Mitek – Massive Margins, Huge Moat, and Multiple Growth Levers

Mitek is a company that licenses image recognition software for mobile check deposits (67% of revenue) and digital identity verification software (33% of revenue). The stock rose from a penny stock in 2009 to a peak of $12 per share in 2011 and 2012 as it signed licensing agreements with the 4 big U.S. banks, and revenue has grown rapidly since then as signed licensing agreements for the Mobile Deposit product with more and more of the large U.S. financial institutions. In more recent years, the company has focused on expanding its offerings to include identity verification services for banks, which help banks comply with “Know your customer” (KYC) regulations.

Over time, the revenue composition for the company has transitioned from an enterprise software model, whereby the company sells a license for the software and a certain amount of check transactions for use in Mobile Deposit, to a model with some SaaS-like characteristics of recurring revenue from maintenance and services fees and more usage-based transaction fees with its Identity Verification product.  In 2019, services revenue increased to $37.7 million, or 44.5% of overall revenue, driven to a large extent by a 63% growth in the transaction SaaS revenue. Transaction SaaS revenue came in at $13.2 million in 2019, or 15.5% of overall revenue.

In recent quarters, the growth rate has slowed down and investors appear to be less willing to put a high EV/Sales multiple on the company due to the deceleration in growth. Most of the slowdown in growth is coming from slowing license sales for the Mobile Deposit product, as the company has likely saturated the natural market of financial institutions. The CEO estimates that Mitek now has a 98% market share of mobile deposit among U.S. financial institutions, with only 1-2% of the market represented by USAA, which developed its own mobile check deposit software. The number of physical checks in use is also in decline, with a consistent decline of 3-4% every year in check volume. I think this natural market decline along with saturation of the end customer has led the market to discount future growth rates for the company.

However, the CEO cited in early 2020 that only 18% of checks are deposited via mobile deposit, with the vast majority being deposited in bank branches, leaving plenty of room to grow check volume. Since the banks purchase a certain quantity of check deposits each year from Mitek, these deposit numbers might continue to increase for some time to come. There is a tremendous cost-savings to the bank from mobile deposit – mobile deposit only costs the bank a few cents per deposit, whereas in-branch deposits, when taking into account personnel costs, real estate costs, and processing, can cost up to several dollars per check. As the Mitek CEO has pointed out on numerous occasions, “There is no alternative to this technology” and “We have never lost a customer”. This means that Mitek has tremendous pricing power, which I believe it has not yet exercised in a meaningful way. Mitek already generates an 86% gross profit margin, but it could continue to expand this with pricing increases, with all price increases dropping straight to the bottom line.

I would also guess the amount of mobile deposits utilized by bank customers has increased dramatically during the COVID pandemic. I think many of these changes will be permanent changes in consumer behavior. I know I personally deposited my first check via mobile deposit during the month of April because I didn’t want to bother with masking up for the bank run, and I probably won’t ever deposit in person again because it was so easy. I would guess the banks have used up all the checks that they bought earlier this year, and will be returning to Mitek in Q2, Q3 and Q4 for further mobile deposit purchases, leading to an unexpected acceleration in revenue growth.

The company has been growing its identity verification products, which now make up 33% of revenue. This business is growing much faster, however has more competition than Mitek’s mobile deposit business. The Mitek CEO estimated the company has a 20-25% market share in this business, mostly composed of the same financial institutions that use its Mobile Deposit product. As I mentioned earlier, the company has been growing its transaction based revenues, which is describes as “Transaction SaaS” revenue, at a rapid clip. Most recently, these revenues made up 16% of overall sales, and are growing at over 50% per year. As these revenues increase, they will cause the overall revenue growth rate to accelerate as well. Management estimated the Identity Verificaiton business overall ought to grow at about 30% this year pre-COVID. I would guess this business has also received a tailwind during the COVID pandemic, particularly as home-buying has ramped up with many consumers viewing homes and getting mortgages entirely online. The identity verification business does sell to the hospitality industry, and these sales suffered in Q1 and will likely continue to suffer for the rest of the year. But in coming quarters, these effects will be swamped by the larger revenues from financial institution customers. Furthermore, upon the rebound in hospitality in 2021, Mitek should enjoy a return to higher revenues among the hospitality customers as well.

I’d mentioned the company has likely saturated its core market of U.S. financial institutions. However, recently it made two acquisitions, ICAR and A2iA, located in Spain and France, respectively. Management now appears to be pivoting for growth to European financial institutions. The acquisitions have taken a toll on gross margins, adding significantly to COGS. However, in fiscal Q1 2020, the company announced it was restructuring the Paris operations of A2iA, and, concurrently, the COGS dropped from 16% of revenue to 13% of revenue year over year. Prior to the acquisitions, the company typically had a 90% gross margin, and I’d expect margins to creep back to this level as the company continues to rationalize its European operations. Furthermore, the European operations provide a platform for growth among European financial institutions, provided the company can navigate the more complex regulatory structure in the European Union.

These acquisitions have also obscured the operating profit and free cash flow picture. Additional payouts from the acquisitions, restructuring costs, and amortization of goodwill associated with the acquisitions have added up to about $10.1 million in the TTM period. This is actually a positive as it has reduced the tax burden (the company typically realizes an income tax benefit rather than expense), but has little use for calculating the long term profitability of the business.

Though the Mobile Deposit business is still growing (management estimated growth at 10-13% pre-COVID), it is highly profitable. Margins may actually have some upside as check volumes increase and the company exerts its pricing power. The Identity Verification business is actually losing money, but the company estimates it will get to profitability at some point within the next year or two. Currently, the company has a non-GAAP operating margin of about 20-22%. Keeping in mind this figure adds back stock-based compensation, which I regard as a real cost, it still reveals a company which will be highly profitable at scale, once the Identity Verification business begins to contribute to the bottom line rather than subtract.

I’d guess the operating margin for this company at scale is somewhere in the 25-30% range, meaning its an incredible business with a very high return on capital. It’s got an asset light business model, and ought to throw off tons of free cash flow at scale.

I’d also figure that the many growth levers mentioned above will get revenue growth to accelerate from 16% in the most recent quarter, to above 20% by year end. A software company with huge margins and a 20% growth rate probably should not be valued at an EV/Sales ratio of 3.9X. The transition to a more SaaS-like business model might also get investors to place the company alongside some of the high-flying SaaS names, which might cause the stock to re-rate. I would guess a more appropriate EV/Sales multiple might be closer to 8X, indicating about 100% upside to current prices.

Technically, the stock price has shown a strong predilection to round numbers, and is sitting just above $9 which has proved to be a strong support and resistance in the past. I’ve got a big position on just above this level and am intending to ride this out for Q2 and Q3 results. I’m looking for a target price in the $18-20 per share range.