Description

As I discuss below in detail, FDC is a business that is significantly undervalued relative to its strong cash flow generating capability, robust growth outlook, leadership position, accelerating underlying business momentum, and good leadership.  FDC’s value is apparent when one asks: how much should one pay for a company that will grow FCF 8.5% for the next 5 years, 5.8% for the following 5 years, and 2.5% for a very long time after that?  A DCF at a 9% discount rate suggests 21x!  FDC currently trades at only 15.8x 2007 sustainable FCF, a significant discount to this fair valuation (that’s a 6.3% sustainable FCF yield!).

 

Financial Summary

 

                                                2006                2007                2008                2009   

Reported EPS                         $1.11                $1.33                $1.50                $1.66

Sustainable FCF                     $1.31                $1.57                $1.78                $1.98

FCF                                         $1.65                $1.87                $2.04                $2.20

 

PE Multiple                            22.3x                18.6x                16.5x                14.8x               

Sustainable FCF Mult           18.9x                15.8x                13.9x                12.4x

FCF Mult                                15.0x                13.2x                12.1x                11.2x

 

Sustainable FCF Yield                                     6.3%                7.2%                8.0%

FCF Yield                                                         7.6%                8.3%                8.9%

 

 Comment on Key Financial Metrics

FDC is a business that has zero to negative Net Working Capital.  Thus, regardless of the growth rate, the need for incremental working capital on the business is essentially 0.  Furthermore, FDC has about $400mm of pre-tax amortization that makes reported EPS < reported FCF and sustainable FCF. 

 

The best metric to show FDC’s underlying cash flow generating capability is a metric we define as “Sustainable FCF”.  Because of FDC’s low working capital needs and the need for little incremental investment to support 4% growth vs. 10% growth, Sustainable FCF is roughly equivalent to a traditional “Cash EPS” definition.  However, I have chosen to use the label of “Sustainable FCF” because it highlights that the company will have 100% FCF conversion of Cash EPS even when the business is growing around 10%/year.

 

Because FDC currently reaps the benefits of tax-deductible amortization, the reported FCF for the foreseeable future is even better than the “Sustainable FCF.” 

 

To summarize the two key definitions:

·         “Sustainable FCF” = Reported EPS + (D&A – CapEx – Cust Acq Costs) * (1 – 40% tax rate)

·        FCF = Reported EPS + (D&A – CapEx – CustAcq Costs)

  

Valuation Summary

 

NPV of FCF @ 9%:   $34.80

 

Multiple-Mix Analysis:

2007

2007			EBITDA	Sustainable	FCF
			$MM	FCF/Share	MULT	VALUE
Merchant Services			1,543.3	$0.98	20.0x	$19.58
Financial Institutions Segment			559.6	$0.36	12.5x	$4.44
First Data International			452.1	$0.29	25.0x	$7.17
IPS			19.8	$0.01	9.0x	$0.11
Corporate/Other			(107.7)	($0.07)	19.0x	($1.30)
TOTAL			2,467.2	$1.57	19.2x	$30.01

 

2008

2008			EBITDA	Sustainable	FCF
			$MM	FCF/Share	MULT	VALUE
Merchant Services			1,697.7	$1.11	20.0x	$22.25
Financial Institutions Segment			581.4	$0.38	12.5x	$4.76
First Data International			554.4	$0.36	24.0x	$8.72
IPS			20.1	$0.01	9.0x	$0.12
Corporate/Other			(137.1)	($0.09)	19.0x	($1.70)
TOTAL			2,716.5	$1.78	19.2x	$34.14

 

The multiple/mix analysis above uses multiples for each segment that are conservative.  The fair multiples based on a DCF of FCF’s at 9% would be:

·        22x for Merchant Services

·        15x for Financial Institutions Segment

·        31x for First Data International

 

 Thesis

FDC is a business that is significantly undervalued relative to its strong cash flow generating capability, robust growth outlook, leadership position, accelerating underlying business momentum, and good leadership.  FDC’s value is apparent when one asks: how much should one pay for a company that will grow FCF 8.5% for the next 5 years, 5.8% for the following 5 years, and 2.5% for a very long time after that?  A DCF at a 9% discount rate suggests 21x!  FDC currently trades at only 15.8x 2007 sustainable FCF, a significant discount to this fair valuation (that’s a 6.3% sustainable FCF yield!).

