SSNC - SS&C Technologies: A Good Buy Based On Strong Fundamentals

2023-03-06 11:46:43 ET

Summary

• SS&C Technologies Holdings is deeply integrated software in the finance and healthcare sectors.
• A solid M&A track record and margin improvement should offset higher interest expenses.
• Management has outlined more M&A opportunities, alongside balanced allocations to share buybacks and debt retirement.
• The business is valued at an estimated 11x FY24 earnings.

SS&C Technologies Holdings, Inc. (SSNC) offers software-enabled services to financial services and healthcare industries, including hedge funds, private equity, and overall asset management as well as pharmacy and medical end markets. SSNC represents a good buying opportunity given its growth potential, primarily through future M&A, strong margins, and ongoing cost efficiencies derived from its Blue Prism acquisition.

According to the company's 10-K, on the finance side, their software services offer critical workflow functions: "comprehensive fund administration services to alternative and traditional asset managers, including fund manager services, transfer agency services, funds-of-funds services, tax processing and accounting." On the healthcare side, serving health plans and pharmacy benefit managers, they support: "core claims processing, operational software and high value applications for risk adjustment and quality management."

These end markets provide SSNC with longer-term growth runway and a sticky revenue base. A forward 11x FY24 earnings is an inexpensive multiple, which effectively prices in limited future growth.

Target Market & Growth

SSNC offers many different products and solutions for finance and healthcare across front, mid, and back-office functions with many use cases. In particular, SSNC competes with larger custodian operators like State Street, BNY Mellon, Northern Trust and CITCO Group.

SSNC details the quality of their product and service offerings on their website and their marketing resources speaks to the breadth and depth of their professional expertise in aiding finance and healthcare clients improve their operations and workflows. Overall though, a key reporting item is that SSNC has increased their net revenue retention rate from 90% to 95+%, a nice incremental gain showing the quality of their products and services has improved. For context, $5.28 billion in revenue against their reported 20K clients equates to an average contract of about 264K. By comparison, the median expected gross revenue retention rate of $250K contracts is typically 95%, so SSNC is at least meeting but probably slightly exceeding the average company.

About 78% of revenue is derived from North America and 22% from international, which bodes positive in terms of the company's geographic revenue diversify and growth runway into global markets.

Historically, the company has grown through M&A with various acquisitions, primarily financed with cheap bank debt financing. For about $7 billion in debt, the company has built an enterprise that generates about $5.5 billion in annual revenue and $1+ billion in free cash flow. Overall, that's a pretty solid outcome that indicates management clearly understands how to buy companies at reasonable valuations and implement some level of integration as the company has exploded in size yet margins remain consistently strong.

This isn't particularly new, but management outlined in the latest conference call that organic growth will be in the range of 2-6% in FY23. Management outlined key factors in the call stating that finance is generally upgrading their contracts, including upgrading onto new platforms, while healthcare has experienced some customer losses. My view is that part of that has been management intense focus on finance M&A and reinvestment, while healthcare has been the less focus of the two.

I'm generally in favor of companies that grow employees to expand the business, which also generally bodes positively for growth and employee. SSNC looks good on that front:

Most of this is due to acquisitions, but it's constructive that management isn't simply looking to layoffs to drive earnings growth.

Performance & Margins

The acquisition of Blue Prism in early 2022 for $1.6 billion appeared expensive on the surface at nearly 10x revenue. However, there are two important factors to consider. First, the company has quickly grown revenue from $141 million in 2020 to $201.2 million in 2022, or 19.5% CAGR, which is strong organic growth relative to the total enterprise of 4%. The company has already reached breakeven profitability in this unit. The second is that management has outlined that Blue Prism will help the company achieve historical EBITDA margins by eliminating time-intensive labor ( bold is my emphasis):

We have, for instance, validated 1,200 monthly client statement using digital workers, replacing over 40 hours of manual checking . We expect to have over 100 digital workers deployed by the end of the year and over 10x this number in 2023. In an era of high labor costs, Blue Prism will prove to be a very smart acquisition."

