Description

Elevator Pitch

This is a relatively staid pitch of a high quality business trading at an attractive valuation.  FIS is a processor and software-based technology solutions provider operating within three segments: Banking, Capital Markets, and Merchant.  FIS recently agreed to sell 55% of its weakest segment, Worldpay (merchant processing), to private equity, with the remaining 45% accounting for less than 10% of FIS’s proforma value.  Remainco is a high quality compounder characterized by high recurring revenue, economic resilience, and meaningful competitive advantages which lead to a highly durable franchise.  Financials are characterized by high returns, high incremental margins, low-mid single digit organic growth, lower post-transaction leverage, and a management team committed to returning capital.    

Excluding the implied (transaction) value of FIS’s 45% stake in Worldpay (WP), remainco is trading for only 10.3x ‘24e EPS and 7.7x EV/EBITDA, a massive discount to the 19x earnings FIS averaged in the five years prior to the 2019 acquisition of WP.  At just 16x earnings, we estimate an almost 50% total return over the next year.  While the return is not mouth-watering, we find it attractive on a risk-adjusted basis in what feels like a late-cycle economy.  

Investment Thesis

The Banking Solutions segment will account for approximately 63% of remainco operating earnings, Capital Markets 29%, and WP minority interest 8%.  Let’s take a look at each segment.

Banking Solutions 

The Banking Solutions segment provides core bank processing software & systems which is mission-critical software used to maintain customer financial records and is at the heart of everything banks do on a daily basis like processing deposits and loans.  FIS offers many complimentary applications like digital payments, regulatory & compliance, fraud & risk management, mobile, card, etc. that are integrated into the core processing and ledgering system.  The slide below lists many of the solutions they offer.

This segment also houses the NYCE network, a proprietary debit network and issuer processing business for debt and prepaid cards.  Lastly, the banking segment offers processing software & services to wealth and asset managers.  They recently onboarded T.Rowe Price and Franklin as new clients (not sure why they put this in the banking segment and not the capital markets segment).

The Banking Solutions segment benefits from a strong competitive position resulting from two key advantages: scale and switching costs.  Morgan Stanley estimates FIS has 80% market share among medium and large banks.  This provides massive scale which results in a huge cost advantage vs. smaller competitors.  A mostly fixed cost structure leads to extremely high incremental margins and returns.  Regarding switching costs, given the critical nature of a bank’s core processing system, they are very hesitant to ever switch providers.  Other than putting the whole system at risk, employees would have to be retrained on a whole new system.  As a result, customer retention is ~99%.  

So it is no wonder Banking Solutions has deep client relationships and long-term contracts leading to high renewal rates and ~80% recurring revenue.  A transition from software licensing to a SaaS model over the last few years helped to increase the recurring nature of revenue.

Key to getting a full multiple recovery is returning the banking segment from the recent 1-3% organic growth to management’s stated expectations of 3-5%.  Trailing five-year sales CAGR is 4.8%.  Segment sales began to soften last year as banks slowed their decision making due to an uncertain macro.  Backlog has been flat for several quarters.  It is very important to note here that FIS is paid on the number of accounts (60% of revenue) or number of transactions (40% of revenue).  So while the pipeline is flat, revenue can still grow at the targeted 3-5% without a growing backlog as long as the number of accounts and transactions is stable and growing.  Also notable is they have not been aggressive on pricing in recent years.  We believe they can easily achieve 2-3% annual pricing and get to 3-5% total growth with modest growth in accounts & transactions.  

While Banking segment sales were up almost 5% last year, margins were down a couple percent due to a mix shift from software to services as well as cost inflation.  We expect this to stabilize and possibly reverse as labor costs have recently stabilized.  Also, FIS is making a committed effort to improve the software/services mix to improve margins.  At a recent Goldman Sachs conference the CEO mentioned “green shoots” in banking with the pipeline getting filled with higher margin business.  She expects this to benefit 2H23 and 2024 margins and growth.

