📍 TL;DR

• Fundamentally speaking, MITK looks like one of the market’s cheapest stocks.

• But the market is discounting risks related to delayed financials, and, more importantly, a series of patent litigation cases.

• The risks are real, but perhaps overblown. Valuation looks cheap enough for investors to take a swing.

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Fundamentally speaking, digital identity verification developer Mitek Systems MITK 0.00 is too cheap. The company has grown at an impressive clip for years and still has opportunity ahead. Any reasonable valuation method, based on what Mitek has achieved to this point and what’s likely to achieve going forward, would suggest that MITK is a steal just below $10.

The catch is that MITK is not just a fundamental story. Rather, there are two significant concerns not captured in the company’s financial results. One of those concerns, perhaps ironically, is that Mitek literally hasn’t delivered recent financial results; audited results for fiscal 2022 (ending September) remain incomplete, and Mitek hasn’t delivered unaudited results for the fiscal fourth quarter. The more important issue is legal uncertainty related to Mitek’s core offering.

Both risks are real, and worth considering. MITK has short interest of ~6.5% of the float, a not-insignificant amount for a stock with a ~$450 million market cap. It’s likely those risks explain the soft headline valuation and recent underperformance. Shares are up only 2% year-to-date despite a broad rally in small-caps (particularly small-tech). Since the end of 2021, MITK is -44%, while the S&P 500 is down 14%, even though value has outperformed growth during that stretch.

In other words, Mitek Systems stock is acting like it’s a value trap, not a value play. It’s acting like the market is trying to tell us something. The question is if the market is right. We believe, at this valuation, it’s worth betting that it isn’t.

source: Mitek investor presentation

Introducing Mitek Systems

Mitek (pronounced ‘my-tech’) develops technology, primarily for financial institutions, that centers on identity verification. The core revenue stream comes from solutions for mobile depositing of checks, which in FY21 accounted for 63% of revenue.

Mitek claims to be the originator of this technology. As we shall see, that claim is disputed. But what is clear is that Mitek has dominant market share. The company in fact appears to have close to a monopoly in that business. Other products, such as Check Reader, which extracts data from checks for financial institutions, build on similar capabilities for similar customers.

The remainder of the business primarily focuses on verifying users instead of checks. Mobile Verify is, as the name suggests, a tool for identity verification that combines image capture, biometrics, and document authentication to combat fraud. Mobile Fill captures data from an identify document and pre-fills online forms, minimizing time to completion and reducing friction. IDLive Face ensures that the facial image submitted to apps is ‘live’, and not a reproduction.

Those programs are just a sample of Mitek’s offering, which expanded in March. Mitek spent a little over $100 million on the U.K.’s HooYu, which combines biometrics with access to law enforcement and sanction databases. HooYu thus adds the ability to fight money laundering with the ability of the broader portfolio to fight fraud and satisfy AML (anti-money laundering) and KYC (know your customer) regulations. It also has an added regulatory component: it’s allowed to access U.K. databases for the country’s Right to Work and Right to Rent laws.

The Broad Bull Case

All told, Mitek offers a holistic offering (now under a platform called MiVIP) for financial institutions (and other enterprises) to fight fraud. That would appear to be an attractive business model at the moment, with the coronavirus pandemic increasing mobile usage and geopolitics creating ever-more sophisticated bad actors.

Indeed, this has been an attractive business model:

source: Mitek investor presentation

Admittedly, this growth is not all organic: Mitek spent roughly $115 million on acquisitions between 2015 and 2021.

But clearly Mitek didn’t just buy its growth, and the M&A strategy was a grand success for the MITK stock price. From the end of 2014 to the end of 2021, MITK rallied 436%, a 27% annualized return. Yes, markets in 2020-2021 were a little bubbly, but even in that context, and even with a sell-off toward the end of the multi-year period, MITK obviously outperformed.

Growth didn’t come to an end in FY22, either. Through the first three quarters, revenue increased 23%, with three-plus points of help from HooYu. Adjusted net income for the nine months rose 30% (though with a modest decline in Q3 which management attributed to investments behind the business, including MiVIP).

This looks like a stock that should be valued as a growth play. It isn’t. Shares trade at 10x trailing twelve-month adjusted earnings per share (as of FQ3, of course). There’s share-based comp (and a decent amount of adjustments) in there, but add back dilution and the TTM P/E is still at ~16x

Investors can debate over what, external factors aside, the ‘correct’ P/E should be. Given a lack of public peers and uncertainty in the market, comparisons can result in a reasonably wide range.