Management outlined that for every "digital worker transformation", they expect to obtain about $50K in cost reduction. They explained that their core focus is not layoffs, albeit there may be some redundancies, but rather the strategy applies to future attrition and incremental hires. The goal is to offset the wage and salary increases that will apply to SSNC's existing workforce. We don't know what the aggregate workforce salary increase would be exactly, but for argument's sake, rather than a 6% operating expense increase year-over-year, the company might only realize a 3% increase in labor ( bold is my emphasis).

But other than that, the productivity we expect out of the deployment of digital workers should offset some of the expenses that we would paid for higher salaries and other expenses.

With an estimated mid-point target of 2,000 employees for the end of 2023 and an employee base of 27,600, even if implemented to one-fourth of the company's workforce over time, there's excellent cost savings runway.

Between M&A growth, organic growth, economies of scale, and operating expense leverage, management is now targeting EBITDA margins of 39%. For context, an increase from ~35% to ~39% is approximately $200 million in additional operating profit. Although execution and time is needed, this would be in-line with the company's historical high back in 2014-2015:

If the digital transformation persists, EBITDA margins could have room to run above 40%. I think with enough time, the Blue Prism acquisition will prove to be one of SSNC's better acquisitions that will reward shareholders.

Over the last 10 years, free cash flow margins have averaged about 20%, which is also quite good for software. On that front, share-based compensation has also been reasonable over the last decade, and about 11% of FCF adjusted for changes in working capital.

Balance Sheet

SSNC has varied debt arrangements, including senior secured credit facilities and senior notes due in 2027. About 72% of the debt comes from the credit facilities, which is variable rate debt of $5.129 billion. A 100bps increase in the risk-free rate, or SOFR, would increase the company's annual interest expenses by $51.3 million. The average interest rate in the quarter for our amended credit facility including the senior notes was 5.64%. Before the credit facilities were the cheaper form of financing, but now the 5.5% fixed senior notes are the better part of capital structure. Fed Fund futures are topping out at slightly above 5% over the next year. All in all, TTM net interest expenses will increase from about $312 million to $436.8 million, or an increase of $125 million. That's a decent chunk of earnings, as shows the risk of not locking in debt financing. That said, total debt relative to EBITDA is very manageable around 3.8x.

Future Capital Allocation

Management mentioned they are now still looking into the market for further M&A opportunities at reasonable valuations ( bold is my emphasis).

We remain methodically opportunistic in our acquisition strategy, valuations have come down more in line with our disciplined strategy and we are evaluating several opportunities. We remain very bullish on our Blue Prism acquisition and we are wrapping our digital workers deployment throughout our business.

Fortunately now, SSNC is gushing about $1 billion in cash flow to internally finance M&A if necessary.

Beyond M&A, management stated that remaining free cash flow will be having a balanced approach of a 50/50 split allocation between buybacks and debt retirement. I think that's a good approach in order to return some capital to shareholders while maintaining their leverage ratios. With the expected improvement in earnings and EPS, buybacks appear to be a fair use of capital at 11x forward earnings:

Bottom Line

SSNC has largely grown through strategic M&A, which has boded incredibly well for the company and shareholders thus far. Of course, this space is crowded, but management has shown promise with its disciplined capital allocation and now has a formidable business that can stand up to the competition. The most significant headwinds to the business are higher interest rates and recent healthcare client losses. However, I believe that growth in finance and margin improvements, in addition to incremental M&A, should enable the company to post decent earnings growth over the next 5 to 10 years. Sure there will be hiccups, but for a growth business, the valuation isn't very demanding at 11x FY24 estimated earnings. I plan to accumulate shares in the coming days/weeks. How do you think SSNC will perform? Let me know in the comments section below. As always, thank you for reading.

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