 

The first question to answer is “Why is FDC undervalued?”  I believe two key factors are at play.  First, FDC has a significant amount of amortization and the difference between its FCF and reported EPS is very large.  FDC does not report “Cash EPS”, and most of the analysts focus on FDC’s valuation relative to reported EPS.  Cash EPS for 2007 will be $1.65 vs. the reported $1.33.  This is a big difference, and one that most analysts do not highlight or even mention!  Furthermore, FDC has a very impressive future FCF profile.  Specifically, because the business has 0 net working capital needs and minimal incremental cap ex needs to fund growth, FDC can have 100% Cash EPS to FCF conversion as it grows 10%.   That is an exceptional profile that is not reflecting in the stock right now.

 

The second reason FDC is undervalued is that prior to the spin-off of Western Union (earlier this year), it was viewed as the less attractive of the two businesses.  WU was viewed as the gem and the reason to own the former FDC and the “new” FDC was viewed as something you have to buy in addition to get exposure to WU.  WU may be a better business (or it may not be), but the focus on WU made people miss the point that the “new” FDC business is an excellent business in its own right.  FDC has some of the key elements that make post spin-off stocks very successful investments including some neglect by the analyst community and being the less desirable step-child while part of the prior conglomerate company.

 

The new, post-spin FDC consists of three main segments: Merchant Acquiring/Servicing (60% of EBITDA), Financial Institutions Segment which consists of credit card processing and the STAR PIN debit network (22% of EBITDA), and International which represents the two aforementioned businesses in ex-US markets (18% of EBITDA).  The main drivers of growth are merchant acquiring/servicing and International.

 

Merchant acquiring is a good business that has the ability to grow revenues 8-10% for the next 3-5 years, EBIT 10-12%, and to generate 100% FCF conversion while generating this growth.  This business is all about FDC getting both on-ground and on-line merchants to accept plastic payments of many different types (Visa, Mastercard, Debit, Prepaid, Gift, and a few other emerging options).  This business has grown 6% organically over the past few years, and the growth rate has recently accelerated to 8-10%.  FDC dominates this market with a 50% share (the #2 player is Bank of America with a 16% share).  The overall market looks as follows:

 

                                                2005 Mkt Share

FDC (direct & alliances)           49%

BOA Merchant Services           16%

US Bancorp                             8%

Fifth Third Bank                       7%

Global Payments                       3%

Heartland                                 2%

Others                                      15%

 

FDC’s 49% shares is actually 15% from FDC direct, 28% from the Chase Paymentech JV, 4% from the Well Fargo JV, and 2% from other JV’s.

 

The merchant acquiring business is a good business because it has strong secular growth and FDC has a leadership position that gives it several scale advantages.  The merchant acquiring market is a beneficiary of the trend in the US (and abroad too) toward plastic payments.  As more and more consumers turn to plastic and more and more merchants decide to accept plastic, FDC benefits.  The model is for FDC to get a fee per each transaction done with each merchant.

 

FDC is the 800 lb gorilla in the merchant acquiring market, and its market dominance gives the company scale advantages.  To be specific, the merchant acquiring business has a certain amount of fixed or scalable data processing, networking, and computing costs.  As the largest player, FDC’s average costs and incremental costs in this area are lower than its other competitors.  FDC also enjoys some benefits by having better density economics for its salesforce, though this is of secondary importance.   FDC has also positioned themselves as the partner of choice (partially because their superior scale allows them to write better contract terms profitably) for banks who partner with FDC on join-venture marketing.  In fact, about 2/3 of FDC’s market share comes from sales made with JV partners.  Partnering with a bank is great because the customer acquisition costs are $800-1000 vs $1,500 when going direct.  The beauty of the JV is that customers naturally go their bank to see about getting set up to accept credit cards, so the acquisition costs are lower.

 

FDC appears to be executing well, as evidenced by the recent accelerating organic revenue growth and nicely expanding margins.  The division is headed by a new president, Ed Labry, who took the reins in January 2006.  In our field calls with industry experts, Mr. Labry has received high markets and is viewed as a strong leader who is taking the company in the right direction.  He is known to be an effective salesforce manager, and one of his big initiatives is to improve the retention of existing customers.  He is already showing progress on this dimension.