But we can point to Sterling Check $STER, which has a much lower-tech offering, weaker growth, and a worse balance sheet. Yet on both P/E and EV/EBITDA, STER trades at only a modest discount to MITK. The U.K.’s GB Group $GBGPF is an imperfect peer, but trades at more than 20x trailing adjusted EPS despite declines in FY22 (ending March) and 1H FY23. Both peers lay the groundwork for arguing that MITK, freed of external worries, could pretty easily double in 12 months.

Absolute models too suggest solid upside. Free cash flow nearly tripled between 2019 and 2021. Yet a basic discounted cash flow model at 12% growth for eight years, 3% long-term, and 10% discount rate values MITK just shy of $15, pretty much exactly 50% upside.

We don’t see those assumptions as aggressive (we’d argue the opposite, in fact). But the specific assumptions aren’t the point. However an investor wants to model growth going forward, MITK at the moment looks somewhere between “too cheap” and “way too cheap”, perhaps with an expletive thrown in for good measure.

Why Is MITK So Cheap?

Clearly, the market is not focused on the fundamentals. And so this is a bull case that relies on refuting the reasons not to own the stock rather than making the argument for actually owning it.

We’ll get to the two core reasons momentarily, but it’s worth also highlighting one obvious concern about the business itself. The most obvious, at least from a distance, is that Mitek is relying on people actually using paper checks at a time when that usage is in decline. Deluxe Corporation DLX 0.00, for instance, actually manufactures those checks (among other products) and its shares yield 6% and trade at 5x forward earnings.

Indeed, per the Atlanta Fed, check usage has been in decline since the turn of the century [pdf]. Check payments fell 7.2% annually between 2015 and 2018.

But Mitek is counteracting that decline in two ways. First, the share of those checks being deposited via mobile methods is increasing. Mitek last year commissioned a study that claimed, of the group of consumers who use banking apps, 53% deposited via mobile in 2022 against 43% two years earlier.

Secondly, Mitek appears to be taking pricing. The number of banking customers doesn’t seem to have increased much, if at all, in recent years. Again, Mitek dominates the market and has for some time. Yet revenue from mobile deposits has grown at a double-digit clip for a decade. That’s continued even during and after the pandemic (+11% in FY21, +16% 9M FY22) despite the tailwind behind digital payments.

Growth likely will decelerate at some point, but there’s still a large base of end customers for Mitek’s banking partners to capture, even as the total number of checks written continues to decline.

Delayed Financials

In May, Mitek’s auditor resigned. Mitek said at the time the departure was not caused by a disagreement, and the company brought on BDO less than two months later.

On Oct. 27, Mitek disclosed a modest restatement of its results for the first half, relating to its acquisition of HooYu. The Q3 10-Q was filed the following day.

Since then, it’s been mostly crickets. The most recent update from Mitek was on Dec. 19, when it said it was still gathering information for BDO, as well as evaluating deficiencies in its internal control over financial reporting.

The length of the delay is a bit of a concern. FY21 results were released in November, and the 10-K in mid-December. We’re now heading into February with no news on Q4 FY22. That concern is amplified by the fact that Mitek made a minor error last year as well. That one was also attributable to acquisition-related accounting.

On Jan. 4, Frank Teruel, the company’s chief financial officer resigned. The 8-K filing said that Teruel left “to pursue another career opportunity”. That resignation probably only adds to the market’s sense of unease.

Still, there’s only a little smoke, and no apparent fire. Teruel’s departure presumably did involve another job (though we could find no such information), and it’s also possible the Mitek board was not exactly sorry to see him go. Another 8-K on Dec. 20, related to a notice from NASDAQ related to the late filing, said Mitek “intends to file the Form 10-K as promptly as possible,” instead of delineating a plan to regain compliance.

From here, it appears the delay is not going to be material to MITK once the 10-K issue is resolved. It’s worth noting that while the stock hasn’t rallied, it also hasn’t fallen off the table since the 10-Q originally was delayed. Still, it’s certainly a risk worth mentioning, and monitoring.

The Legal Battle

And now we get to the biggest issue, which relates to Mitek’s potential liability for indemnifying customers from patent lawsuits.

At the beginning of the last decade, Mitek and USAA (a not-for-profit financial institution that serves military members and their families) engaged in a protracted patent lawsuit. As we allued to earlier, both companies claimed to have developed mobile check capture technology first.

The two companies eventually settled in 2014 in what looked like an agreement to simply forget the whole thing. Both companies kept their patents; neither compensated the other. The issue seemed to be in Mitek’s rearview mirror.

But in 2018, USAA sued Wells Fargo WFC 0.00 for infringing its patents. As one MITK bull has argued, USAA was acting as a patent troll. That moniker makes sense: USAA is not a software developer, nor had it shown any interest in licensing its technology until (per Mitek’s telling) roughly 2017.

