Black Knight: Lungs of the Mortgage Industry

Americans hold more than $11 trillion in mortgage debt. The massive mortgage market is widely followed from Wall Street to Main Street and the biggest players – Wells Fargo, Bank of America, PNC, and Mr. Cooper, among many others – are household names. Lesser known, but just as important, are the back-end “plumbers” that connect originators, servicers, and payers. Black Knight lies at the center of these participants.

Background

Black Knight is one of the original software-as-a-service (SaaS) businesses. Black Knight’s predecessor, Computing and Statistical Services, can trace its roots back to the 1960s. In 2014 Fidelity National Financial acquired it and changed its name to Black Knight. They IPO’d part of their stake in 2015 and spun off the rest in 2017.

Source: 2020 December Investor Presentation

Black Knight is one of just nine public tech companies with over $1B in revenue, revenue growth greater than 5%, and EBITDA margins north of 45%. Peers like Visa, Facebook, and Moody’s place Black Knight in good company. These are among the best businesses in the world and have delivered tremendous shareholder returns.

Operating Segments

Black Knight operates in two segments, Software Solutions and Data and Analytics (D&A).

Software Solutions (85% of sales) is Black Knight’s core business. This segment automates and facilitates the mortgage process for lenders. Software Solutions allows borrowers to apply for mortgages online, upload documents, e-sign, receive statements, and handle escrow. Black Knight’s software covers a mortgage’s entire life cycle, from origination to closing, servicing, default, and foreclosure.

Black Knight is the dominant player in this space, with over 60% market share in first lien mortgages and 20% in second lien. Market share bobs around year to year, but share in both areas is headed steadily upward over time.

Customers use Black Knight’s software for three reasons – to save money on historically manual and repetitive processes, reduce compliance risks, and improve customer experience.

In virtually all of its mortgage servicing products, Black Knight enters into long-term subscription contracts with customers that are subject to annual escalators and based off of the number of mortgages serviced.

Data and Analytics (15% of sales) leverages the information from the millions of mortgages serviced to provide insights to lenders, real estate investors, and other capital markets players. Solutions include analytics around property information, lien data, servicing data, valuation models, collateral risks, and multiple listing services, just to name a few. The plethora of data and analytics offerings are designed to help lenders make more informed decisions and better manage risk.

Data and Analytics revenue is less recurring in nature than the software servicing segment, but still highly valuable and subject to long-term relationships with customers. Cross-selling D&A solutions to existing mortgage servicing customers is a key part of the company’s growth, which I’ll look at later.

Business Model

Black Knight enjoys a formidable competitive position thanks to mission-critical solutions and an embedded customer relationship.

High Switching Costs

One of the most desirable competitive positions for any business is to benefit from high customer switching costs leading to predictable and recurring revenue. The mortgage servicing segment is about as sticky as it gets. Black Knight’s servicing software is so embedded in mortgage servicers operations that replacing it is akin to ripping the lungs out of a major institutions mortgage department. While technically possible, it almost never happens at scale. As disclosed in the company’s 10K, it can take up to 18 months for a major bank to switch to competing software.

Switching software vendors isn’t just a logistical nightmare. It also creates compliance risks. After the financial crisis of 2008, mortgage regulations and costs have proliferated. Customers have chosen to outsource much of the compliance process to Black Knight’s automated software rather than develop solutions in house. Black Knight is more cost effective and reliable, reducing compliance risks and costs for servicers. Switching solutions introduces unnecessary compliance risks either during or after the integration of new software.

Because Black Knight offers the full range of servicing products (and is the only business to do so) and maintains an excellent reputation in product quality, there is no reason for customers to switch to a piecemeal solution from niche competitors. It’s not worth the integration time, effort, risk, or cost.

As a result, Black Knight benefits from predictable, recurring revenue, low churn, and pricing power.

Pricing Power

While recurring revenues due to high switching costs are great from a predictability standpoint, the real benefit is pricing power. As Matt noted a few weeks ago, this is one of the most enviable characteristics of any business, especially in the face of potential inflation.

Black Knight’s entrenched position allows it to increase prices annually. Total loans serviced plod higher at ~2% annually, while revenue per loan has grown at 4%, leading to a healthy 6% annual revenue growth since 2016.

While 6% growth isn’t the fastest, this growth is virtually guaranteed for many years into the future. Further, because much of the growth is due to price increases and the software is highly scalable, most of the revenue growth drops straight to the bottom line as it comes with almost no incremental costs.

