ASX now home to the world's cheapest Wide Moat company
This moaty yet volatile small-cap stock hit another slump. Our analyst thinks the business is misunderstood and its shares severely undervalued.
Mentioned: FINEOS Corp Holdings PLC (FCL)
“Why do the prices of all these businesses move around so much each year, if the values of their businesses can’t possibly change that much? Well, here’s how I explain it to my students: Who knows and who cares? Maybe people just go nuts a lot.” Joel Greenblatt
If you ever needed proof that a business and its stock price are two separate things, consider the case of Fineos (ASX: FCL), a core software vendor to the global life, accident, and health insurance industry or LA&H industry for short.
Let’s start with how the shares have performed.
In the first two weeks of January, Fineos shares were up almost 20%. By the end of February, they had lost 25% from that peak. They then rallied 30% from February to May, lost 20% between May and June, rallied 25% from June to mid-July and dumped 30% from mid-July until now. Phew.
Now consider what Fineos the business did over the first half of 2024. I am quoting here from Shaun Ler’s summary of its recent earnings update:
“Fineos' first-half 2024 results met our expectations with revenue growth, a positive mix shift, and cost control driving improvements in gross profit and EBITDA by around 7% and 60%, respectively, from the previous corresponding period.
Gross profit and EBITDA margins improved by around 4% to 74% and 11%, respectively. Free cash flow more than doubled to EUR 5 million from EUR 2 million in the prior comparable period… notably, subscription revenue now comprises 54% of total revenue, up from roughly 40% three years ago.”
The overall trajectory of Fineos’ business does not seem to be changing enough to merit such big swings in its market value.
According to Ler, this stems mostly from markets misunderstanding the company’s story. And thin disclosures from management are doing little to help them do so.
Sticking points in the recent results included slow sales growth last year (up just 1.5%), client losses in non-core businesses and management saying that revenue in 2025 would likely be at the lower end of previous guidance.
Looking longer term, though, Ler sees Fineos as market leader with a sticky customer base, long-term growth opportunities and a clear path to higher profitability. Let’s start with why Ler thinks Fineos deserves a Wide Moat rating.
A niche player with staying power
Fineos is a niche player in the LA&H space with few direct competitors. Ler says its suite of software products performs mission critical functions for its clients, which demonstrates substantial risk aversion when it comes to changing software providers. Doing so could bring disruption that get in the way of running a seamless and uninterrupted insurance business.
Once Fineos wins a customer, the cross-selling of further capabilities like billing, payments, engagement apps, data analytics, only increases the future cost to clients of switching away. Not only do adopted modules embed Fineos deeper into their workflows, they also require upfront investments to set them up and train staff.
These factors are reflected by Fineos’ long customer tenures. Ler estimates that Fineos' ten 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, which implies that the life span of its customers is around 10-20 years.
A double-edged sword
The reluctance of LA&H insurers to change software systems is a double-edged sword.
On one hand, Ler sees it as a potential barrier to entry that could deter new entrants making the heavy investments needed to build a product as broad as Fineos offers. On the other, it has slowed the pace at which Fineos has been able to penetrate its target market. Ler estimates that around 55% of LA&H firms still use legacy systems with far less functionality than Fineos.
Ler says that software vendors able to crack this inertia can secure a long duration income stream and use existing deals as blueprints to win over other insurers. This one of two slow-moving trends he sees supporting the long-term value of Fineos shares.
Ler’s long-term optimism on Fineos rests on two key factors:
- Fineos earning a higher revenue from cloud-based offerings
- Fineos luring more LA&H insurers away from legacy systems
1. Switch to cloud-based SAAS offering
Fineos is on a multi-year journey to migrate its customers to a cloud-based offering from on-premise products. This will make it far easier for Fineos to provide support and new product features at lower marginal costs, while also providing the company with more recurring subscription revenue.
Ler says that migrating clients to the cloud also allows for much faster deployment of product updates/features, which could augment the company’s land and expand strategy. New software versions are made available to clients twice a year in the cloud, whereas the upgrade cycle is longer when the software is hosted and managed entirely in-house.
Overall, Ler expects the migration of Fineos clients to cloud-based offerings to support faster and more profitable revenue growth.
2. Winning more LA&H clients
Fineos is an early mover in providing a full-suite solution focused purely on LA&H insurers. And its progress to date has been impressive.
Seven of the US’s 10 biggest LA&H insurers are Fineos customers. It also has a 70% share of the Australian group insurance market, processes 100% of the accident claims made in New Zealand, and serves several mainline insurers in Europe.
Despite this, Fineos still only has about 1.3% share of the USD 10 billion Ler estimates is spent on external core systems software by LA&H insurers each year.
He thinks that Fineo’s strong customer base provides a solid base of credibility from which it can take more of this spending, as insurers often require several references before they are comfortable moving forward with a purchase.
Ler forecasts that Fineos can grow its market share to about 1.8% in 2028, and to 2.4% in 2033. This would amount to a revenue base of close to EUR 195 million in 2028 and EUR 300 million in 2033, which equates to annual revenue growth of around 9% per year from current levels.
Ler thinks Fineos shares are worth $3.10 each, an estimate that also builds in improved gross and operating profit margins as the company scales and continues its transition to a SAAS model. At a current share price of around $1.30, he thinks the shares are materially undervalued.
Value comes with significant uncertainty
Ler notes several factors that could affect the long-term value of Fineos – hence his Uncertainty rating of Very High.
Chief among these risks is Fineos’ high current levels of client concentration. This could limit the company’s ability to raise subscription fees as its customers leverage their position to negotiate back on pricing. While the switching costs we mentioned earlier make it unlikely that clients would actually leave, it could put more onus on Fineos to keep adding value to justify its pricing.
As there is a still a long runway for growth in the insurance software market, Fineos is likely to see a lot of competition from other solutions trying to grab market share. This could involve more discounting and companies investing to replicate Fineos’ leading solution. Ler doesn’t expect a new entrant to emerge and steal share overnight, but Fineos will need to continue investing to improve its product and stay ahead of the competition.
As Fineos’ current market share is so small, minor changes to Ler’s forecast in this regard could also have an outsize impact on his valuation for the company either way.
Considering potential downside risks like this is an important part of the investment research process. But remember – an individual share or investment shouldn't even be considered until you have a broader investing strategy in place first. Go here for a step-by-step guide on how to formulate yours.
Fineos
- Economic moat: Wide
- Fair Value estimate: $3.10 per share
- Star rating: ★★★★★
- Uncertainty: Very High
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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 more about how to identify companies with an economic moat, read this article by Mark LaMonica.