Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Mark LaMonica: So, this is a big night for you Shani because it is Budget night.

Jayamanne: It is Budget night.

LaMonica: And you are a Budget nerd. But tonight, you are going to meet up with some friends and originally you were going to have them over but as we’ve said before, you purchased a house and you’re getting ready to move out of your apartment over the next couple weeks and you’ve managed to sell all of your possessions.

Jayamanne: Yeah, I mean I didn’t really have much to begin with but did manage to sell everything yes.

LaMonica: Yeah, so now you have nothing. You don’t have a place to have people over to even sit down.

Jayamanne: I’ve got a dining table so we can do like interview style.

LaMonica: Yes, well, anyway. So you’re going to go out and meet somebody but then you have to get home very quickly for Budget night.

Jayamanne: Yes – could you do that thing that friends do when they call and say “Oh there’s an emergency” when it’s a bad date, but I just need to get home for Budget night.

LaMonica: To get you out of this?

Jayamanne: Yeah

LaMonica: Okay, I can try to do that. But whether you have lots of furniture or no furniture, hopefully you will enjoy this episode and it’s something we haven’t done in a while – we’re going to do a share deep dive. And we’ll continue to do these on a semi-regular basis, so if there’s any particular stock that you’d like us to do an episode on, you can email us to the email address in the episode notes. 

Jayamanne: Today, we’re going to be exploring an Aussie stock that is on our Global Equity Best Ideas list and it’s currently a five-star stock.  

LaMonica: And that stock is FINEOS Corp. A disclaimer here that this isn’t going to be some sexy tech start up, but again, most good businesses are boring. 

Jayamanne: I think it’s pretty early in the podcast to declare that it’s going to be boring Mark.

LaMonica: I said the business was boring – not the podcast. But the podcast could be boring as well.

Jayamanne: Who knows, we’ll see. FINEOS is a tech company – they’re a software vendor that was founded in Dublin in 1993 with a mission to use modern technology to provide great service to their customers. 

LaMonica: But they’re a software vendor to the insurance industry. But please stick with us. 

Jayamanne: Customers are primarily large multinationals and midmarket insurers, and they generate their revenue mainly from subscriptions and product implementation services.  

LaMonica: About 80% of their revenue is generated from the U.S. and the rest from Asia Pac and Europe. And although they were founded in Dublin, they’re listed on the ASX. 

Jayamanne: Fineos helps insurers streamline their workflow, save costs and win new business.  

LaMonica: Their products help insurers by automating the work, centralising data and reducing the time to market for new products, and assisting business wins and client retention. 

Jayamanne: In other words, they provide a lot of value for businesses by automating administrative work that saves money, and win business which brings in money. It’s a win win.  

LaMonica: They’re also currently migrating customers to a cloud based offering –  from a desktop program. This means that they can rollout new features and support at a lower marginal cost, and they can also provide more recurring subscription revenue.  

Jayamanne: And so now is a good time to roll into economic moat – because these features are key to their wide economic moat that comes from switching costs. FINEOS has a comprehensive product suite so it is a one stop shop for their customers. The suite performs mission critical functions for life, accident and health insurance carriers which means that they are central to the business operations.  

LaMonica: And what this means is that their customers are extremely hesitant to switch products. They need to run a seamless and uninterrupted insurance business, and the friction that comes from switching software providers is just not a risk that they want to take on. 

Jayamanne: Adding to this, FINEOS is a niche player that doesn’t have that many direct competitors so there isn’t an abundance of software providers to choose from anyway. 

LaMonica: Let’s speak about competitors very quickly before going back to why Fineos has a wide economic moat. 

Jayamanne: There are large investment costs to enter the life, accident and health insurance vertical and this discourages new entrants. Potential competitors, like Guidewire and Duck Creek, are themselves busy building switching costs in their own turf. 

LaMonica: By our estimations, Fineos’ competitors currently don’t have the earnings capacity to develop a LA&H, that’s life, accident and health, software as comprehensive as Fineos. Then, adding to this is that the need to adhere to the capabilities of different insurance lines, statutory rules and regulations globally and this is prohibitive. 

Jayamanne: and then secondly, the difficulty in overcoming the risk aversion of insurers is substantial. When we think of insurers, they specialise in assessing risk but they are pretty risk averse themselves. Because of this, the majority of insurers, so around 55%, still have the same legacy systems that they had 10 years ago. The vendors who can crack the inertia can secure long duration income streams and use existing deals as blueprints to win over other insurers. 

LaMonica: A bit like a snowball rolling down a hill. 

Jayamanne: We talk about snowballs a lot on this podcast. 

LaMonica: We do. Especially considering that you’ve seen snow once in your life.  

Jayamanne: So what this has resulted in is insurance software vendors looking to replace legacy systems of clients instead of trying to poach clients from each other.  

LaMonica: When we look at operating metrics, they are trending in the right direction, with falling customer concentration, increasing customer retention and decade long customer relationships, and ongoing growth in annual recurring revenue and revenue per customer. 