 

The international segment is also driven by the merchant acquiring/processing segment and is even more attractive than the US market because it is at an earlier stage of its growth curve and offers a huge secular growth opportunity for the next 10+ years.   FDC has a leadership position in its international markets and is continuing to expand with additional acquisitions and JVs.  EBITDA margins are currently lower for the international segment than the US segment (26% International vs. 33% US) but they are set to grow over time as FDC gains scale in its individual international markets.

 

The US financial institutions segment (22% of EBITDA) is FDC’s least attractive business.  Fortunately, expectations for this segment are low and FDC is poised to beat these low expectations.  Specifically, the market appears to be pricing around 0-3% organic revenue and EBIT growth for this segment.  This segment has had a rough past few years with modestly negative revenue growth as a result of several large customers deciding to bring their business in-house and some competitive losses to TSYS and Visa’s debit network.  While I do not expect this segment to become as robust a business as merchant acquiring, we do believe that the drags of the past few years are unlikely to recur (and if they recur, the magnitude will be a lot less).  I expect growth to get up to 3-5%.  Management actually has the official target of getting back to 8-10% growth in this segment in a year.  I view this expectation as optimistic, but not impossible.  There should be no major de-conversions in the next few years and the STAR debit segment in our estimate now represents more than 50% of that segment’s EBIT and is poised to grow nicely for the next few years.  Most importantly, expectations for this segment are low, and hitting this target would be additional upside to our current target (we are only giving this business a 12.5x sustainable FCF multiple in our current valuation due to some of our lingering skepticism of this segment).

 

It is important to note that the business momentum has been strong over the past few quarters.  Organic growth in merchant acquiring and international has been robust, and both Merchant Acquiring and FIS have shown nice margin expansion:  Managements official targets do not call for a continuation of the robust margin expansion seen over the past few years, and they say they plan to reinvest the potential upside into growth initiatives.  I believe the current operating backdrop leaves a nice margin for management to hit its targets.

 

Finally, FDC should be a beneficiary of the current market environment which will reward stable, cash-flow generating companies with a higher valuation as investors search for yield.  In the current market environment where the 10-year and 30-year bond rates are low, risk premiums are minimal, and equities provide one of the few sources of decent returns, we believe FDC is a candidate for upward revaluation as the implicit discount rate for this growing perpetuity company goes down.  FDC is currently underleveraged, and it is even possible that FDC could emerge as an LBO target.

 

Management has been a good steward of shareholder capital.  The company has been actively and aggressively buying back shares, and pays a 1% dividend too.  I am confident that FDC will continue to deploy its copious FCF in an effective manner.

 

One last final kicker comes from the IPS segment (this business processes official checks).  This business is currently generating negligible profitability because it is a spread driven business and the current yield curve has hurt the business.  However, over time, this segment could normalize to generate ~ $0.15 of earnings power worth an additional $1-2/share.  I have kept this business at zero, but it is a source of some additional incremental upside in 2008 or beyond.

 

One of the big concerns on the stock is that while the company talks about 8-10% revenue & EBIT growth for each segment, the company is also talking about “only” 8-10% EPS growth too.  If this company is such a FCF machine, why doesn’t the official model allow EPS growth to grow faster than EBIT growth?  The answer is two fold.  First, the way that FDC is expensing options is creating a 4c/year incremental headwind for each of the next three years!  This takes away 3% of growth right there and is a big part of the disconnect.  Second, it appears that management is just being a little conservative with their guidance and leaving some room to outperform.  After investigating this issue at length, I am confident that the model will provide room for EPS to exceed FCF growth by the FCF yield over time.

 

Thesis Summary

§         FDC is undervalued

ú         Significant FCF and cash earnings generation is masked by lower reported earnings

ú         Legacy perception that FDC is a weaker business versus Western Union

§         Key businesses are attractively positioned

ú         US Merchant Services (60% Ebitda)

§         Strong underlying secular industry growth

§         Improving organic revenue growth

§         New leader has excellent industry reputation

§         Market leadership = lowest cost processor

§         Bank Alliance = competitive advantage

·         Lower cost to acquire   

·         Hard to replicate

ú         International (18% Ebitda)

§         Faster secular growth versus US

§         FDC has best positioning

ú         US Financial Institutions (22% Ebitda)

