for the bank customer as its platform grows – i.e., AOF fees tiered by scale), Jack Henry billing tends to be more asset-based (at least relative to FIS & FISV).
1) a sub-set of banks may prefer to work with third-party FinTech providers for certain ancillary services (e.g., digital consumer facing products), but a combination of inertia, contracts, and fees associated with accessing data within the core make this more challenging for banks & credit unions; 2) while emerging core platforms may provide a degree of negotiating power for banks & credit unions, the reality is that migrations involve term fees, de-conversion, conversion, staff training, and management bandwidth (resulting in just ~2% annual turnover); and 3) current contracts with core providers have fewer exclusivity provisions vs. ~10 years ago (allowing banks & credit unions the right to switch providers for certain services).
Credit Suisse View as it Relates to Covered Companies (FIS & Fiserv)
We detail our views on bank technology segment within our industry slide deck (theme # 29 touches on core banking platforms, revenue growth components, competition, etc.). We believe that in a normalized environment, the bank technology businesses at both Fiserv and FIS are positioned to sustain their more recent (pre COVID-19) top-line trajectory, fueled an increasing need for banks to modernize their infrastructure (due to “barbell” pressures) by leaning on technology providers (with Fiserv and FIS in the pole position given existing core account processing relationships). We believe that next-gen core providers (e.g., Finxact, Neocova, MAMBU, Nymbus) have the potential to be extremely successful in their own right, accumulating more bank customers over time (with ample room for growth ahead). However, given a large marketing (~11k banks, albeit consolidating at negative ~3-4%) and a limited number of contracts up for grabs each year (~200 banks per year, or ~1-2% of the market) - even with a great deal of success by next-gen platforms, we believe it is unlikely that a meaningful financial impact would be felt by FIS, Fiserv, and/or Jack Henry over the foreseeable future. Further, bolstered longer-term FCF profiles (following mega-mergers) increase their ability to invest (both via organic/innovation and further bolt-on M&A). In the near-term, COVID-19 impacted environment, we continue to view both FIS & FISV as relatively well positioned within our coverage universe. And while not without revenue and EPS impacts in 2020 and into 2021 (albeit more manageable relative to V & MA with greater cross-border exposure [earning meaningful premiums on these transactions], and GPN & SQ with greater SMB acquiring exposure), our analyses of the various sub-segments of these business lead us to conclude that current near-term dislocations (which, given macro headwinds, could persist) provide attractive risk-rewards for a set of high-quality businesses that are relative share gainers in attractive secular growth end-markets (including for Neutral-rated FISV). Further, we believe both have a degree of cost flexibility to help protect earnings, either by delaying investment (e.g., $500mm innovation investment for FISV, ~150bps of incremental delivery investment for FIS) or by pulling forward cost synergies (current targets of $1.2b for FISV, $400mm for FIS).
Replay Dial-In Details
A replay of the call will be available through April 21st. Dial-in number: (855) 859-2056, conference ID 2759419.
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