Go ahead and get started here. Thank you for joining us this afternoon. Very pleased to have Jack Henry & Associates here in this time slot. We have Mimi Carsley, the CFO and T reasurer, that we'll be talking to for the next few minutes. But before we get started, let me introduce myself. I'm James Faucette, a Senior Fintech Analyst here at Morgan Stanley, and I'll be hosting today's conversation. As we go through the conversation, though, if there's anybody in the room that has questions they'd like to ask, please feel free to raise your hand, and we'll get you a microphone. And finally, last important thing for me before we get started, please see the Morgan Stanley Research Disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So Mimi, great to have you here at our fintech conference.
Always great to spend time chatting with you about Jack Henry. But for those that maybe aren't familiar with your business, can you provide a quick overview of the three core businesses at Jack Henry, as well as the cohort of bank and credit union customers that you typically serve?
Sure. So Jack Henry is a well-rounded financial technology firm. So we do have three reporting segments that kind of typify our structure. The first is core. So you think about an ERP system for a financial institution. We serve credit unions and banks alike. So that is helping them everything from an account to posting interest on a loan to day-to-day back office operations. Really big, like 30 big nuggets of functionality, if you will, in a core system. That's about 1/3 of our business. The other 1/3 is payments. So we do both credit and debit card processing. We do enterprise payments, services around payments, and then we do bill pay, which is really migrated into bill management more than just bill payment. That's another 1/3 of our business.
And the remaining 1/3, I always like to say, if it's not core and it's not payments, well, then it's other. And that makes it easy for complementary, because complementary is just a portfolio in itself. That's where our digital assets are. That's where our fraud solutions are, our lending solutions are. And so we really provide from end- to- end. Jack Henry started at that core side of the business, more back office. But today we have more and more front-facing, member-facing, account-owner-facing applications, digital presentation applications. So really helping a bank or a credit union with any need that they might have.
Sure, sure. So let's start, and I want to spend some time looking at each of those different segments and how Jack Henry's positioned and delve a little more into the capabilities that you have there from a product perspective. But let's talk about the demand environment. How would you characterize the overall demand environment for your solutions right now? It feels like you continue to set bookings record every quarter while pipelines seem like they're being quickly replenished. So what are some of the key dynamics driving that, and how would you summarize the demand environment right now?
Yeah. So we operate primarily for domestic institutions. So we're very focused. Jack Henry has a really clear mission. We serve the U.S., primarily U.S. financial institutions. And so the demand cycle has been good for a number of years here, which has surprised some in recent years because of economic volatility being what it is. But the reality is that the institutions have development and need for technology to keep them competitive, to make sure that they are serving the needs of their members and account holders and making sure that they can use technology to help them on their growth strategy. So as I said, we started in the core side of the business over 48 years ago, and it was more back-end facing. And so in times of economic uncertainty or anything else, you could potentially slow down that train if it's back office.
Those who focus mostly on the Tier 1s, if we talk about the largest 30 institutions in the U.S., they have more development to do on the back ends to modernize these systems that are really old systems. But Jack Henry's core is really so advanced that what we're really serving most customers with today is that integration into things that are more around the efficiency of the organization, around growth strategies, around how to get deposits, how to get new members, how to get new account holders. And so those types of things, you really can't hit the pause button on.
Right, right.
Or you're just going to slow down and not be competitive. So in order for them to stay competitive in this world where you can bank anywhere, fields of membership for a credit union have exploded. And so for our customers to stay competitive, technology is at the center line of their strategy.
Got it. As a follow-up to that, it seems like tech spend growth at your end customers has been remarkably stable in a 6%-10% growth range. I mean, I guess maybe given the stability of the businesses, there is some variation there, but it's certainly not what we see in the broader economy. Have you noticed any differences in demand between that spend growth for core banking versus digital banking or even digital lending?