Unfortunately for Wells, the two cases were heard in Marshall, Texas, which Bloomberg the prior year had called "The Texas Town That Patent Trolls Built". Wells lost both cases and settled for $300 million

Mitek isn’t party to any of these actions. But Mitek has received multiple indemnification demands arguing that the company should pay for claims arising from these suits.

In response, Mitek sued USAA requesting a declaratory judgment that its patents did not infringe on the USAA patents. Ostensibly, that judgment would relieve it of any responsibility for indemnification. That case was thrown out in 2021, and then restored on appeal last year.

We’re not legal experts, but the path from this point to financial ruin for Mitek looks exceptionally narrow. It bears repeating: Mitek has not yet been sued by USAA. As to the risk that it might be, USAA challenged the request for declaratory judgment, and the district court originally agreed. One core reason why, per the district court [pdf]:

The repeated testimony given during the Wells Fargo trial was that without significant customization by Wells Fargo, the Mitek Mi-Snap product does not infringe the asserted patent.

The appeals court which restored Mitek’s declaratory judgment request did not argue otherwise; it simply said the court hadn’t gathered enough information for a dismissal. Certainly, there is not much evidence to suggest that Mitek itself will be a target, particularly five years after USAA’s legal strategy began and given the 2014 settlement.

The risk of actual indemnification appears low for the same reason. It’s possible aspects of the other suit bring Mitek’s patents into play, but the stock hasn’t directly reacted to legal developments to this part. It seems likely legal risks are providing a general overhang — a $450 million market cap and news of $500 million-plus in indemnification requests is an unnerving combination — but there’s been no one-to-one moves in MITK during this legal battle with USAA (as there were last decade).

Of course, even if an indemnification request somehow held, it would do little for the parties, who would simply bankrupt Mitek in the process, in which scenario no one wins. And it’s not as if there is some alternative out there: USAA isn’t offering to sell its software, but simply license its patent for 85 cents per deposit.

So what needs to happen to truly tank MITK from here is:

• Mitek’s efforts to gain a declaratory judgment have to fail;

• Indemnification demands have to succeed, even though existing cases suggest its Mitek customers themselves who are infringing USAA patents;

• Those demands, plus any efforts by USAA, have to be structured in such a way to neutralize Mitek’s profitability but not ruin the company, and also presumably would leave untouched the identity verification side of the business which at 3x-4x revenue probably covers 30%-40% of the market cap.

• Mitek customers have to be comfortable essentially giving up mobile deposits, at least for some amount of time, instead of just paying a licensing fee to USAA or coming to some other global agreement that risks destroying a valuable and cost-saving technology.

We’re not expert enough to say that this path can’t play out, or that another risk won’t arrive. We’d be loath to ignore the point made by a MITK bear, who noted that Mitek’s own counsel said in court that the company was facing “death by a thousand cuts”, only for Mitek management to essentially whistle by the graveyard.

But the most likely outcome seems to be that at some point Mitek’s lack of liability is confirmed, either directly by a court or through the successful rejection of indemnification requests.

Those efforts will cost money — Mitek has booked ~$5 million in legal costs over the past 11 quarters — but that’s not what is baked into the MITK stock price. What is baked in, clearly, is a significant, material legal loss. And the risk/reward in betting against that kind of loss, to our eye, looks skewed to the upside.

Back Of The Envelope

Again, this looks like a $15-$20 stock relatively easily if/when the proverbial clouds part. A market valuing the cash cow that is check capture plus the optionality in verification is not going to value this business at 16x earnings power. Multiple expansion (ballpark it 25x-30x) plus growth gets in the range of a double.

As for the downside, there are scenarios where Mitek ‘loses’ and yet the company’s earnings power is not crippled. The true worst-case scenario seems exceptionally unlikely because, in that scenario, nobody wins. Even if legal losses crush profitability in the check capture business, there’s still ~$60 million in FY22 ID verification revenue, growing at a high-30s clip. That’s probably enough to account for something like $250 million in value, against an enterprise value of ~$500M and a market cap of ~$460M.

If the two scenarios were roughly equally weighted, MITK might be intriguing, but hardly compelling. To our eye, they’re not equally weighted. Even understanding the uncertain nature of patent litigation, far and away the most likely possibility seems to be Mitek emerging from this crisis largely unscathed. There’s simply no concrete evidence that Mitek is infringing USAA patents or causing its customers to do so.

Without that evidence, the odds favor Mitek dodging liability from those patents — and that means the odds are significantly in favor of a long position in MITK stock.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a long position in MITK in the near future.

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