Higher One (NYSE:ONE), a payment solutions provider to higher education institutions, faces the perfect storm of lower enrollment growth, lower service fees, and increasing regulatory scrutiny. However, these challenges are more than offset by the steps taken by management in response, the secular demand for higher education, as well as the fact that the bark from regulatory scrutiny is almost always worse than the bite.
Buying when there is blood in the streets is easier said than done
The short-term challenges are overblown and cloud the bullish long-term outlook for three reasons.
First, the secular demand for higher education remains intact as it represents the single greatest determining factor in earning a higher salary. Investors should not be discouraged as every long-term trend experiences periods of weakness, which brings into question its strength and longevity. However an encouraging "green shoot" is healthier state budgets that typically result in increased community college funding.
Second, while fee changes resulted in lower revenue, there are important mitigating factors. These changes should silence critics and reduce pressure for further reform. For example, even though the FDIC only requested the elimination of one fee, the company eliminated 10 different account fees such as the fee for inactive accounts or insufficient funds. Moreover, these accounts are a low-cost alternative (link opens PDF file) to national/regional banks and offer similar features such as mobile banking. Companies that go above and beyond in response to a crisis (e.g., Johnson & Johnson with the Tylenol scare in 1982 for an extreme example) should be given the benefit of the doubt in the form of a higher valuation.
There is an overlooked long-term benefit in the form of greater account usage and "stickier" account holder relationships. For example, management said on the 2Q13 conference call that non-financial aid deposits are increasing while customer satisfaction is at the highest levels. The OneDisburse ID product, a combination of debit/campus ID card, should drive a higher rate of account holder retention even after graduation.
Strong growth in the campus solutions business and a significant decrease in the operational loss provision help offset lower service fees. Moreover, lower interchange fees mandated by Dodd-Frank should not affect the company as its banking partners have less than $10 billion in assets while the elimination of overdraft fees should have no effect as the company does not charge them.
Third, management effectively neutralized criticism by making significant compliance investments, implementing transparent and simpler disclosures recommended by Pew Charitable Trust, and even working with one of its most vocal critics (Public Interest Research Group).
On the 3Q13 conference call management announced a settlement agreement in principal that would resolve the outstanding class action litigation involving the marketing of its OneAccount suite. Management said the changed practices have already been implemented and are not expected to materially impact revenue. Furthermore, the Department of Education rulemaking committee is not addressing cash management, which removes a significant regulatory overhang.
Higher One enjoys a leading market position and attractive business model
The company is a market leader based on its market share and number of campuses that use its products (e.g., available at schools with about 13 million students, or about 60% of the higher education population). Its broad offering of value-added products and services ensures strong customer relationships and provides a significant competitive advantage.
These relationships remain strong for three reasons. First, since its founding in 2000, the company saved higher education institutions more than $300 million with its electronic disbursement system compared to the traditional paper method. Its system is more efficient, gets students their money faster, and provides the ability to detect fraud in seconds, not years. Second, the company helps higher education institutions comply with increasing and burdensome regulations. Third, its data analytics provide quantitative proof of the value of higher education.
The 98% renewal rate, multi-year contracts, and monthly account deposit fees provide high revenue visibility while declining capital expenditures drive significant gains in free cash flow.
For example, free cash flow rose 93% in the quarter ended in September for a yield of 9.6%, while capex as a percentage of revenue on a trailing 12 months basis declined to 4.3%, compared to 23.7% for the preceding four quarters. The company used this cash flow to repay $12 million of debt and buy back 15% of its shares in the past year. The fee it receives based on the prevailing interest rate should contribute in a more meaningful way going forward as rates eventually rise.
The significant economies of scale provide high operating leverage, which translates into a high percentage of incremental revenue (e.g.,from cross-selling, new products, or customer additions) dropping straight to the bottom line.
Increasing diversification reduces risk
Strong organic growth and acquisitions have resulted in a healthier revenue mix as the payment transaction and higher education institution segments have grown significantly. For example, premium payment transaction revenue rose 75% in the quarter ended in September while higher education institution revenue rose 51%.
Furthermore, account revenue as a percentage of total revenue declined from 85% in 2008 to 58% in the quarter ended in September.
The company faces competition from its primary competitor TouchNet Information Systems, as well as alternative forms of payment such as cash, checks, wire, ACH, and card-based payment systems. Although TouchNet is private, the following payment processing companies provide a sufficient peer comparison.
Alliance Data Systems (NYSE:ADS) provides transaction-based marketing and loyalty solutions, while Total System Services (NYSE:TSS) provides electronic payment services to financial institutions. Both companies, much like Higher One, have consistent growth, a high EBITDA margin of about 29%, high operating leverage, and high free cash flow. However, Alliance Data trades at 14.7 times trailing 12 month EBITDA, and Total System Services trades at 11.7.
Alliance Data and Total System Services have significantly outperformed Higher One year to date by rising 68% and 41%, respectively, compared to an 11% decline in Higher One.
Value maximizing shareholder base
In addition to the modest insider ownership of 13.3%, the company has a strong shareholder base consisting of private equity firm Lightyear Capital, who owns 18.9% after making a significant investment in 2008, venture capital firm Club Circle Partners, who owns 6%, as well as Wellington and Wasatch, who own a collective 19%.
Hedge fund Brave Warrior Advisors owns 9.9% and filed a 13D in September. Brave Warrior plans to meet with the board in order to increase shareholder value. Brave Warrior should receive a welcome reception given the relative underperformance while the concentrated institutional ownership profile significantly reduces the time and expense associated with persuading other holders of its shareholder-maximizing ideas.
The thesis should be reevaluated in the event of material adverse regulation (especially from the Department of Education, Dodd-Frank or CFPB), a significant decline in enrollment, or lower renewal rates.
Long-term investors can use these short-term challenges in order to buy a market leader with multiple tailwinds at an attractive valuation. However, investors may want to wait for a pullback after the recent rise driven by positive earnings. Remember, the best time to buy is when there is the most uncertainty, as investors who wait until all is well often miss most of the gains.