Chit Chat Stocks - nCino (NCNO) | Fundamental Analysis

Episode Date: November 8, 2020

On this week's FA, Ryan and Brett, analyze nCino the bank operating system. nCino is a financial technology company founded in 2012. Your hosts, Ryan and Brett, cover a lot in this episode. Ryan gives the business overview (0:57), Brett covers the current valuation (5:15) and Ryan dives into the earnings (7:19). Right after the break your hosts cover nCino's moat (9:26), any further reading (11:07), what the future growth opportunities are (13:02) and finally highlights and lowlights (15:27). Please enjoy this week's FA! Subscribe to 7 Investing with the code "CCM": https://7investing.com/subscribe/ Watch this episode on YouTube: https://youtu.be/Ye5r0o2WfHw Follow Chit Chat Money on Twitter: https://twitter.com/chitchatmoney Visit our website to see more from your hosts Ryan and Brett. https://www.chitchatmoney.com --- Support this podcast: https://anchor.fm/chit-chat-money/support Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investment. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are not financial advisors. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guest is not formal advice or a recommendation. Now, please enjoy this episode. all right we're ready to roll today the sunday show hopefully at this point the election is done at least if you're in the united states here and can focus back on your normal life uh because we were talking another company today and is encino how are you feeling about them

ryan uh how am i feeling about encino yeah i like them it's a good business um valuations a little here and there, but I'll just get into what they do. Encino provides a cloud-based bank operating system. So Encino's goal is really to streamline all customer and employee interactions through their operating system. So they tout the transparency that the platform creates for all sides. So customer, the bank, third parties, they all get access to the same information through this cloud-based platform.

And they have basically three primary components to the business. So the Encino applications, which is client onboarding, loan origination, deposit account opening, and then there's the Encino platform, which the applications were built on. So all the – so the platform helps take care of business process automation, so sort of the workflow for the banks, and then compliance and risk management, and then there's the 360 client view and reporting. And then lastly is their Encino IQ. This is – It's new though, right? it's like launching this fall correct i think it's launched they said it's like or maybe it's in beta they were mentioning on the conference call that it's like either very early days or

about to launch okay so this is basically their ai so their artificial intelligence machine learning tool and financial institutions can add this to their subscription uh basically you can scan documents and immediately extract important data they can automate loan originations and stuff like that basically all the good things that artificial intelligence could do the the banking interns are like wow they are they uh coming for my entire job yeah it feels like they might be removing some of the banking employees some of the grunt work yeah right uh but a little bit about the history encino was actually started by two bankers in 2011 at one of the uh top small business loan originators in the country the two bankers are chip mayhan and

neil underwood and this is why they really they really advertise their slogan built by bankers for bankers. So basically they were working for a bank and they were like, how can we automate this process? And I guess they were developers as well. And they did that. Encino is now headquartered in Wilmington, North Carolina, and they have some big name customers like Barclays, TD Bank, SunTrust, but then they also serve the smaller regional banks as well as credit unions. The CEO is Pierre Naudet. I might be getting that wrong. I believe he's from South Africa and he has been there since the founding yet he owns only 1.6 percent so here's what i'm taking away from this it looks like they struggled to get funding initially they had a nine million dollar

friends and family round early on and i'm sure it's a little daunting for a lot of vcs or seed investors to say yeah we're gonna go in sell to the biggest banks in the world and uproot their entire operating system. That seems like a tall task. So sorry, Jeffrey Horring is a representative or a managing director at Insight Partners. That's a venture capital firm. They now own 46.6% of the shares outstanding and they got that ownership at $8 a share. So I have to imagine they got pretty favorable terms at some point when Encino needed the money because right now shares are what 77 bucks yeah 77 bucks they just ipo'd this summer and that kind of indicates to me that they're a low float stock right now because i'm sure that that half of those shares

that are owned by that vc is in the lockup period so it'd be um if i held the stock right now i'd be worried that when the volume you know or sorry when the lockup period ends um inside partners is likely going to want to sell all their shares or the majority of their shares to give it back to their partners for profits because they've probably been waiting for five six years um i don't know that that'd worry me if i was but that it doesn't guarantee it's gonna they were the first vc in on encino so they got like whatever it is 47 basically at the price they probably chose and then two years later bessemer venture partners and i think one other one came in at like two times the price or something so i've got a feeling insight sort of uh exploited encino at a bad time but