Yeah. So we do an annual survey with our customers. As you said, the most common response was growth around 6%-10%, which was great to see that continuation expectation. The top 3 priorities were around gathering deposits, were around lending, and then efficiency. So if you would have where spending you might see from year to year a little bit different depending on the need, I would say maybe five years ago, there was less around digital. So people needed to invest, particularly around the pandemic when branches were shut. People all of a sudden realized, wow, we really need to do digital. And when I see digital, I mean more than just how to pay a bill online. I mean every service that a bank or a credit union offers, how do you serve that in a way that doesn't require a face-to-face in a branch experience?
And so there still needed to be modernization. But as people invested a lot into digital, you still see that on the top five, but now you're seeing others. So fraud is a really big topic as well. You're seeing a lot of modernization in fraud solutions. So the beautiful thing about Jack Henry, and we have over 200 solutions, is it is a portfolio. And so we meet all those needs. And so depending on what is needed most at that time, we likely have a product to help serve it.
Right, right, right. Let's progress through the various businesses. We'll start with core. Adjusted growth there has been fairly healthy at around 8% through the first half of your fiscal 2024. We've seen about 24 competitive takeaways this year, putting it on a run rate broadly in line, but maybe slightly below what you've seen historically. We're not adjusting for size just in terms of the number of takeaways that you've had. For those competitive takeaways specifically, are the customers getting larger on average, and are they consuming more of your solutions upfront relative to historical trends? Just give us a sense of what those competitive takeaway dynamics look like right now.
So right now, our average both on the credit union and on the bank side is roughly about $1.2 billion, which is bigger than if we had looked maybe three years ago; it probably would have been just shy of $1 billion. So we're definitely growing. That growth is coming organically from our existing customers growing, as well as from being more and more successful and taking share in the larger size segments of the universe. So that's something we expect to continue. We have customers that are $50 billion today with aspirations of being $100 billion. We certainly have the tools and technology and operations to serve them and their growth. But we're also having great traction through, as we talk to clients about where we're headed from a journey and a roadmap perspective, they're really excited.
We're getting to have more and more prospects of these larger size institutions. It's hard. No one usually wants to come in and surpass and be your top number one. But we have roughly 20 customers that are over $15 billion in size, with many of those being over $30 billion in size. It helps us know what their needs are more and more. It also helps with prospects because we have more references for them to talk to. We're getting quite a bit of appetite in the larger universe.
Got it. As a follow-up to that, Greg has made a comment recently that as you've continued to win customers from larger competitors in the core space, those larger competitors have gotten increasingly willing to concede on price in order to try to retain the core business. How would you characterize the pricing environment right now for both renewals and net new opportunities?
So it has always been a competitive landscape, for sure. Aside from the three largest competitors, ourselves being one of them, there are many other core providers. Most people don't know it, but there's a handful of customers that may, they may only have one customer or four customers, but there's a lot of core providers out there. But it is a competitive field. A lot of FIs hire consultants to help them along with the contract negotiation, help them make technology decisions. Along with that comes cramming you down on price and contract terms. But we are very disciplined in our analysis. We know that we are not the low-cost provider. We are the value provider. We are the service provider. We are the best technology provider. So our customers come to us. It is hard to sometimes compete when people do unnatural acts to retain their business.
Once people make the strategic decision that they are going to change a core provider, either because they are getting poor service or because they're getting lack of innovation on their existing core, it's hard to go back. So they may be tempted when people are throwing some checks at them. At the end of the day, for them to progress in their own strategy, they need to align themselves with a technology partner that can bring the tools and resources to bear to help them achieve their strategy.
So can I ask you, historically, one of the key drivers on any given year was deconversion fees, right? So that was typically where your customer, a customer of yours, was acquired by another bank, usually. And then that larger bank usually had a different system, and they would choose to stay with that. And so you'd basically get paid out for the rest of your contract and that kind of thing. A couple of things there. First, it doesn't seem like there's as much of that happening right now as there has been historically, and maybe give a little context for if that's true or not. But secondly, as Jack Henry becomes larger and can do more, in the future, if there is more M&A, should we expect to see maybe a little less deconversion fee revenue generally, just because you're more likely to retain the customers overall?