One reason FIS may be out of favor today is its exposure to the banking industry, which is under pressure on a number of fronts (large unrealized losses in bond portfolios, increased regulation, deposit flight, recession fears).  We actually share these concerns and, intuitively, they could pressure bank industry technology spending.  However, we think the impact on FIS would be marginal, similar to what we’ve seen this year with sales growth slowing from 4% to 2%, but not going negative.  Consider,

1. FIS’s earnings have historically been resilient to industry weakness due their long-term contracts and the recurring nature of processing.  A 99% renewal rate and >80% recurring revenue provide a stable base.  And again, revenues are tied to the number of accounts or number of transactions, not spending levels or credit quality.  So while they have seen “sales cycle elongation” in recent quarters and the pipeline has gone flat, they still grew segment recurring revenues 3% last quarter. 

2. Despite industry pressures over the past year, Gartner forecasts (based on industry CIO surveys) banking and investment services technology spending to increase by 8.1% this year, with software leading the way with an estimated 13.5% increase.  A survey by S&P conducted after the SIVB collapse found similar results.  Rather than cutting IT budgets, banks see technology as a way to improve business outcomes.  For example, higher rates should lead to greater competition for sticky deposits as they become even more valuable to banks.  In 2Q FIS saw bank clients increase conversations around deposit gathering applications such as their digital bank offerings.  They have also seen an increase in new accounts since  SIVB-geddon.  The point is some of the industry concerns could actually lead to more tech spending in some areas.  Another surprising result from the S&P survey was only 35% of bank customers are transacting digitally, and that’s after the pandemic which forced many to transact online.  Fintech should benefit as this number increases.

Another concern is bank consolidation.  Again, this concern is unlikely to impact FIS.  First, Morgan Stanley estimates that FIS has 80% market share in core bank processing among mid & large banks, with Jack Henry primarily focused on the small bank market.  With such high market share, the opportunities to lose a large account via consolidation are limited.  And assuming large banks acquire small banks, consolidation should actually benefit FIS because their revenue skews toward the large banks.  Second, FIS has thousands of bank clients and doesn’t really care if this number declines via M&A because the number of accounts and transactions don’t change.  

In the broad scheme of things, this remains a highly defensive business in almost all economic environments, with industry or economic weakness taking growth from 3-5% to maybe 1-3%, but not negative. 

Capital Markets Solutions

The Capital Markets Solutions segment was formed via the 2015 acquisition of Sungard Data Systems.  It is about half the size of the banking segment accounting for almost 30% of EBITDA.  Similar to the banking segment there are a few sub-segments.  The biggest is traditional trading and processing systems for both the buyside (asset managers) and sellside (brokers), as well as private equity.  Second, FIS offers treasury and risk management software for banks, insurance companies, or really any company that needs software to run a treasury dept.  Similar to the banking segment, the capital markets segment offers a lot of different applications that integrate with their core product which allows CFO’s to more efficiently manage the treasury function.  Lastly, the Capital Markets Solution segment offers commercial and asset-based lending products.

This segment has similar competitive dynamics to the banking segment, however, barriers to entry are a bit lower.  Traditional competitors include SS&C and Broadridge, and a lot of small next-gen competitors.  

The Capital Markets Solutions segment is firing on all cylinders today as their modernized technology in a SaaS model is resonating with clients.  Recurring revenue grew 10% last quarter, accelerating from the already healthy five year CAGR of over 5%.  And the business is exhibits excellent scale with margins expanding every year the last five years by roughly 1% annually.  This has led to an EBITDA CAGR of over 7% the last five years.  EBITDA margins are over 50%.  At this level of profitability management prefers to reinvest for growth, so we do not expect margin expansion from here.

Lastly, the transition to a SaaS model in the Capital Markets segment has made results more consistent and driven more stable growth and higher margins.  It has also helped recurring revenue improve to over 70%. 

