Research Notes: Is Q2 Holdings' 28% Decline Justified?
QTWO seems like an unjustified victim of a widespread banking panic. A closer look suggests the market has it right.
Investors looking to “buy the dip” amid a rout in banking stocks might well take a look at QTWO.
Q2 isn’t a bank: it’s a software platform serving banks. The nature of its business would suggest that, barring a massive string of failures, financial results should hold up.
But the nature of the business model suggests a 28% one-week decline might actually make some sense.
Meanwhile, valuation problems still dog the software sector as a whole.
Looking at a chart, you’d be forgiven for thinking Q2 Holdings QTWO 0.00 is a regional bank selling off amid concerns surrounding its long-term bond holdings:
It isn’t. Q2 is a software platform that serves regional banks, and apparently right now investors believe that’s roughly the same thing.
Of course, it’s not the same thing. As such, it’s easy to wonder whether the market is overreacting, and if that overreaction creates a buying opportunity in QTWO.
Introducing Q2 Holdings
Q2 offers cloud-based solutions to financial institutions. Regional banks were the original target market when the company was founded in 2004, but over time the addressable market has expanded to include larger banks, credit unions and fintechs.
The core product is a digital banking platform, which drives ~80% of revenue. That platform serves both retail and commercial customers, offering any and all services users need online (onboarding, account management, transfers, etc.). But over time Q2 has expanded its reach, part of a strategy it refers to as moving from “digital banking” to “the digital bank”.
A lending platform, built in large part through the 2019 acquisition of PrecisionLender, supports workflow management as well as pricing and decisioning. The Q2 Innovation Studio allows developers (both internal and third-party) to add features that expand the core platform; Q2 takes a commission (ranging between 15% and 40%) on any such sales.
The banking-as-a-service platform, now known as Helix, allows fintechs and other content producers to embed banking applications in their own platforms. For instance, users of Betterment, a wealth management product, can access checking on that platform; Q2 provides the software that connects Betterment with its partner financial institution. Helix only generated 3% of Q2's total revenue in 2021, and the segment actually declined in the second half of 2022 (per the 10-K), but management has high hopes. At the company’s Investor Day toward the end of 2021, Q2 forecast $100 million in revenue from BaaS by 2026. That target has been pretty much walked back since, but it’s likely management still expects Helix to be a reasonably important contributor to revenue growth and particularly to profit margins.
Q2 Last Wednesday
Over time, this has been a pretty good business. As noted, the company was founded in 2004; 19 years later, it expects $600 million-plus in revenue this year. Q2 has over 1,400 customers, including more than 40% of both the top 100 banks and the top 100 credit unions. Penetration in the largest banks, in particular, seems reasonably impressive given that a decent number of those institutions no doubt choose to build rather than buy.
As a result, QTWO stock has been a decent investment. The 2014 initial public offering priced at $13; at the $32 close last Wednesday (March 8), QTWO had returned 10.5% on an annualized basis.
Those gains include a significant crash over the past two years. QTWO was a clear pandemic winner, as regional banks and credit unions raced to build out digital capabilities during the pandemic. In February 2021, QTWO cleared $140; even before the recent sell-off it had plunged more than 75% from those highs.
Part of the reason for the plunge is relatively disappointing results. (As with so many of these pandemic-boosted growth plays, a simply insane valuation in early 2021 is the larger part of the problem.) At its Investor Day in December 2021, Q2 forecast 2022 revenue growth of 15% to 16%; the actual figure was about 13%. At the same event, management had 2023 top-line growth accelerating to 18%-19%; initial guidance for the year, given after the Q4 release last month, projects a growth rate about 6 percentage points lower.
That’s not the first time Q2 has disappointed. At the Investor Day back in 2019, management forecast long-term Adjusted EBITDA margins of 20-25%. Two years later, it was 20% five years out. Another two years later, 2023 guidance suggests a roughly 10% print, and that target of 20% in 2026 looks wobbly (to say the least).
In management’s defense, the macroeconomic environment of late has not cooperated, even before SVB. Regional banks were seeing some pressure in the second half of 2022, and fintech growth and aggressiveness has slowed markedly. The combination has led to reduced customer demand. Q2 still seems to be winning in the market: rival NCR NCR 0.00 saw revenue in its Digital Banking segment grow only 9% in 2021 and 6% in 2022. Q2 grew more than twice as fast.
