Description

DISCLAIMER: This is not an offer to buy or sell securities. We may own CEY and may buy or sell at any time. This posting is merely for informative purposes.
Certegy (NYSE: CEY) is a compelling long opportunity which trades at a low multiple of forward free cash flow (11.5x ’07) and grows. Total upside should be near 25% over the next twelve months, driven by 18x my 2006 EPS or FCF estimates plus a $3.75 special dividend received at the close of CEY’s planned merger with Fidelity National Information Systems (“FIS”). The stock is currently trading at a 15x 2006 P/E and 13.8x FCF multiple, versus the group average at 19x EPS. Downside should be limited at current levels by a diverse recurring revenue model, cash EPS growth at an annualized 18% from ’05 to ’07, conservative merger cost synergy assumptions (80% of estimated 2-year cost savings) and zero assumed revenue synergies. There are several upcoming catalysts: A simultaneous deal close and $3.75 dividend payment in late-January (after which the stock will screen less expensive to investors) and an analyst day in early February when pro forma guidance will be given to investors for the first time.

Business description: Certegy provides credit card, debit card, and other transaction processing and check risk management services to financial institutions and merchants in the U.S. and internationally through its two business segments, Card Services and Check Services. Card and check services will represent 15% and 12% respectively of combined company revenue. Fidelity National Information Services “FIS” (currently a subsidiary of Fidelity National Financial) provides technology solutions, processing services, and information services to the financial services and real estate industries. Over 2,800 financial institutions use FIS’s services, including 44 of the 50 largest banks in the U.S. FIS’ three divisions Financial Institution Software and Services (“FISS”), Lender Outsourced Services (“LOS”), and Information Services (“IS”), represent 43%, 10% and 19% of combined company revenues. On September 15, 2005, the two companies announced a merger by which FIS will reverse merge into CEY in a stock transaction with CEY holders owning 33% and FIS holders owning 67% of the Newco which will trade under “FIS”. The transaction is expected to close in late January, pending final SEC approval and a CEY shareholder vote.

Valuation:
Stock price 39.50
Less: dividend (3.75)
Adjusted stock price 35.75
Pro forma shares 196
Market cap 7,007

Cash 280
Debt 3,016
Ent value 9,743

2006 2007
FIS Revenue 2,913 3,072
CEY Revenue 1,129 1,229
TOTAL Revenue 4,042 4,301
FIS EBITDA 851.1 896.4
CEY EBITDA ` 277.1 308.1
FIS corporate -50.0 -52.5
Synergies 67.5 82.5
Consolidated EBITDA 1,145 1,234
D&A 416 420
Interest expense 154 141
Tax 221 259
Cash EPS $2.40 $2.71
Capex 261 225
FCF/Share $2.59 $3.11
Notes: Cash EPS excludes $190m in pre-tax amortization associated with this and prior acquisitions. CEY revenue excludes card reimbursable revenue. Cash and debt are pro forma for transaction close.