now as shareholders it looks like they're doing all right yeah they're doing quite well i'll reiterate all those with this valuation here they have an enterprise value about 6.6 billion ticker ncno price 77 or around that uh trailing evita sales is 39 uh which everyone knows that's very very high. EV to gross profit is 70. Again, a very high number. And then margin adjusted EV to sales is 139. That's the metric we like to use to kind of include trailing revenue growth. Although when we say this number, it's not a guarantee that revenue growth will stay the exact same. That's probably something that can actually adjust quite a bit compared to the other margin metrics. That's about 140 for Encino right now, which is very, very high. If we look at the average of the

companies we do it's about 50 um they have no dividend price to sales not necessarily easy easy to sales which it's a little different but still 140 is um it's expensive right it's yeah typically still in the range of 50 to 60 yeah and then they have no dividend because they just went public uh you know shares outstanding are going to be increasing but really that's just post ipo they have about 330 million in working capital from their ipo funds their largest liabilities are deferred revenue and they have really small amounts of liabilities in general so it smells to me like a stock that you really don't have to worry about share dilution more or sorry you do want to worry about share dilution because that's how they're funding a lot of their operations but

they're not funding it through debt so it's just the give and take when evaluating the stock do you know the share count what it looks like have you did you read that well i mean it went up a lot because of the ipo so it's hard to tell but um they're stuck by compensation i believe gosh it was like 14 million of the revenue last quarter or the first six months six months first six months uh which is sizable number because of what you have here 93 million in revenue so yeah around 15 to 20 which is high but in 2019 it was a lot lower um so there might be some inflated statistics because of the ipo people you know changing shares when the company goes public Okay, I'll get into the earnings then. This is for the first six months of the year. They had 93.5 million in revenue. That's up 51.2% year over year. 79% of that revenue is from subscriptions versus professional services. The year prior, it was 71% subscriptions. That's good because the subscription gross margin is 70%, whereas professional services actually has negative gross margins.

Wow. And so professional services is basically the onboarding, the implementation, and basically everything you're going through in the sales cycle other than going out and reaching out to the client. I'm sure that goes under operating expenses, but sort of customer service, implementation, that kind of thing, very low margin. And then they had a negative $19 million in operating income for the first six months or a minus 21% operating margin. Last year, they had negative 18.5% operating margin, so going the wrong direction, but they are cash flow positive. They had around $32 million in operating cash flow for the first six months and $29 million in free cash flow.

Most of that ad back came from deferred revenue and stock-based compensation. About 40% of operating expenses was spent on R&D. Another 40% was spent on sales and marketing. It's basically split equally between those two, and they had nearly $400 million in cash following their ipo yeah not bad not bad and we gotta hit the ad here but first we want to talk about our friends at seven investing uh we say it on every show but you can get ten dollars off uh your first month with the code ccm or using the link in our show notes uh you that means that your first month is only seven dollars which we think is a bargain and if you use this code it's

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all right welcome back uh next up is digging trenches so what do you think about the moat rating here ryan i think it's pretty high i think uh it's just the nature of their business the long sales cycles, the customer lifetime value, and how long they stick around for, and just how large their clients are, how long it takes to implement everything across all their branches makes it pretty sticky. But I also don't have a great grasp on the legacy systems and how sticky those are, or even how hard it is to switch. So it's kind of a double-edged sword in that way, but I don't think once people have switched to Encino, they're like, all right, I'm willing to switch again in a year yeah they don't have so two yeah they don't have economies of scale um they

may have a network effect just because of all the banks working with each other on the one platform uh but they probably have high switching costs because if they're going on to these giant banks with hundreds of analysts and workers and load loan originators things like that uh switching to this cloud-based system is probably better than the legacy system and then if there's nothing even close to being better or even if there's something that just slightly better they're not going to want to leave encino it's also not even it's not the sexiest business in the world like a bank operating system isn't really as appealing as some other software companies i imagine it's not as exciting so maybe that deters some competitors and there's also sort of barriers to