Yeah. Deconversion revenue, it's an oddity. It is a revenue you do not want, really. It's great from a cash flow perspective, and it's like a nice little Easter egg of sorts, but it also means you've lost a customer. So to get that 7%-8% the next year, you have to overcome that loss. And so we actually treat deconversion revenue as non-GAAP because it is non-recurring in nature and hard to predict. The industry has been consolidating for four decades now at roughly 4%. But as you aptly called out, we're probably the low point of M&A that we've seen, at least in the last several years. The deconversion dollars, though, vary in every year. Yes, it is somewhat correlated to the absolute level of M&A happening in the industry, but it depends on who gets acquired. And it isn't necessarily size that indicates the dollars.
It's where they are in their contract life. So if someone just renewed and then happens to get acquired, there's a lot of terminal value left in that contract. If someone's six months before their renewal date, probably not a lot of value left in that contract. So this year, it is pretty low relative to historic levels. So hard to imagine it going much lower. I think as we grow, though, what I see is, one, you don't always lose all of the products. People tend to maybe switch the core, but they may keep the ancillary products. The other is you occasionally get what we call win a merger, which is the acquirer may typically is typically going to choose their system for the core. But if the acquired property has a better core and can demonstrate that, there have been occasions that we win both.
But over the long cycle of M&A, we tend to have M&A as a tailwind rather than a headwind for us. And that's because mostly it's our customers buying smaller institutions as part of their growth strategy. So that customer I said that's $50 billion today that wants to grow to $100 billion, well, they're likely to do that through M&A. So I think more of our customers are the acquirers than the acquiree in that sense.
Got it, got it. Thanks for that. So let's turn to the payments business. Growth is tracking at roughly 6% through your fiscal third quarter. If we look at volume growth at the card networks, it's probably closer to 5%. So you're still in line to maybe even slightly better than the networks broadly. But growth is still a little bit below your historical normalized range of 8%-9%. Recognizing we're still going through kind of the budgeting process, but how should we be thinking about the building blocks that could cause a reacceleration in the next year? Or do you think we're kind of brushing down into a slightly slower growth algorithm?
Yeah. So our payments business, we have three segments within payments. We have the card business, the card processing business. We're mostly a debit issuer. So we have about 1,000 FIs that we issue debit and process debit for. That's about 98% of the transaction volume, but only 90% of the revenue. We started back in credit offerings the last couple of years, mostly because we wanted our clients to have one platform to be able to do both on. So credit's been a slow grower, but a nice, and then also a nice defense to the debit side of the business. There, it's really tied to the health of the U.S. consumer. So as you say, aptly, we track in line with the major providers.
We tend to sometimes do a little bit above them because there's still penetration left, and we're still signing new banks, and we have new banks coming out of the backlog. So our growth tends to be there, but the U.S. consumer has proven to be quite resilient. You did see in the last quarter a little bit of a shift in transaction size versus transaction volume, where they were doing a little less volume, but a little higher ticket. We don't participate in the interchange. So we're kind of ticket size indifferent, if you will. We always joke that it doesn't matter if you're buying a latte or a laptop, we're going to have the same earning. I don't think that's a long-term sustainable trend.
Most people use their debit card more for everyday purchases like gas and groceries and dry cleaning than they're buying huge big ticket items for. But if that were to, that trend were to occur, you might see some impact on our financials if transaction volume were to decrease. But everything we're seeing, and we certainly track it on a daily and weekly volume, indicates that the U.S. consumer will remain strong. The other segments of our business are more enterprise- resilient- based. So we have the enterprise payments business. That's a big ACH business. That's a big remote capture business. You would think people don't write checks anymore. Businesses still write a lot of checks.
They write a lot of checks.
And so we help process a lot of checks for businesses. Then the last segment is our bill payment, bill management business. That's where you have the PayCenter , you have Payrailz and iPay business. And that's where a lot of exciting stuff is happening. That's where you're seeing the expansion of faster payments. That's where you're seeing more of everyone needs to have go on bill pay type of thing. That's ubiquitous. But now it's more around what are their ancillary services from an experience perspective. So can you pay a loan? Can you schedule? Can you do least cost routing? Can you introduce the new faster rails into that? So that's where that bill payment business is as well.