So, again, this seems like a decent business. The concern a week ago was valuation. An enterprise value just shy of $2.5 billion was about 38x the midpoint of 2023 Adjusted EBITDA guidance.
That's a tough multiple to swallow. But there is a reasonable long-term opportunity here: Q2 believes its addressable market will be ~$23 billion in 2026, with 2023 revenue barely 2% of that figure. But it’s not clear how ‘real’ that TAM is, given that in-house solutions are likely the biggest competitor. For what outsourced business exists, the likes of NCR, Fiserv FISV 0.00 , Alkami ALKT 0.00 , and others remain rivals as well.
Continuing consolidation in the space may further reduce that TAM. Management has emphasized that, in acquisitions, it’s usually a Q2 customer acquiring a non-Q2 customer, which in turn can boost the company’s revenue growth over time. But on the whole, the steadily shrinking number of banks in the U.S. (the number of FDIC-insured institutions was nearly halved between 1999 and 2021) does seem like a headwind.
Macro conditions withstanding, it’s tough to get too excited about paying almost 40x EBITDA for low double-digit growth. (Margins are expected to expand nicely this year, but they compressed in 2022. Like so many similar companies, Q2 is pulling back the throttle on spending this year.)
Even Wall Street isn’t all that impressed with the stock. The average target price for QTWO last week was below $37, suggesting upside of only about 14%. In this environment, that’s hardly a vote of confidence — and the consensus view now is even lower, given that yesterday Canaccord Genuity cut QTWO to hold, and slashed its price target from $60 to $25.
Why Has QTWO Stock Plunged?
Of course, QTWO is not at $32, as it was last Wednesday. It’s 28% lower, closing yesterday at $23.18. And this is a good enough business that, even if $32 wasn’t compelling, a lower price might be.
Meanwhile, at least on its face, it does seem somewhat weird that the stock has tracked the regional bank group so closely:
source: YCharts; one-week chart
After all, it’s not like hordes of regional banks are necessarily going out of business. Admittedly, we might see more tumble after SVB and Signature. But there are over 4,000 FDIC-insured banks in the United States. If the total gets to, say, 20, that only reduces the potential customer count by 0.4%.
Neither SVB itself nor Signature change the investment case. On Monday, Q2 filed an 8-K disclosing that SVB was a customer, but accounted for less than 0.5% of total revenue in 2022. (Q2 also had less than $5,000 — five thousand dollars, to be clear — deposited at the bank.) Signature was not a Q2 customer.
Indeed, per the 8-K, Q2’s largest single customer in 2022 generated about 4% of revenue. The top 20 in total accounted for less than 25%.
And assuming nearly all of Q2’s customers do stay in business, it’s not like they can simply stop their digital efforts. Certainly, net new business probably grinds to a halt in the first half of the year (at least). Particularly when it comes to major projects. Regional banks have other priorities right now, and every penny of spending will be closely scrutinized.
But Q2 also has a book of business with contracts that on average last over five years. Management already expected some softness in professional services revenue (consulting, essentially) in 2023, so the incremental step down in that channel (services and other revenue was ~15% of the 2022 total) is probably not that severe.
That revenue also comes with a lower profit margin. And, overall, incremental EBITDA margins are not necessarily that high (historically in the high 20s), because consolidated gross margins remain in the low 50 percent range. Newly acquired revenues do even worse, due to required startup costs.
It doesn’t necessarily seem like profits this year have to fall off a cliff. Nor does it seem like a massive proportion of Q2 customers (again, some 1,400 organizations) are going to go out of business.
From this perspective, it seems like the sell-off here is an overreaction, with the market simply selling off anything tied to regional banks. But there is in fact an explanation that makes some sense.
The Customers’ Customers Problem
The potential headwind for Q2 is not that a wave of failures will drive the company to lose existing customers. It’s that those existing customers — in particular, regional banks — are going to lose their customers.
Q2 generates revenue from transactions. Per the Q4 conference call, the figure was about 12% in 2022. Commentary suggests that revenue stream was about flat year-over-year, again due to macro considerations (with the weakness at Helix no doubt a contributor). Management anticipated a similar performance this year (again, before the dramas with SVB, Signature, et al.).
But there’s also a usage component to Q2’s pricing. The company’s subscription agreements have a base level of “End Users”; beyond that point, Q2 is compensated on usage. It does appear that the flat fee is the largest portion of these agreements— but both usage-based and transactional revenues should offer rather high incremental margins.