Jayamanne: Now we obviously work in a subscription based service with Morningstar Investor. Those metrics are basically what keep us both in a job, and that’s what as investors, you’d be looking for in a strong and sustainable business in the subscription software space. 

LaMonica: When we take a closer look at retention, we can see that it’s stickier than ordinary enterprise customers in other industries like retail or manufacturing. Around 80% of their revenue is derived from the US, and more than half is large, Tier one insurers that have annual written premiums of over 2 billion Aussie dollars. It also works with 6 of the 10 largest life accident and health insurers in Australia, and processes 100% of accident claims in New Zealand. 

Jayamanne: And so Fineos has chosen to operate in this space. It is an early mover providing a full-suite solution specifically designed for LA&H insurers. Fineos' 10 largest customers are contracted with the company for an average of eight years, with the longest close to 20 years. This is validated by its mid-90s percentage retention rate, implying the life span of its customers is around 10-20 years. 

LaMonica: Switching costs strengthen as Fineos cross-sells new capabilities beyond their core product – so this includes add on products like billing, payments, engagement apps, data analytics, and more.  

The pattern is usually that insurers are more likely to install one capability, then expand their uptake over time, rather than buy the full suite at the get go. The sales and implementation cycle lasts around 6-12 months, which comes with implementation services like training, configuration and integration.  

Jayamanne: Clients typically return thereafter to sign up for an additional capability, necessitating another sales and implementation cycle. This multiyear engagement process creates a dependency on Fineos and really cements their switching costs. 

LaMonica: Ultimately, replacing core systems is a lengthy, costly, and risky ordeal for insurers. Customers are averse to changing core systems, as failed attempts at implementation carry high sunk costs. Switching costs include direct time and expense of implementing a new software, lost productivity, loss of data during changeover, and business disruption.  

Jayamanne: A hypothetical competitor who comes out with a better (presumably faster and more seamless) product than Fineos only wins half the battle. The other half is to get the insurer to disconnect Fineos across a complex web of processes and reconnect new ones, which is daunting as the perceived benefits from switching are often uncertain. To Fineos, this means revenue is more predictable as customers would mostly rather stick with the group than risk a years-long disruption with another competitor. 

LaMonica: We mentioned customers as reference points before. Basically, customers who use Fineos may become a reference point, boosting Fineos’ credibility to win new business--especially from larger prospects, who typically require multiple reference accounts.  

Jayamanne: As Fineos establishes itself across geographies, we also think it’ll be an obvious choice for prospective customers. And what Fineos are trying to do is focus on creating a superior product and nurturing its business relationships through the cross selling that we spoke about. This is so it can extract more money from the client and turn it into a reference account. In our view, this helps it win accounts steadily, versus aggressively tendering for business deals at the get go. 

LaMonica: Another plus for Fineos is that their customer concentration has generally been falling, which reduces the risk of value destruction in the unlikely event a customer leaves.  

Jayamanne: Okay, so I think that covers the economic moat and why we’ve awarded it a wide moat. 

Let’s look at risk and uncertainty. We’ve assigned Fineos with a high uncertainty rating. 

LaMonica: The first reason is that the insurance software market is ever evolving, so it’s difficult to project earnings. We’ll get to the fair value that we’ve assigned soon, but there’s uncertainty built into that because any changes in market share assumptions, particularly on winning clients or upgrading them, could materially impact earnings forecasts, and in turn, fair value. 

Jayamanne: Then, client concentration is a risk. We’ve mentioned that this is decreasing, but a likely downside from a large client with substantial revenue is where they leverage their purchasing power to halt fee increases, or even drive down fees. This would put the onus on Fineos to keep adding value to justify its pricing. We don’t envisage customers leaving, as they also stand to suffer should this occur – like we mentioned when we spoke about switching costs – there’s prohibitive hassle.  

LaMonica: We’d like to see falling customer concentration, before upgrading our uncertainty rating to medium. But – we’re seeing a trend towards this falling customer concentration so this may not be that far away. Then – there’s competition. We mentioned that competition wasn’t a huge detractor long term when assessing an economic moat, but competition will likely  constrain earnings growth in the near term. The strong growth runway in the insurance software market will likely attract more discounting, marketing or replication by competitors. We don’t anticipate a competitor to simply emerge and steal share, but there will be an ongoing need for Fineos to invest and improve its product, which may prolong the timeframe to cash flow breakeven. Heightened competition may also lead to slower deal wins, particularly from mid-downmarket insurers. 

Jayamanne: Lastly - Fineos is exposed to regulatory risks. Regulations which affect Fineos, or the operations of its insurer customers, may lead to a need to increase spending on compliance, reduced income, changes in product features, with potentially adverse effects on profitability. We’ll speak about profitability soon when we speak about fair value, but let’s go quickly to capital allocation. 