Got it. Finally, let's talk about the complementary business. It is, like you said, kind of everything else. In particular, within that, the rollout of Banno Business seems to be gaining nice traction with a fair number of clients being live and many others in the implementation phase. I think you're at about an 8% penetration of Banno users now with the ultimate intention of getting to 60%-70% eventually. How are you thinking about the potential uplift to ACV there?
Yeah. So Banno has been a flagship grower for our digital segment, and our digital segment has been a huge grower in our complementary bucket overall. It's an exciting time. So when we first launched Banno, we used to refer to it a lot as Banno Retail [view] . And then there was Banno Business. But I really think about Banno more of a platform. So today, Banno is still only within our Jack Henry base. So if you think about that 1,700 FIs, over 800 have Banno the platform, if you think about calling that Banno consumer or Banno Retail. But Banno Business is really just an add-on, the same way electronic statements would be Banno Conversations, Banno for Spanish. And so it adds that RPU, but it's an easier turn-on than it is getting the initial of the platform.
That's similar to others in the industry of how it operates. So as you have more functionality, as you have more complementary solutions on top of Banno the platform, you'll see RPU go up. But those users, as you have an FI come on, that FI user might turn on Banno Business. Well, that's for all of their active users. So where we have almost 12 million active users on the Banno platform today, you can really see that fueling future growth. So there's still penetration from a Banno platform. There's more we're doing in credit unions, for example. And the Banno Business is still early days in terms of the penetration there. But the great thing is we are now on parity. We have feature functionality for both.
I think by the end of calendar year, we will be at parity, if not surpassing others in the industry. Some of the customers who are waiting to have both that functionality for business and consumer have now the offering, a complete offering.
Got it. Got it. As a follow-up to that, do you think there's potential to change the growth profile of this complementary segment? Or do you still expect it to operate in the historical range? Kind of what's the historical range for that business? And what could, if anything, do you think move it up into a higher rate?
Yeah. I think there's probably two things. I think you run into a bit of the law of large numbers. It is a portfolio. And so there's some slower growers and there's some fast growers in it. Banno is obviously an anchor tenant for growth and exciting. So it's Financial Crimes Defender and Treasury and a lot of our other new and innovative products that we have coming out. But we also have some mature products there, some of which we're migrating. We migrated a product called Yellowhammer, now Financial Crimes Defender. So there is some migration story there. There's two things I think that can fuel future growth. One is just the continuation of digital and where that's going and Banno and all the adjunct products that come on.
There's also a lot of other products that you start to unlock when you get the tech modernization and things that we're talking about, DataBroker and dashboarding and insights, exciting new products in that space. The other way is over time as we continue to think about lifecycle management and addressing what might be some of the lower growers or things that have just matured, as we think more rationally about, is that a bundling? Is that a divestiture? Is that just cash cowing that can lead to raising the ship for all?
Got it. So let's talk about margins. On the margin front, I know this is an area that you've been spending a lot of time on in order to deliver more predictability and consistency to the shareholder base. So I have two questions related to that. So my first question is, with the ongoing transition to public cloud, Jack Henry is still running some of its own data centers given the residual on-prem mix. With the tech modernization strategy, are you envisioning any step function changes in margins associated with that transition? Or will it continue to be fairly gradual?
Yeah. The first, James, is integrity means so much to us. And we really want to put numbers out there that we can predictably, consistently, dependably execute and deliver on. It isn't that we don't aspire to more and we hope to deliver more, but we want to make sure that we hit every year in an additive, cumulative way to margin expansion. It's a key part of the value proposition for our shareholders. So margin expansion is near and dear to my heart. In terms of where that can get us, I think we'll be in the data center business for a while. So 72% of our customers today are hosted in a Jack Henry environment. You've seen that transition over many years.
