FOOL ON THE HILL
An Investment Opinion
A Checklist for CheckFree

By Matt Richey (TMF Verve)
May 23, 2000

I don't know about you, Fool, but fiddling with bills is one of my least favorite chores. Writing checks, licking envelopes, making sure to send the bills before they're due -- disgusting stuff. And let's not even talk about the price of stamps. So when I saw the chance to become "check free" and automate many of my recurring payments, I jumped at it. My bank, Wingspan.com, and many other Internet banks offer unlimited online bill payment for free. Plus, the ability to schedule the exact day of payment allows me to maximize the period of time during which I earn interest on my balances. Saving money and, more importantly, saving time have made me an evangelist for the joys of online bill payment.

Whenever I'm this happy as a consumer, I figure there's got to be an investment opportunity lurking nearby. In this case, it's not the online banks, discount brokerages, or other bill payment distributors -- nope, too much competition and heavy lifting there. But if you look below the surface, you'll find that most of the online bill payment providers, including 23 of the top 25 U.S. banks as well as Yahoo!'s bill payment service, all run on the technology and service platform of CheckFree Holdings (Nasdaq: CKFR).

CheckFree is far-and-away the first mover and top dog in the electronic billing and payment space. All the way back in 1981, founder and CEO Peter Kight developed the first electronic consumer bill payment system as a way to expedite annual payments at his health club. Now, nearly 20 years later, CheckFree is still in the lead, holding at least 75% of the market. Even so, the company is just beginning to show its true promise because consumer adoption of online bill payment is only in its infancy.

As I mentioned earlier, I've been telling most of my friends how great Internet banking is -- and these are folks who use the Internet daily -- but almost none of them have yet made that crucial step into the convenient world of e-finance. I think it's only a matter of time. Online bill payment poses a clear and present value proposition to almost every adult out there.

Currently, out of approximately 101 million households in the U.S., only 3.5 million households utilize online bill payment. As you can see, penetration is low right now, but that number is expected to soar in the years ahead as consumers increasingly integrate the Internet into every aspect of their lives. Comfort with the Internet and an always-on connection in the home should both serve as catalysts. Prognosticators seem to agree. Market research firm Jupiter Communications is calling for 18.4 million online-bill-paying households by 2003. Goldman Sachs projects 35 million households by 2004.

With all this growth projected, you'd think CheckFree's valuation would already have much of that growth potential priced into the stock. But, no, that's not really the case. A market value of $2.1 billion based on run-rate sales of $319 million doesn't seem too outrageous considering the potential to multiply sales tenfold over the next five years. Consider also that as CheckFree gains scale, I would expect the company's technology platform to show operating leverage that would allow net profit growth in excess of sales growth.

So the question becomes, what metrics should investors focus on in the quarters ahead to identify if CheckFree is emerging as the Rule Maker of electronic bill payment? I propose six financial standards that will reveal whether CheckFree is a Maker or a Faker:

1. Sales Growth -- In the most recent quarter, CheckFree grew sales by 27%, which marks an acceleration from past quarters. Spurring that growth was strong 9% sequential quarterly subscriber growth -- the highest in eight quarters -- which brought the total subscriber base to about 3.3 million. If online bill payment is really taking hold with consumers, then the year-over-year sales growth pace should accelerate.

2. Gross Margins -- CheckFree's gross margins have held steady at about 40% for the past two years. CheckFree's investment potential will be much greater if it can grow sales faster than the associated costs. That would reveal itself in higher gross margins, which would indicate that CheckFree's model has operating leverage like that of a software company.

3. Net Margins -- For the past year, CheckFree has hovered around the break-even level, so net margins have been around 0%. Look for this number to expand in the quarters ahead as the company gains scale. Again, if scale becomes apparent through rising margins, then that would mark a major inflection point in CheckFree's business.

4. Net Cash -- Here's a number to pay especially close attention to. Over the past year, CheckFree's level of net cash (cash minus debt) has declined steadily from positive $21 million to negative $29 million. A business that's bleeding cash isn't a good sign. Success in CheckFree's model would reveal itself in a reversal of this trend.

5. Flow Ratio -- Without any inventory, CheckFree operates with fairly lean working capital requirements. Over the past year, the company has improved its efficiency even further on this front, as revealed in a Flow Ratio that's declined from 1.34 to 0.96. That's a nice increase in efficiency that helps conserve much-needed cash. Investors should watch this number and hope for more of the same.

6. Cash King Margin -- Finally, like any successful business, CheckFree needs to begin generating positive free cash flow. Over the past nine months of the current fiscal year, CheckFree has actually lost $9 million in cash. As a percentage of sales, that's a negative 4.1% Cash King Margin. Like the other margins listed above, this number should increase rapidly with sales growth. But if not, that would be a very bad sign.

With an eye to these metrics in CheckFree's upcoming quarterly financial results, I think a Fool should be able to capably assess the company's investment potential. The cool thing about a company like CheckFree and an industry like electronic bill payment is that we as consumers can use our life observations to give us insight into a potentially lucrative investment. The key is to look to the numbers for confirmation or denial of what our common sense seems to reveal.

If you're new to online bill payment but curious to learn how it works, go to CheckFree's homepage and give the demo a whirl. Other research resources include the following: