Wide-moat Fineos’ (ASX: FCL) second-quarter 2024 update shows continued progress toward sustainable cash flow generation. We remain optimistic about Fineos’ earnings outlook, which is driven by product up/cross-selling, new client wins, and strong cost control.

Free cash flow generation has improved considerably from prior quarters, mainly from cost reductions. Amid these measures, the firm still secured a new client, and numerous product upsells with existing core business clients, demonstrating its product utility. While the loss of two clients is disappointing, these are noncore clients, meaning they are not part of Fineos’ core customers of life, accident, and health insurance carriers. This makes the impact immaterial to our unchanged $3.10 per share fair value estimate.

Shares remain materially undervalued at the current price of $1.63. Free cash flows for the six months to June 2024 more than doubled to EUR 5.3 million from EUR 2.3 million in the previous corresponding period (“PCP”). Customer receipts were broadly flat from the PCP despite reduced reliance on one-off services revenue, indicating growth in recurring revenue with greater product uptake among existing customers. Operating cash outflows reduced by 8% from the PCP, decreasing as a proportion of customer receipts.

The firm secured a new client contract, and prospects for new deals are strong, with two ongoing negotiations in North America, where Fineos is the preferred vendor. Projects with major clients, Guardian and New York Life, are on track for implementation later in 2024, which should enhance recurring revenue.

The two impending client losses do not affect our investment case. One client, BCG (Britannia), reportedly discontinued its usage of Fineos due to changes in its business operations, not because it switched to an alternate provider. The other departing customer uses Limelight, an ancillary (rather than core) product of Fineos, which we estimate contributes minimal earnings.

Business strategy and outlook

Fineos is a core software vendor to the global life, accident, and health, or LA&H, insurance industry. Customers are primarily large multinationals and midmarket insurers. The firm generates revenue mainly from subscriptions and product implementation services. About 75% of revenue is generated from the US, the rest from the Asia-Pacific and Europe.

Fineos help insurers streamline workflow, save costs, and win new business. Benefits of Fineos’ products to insurers include automating/unifying work processes, centralizing data, reducing the time to market for new products, and enabling greater user interface, assisting business wins and client retention. Fineos is currently migrating customers to a cloud-based offering (from on-premise products). This makes it easier to roll out new features and support at lower marginal costs, while also providing more recurring subscription revenue.

The firm executes a classic land and expand strategy. Building on its leadership in claims and absence products, Fineos aims to cross-sell its broader product set including payments, billing, data and more. It intends to expand the use of the Fineos platform across multiple jurisdictions with existing multinational clients. Higher customer expectations, cost pressures, regulatory requirements, or increasing competition are prompting insurers to switch from clunky internal systems to external software like that from Fineos.

There is ample room for Fineos to deploy new modules to existing customers and grow penetration over time. This further increases switching costs. To date, more than half of insurers globally still use in-house legacy systems with limited functionality and high operating costs. Fineos has built multiple reference accounts from doing business with large insurers, who help with additional business wins.

Risks include competition from larger competitors, and customer concentration, which may limit price hikes. These may be offset by Fineos' high switching costs and the risk aversion of insurer clients in changing core systems. Fineos’ product switching costs are contingent on the group continuing to invest (such as in product development) to add value to customers.

Moat rating

Fineos has a wide economic moat built on switching costs. Its comprehensive product suite performs mission critical functions for life, accident, and health, or LA&H, insurance carriers. This customer cohort also demonstrates substantial risk aversion to changing software providers due to the importance of running a seamless, uninterrupted insurance business. Fineos is a niche player in the LA&H space with few direct competitors.

Operating metrics are trending in the right direction, with generally falling customer concentration, excellent customer retention, decade-long customer relationships, and ongoing growth in annual recurring revenue and revenue per customer.

FINEOS’ insurance customers are stickier than ordinary enterprise customers like in retail or manufacturing. Around 75% of revenue are derived from the US, and more than half of them are large, Tier 1 insurers (with annual written premiums of over AUD 2 billion). Notable customers include seven of the 10 largest LA&H insurers in the US. It also works with large multiline insurers in Europe, Middle East, and Africa; has a 70% share in the Australian group insurance market; and processes 100% of accident claims in New Zealand.

While insurers specialize in assessing risk, they are themselves typically risk averse, skeptical to new technology and often scrutinize software vendors rigorously. As a result, a majority of insurers (around 55%) still hang on to decades-old legacy systems that have limited functionality and high operating costs, and herein lies the opportunity to build a moat. Software vendors who can crack the inertia can secure a long duration income stream, and use existing deals as blueprints to win over other insurers. And this is where Fineos has chosen to operate. It is an early mover providing a full-suite solution specifically designed for LA&H insurers. We estimate 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.

Insurance software has prolonged sales and implementation cycles, which help Fineos capture more touch points across an insurer over time. Switching costs strengthen as Fineos cross-sells new capabilities (beyond its flagship claims and absence products) like billing, payments, engagement apps, data analytics, and more. Insurers are more likely to install one capability, then expand their uptake over time, rather than buy the full suite (module) at the get go.

 The sales and implementation cycle lasts around 6-12 months, which comes with implementation services like training, configuration and integration. 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. The move to migrate clients to the cloud allows for much faster deployment of product updates/features. New software versions are made available to clients twice a year, whereas the upgrade cycle is longer when the software is hosted and managed entirely in-house.

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. A hypothetical competitor who comes out with a better (presumably faster and more seamless) product than Fineos only wins half the battle. Another 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. We point to Fineos’ growing software revenue per customer.

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. As Fineos establishes itself across geographies, we also think it will be an obvious choice for prospective customers looking for external LA&H software. We agree with Fineos’ focus on creating a superior product and nurturing its business relationships (through cross-selling value-added features). 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. Drawing from Majesco’s accounts (before its acquisition by Thoma Bravo), we estimate Fineos had around 4 times fewer customers than Majesco as of fiscal 2020, but its revenue per customer is more than double that of Majesco’s.

Customer concentration has generally been falling, which reduces the risk of value destruction in the unlikely event a customer leaves. Fineos reduces proportionate revenue contributions from flagship customers by up/cross-selling to other customers with less product holdings. We estimate as of fiscal 2022, seven out of Fineos' top 10 customers delivered revenue growth from the previous corresponding period, versus seven in fiscal 2021 and five in fiscal 2020. In fiscal 2019, the three largest customers made up close to 50% of revenue. This reduced to 35% in fiscal 2021 as other customers onboarded more modules.

Moreover, we estimate that more than 60% of Fineos’ carriers are monoline LA&H carriers who do not sell other forms of insurance like property and casualty, or P&C. This minimizes the potential risk of a P&C software vendor nabbing a Fineos customer sometime down the road.

The capital intensity of Fineos makes it lower returning than accounting software (like Xero) or financial planning software counterparts (like Iress). We estimate Iress and Xero spend on average 25%-50% of gross profits on product development (including capitalized expenses). For Fineos, this has been around 60%.

The blessing in disguise for Fineos is that the investment costs to enter the LA&H vertical are prohibitive enough to discourage new entrants. Potential competitors, like Guidewire and Duck Creek, are themselves are busy building switching costs in their own turf.

By our estimations, Fineos’ competitors currently don’t have the earnings capacity to develop a LA&H software as comprehensive as Fineos. Moreover: (1) the need to adhere to the capabilities of different insurance lines, statutory rules and regulations globally is prohibitive; and (2) the difficulty in overcoming the risk aversion of insurers is substantial. This explains why insurance software vendors tend to focus on winning from legacy systems and operate in their niches, rather than actively take business away from their vendor peers.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

Get Morningstar insights in your inbox