I think you eventually get to a place of probably 90% where you have the last legacy of folks shifting from on-premise to hosted in a Jack Henry environment. But it's possible some people leapfrog that private cloud and go straight to public cloud. The nice margin tailwind that we get from on-premise to private cloud, it's about 2x revenue. And because we're a multi-tenant SaaS basis, there's very little incremental costs that go into hosting more from a data center perspective. And you might ask, why would someone pay you double? It's because the bank is not paying that cost anymore. Today, if it's on-premise, they have to pay for their own hardware equipment, millions of dollars for servers. They have to have their own CTO. They have to have their own resiliency plans, data recovery, just the data center management.
And so a lot of FIs are thinking about that part of our core competencies. Is that where we want to spend our resources? Or could we just put that to Jack Henry and continue to? So it's almost economically indifferent for them, but it allows them to focus more on their growth strategy. I think you'll see that trend continue. It's been at a nice healthy clip of 40-50 FIs a year. I think you'll see that continue. But I think that there's parts that moving to the public cloud. And as we ease that transition, both from downscaling our own private cloud, maybe doing a little colo as you migrate to a public cloud environment over time, some people will never want to be in the public cloud. And that's okay. We will have private cloud solutions for everyone.
Today, there are public cloud products today. Everything is being built digital cloud native API first. Banno is public cloud. Financial Crimes Defender is public cloud. Treasury Management is public cloud. Payrailz is public cloud. It's just the regulators aren't ready yet for core in the public cloud. I want to make that distinction. We're doing public cloud today. We're doing public cloud today very largely. It's just not core PII information. I think you'll get there. The nice thing about public cloud is there's a nice amount of margin expansion that comes with public cloud. Being able to buy compute at scale when you need it as you need to digest it versus having to maintain that level at all time allows for burst processing. The security infrastructure at the big public cloud providers is world-class. Being able to get the FinOps tools.
So some of those will have great margin expansion components to it. The other thing that we're not waiting on is we're doing a lot within our engineering department, as I call it, kind of write once, use often. And so as we write these components of tech modernization, we're trying to reuse them in as many products as possible. One, because it makes sense from a solution perspective. But two, it helps you from the interoperability, but it also helps you from the infrastructure management. Then you're only testing once. Your support cost is lower. Your customer service team training is lower. So we're doing more and more of that from an engineering perspective that I also think will have a margin impact.
So quickly, you mentioned regulators not quite ready for public cloud for core. What's your guesstimate as to when we might start to see that be more palatable?
Yeah. So I like to say that we're not constraining ourselves development-wise from a resource. It's not dollars that we're constraining. We're trying to develop the technology when we think clients will be ready for it and when regulators will be ready for it. So there are bits today, but I think it'll probably be three to five y ears before you see those full 30 components that we call a core today fully available in the public cloud where people have all of them. Now, we're helping the regulators think about process changes, how they can think about compliance and supervision in a public cloud domain the same way we did when we started Banno and we helped them kind of adjust to the adoption of the public cloud. So I think it's a couple of years off.
Now, that being said, the great thing about modularizing or decomponentizing, I don't know if either of those are actual words, but I'll just make up vocabulary. It sounds like it could still work. It sounds like it could still work. It should be a word. Is that it de-risks that migration. So today an FI will shut down on a Friday and you open up on a Monday and you're a completely new system. And every employee, every process you have that touches the core is changed. That's a big risk for an institution. And so by taking a modular approach to the core in the public cloud, you might have a regulator comfortable.
You might have a bank comfortable saying, "I'm going to take these three," or "I'm going to start one by one," or "I'm going to take a chunk," and do that phasing over time, which both completely lowers the risk profile of a migration, but it might also help the regulators think about the comfort of having PII in the cloud as well.
Got it. Let's go to my second margin question. How are you thinking about the steady state margin potential of the business longer term?
I don't like to go pretty much outside of three years at this point. Technology is evolving so quickly. But I think the near-term horizon, and we're just locking down the FY 2025 budget this month, but I think near-term horizon, and I feel very confident about that 20-40, which is our guide. Do we aspire for more? For sure. Hope to deliver more? For sure. But I know that the model can create the other.