LaMonica: Fineos gets a standard capital allocation rating. As we’ve mentioned previously, this is the allocation rating that the majority of companies get and is not a sign that the company is substandard at capital allocation. It takes a lot to get an exemplary rating. 

Jayamanne: So this rating is based on the assessment of investment efficacy, balance sheet risk and shareholder distributions. As investors, all three of these factors are incredibly important to us because the decisions around them impact the future earnings of the company, as well as how the company grows those earnings.  

LaMonica: We rate Fineos’ investment efficacy as exemplary on grounds that it consistently prioritised higher-returning investments and has a sound track record of execution. This gives us confidence that its future investments will add value.  Fineos secured a dominant position in the life, accident and health, or LA&H, insurance industry--a less contested space than the property and casualty, or P&C, industry--at the get go. The firm had a short stint in the more competitive P&C space several years back, but promptly pulled out from this low-returning pursuit. This shows us that they know to cut losses when they need to to focus on more lucrative pursuits. 

Jayamanne: We spent quite a bit of time talking about their strategy to focus on their existing customer base and entrench their products further there, but We think this focus on quality over quantity is a more sustainable way to retain clients and compound earnings. 

What we’d like to see from Fineos is for them to generate positive free cash flows long term (which we expect to be around fiscal 2027) before we are comfortable in its balance sheet strength to both withstand a material downside event and self-fund its growth.  

LaMonica: The need to invest in product development or make feature-driven acquisitions meant that investing cash flows often outstripped operating cash flows, and this means that they need capital raises. Fiscal 2021's cash balance barely moved from fiscal 2018 levels despite revenue doubling over the three years to fiscal 2021.  

Prospective business acquisitions over the next five years will likely require equity raises. We do think though that Fineos is deploying capital sensibly to strengthen its economic moat and operating metrics are trending in the right direction. 

Jayamanne: Fineos doesn’t pay a dividend, nor would we expect it to given its medium-term focus on growth. Dividends or share repurchases are sometime away, and only when Fineos is at scale to generate maintainable profitability as industry growth plateaus. 

LaMonica: Okay – finally we’re getting to the juicy stuff. We’ve briefly mentioned so far in the episode that Fineos isn’t profitable yet. Let’s dive into that a little deeper as we look at fair value and profit drivers. 

Jayamanne: Our fair value estimate for Fineos is $3.40 per share. We expect Fineos to turn NPAT – or net profit after tax – profitable in fiscal 2025 – two years away. At this point our model suggests that NPAT will exceed 10 million euros by fiscal 2023, and exceed 40 million euros by fiscal 2032. 

LaMonica: We forecast Fineos to grow its market share of the circa USD 10 billion industry they are in – external core systems software by life, accident and health insurers. We expect growth to 1.9% in fiscal 2027, and then 2.2% in fiscal 2032. They’re currently at about 1.3% of the market.  

Jayamanne: We also expect that the mix of higher margin subscription revenue to grow to about 80% of group revenue by fiscal 2032, from around 42% in fiscal 2022. This is forecasted to happen as more of their customers move to the cloud based software which is higher margin than their current desktop offering. 

LaMonica: And this move to cloud based software will transform Fineos into a SAAS company or software as a service company. And investors do love that model for a lot of the reasons we mentioned earlier. The predictability of revenue through a software model and the scalability of the business which ultimately can result in really high margins if enough market share is gained.  

Jayamanne: As Fineos starts to build scale, they’ll improve operating margins to 19% by 2032. And we assume long-term gross profit margins of 72%, above fiscal 2022's 65%, which is strong. 

LaMonica: There is room for Fineos to earn more high-margin software revenue in the long term, but we have to keep in mind that there will be increased direct costs in the short term like cloud support expenses as the uptake rises for their cloud based services, and rates payable to the system integration partners.  

Jayamanne: These are promising prospects for future growth, and we think that Fineos is currently undervalued. It’s currently trading at $1.63 as at 3rd May, which puts it at a 52% discount on a stock with a wide moat.  

LaMonica: As listeners to Investing Compass know, we are advocates for ensuring that you buy good quality companies at compelling prices, but you also buy companies that are going to achieve the objectives of your portfolio.  

Jayamanne: A little bit about the company – it is a small cap at 500 million market cap, and it is in the software infrastructure space. It’s volatile comparative to the market when we look at its beta of 1.9 over three years, and although this is an attractive opportunity when we look at the price to fair value, it is currently unprofitable and does not pay dividends. It is unlikely that in the foreseeable future, that it will pay dividends to shareholders. 

LaMonica: This is a long term holding that is dependent on Fineos growing and maintaining market share whilst deepening relationships with existing clients. It is dependent on short term costs to disappear with scale and once software structures are set up. The main risks to this are regulatory, and large clients leaving, both of which are minimal in our analyst’s opinions.  

Alright so that was a lot of talk about insurance and insurance software so I think Shani, Will and I have earned a Duck Creek wine - so we're going to go out and try to find that but thank you very much for listening. We would love any comments and ratings in your podcast app.