2023-09-21 02:18:53 ET
Summary
- I recommend a buy due to the strong secular trend of digitalization in the banking industry.
- Despite temporary growth slowdown, Q2 Holdings is expected to see a resurgence and accelerate its growth.
- The company's strong booking momentum, increased ASPs, and improved win rates suggest sustained demand for digital banking solutions.
Summary
I am recommending a buy rating for Q2 Holdings ( QTWO ). The strong secular trend in digitalization within the banking industry is a strong and inevitable one. While growth has slowed down due to macroeconomic conditions, this does not mean that the secular tailwind is over. I expect growth to return once we get past this weak period, and QWTO should see growth accelerate.
Business description
QTWO is a provider of secure, cloud-based virtual banking solutions. The company enables regional and community financial institutions and other relevant entities to deliver a suite of integrated virtual banking services. QTWO has had an outstanding performance over the past decade, with consistent positive revenue growth every single year. Revenue has almost doubled since 2011, from $27 million to $598 million in LTM2Q23. However, due to the rising rate environment, growth has slowed down to low teens in FY22 and recent quarters from the previous 20–30+% growth rates. The current ongoing debate is when QTWO will reach EBITDA-profitable status, and as of 2Q23, the business generated $3 million in adj. EBITDA, providing hope that it will turn profitable over the next few quarters.
Financials / Valuation
2Q23 sales were $154.5 million, up 10.1% from the prior year's quarter and in line with the consensus estimate of $154.3 million. QTWO's user count increased 7.4% to 21.7 million at the end of 2Q23. While ARR increased by only 7% to $681.2 million, RPO increased by 11.7% to $1.53 billion. Due to an increase in subscription income, gross margins also increased by 290bps to 54.2%. As a result, adjusted EBITDA of $17.6 million exceeded the expected $15.3 million.
Based on author's own math
Based on my view of the business, QTWO should see growth accelerate back to its previous levels (20%) over time. My assumption is based on the fact that digitalization within the banking industry is an inevitable one. The slowdown seen in QTWO over the past few quarters is simply a delay in investments by the banks given the macroeconomic situation. As soon as we get past this weak period, growth should return. The booking trends also further support my view that demand has not died down yet. That said, given that QTWO growth is slower than its peer Alkami Technology (expected to continue growing at 20 to 30+%), it makes sense that it continues to trade at a discount for the time being (Alkami trades at 5x forward revenue).
Comments
During the most recent quarter, QTWO achieved its best ever first-half bookings total. The underlying tendencies were also very promising, lending further support to the company's near-term outlook. In particular, QTWO's ASPs have been on the upswing, increasing by 30%, and I anticipate that this ASP growth will continue as lower-tier deals begin to close the ASP gap. QTWO's 2H23 win rates also increased, reaching over 50%.
As a result of the expansion in ASP, many of our Tier 2 deals from the first half had an initial bookings impact similar to our historical Tier 1 For example, our largest deal from the second quarter was with a $3 billion credit unit. Source: 2Q23 earnings
I anticipate that the growth momentum in bookings, which directly influences revenue, will persist. I believe there will be a sustained demand for consumer-oriented retail and commercial digital banking software solutions, driving this growth. The banking industry is vast but has generally lagged in digitalization , particularly among larger banks burdened by legacy operations that are challenging to transition to digital platforms. In my view, two primary factors contributing to this are cultural and technological. Cultural change is difficult and requires internal efforts, whereas technological upgrades and shifts present the value proposition of QTWO.
Given the ongoing trends in digital banking , banks are recognizing the imperative need for upgrades, or else they risk falling behind their competitors. This is especially true in the current era, where younger generations prioritize convenience and mobile-centric solutions. Consequently, I expect QTWO to continue benefiting from this long-term trend and to remain in demand among financial institutions that historically underinvested in customer-facing banking technology. Additionally, the current interest rate environment provides further positive momentum for QTWO. Unlike the previous zero-interest-rate setting, where lending and growth were relatively simple, higher rates and reduced loan demand have prompted banks to refocus on retaining existing customers. This underscores the importance of consumer-facing technology to ensure customer retention and loyalty.
This gives me confidence that growth will continue to be positive and will pick up as the economy improves, allowing more financial institutions to free up funds for tech stack upgrades. In terms of profitability, I believe margins should expand accordingly as revenue growth. One factor that should boost gross margins is the expansion of high-margin subscription revenue streams like Innovation Studio's. Keep in mind that Innovation Studio was mentioned as a major factor in the success rates. Two, it is expected that operating costs will decrease as a result of the current emphasis on productivity through better utilization of existing workforce, offshoring, and internal leverage of automation.
Q2 Innovation Studio has become a significant differentiator in virtually every digital banking opportunity. It continued to be cited as a key driver in the majority of our digital banking wins from the first half and was included in every single digital banking win in the second quarter, whether retail or commercial.” Source: 2Q23 earnings
The year-over-year and sequential decrease in operating expenses as a percent of revenue were driven primarily from improved cost scaling to revenue within sales and marketing and research and development through the effective utilization of our global workforce and enhanced productivity which more than offsets the increase in G&A expenses which were predominantly related to third-party fees. Source: 2Q23 earnings
I think, we've talked in the past about back office automation, staff augmentation, efficiency projects being the areas that people are looking to trim right now, is it largely the same tune on that front?” Source: 1Q23 earnings
In general, I hold a positive outlook for QTWO's future. Despite the challenges posed by the unpredictable macroeconomic conditions and the departure of First Republic from the platform, there is a noticeable increase in subscription revenue, and the management is implementing additional measures to reduce costs. Despite these obstacles, my optimism stems from the consistent flow of new business deals secured by the company and the long-term trends that I believe will drive the adoption of digital banking solutions.
Risk & conclusion
Q2 will need to allocate substantial resources to sales, marketing, and R&D if it is to continue growing in a highly competitive market. The time it takes to reach profitability could increase if unexpectedly high costs are needed to maintain rapid growth.
Overall, I recommend a buy rating for QTWO due to the strong and inevitable secular trend of digitalization in the banking industry. While macroeconomic conditions have temporarily slowed growth, I anticipate a resurgence once these challenges abate, with QTWO poised to accelerate its growth. The company's strong booking momentum, increased ASPs, and improved win rates in the second half of 2023 suggest sustained demand for digital banking solutions. The cultural shift towards digital banking, driven by the convenience demanded by younger generations, and the need for technological upgrades in the banking sector further support QTWO's growth prospects. Additionally, the current interest rate environment favors the retention of existing customers through digital solutions. As the economy improves, financial institutions are likely to allocate more funds for tech upgrades, potentially boosting QTWO's profitability.
For further details see:
Q2 Holdings: Digitalization Secular Tailwind Is Inevitable In The Banking Sector