§         Least attractive but investor expectations are low

§         Evidence of improved execution

§         Potential for higher growth from STAR as customer losses have been anniversaried

§         Downside mitigated by

ú         Share repurchases

ú         Low financial leverage (Net Debt ~ 0.6x ebitda)

ú         Normalization in earnings (+ $0.15) from official checks business

Potential Risks

§         Faster price erosion in Merchant Services

§         Loss of key JV partners in Merchant Services or customer losses in Financial Institutions

 

Risks

 

1)      Intensified Competition / Faster Price Erosion: The biggest challenge in forecasting FDC’s future growth and profitability is trying to figure out how quickly prices will erode over time.  While underlying transactions appear to be pretty predictable, price erosion of 3% a year vs. 5% vs. 7% would have a big difference on the growth rate.  I have comfort on this issue because the rate of price erosion has consistently been 3-5% over last several years, and it appears the trends have been stable.  There is no major new entrant disrupting the pricing dynamics, and some industry observers are hopeful that as the mix moves to more small and midsized merchants who have less bargaining leverage that the rate of decline can actually get better.  The rate of price erosion is primarily a function of overall volume growth and the march down the scale curve.  The industry is competitive, and the players are forced to share some of the improving scale economies with their customers (lest they would be tempted to insource or find other alternatives over time).  Fortunately, FDC is growing at least as quickly as the market and has leading scale, so the rate of erosion should be manageable for FDC.

2)      Loss of Key JV’s in Merchant Services: Significant JV’s are with Chase Paymentech (58% of Merchant Services volumes) and Wells Fargo (8% of Merchant Services volumes). The contract with Paymentech was resigned in October 2005 and expires in October 2010.  If the parties choose not to renew the contract then the merchant portfolios will be split between Chase and FDC in proportion to each party’s economic ownership (Chase 51%:FDC 49%) in the JV.   I believe that it would not be in Chase’s economic interest to terminate the JV as they would have to forgo operating scale in the Merchant Servicing business.

3)      Loss of Key Credit Card Processing or STAR customers in FIS:

GE and Citibank are now the largest card processing customers and are signed under long term contracts.  We believe that as long as FDC continues to execute well in this area they will retain these key customers.  In fact, FDC announced recent competitive contract wins in resigning Wells Fargo Bank and signing the Sears Bankcard Portfolio (owned by Citibank) which suggests that FDC is performing better than anticipated.

STAR experienced ~ 25% loss in processing volume due to significant customer losses to VISA Interlink in 2004.  Due to the lengthy de-conversion process, earning loss was only anniversaried in Q3 2006. I believe that the risk and impact of potential future customer losses is low because:

§         STAR’s bank customer base now primarily consists of regional banks that individually have low negotiating leverage over STAR

§         STAR’s pricing is now competitive with that of VISA

§         STAR and VISA now have similar market share and banks have a vested strategic interest in the viability of more than one competitive network

§         VISA is set to go public and as a public entity will have less flexibility to make non-economically motivated contract bids

 

Visa/Mastercard attempts to push rules that prevent other “bugs” on cards: According to the association’s rules, Visa and Mastercard have the right to prevent member banks from using competing networks that the associations deem to be “competing national networks”.  I think that the associations will not choose to exercise this right as other national networks (American Express and Discover) have successfully legally challenged the associations attempt to engage in similar anti-competitive practices.

 

Key Background Information

Company Presentations

·         “2006 Investor Conference Slides” -- 9/20/2006

·         “2006 Investor Presentation” -- 1/26/2006

 

Sell-side Notes

·        First Analysis  10/9/2006

·        CIBC 10/5/2006—“After the Spin-off of WU: Cash Generation Is the Key to Valuation”

·        Merrill Lynch 10/3/2006—“Single and attractive; seeking cash flow fans”

 

Sell-side Initiations

·        Morgan Stanley 5/17/2006—“Assuming Coverage with an Overweight Rating: Breaking Up is Good to Do”

·        CIBC 10/5/2005—“Initiating Coverage: Recognizing Undervalued Assets”

Catalyst

increasing recognition and following of this company post the mid-2006 spin-off; possible LBO; upward revauation as 7.6% FCF yield hits peoples screens; active share repurchsae that could get more aggressive over time; LT potential to level the company up and do an aggressive buyback/recap