entry uh because a you have to have a foot in the door with big banks and you know it's cost intensive to figure out all the regulatory and compliance stuff behind it yeah i'd agree all right uh if you or sorry further reading what's something that you'd want to look into if you're gonna research uh encino as an investment yeah who does encino have to replace so basically you know you think about the big banks the wells fargo's the uh chase how many i forget the other two big four jp morgan jp morgan bank of america bank of america uses them actually really yeah okay so i mean i'm just curious what they use now how hard it is for them to switch um like is this sort of a business where they're like if it ain't broke don't fix it kind of thing

if so that kind of makes the sales cycle a little more cost intensive for encino but on the flip side it makes them last longer as well as customers yeah yeah definitely i mean it's just that double-edged sword long lifetime value for these type of companies but also they may have to have a lot of onboarding costs and a lot of marketing costs so that's a give and take what are you looking for uh my question is because i worry about whether they're going to run up into not having any customers you go after. So will other financial businesses, funds, investment funds, RIAs, brokerages, financial advisors, would they benefit from using Encino? They say that there's 28,000 businesses that are in their target market. I wonder how many of those they're

actually going to be able to get. I know right now they already have 1,200 or something around their customers. It worries me about that. So that's something I want to research, especially with a valuation hat trailing EBITDA sales of 40. Yeah, and I know that they also reach out to credit unions and smaller regional banks, but I'm curious. Well, that's in the 28,000 for sure. Yeah, yeah. I mean, that is how much market penetration do they have?

Somewhere around a little less than 10%. Yeah. All right. What about future growth opportunities? Okay, they just signed Barclays. That's a big announcement. that was in mid-october and it's one of the largest banks in the world uh if they become standard at the top 20 or so gigantic banks worldwide i know there's about four maybe eight

in the united states that would kind of be up in that getting close to a trillion dollars in assets or over a trillion dollars in assets that seems very valuable um i don't know what the lifetime value of a customer would be there what kind of retention they can get uh you know can they get that expansion that you know the expansion rate they claim is very high upwards of 140 percent so if they can continue that they don't have to land new customers and if they're at these giant organizations um and they're saving these analysts so much time they're saving uh you know just cost from either overhead or just efficiencies with people working if they're saving a company like upwards of 100 million dollars a year um that's very valuable and they could be end up spending

you know 50 or so million yeah i'm just thinking about it now i i imagine like wells fargo jp morgan a lot of those banks throughout their different branches have sort of an in-house operating system yeah so that could be another thing and 50 million is a lot higher than what they're likely paying right now um and that's probably way on the high end but i mean it still is very valuable and it's kind of i don't know seems like uh something that could help them drive revenue growth without getting new customers. Yeah, I'm going to talk about Encino IQ. So this is their artificial intelligence slash machine learning program. So if they can get like really solid artificial intelligence for compliance and regulatory automation, that would be huge.

According to Thomson Reuters report, compliance costs for financial institutions have increased 13 year over year since 2017 i also spoke to jason moser this summer uh during my internship and he said he used to work at a bank if i'm not mistaken and he said uh having a system where when compliance changes or there's new regulatory rules that get changed and it's automatically uh updated that's not would be absolutely huge but they also put in their s1 that that sort of thing could attract more competitors because banks are willing to spend a lot for an automated software that automatically you know takes care of all your compliance and regulatory needs yeah it seems like the value there is it's strong it seems very very strong what about highlights

and lowlights uh okay they're already cash flow positive i think that's a plus so they likely not need to raise more money however all of their operating cash flow comes from stock-based compensation and deferred revenue deferred revenue one's not bad it just shows that they're getting more cash coming in than if they're realizing and if it's a subscription model this is likely going to stay like that over time unless they stop growing at all but the stock face compensation one you know you gotta include that in there because it is an expense and it will come back and dilute your shares so the revenue or cash flow per share will go down over time they say they have 147 percent subscription revenue retention rate thanks to their land