Investment case:
- CEY is trading at a significant discount to its peers at 14.9x ’06 EPS versus a 19x average transaction processing average. CEY’s value is obfuscated because the company will issue a $3.75 dividend directly prior to the merger closing with FIS, management has not provided pro forma estimates, and FIS was itself a subsidiary of FNF without stand-alone reported financials.
- CEY has earnings power of $2.41 in ’06 and $2.71 in ’07 with FCF in excess of EPS as a result of excess depreciation and limited capex requirements. FCF is expected to be $2.59 in ’06 (13.8x) and $3.11 in ’07 (11.5x). I am estimating $261m of ’06 capex versus management at $225m, so on management’s numbers the company is trading at 12.9x 2006 free cash flow.
- CEY/FIS is in a more dominant industry position than prior to the merger. Pro forma revenues are $4b in 2006, versus competitors Fiserv at $4b, Bisys at $1b, Total System Services at $1.4b, and Jack Henry at $640m. CEY has a full solution, from bank front-office, core bank processing, mortgage processing, property data services, real estate valuation services, check verification and card issuing. As such CEY can bundle its service offering as a “one stop shop” for bank customers; no other competitor has as broad a product suite.
- Management’s cost synergy estimates are too low. Management stated in its conference call that cost synergies are $50m, and most analysts are estimating $0-$50m. In FIS’ three previous acquisitions, management beat its synergies target by an average of 33 percent. As a percentage of the acquired revenue base, estimated synergies in this deal are 4 percent vs 12 percent in the three previous deals. I believe $100m is a reasonable assumption for this deal.
- Management and my numbers assume no revenue synergies despite several opportunities. Synergy/upside opportunities include:
--Sell CEY card issuing services into the FIS customer base. Approximately 15 percent of the combined customer base is composed of FIS customers who are not served by CEY. This is approximately a $50-$60m revenue opportunity.
--Management is close to signing a card issuing agreement in Brazil which will ramp from $60m at the beginning of ’06 to $150m over three years and should have 15% ebit margins.
--Sell check risk management to FIS’ large bank customers. CEY can leverage FIS’ large bank relationships to sell a new product which prevents banks from incurring check fraud and notifies bank customers if their account is compromised. The revenue impact is difficult to estimate, but certainly greater than zero.
--Sell FIS core processing to CEY bank customers that FIS does not serve. This opportunity is a 5x increase in the community bank customers currently served by FIS. Again, difficult to estimate, but certainly greater than zero.
- CEY and FIS have recurring revenue business models with processing contracts that average 5 years. Retention rates are generally 99%. As such, revenue visibility is generally quite good.
- CEY’s card issuing business (19% of CEY/FIS EBIT) grows revenue at 9% per year, generates mid-20’s% EBIT margins, and is very defensible. This business is not very competitive as community bankcard issuing requires significant scale, and competitors First Data and Total System Services design their services for larger accounts. Local banks are seeking to enhance their card offerings as a customer retention tool versus BofA, Citi and other large banks. CEY’s full service offering enables it to generate average revenue of $18 per card versus $4 at First Data.
- FIS’ has a dominant share in its mortgage processing business (9% of 2005 revenues), and processes approximately 50% of US mortgages. This business grows historically at 6-8% per year as the number of mortgages outstanding continues to grow despite the ups and downs of the refinancing market.
- FIS’ bank processing business (33% of 2005 revenues) grows in line with the pace of bank technology spending at 4-5% per year. Similar to mortgage processing, the retention rate is extremely high at close to 99%.
- FIS’ Lender services is an automated solution for existing, large-bank mortgage customers to process refinancing applications. This is highly correlated to the refinancing market, and has been a sore spot for FIS: revenue has declined from peak 2003 levels by approximately 60%. I believe that further decline in this segment is now mitigated for several reasons. First, lender services is now insignificant at 4% of revenues and 5% of EBITDA. Second, lender services has taken market share in the past few years with several large accounts such that further declines in refi activity should result in lower declines in revenue. Third, FIS’ default management business, which provides lenders outsourced management for defaulted loans, is inversely correlated to the refinancing market because defaults will increase as mortgage rates rise. The default management business grew 11% annually from ’03 to ‘05 through market share gains despite a very weak default market. As defaults are expected to increase in ’06 and ’07, this business could grow 20% annually.
- FIS’ Information services (IS) segment provides property data (such as flood, tax and credit) services as well as a variety of software applications which facilitate real estate transactions. This segment is less correlated to mortgage originations than perceived; only approximately $300m of $738m IS revenues are directly related to mortgage originations. While mortgage originations declined by 28% from ’03 to ’05, IS grew total revenues by 25% during that time period through market share gains. The estimated 60% of IS revenue unrelated to originations grew 15% in 2005. Also, FIS books deferred revenue over the life of the loan for its origination sensitive IS segments (Flood and Tax). This balance stands at $323m and is recognized over 3-4 years, providing a buffer to revenue. As a result, despite anticipated declines in originations of 9% annually over the next two years, IS revenue growth is expected to be in the 5-6% range per year. Because of limited competition, scale, and low incremental costs, this business generates low 30% ebitda margins.
- FNF has a 50.3% stake in CEY post-transaction, and in order to continue to consolidate FIS in its financials, FNF will have to buy stock to prevent dilution from options or acquisitions.

Risks:
- CEY’s check verification business is in secular decline. As a result of the transition to electronic forms of payment such as debit cards, the number of checks written domestically declines by 3-5% per year. Secondly, the company loses check volumes due to attrition in its customer base from bankruptcies, acquisitions, etc. Because its customers are largely retailers, the segment is also susceptible to weak consumer trends. Mitigant: The company has been adding large customers as its fraud prevention capabilities improve due to its growing database. Its main competitor, First Data’s Telecheck, has been losing customers over the past few years. Domestically, check fraud is actually increasing as “good” check writers are moving to debit and credit, leaving higher risk check writers as a greater percentage of total checks written. CEY’s check volumes have actually grown 30% in 2005, but new customers are using the less expensive “verification” product rather than CEY’s “guarantee” product. As these customers migrate to guarantee, revenue per check should increase. Finally, the international business (17% of check) is a greenfield opportunity as check writing is on the rise internationally and the international market is less penetrated.
- Several private equity firms including Thomas Lee and Texas Pacific Group will own 17% of CEY/FIS stock after the transaction closes. These firms are subject to a 90- day lock up for 50% of their holdings and a 180-day lock up for the remaining 50%. Mitigant: FNF’s stock purchases should offset this supply of stock to some extent.
- Cyclical stigma attached to FIS business. FNF attempted to IPO FIS in 2004 but withdrew the IPO due to significant revenue declines in the Lender services segment stemming from lower refinancing activity. In addition, the FNF parent has always been viewed as cyclical by the market and has historically traded around 10x EPS. Mitigant: Only approximately $400m or 10% of combined company revenues is dependent on new mortgage originations. These businesses have grown in aggregate in 2005 despite continued declines in originations. As the worst deceleration appears to be behind us, FIS should be able to grow these businesses in the mid-single digits. Secondly, the $230m default management business has grown in a weak default market since ’03 and should accelerate meaningfully in ’06 and ’07. Fiserv has similar mortgage exposure and trades at 17x forward EPS.
DISCLAIMER: This is not an offer to buy or sell securities. We may own CEY and may buy or sell at any time. This posting is merely for informative purposes.

Catalyst

- Payment of $3.75 special dividend just prior to merger close
- Merger close in late January
- Analyst day in February where pro forma guidance will be given for the first time.