Got it. Got it. Got it. So let's talk about free cash flow conversion. I know there have been quite a few developments recently just in terms of some of the tax treatment of development expenses. Last quarter, you had outlined two paths. One, that Congress passes that legislation, which will result in a swift return back to 80%-100% free cash flow conversion. Or secondly, it would be a "journey back to historical levels of free cash flow conversion." Any update there that we should be aware of?
Yeah. It's been a bit of a roller coaster year if we think about the last four quarters on the tax forecasting here. And had we known what we know today, it would have been easier guidance for sure. So last year, I would say about this time last year, our free cash flow was in the 50s range. We hit about $70 million-$80 million of incremental tax payments versus a usual year because of that 174. And for those who are not as familiar with tax code changes and how it works, it changed from being the deductibility of all the development expense happening instantaneously for tax purposes. For GAAP purposes, we still amortize it over its useful life. But for tax purposes, you used to be able to expense or depreciate all of that upfront.
The IRS said when the Jobs Act happened, that was supposed to expire. We all thought that Congress would address it, and unfortunately, it did not. So that deductibility expired, and you had to restart. You went from zero, and you had to restart building that depreciation bucket over five years. That had a significant impact on any company that did development. I heard Lockheed Martin paid an extra $900 million in taxes, but it also hit a lot of small businesses quite hard who were not anticipating it. So for Jack Henry, it hit us. Now, I think what we've gotten in the absence of legislation to address this on a more permanent basis. We did get guidance from the IRS, better guidance clarifying the position. Our own team did more digging into it as well.
So we've been able to mitigate some of that negative impact. So we're now guiding to that 60%-75% range from a free cash flow this year. Now, part of that is that effectively you would have overpaid last year. So there's a little bit of in-year benefit from that. But I think absence of Congress addressing this on a more permanent basis, you're back in that 80% range, 80%-90% range on free cash flow over the next couple of years. I do think Congress will address it. I think it's important enough post-election that either party winning, you will see it addressed, in which case we're back to that 90%-100%+ from a free cash flow perspective.
Got it. Last couple of minutes here. I want to touch on capital allocation and M&A, particularly historically, Jack Henry has been a very good acquirer of other companies, both in terms of the ability to integrate, get leverage on those businesses, and just expand the overall offering of Jack Henry. Dave, on the most recent call, sounded the most negative on potential M&A prospects that I've ever heard of, or at least in quite some time. To the extent that deals remain hard to come by, how are you thinking about the relative trade-off between a sizable buyback versus allowing cash to build on the balance sheet until the right deals start to present themselves?
Yeah. I think we're quite fortunate, Jack Henry, that we're not reliant on acquisition to fuel our growth. So we have a very strong organic growth engine, but we also have great development capabilities. And so from an innovation perspective, we're not reliant on external buys to fuel it. And I would say, well, Dave is probably disappointed.
Yeah, no. I'm sure.
Because I think we all thought that with the market realization and revaluation that you'd actually see some interesting products come to market and technologies come to market of companies that just weren't sustainable on their own, it just hasn't happened yet. But the reality is now versus five years or 10 years ago, there's less gaps in our strategy. So we've done such a great job putting our heads down and building when valuations just were out of control. We're a disciplined buyer. We're not going to chase properties. And so we put our heads down. We did a lot of building in-house. So if things come to the market, we'll definitely take a peek. But at the moment, we're just really not seeing much of interest. So from a capital allocation perspective, we continue to invest 14%-15% of revenue in R&D. I see that remaining consistent.
We have a long-standing dividend growth policy that we're committed to. So that'll stay consistent. We'll look opportunistically at M&A, but if that doesn't happen, we'll continue to delever and we'll look at share repurchases.
Got it. Got it. Well, that's all the time we have. Mimi, appreciate you being here today. And anything else?
Always great to spend time with you, James. Thanks again.
Thank you very much. Reach out to us. Take care.
Thank you.
Take care.