and expand oh sorry that was your note but i put that i had that i i read that as well i think that's strong sorry for taking yours there but i think that their lifetime value of their contracts are very very high maybe 25 to 50 million dollars if they can expand into even more things besides just that loan origination and analytics it means the upfront costs are going to lead to high margins down the line so maybe they have to spend a lot to onboard things like i said before but that could lead to gross margin expansion and cash flow expansion um over the next three to five years as the banks solidify themselves as an encino user um i like that they're on the sales for sales force platform um for marketing you know it helps them just double down on that without

having to bring on a ton of marketing team let sales force do that themselves however that can probably lower gross margin uh low lights though we discussed already amount of customers concerns me uh there are less than 5 000 commercial banks in the u.s and that number is actually shrinking so are you know is their target market actually going down over time as they're coming up against that ceiling that's something you really have to consider with this valuation and then i also had a question of whether they're getting a covid bump because everyone wants to transfer to cloud-based right now because of the work from home stuff is that going to be a temporary bump or a permanent one yeah i didn't see any bump in the numbers i think uh revenue growth was sort of consistent

across yeah that means are they getting a covet bump which means that the numbers aren't as impressive as you might think yeah i know i'm gonna say no on that and their other part that you touched on there uh which kind of goes into my low light i forgot to write down a low light but remember when we talked with matt cochran and he's like i don't think square uh is going to be a huge threat to the legacy banks but it could hurt the regional banks i think the number of customers outstanding could come down a lot um so their sort of target market might decrease but as far as highlights go it's a sticky business uh long the the customers stick around for a long time and the sales cycle takes six to nine months so it's not like they're constantly

onboarding new clients all the time it's really tough to do and if you think about it you have if you're a big bank you have multiple branches across the country let's say you you know you're implementing a new software system for all those branches you have to have tutorials at every branch showing people how to do it that's costly and so it's just it's more it's a more detailed partnership than just some software as a service companies yeah and you You have big commercial offices in New York City, L.A., Seattle, San Francisco, all the big – Chicago. You have those all throughout the country and maybe even internationally. That's something as well.

Yeah, they have demonstrated though that the land and expand model that they're offering where they kind of get the customers and then add on all these adjacent products is working. Like you mentioned, they have the 147% subscription revenue retention rate. that's really high and that shows that a lot of their banks are using their adjacent products as well yeah and then but that also shows to me that the 47 of their revenue growth is of that what was the total 52 so only five percent of it is from new customers yeah it's great 47 is great uh but how long can they do that that's something an investor will have to decide yeah i imagine because the new customers are so slow they're probably getting maybe it's cheaper prices at the start but also they're not adding they're not like doubling their customer count in a year

that's just not the nature of this business and so it's going to be big clients long sales cycles long lifetime value but they spend a lot of money with them yeah so that retention number may be the most important one for investors to follow all right last question before we head out of here are you more or less interested in encino i really do like the business um the valuation is hard to get around and yeah you know it's just one of those where you're kind of in the middle ground where you love the business so much but i guess everyone else does too and so it doesn't feel like there's much of an inefficiency there yeah feels like a great on it today but yeah it's uh the it's definitely something that goes on the watch list if there's a drawdown probably one

of the first ones i'd add to yeah i'm definitely less interested solely because of the valuation 40 EV to sales is high especially if you are not taking out a giant market opportunity and you're not growing that revenue that quickly so the the narratives can turn on you and you're there's no margin of safety priced into the stock uh i would love that if it ever came down to a trailing EV to sales of 10 to 12 um that would be fantastic because i think that's where you can get a lot of value here but that is a long ways away um so it's going to go on the watch list because i think it's a great business but a lot of people think that everyone thinks it's crazy to be like well you know you're waiting for a 70% drawdown like these things happen I am waiting and I'm sure you

could find a lot of SaaS businesses in the range from 10 to 15 EV to sales in March and or lower or yeah so I don't know I don't think it's too crazy to wait no definitely not all right that's gonna do it for this episode thank you all for listening use our promo code set for seven investing ccm at checkout to get ten dollars off remember we are not financial advisors anything we say on this show is not formal advice or recommendation email us at chit chat money podcast at gmail.com for any show recommendations or dm us at twitter at chit chat money thank you all for listening we'll see you on our next episode Thank you.

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