Resiliency to Housing Cycles

Unlike most players in the boom and bust mortgage industry, the housing cycle has almost no impact on Black Knight. While mortgage originators, home builders, and real estate investors are highly dependent on things like the number of homes built, mortgages originated, and interest rates, the key driver of Black Knight’s business is the total number of mortgages outstanding. Over long periods of time, the number of first lien mortgages in the marketplace grows 1-2% annually, and remains remarkably stable in down markets. All the while Black Knight is there to collect annual subscription fees for servicing these mortgages.

A small portion (~6%) of Black Knight’s revenue is tied to origination activities, which will take a hit during downturns in the housing market. On the flip side, during these periods Black Knight’s default management software will experience an increase in usage, further mitigating the impact.

Cross-Selling Optionality

Much like Fastenal leveraged its legacy fastener distribution moat into new areas of dominance, Black Knight uses its entrenched mortgage servicing position to cross-sell data and analytics services to customers.

The desire for more and better data is increasing across virtually every industry, and Black Knight is in prime position to increase its wallet share with existing customers. While D&A makes up just 15% of revenue today, I would expect to see this percentage grow over time.

Since going public, management has prioritize D&A growth. They recently launched a rapid analytics program (RAP) and in Q3 the business added as many customers in the quarter as they had up to that point since launching the product last year. New customers include four top investment banks and the Federal Reserve.

In Q3 the D&A segment grew 27%, thanks to a mix of healthy organic growth and benefits from recent acquisitions.

While tough to predict with any precision in one quarter, I’d bet on the company continuing to push D&A products on new and existing customers and making an occasional acquisition. Most importantly, the sticky software segment gives the company the optionality to sell new products to a stable pipeline of long-term customers in the years ahead.

Growth

Matt and I like simple, predictable, and profitable businesses. Black Knight scores well on all three measures.

Mortgages outstanding tend to rise 1-2% annually. Black Knight is likely to capture its share of the growing market and continue taking market share, especially with mid-sized originators and in second lien loans. Contractual price increases should bring annual growth to 6%.

Historically, Data and Analytics have grown 6% annually as well. It could be much higher in the future.

Source: December 2020 Investor Presentation

Together, this should result in 6-7% long-term annual topline growth. Because all products are highly scalable and the company maintains pricing power, the business enjoys consistent operating leverage, and targets 0.5 - 1% annual margin expansion.

Subsequently, earnings should compound at a high-single digit pace for many years, with upside optionality in the D&A segment.

Per share results could compound by another 2%+ annually as the company executes on its recently authorized 10 million share buyback plan thanks to substantial free cash flow generation.

All told intrinsic value per share should compound at low double-digits for years to come.

Valuation

What should a business with low double-digit growth prospects protected by formidable barriers to entry be worth to owners? While there is no precise figure, my answer would be “quite a bit”.

Because of the durability of its cash flows and reasonable growth characteristics, Black Knight might be thought of as what Buffett has referred to as an “equity bond”. Buffett coined the term to refer to businesses offering bond-like safety of principal and dividends, but with equity-like growth prospects. Of course, I’m not suggesting that investing in Black Knight is risk-free (nothing is). Rather, it’s to say that because of Black Knight’s competitive position a permanent impairment seems remote. That doesn’t make the stock a no-brainer at present prices for enterprising investors seeking outsized returns.

Shares of Black Knight currently trade for around 30x my estimate of this years’ free cash flow, after adjusting for an investment the company holds in Dun & Bradstreet Corporation. I don’t think 6-7% “terminal” growth is unreasonable to get comfortable with, meaning the shares look about fairly valued at 30x assuming a 10% discount rate in a valuation multiple. While this doesn’t seem crazy, it doesn’t offer a wide margin of safety. I certainly wouldn’t bet on sustained multiple expansion from here.

Investors may get a better chance down the road. Despite experiencing almost no ill-effects of the housing cycle, equity investors have thrown the baby out with the bath water multiple times over the last few years in concert with broader economic or housing-related concerns. Black Knight’s stock declined 25% in 2018 as concerns over higher interest rates reverberated throughout the market. In the March 2020 crash Black Knight’s stock fell more than 30% as concerns over how the pandemic would impact the housing market swept the industry. In each case investors were able to purchase shares of Black Knight at around 20x free cash flow, a substantial margin of safety for such a high quality business.

Here’s to hoping that during the next housing scare investors again briefly forget that Black Knight operates with little influence from extrinsic factors.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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