From this angle, the tight correlation between the equity price of Q2 and the equity price of its customers makes much more sense. Both are pricing in an exodus of customers from regional banks to their larger brethren.
Now, it’s possible that the market is wrong. Government intervention over the weekend may calm customer nerves. No matter the headlines in the media, many consumers may not necessarily see (for example) JPMorgan Chase JPM 0.00 as notably more 'safe' than the local bank with which they are familiar and/or have an existing relationship.
The problem for QTWO, however, is that an investor betting that the market is wrong has another trade to make: simply buying the affected regional banks. The SPDR S&P Regional Banking ETF KRE 0.00 itself is down 23% over the past week, and by about one-third since the beginning of February. Individual stocks within that ETF have fallen much further, and offer potentially more upside in a mean reversion scenario.
QTWO probably is lower-risk — but the risk isn’t necessarily that much lower. Based on 2023 EBITDA guidance, and pro forma for the recent repurchase of convertible debt, the balance sheet here is about 8x net leveraged. That’s not quite as bad as it sounds; those bonds yield about 7.5%, and with a conversion price of $88.61 the value of the equity option is relatively minimal.
Still, net debt (again, pro forma) is over one-quarter of enterprise value. Add that financial leverage to Q2’s operating leverage and variance in the total customer base at U.S. regional banks has a relatively dramatic impact on Q2’s equity value (if not quite to the extent it does for the regional banking sector itself). Given the size of its decline, maybe QTWO is a slightly better play than the sector it serves, but in this kind of environment an investor might want something that looks a little stronger than “maybe”.
The Valuation Problem
One of the points we’ve made on several occasions during the past year is that despite big declines in so many sectors, valuations still don’t look that attractive. QTWO provides yet another example.
At Wednesday’s close, QTWO has an enterprise value of $2 billion, roughly speaking. That's still more than 30x the high end of 2023 Adjusted EBITDA guidance for a business that might well post single-digit revenue growth this year. And of course that Adjusted EBITDA excludes stock-based compensation. That figure totaled $65 million in 2022; Adjusted EBITDA is guided to $62 to $66 million in 2023.
Back in late 2021, Q2 forecast 2026 Adjusted EBITDA of ~$240 million ($1.2 billion in revenue at 20% margins). Both figures need to be haircut substantially; back of the envelope, in a high-end scenario we’re probably looking at maybe $900 million in revenue (~12% compounded post-2023) at 15% margins (still ~150 bps expansion annually for three years).
For QTWO to double from here (and we need a path to a three- or four-year double to take on the risk here) the stock needs to hold a ~25x multiple to EBITDA, and probably ~35x to free cash flow, three years from now.
This all seems like a lot to ask in the environment investors expected a week ago, let alone the one being forecast now. There’s absolutely a world where revenue growth nears zero this year, and a recession adds further pressure in 2024 and beyond.
And a similar sense holds with other similar plays: Jack Henry & Associates JKHY 0.00 (-17% year-to-date, still trades at ~30x EPS for FY23); nCino NCNO 0.00 (-16% in a week, still at 6x-plus 2022 revenue and unprofitable); and Alkami Technology ALKT 0.00 (unprofitable, 4x revenue, though ALKT might be the most intriguing of the group). The news might not be as bad as the near-term charts suggest. But that alone doesn't make a buying opportunity.
As of this writing, Vince Martin has no positions in any securities mentioned.
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On the Q4 call last month, management was asked whether that target was still in force. Chief executive officer Matthew Flake replied that “obviously, a lot’s changed…we haven’t given a revised long-term view of [the $100 million target].” Notably, Flake didn’t reaffirm the target, which strongly suggests there is “a revised long-term view” to give at some point.
In the 10-K, Q2 writes that Helix contracts “typically involve relatively lower contracted minimum revenues and instead emphasize usage-based revenue.” The “instead” in that phrasing suggests that the reverse is true for its digital banking product.
Our math suggests $1.91 billion: a fully-diluted market cap of $1.41 billion and net debt just shy of $500 million.
Equity value gets to $3 billion, assuming share issuance, we’ll cut net debt to $400 million thanks to free cash flow in the interim.
do you have any view on FIS which also has exposure to regional banks + payment processor worldpay which they bought for 43 billion.