Davis and Henderson CEO Gerrard Schmid

Davis and Henderson's planned $1.2 billion acquisition of Harland Financial Solutions will make the Toronto-based company a significant player in the U.S. financial services technology market virtually overnight. But success will hinge on whether it can effectively integrate its existing U.S. assets with Harland's offerings and convince community banks and credit unions that it can offer them the greatest number of capabilities with the smallest technology footprint.

Harland Financial Solutions ranks fourth among providers of core banking systems to U.S. financial institutions, behind Fidelity National Information Services, Fiserv and Jack Henry. The Lake Mary, Fla.-based subsidiary of Harland Clarke Holdings also offers a slew of ancillary products and services for payment processing and merchant services, consumer and mortgage lending, as well as compliance and credit risk analytics.

"The main catalyst of this deal was acquiring a strong core banking platform and using that to sell other products and solutions to banks," says John Guzzo, a managing director at investment bank Berkery Noyes. "It's really about providing a full product suite and acquiring a business that's going to get them into different markets."

Many of those products and services will be new offerings for Davis and Henderson, including core banking systems, payments processing and mortgage servicing. Based on their respective full-year 2012 earnings, the combined company's revenue from U.S. operations would account for 36% of total revenue, compared to only 8% prior to the acquisition. The transaction is expected to close on August 19.

"We looked at a few smaller acquisitions and when we found out the possibility of this one, it made all the sense in the world," William Neville, president of D+H USA, says in an interview. "This acquisition clearly demonstrates our desire to be full-time and long-term players in the U.S."

In payments, Harland provides banks with credit, debit and prepaid card issuing and processing capabilities, merchant services for acquiring banks and a person-to-person payments platform that runs on the Automated Clearing House network.

D+H provides Canadian financial institutions with consumer and commercial lending origination and credit risk analytics technology. In the United States, Davis and Henderson established its mortgage technology presence by acquiring Mequon, Wis.-based mortgage point of sale system developer Mortgagebot in 2011 and Charleston, S.C.-based mortgage loan origination system developer Avista Solutions in 2012, combining the two into a subsidiary called D+H Mortgagebot.

It also made a minority investment in Santa Ana, Calif.-based Compushare in April 2012 and later acquired the remaining outstanding shares of the technology management and cloud computing provider in January 2013.

Davis and Henderson's acquisitions have a history of putting a premium on vendors with a large and established customer base. It acquired Canadian mortgage loan origination system Filogix (now called Expert) in 2006, a platform that commands a 90% market share among Canadian brokers. And industry observers say the more than 1,000 bank and credit union customers that Mortgagebot had at the time of its acquisition explains the $232 million price D+H paid for Mortgagebot.

With Harland, the existing client base of 5,400 banks and credit unions is approximately 40% of the addressable market in the United States. Harland holds a 6% share of the core banking system market and its LaserPro compliance platform has 3,200 clients, or 25% of all U.S. financial institutions.

Expanding its product suite with technologies that have an established and prominent market share is critical to D+H's entrance into the U.S. market because there are limited opportunities for cross-border sales. Technologies are designed to accommodate the nuances of the country they were designed for. The differences in how transactions are conducted, regulatory and compliance requirements and the size of the institutions that use D+H and Harland's respective legacy products will constrain deploying the same technologies in Canada in the U.S.

"We've looked long and hard around the transferability of different products from one country to the next and there are some that quite frankly, make sense," D+H CEO Gerrard Schmid said during a July 23 conference call with analysts to discuss the acquisition.

"But when we really think about growth opportunity and where it makes most sense…our biggest opportunity and the best thing for our shareholders is to continue to grow in the markets and products that we currently have, rather than thinking about transferring the product cross-border," he added.

The one potential scenario for offering Harland technology in Canada is in the credit union sector because the institutions are similar in size to U.S. credit unions. However, there are only 339 credit unions in Canada (compared to more than 6,800 in the U.S.) and it's a market segment that continues to contract.

Davis and Henderson, founded in 1875, and Harland Clarke, created from a pair of companies founded 1874 and 1923, both trace their origins back to the check printing business. But both companies have evolved, primarily through acquisitions and other types of financial services technology and services.

While D+H doesn't have core banking systems or payment processing technologies in its current portfolio, Guzzo says the similar histories of the two companies, combined with D+H's previous experience in the U.S., will help smooth the acquisition process.

"They're already in a lot of these midtier banks and credit unions and they already have experience selling to that audience and customer base," he says.

When a small startup gets acquired by a large technology aggregator, it's often a challenge for executives and staff to assimilate into the corporate world of its new parent company. Harland Financial Solutions accounts for only 15% of Harland Clarke Holdings' total 2012 business, but Guzzo says the two cultures will mesh well because D+H and Harland are relatively similar in size.

"Harland Financial Solutions is coming from another large business and they're very comfortable with parent companies and different hierarchal structures," he says. "So I would think that they're comfortable with that sort of corporate structure and from a culture perspective, I see the companies pretty much having a natural transition."

The biggest difference between the two companies is that D+H has historically served a highly consolidated Canadian banking industry, while Harland's bread-and-butter is the myriad community banks and credit unions throughout the U.S.

Still, 850 of Harland's 5,400 U.S. bank and credit union clients already have a relationship with D+H through Mortgagebot and Compushare, Neville estimates. After the acquisition, the combined company will have more than 6,200 financial institution clients, after accounting for overlapping firms.

"The fit is great. This is not a cost-synergy play; it's a revenue-synergy play," Neville says. "We don't have a lot of overlap, so it's all about being able to bring new products and services to D+H's clients and also to the HFS clients."

But there are some reasons for financial institutions to be worried about the acquisition, says Brad Smith, CEO of bank advisory firm Abound Resources.

"In five years, D+H will have grown from 100 customers to nearly 6,000. That’s impressive if you’re a shareholder and frightening if you’re a customer," Smith wrote on July 24. "I hope their management team consists of superstars."

Davis and Henderson had approximately $780,000 in cash and equivalents at the end of the first quarter, down from about $5.6 million at the end of 2012, according to regulatory filings, and it's funding the Harland acquisition through a combination of convertible debentures, equity and debt.

"D+H’s leverage is already sky high and its liquidity is very low…We’ve seen several highly leveraged core processing acquisitions before and none of them survived," Smith says.

The enormity of adding so many new customers and D+H's financial footing may limit new features being added to Harland's core banking technology, Smith adds.

"I wouldn’t expect major development dollars for a while," he says. "History has taught us that vendors will typically focus on integrating their legacy products with their newly acquired ones before they start to tackle new developments in the acquired products."

D+H CFO Brian Kyle said on the analyst conference call that the company will reduce its debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio from 3.4 at the close of the acquisition to less than 2.5 by 2016.

"We believe that strong cash flows from the combined business will support reduced leverage in a relatively short timeframe," he says.

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