Digital Insight Must Prove It Has A Scalable Business Model

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It would be easy to conclude that the application service provider business model has been discredited, but there are a few survivors. Digital Insight Corp., a provider of Internet banking services, has made it through the current downturn relatively unscathed.

Early on, Internet banking caught the eye of some of the major banks as a means to cut costs and increase customer satisfaction. However, the cost of developing a Web site isn't insignificant.

While most of the spotlight has been focused on the larger banks, the U.S. banking industry is very fragmented, with 22,000 banks, thrifts, savings and loans, and credit unions each holding less than $10 billion in assets. For many of these smaller institutions, it makes sense to outsource the development, maintenance, and even the operation of their Internet banking initiatives.

Enter Digital Insight (DGIN--Nasdaq), which offers outsourced Internet banking systems to financial institutions for retail as well as business customers. The company has a line of products under the Axis brand name that let customers get a fully functioning, customized Web site up and running in three to four months. Digital Insight offers Axis Internet Banking (83% of revenue) for retail and business clients, which lets bank customers look up account information, transfer funds, and pay bills. In addition, business clients can do payroll, fund transfers, wire transfers, and stop payments. Another interesting service offered by Digital Insight is Axis Lending Services (17% of revenue), which lets the financial institution offer automated lending services. This means the bank can track loan applications and deliver conditional approvals, with Digital Insight running the operation from one of its data centers.

Some of the company's competition comes from the internal IT departments of the financial institutions. More serious competition comes from established companies, such as EDS, Fiserv, and Metavante, all of which Digital Insight partners with to offer data processing. These companies already have established reputations and also possess the cash to finance their Internet banking initiatives. At a lower valuation, Digital Insight would be a strategic acquisition for one of the established players.

Digital Insight has focused primarily on banks with $100 million to $1 billion in assets--but this market is saturated, with about half of the banks offering Internet banking. This means Digital Insight must focus more on the sub-$100 million market, where the banks have fewer potential online customers and therefore less revenue, although that may be mitigated by better pricing.

How does Digital Insight make money on these offerings? It had about 1,300 financial-institution clients at the end of last fiscal quarter; this translates into 1.8 million active users and more than 27 million potential users. The clients are billed about $2 a month per user. Digital Insight also gets a one-time setup fee that varies by client. Revenue grew 90% relative to last year and 17% sequentially to $20.4 million. Management says it believes revenue will hit $100 million this year and $140 million to $150 million next year, up 85% and about 45%, respectively. Gross margin fell to 34.2%, down more than seven percentage points year-to-year. As with so many other young companies, Digital Insight is spending heavily on product development, sales, and marketing, meaning that it's reporting net losses and using cash for its operations. The company estimates that it will reach profitability within the next two quarters; with about $72 million in cash and equivalents on the balance sheet, it shouldn't have any problem doing so. Earnings per share this year should hit 30 cents, which means Digital Insight is trading at 69 times next year's projected earnings per share.

However, survival isn't enough. The company still must demonstrate that its business model is scalable and truly, not just marginally, profitable. Otherwise, there will be a train departing for Digital Insight as well.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at [email protected].

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