Nearly every business wants to develop a competitive moat -- an advantage that is difficult to replicate, making it tough to unseat the company from its place in the market. Those that succeed in that tend to gain -- and hold -- strong market shares in their industries, allowing them to generate strong sustainable earnings.
One business I think has the potential to develop a strong moat is cloud-based banking software company nCino (NCNO -4.38%). Here's why.
Planting a flag
It is difficult to succeed in the banking technology world. Financial institutions are known for their conservativeness, and replacing their core technology is a heavy lift because even as they bring new systems online, they still need to be up and running at all times for their customers. That's why so many banks still use outdated legacy systems and lots of manual processes. But between the long-term impacts of the pandemic and the general industry trends, updating technology is no longer an "if" but a "when" for most of these institutions -- and NCino could play a big role in these transformations.
In the core processing space -- creating the systems that banks use to facilitate daily bank transactions -- a handful of companies like Fiserv, Jack Henry, and FIS have won the bulk of the market.
While nCino isn't competing in this money movement space, it is providing a technological solution for a core bank operation. Its software helps banks digitize the loan origination process, seamlessly connecting front, middle, and back-office employees with clients and third parties. NCino bank operating systems automate much of the loan origination process, removing human labor in areas such as data entry. This speeds up the loan origination process and creates the potential for more volume.
It also provides banks with all sorts of analytical tools they can use to help with pricing discovery, staying on top of credit trends, identifying new opportunities, and much more. Built as a single cloud-based platform on top of the SalesForce platform, nCino became a critical tool for banks during the pandemic because it allowed the lending process to be more smoothly handled by people working remotely. It also was helpful for banks in managing their part of the Paycheck Protection Program.
In the core processing niche, sales cycles can be lengthy because installing new systems can create big disruptions for a bank, are likely to require a decent amount of training, and can involve big initial expenses, particularly for smaller financial institutions. For nCino systems, the same issues apply.
Once nCino signs a deal, its contracts are typically for three to five years. But the company uses a "land and expand" subscription model. So a bank may first use nCino to digitize its commercial origination lending platform. Then, it may start using some of nCino's analytical tools, and maybe later bring its software to other divisions such as consumer and small business lending, mortgage, or deposit account opening. The result of that is that the software enjoys long contracts that grow in value and increase client loyalty.
As the chart above shows, the small number of customers that started using nCino in 2013 have expanded their annual contract value (ACV) by 360%. However, larger, more recent cohorts are in the range of 120% to 180%. NCino attributed those lower subscription revenue retention rates in its fiscal 2022 cohort, which ended Jan. 31, to a higher mix of new customer sales with longer-than-expected activation schedules. CFO David Rudow advised analysts on the company's March 31 earnings call to look at 130% as a good long-term target. That is still a very strong net revenue retention rate. A customer's annual contract can start at a few hundred thousand dollars per year, and then ramp up to $1 million by year four or five.
Lots of opportunity ahead
Every time nCino signs a new financial institution as a client, its competitive moat grows because these are large and growing contracts, and there are considerable switching costs with these projects.
Moreover, nCino has generally helped its financial institution clients improve efficiency and grow revenue. It has only begun to tap into a serviceable addressable market it estimates to be $16 billion but as of the end of March, it was already doing some type of business with 12 of the top 25 banks in the U.S. Wells Fargo, one of the largest banks in the world, recently announced that it is expanding its contract with nCino.
The company is not yet profitable and is projecting to turn in an operating loss of as much as $35.5 million for fiscal year 2023, which ends at the end of next January. But it is projecting to grow revenue by about 46%. The company on a revenue basis is by no means cheap, trading at about 10.5 times forward sales. But given the flag nCino has planted, the effectiveness of its products, and the company's ability to hold and grow contract values, I think the company's competitive moat makes nCino a long-term buy and hold.