Worldpay

WP is the largest merchant acquirer and card processor in the world with 20% market share.  This is another processing business where scale is a critical ingredient to success due to the fixed cost nature of the business.  WP obviously has massive scale with leading market share and global distribution.  WP is one of just a handful of processors with the size & scale to process for large merchants.  WP has three segments: Enterprise (43% of sales), eCommerce (30%), and SMB (27%). 

WP has struggled under FIS's ownership - losing market share, specifically in the SMB and Enterprise segments.  Lost in the negativity around WP over the last couple of years is the simple fact that they are still #1 in merchant acquiring with $2T in payment volume in a business where scale is critical.  And despite the share losses they are still growing with double digit growth in eCommerce offsetting declines in Enterprise and SMB.  The ongoing societal shift from cash to card allows even subpar merchant acquirers that are losing share to grow, albeit modestly.   

In July 2019, FIS acquired WP for $43B.  In July 2023, FIS announced an agreement to sell a 55% stake in WP to p.e. firm GTCR at an implied value of $17.5B plus a $1B earn-out.  Oops. The transaction price equals 7.8x ‘22e segment EBITDA and 9.8x EBITDA after estimated corporate and dis-synergies.  

FIS will retain 45% of WP worth $7.30 per FIS share at transaction value, and receive $11.7B in cash at closing, anticipated to be in 1Q24.  FIS is anticipated to apply $9.2B to debt reduction and $2.5B to share repurchases, bringing pro-forma debt down to $10B and reducing debt/EBITDA from 3.2x to 2.5x at closing.  FIS will report earnings from WP via the equity method and should contribute ~$.57 to FIS ‘24e EPS.  

WP will operate as a stand-alone private company under the leadership of its prior CEO, Charles Drucker. 

We won’t spend a ton more time here given FIS's reduced exposure to merchant processing other than to say that in merchant processing, the marginal cost to process a transaction is close to zero, so incremental margins are close to 100%.  But the high operating leverage in processing cuts both ways.  As long as the flywheel is moving forward things are great, but when you start to lose volume in a fixed cost network, you get crushed.  And that’s where things stand at WP today.  They are losing share and organic growth is barely positive.  Keeping it positive is critical to maintaining profitability.  Based on management comments it is clear WP wants, and needs, to do some strategic M&A to plug some gaps in their product offering, particularly in SMB.  GTCR has committed an additional $1.25B in equity capital for WP to pursue M&A.  We envision WP doing some needed strategic deals, paying down debt, and IPO’ing in a few years.  FIS management has stated intentions to exit their remaining Worldpay stake.  Given the need to fix the business and de-lever a bit prior to an IPO, an exit could be a ways away and be an impediment to FIS reaching fair value in the near-term.

Financial Characteristics and Recent Results

Processing and software are high margin, capital light businesses that have excellent cash flow characteristics.  Management expects remainco FCF to approximate EPS, although it has historically run ~70% EPS, partly due to working capital needs.  More recently, FCF conversion has been excellent (94% YTD) and management has committed to FCF conversion as a KPI.  The capital light nature of the business leads to an extremely high ROIC.  In fact, FIS operates with negative tangible equity.  Remainco capex has been running slightly less than depreciation the last five years.  (D&A is primarily amortization of capitalized software development costs.)  

As already discussed, FIS is a highly defensive business that should not experience much cyclicality, so EPS and FCF should be stable.  For example, during the financial crisis in 2007-9 (a reasonable worst case scenario), organic revenues only declined by ~1% annually.  During the pandemic in 2020 & 2021 banking revenue grew 6.3% and 7.6%, respectively, while capital markets grew 5.3% and 7.5%.  In 1H23 during the failure of SIVB, Signature, and Silvergate, banking segment revenue grew 2%.  FIS should be able to maintain positive growth in almost any environment simply through pricing.  Management's long-term guidance for 3-5% organic growth at remainco is nothing exciting but probably close to GDP growth with much lower risk and higher returns.  Using history as a guide the high end of this range should not be a stretch.  

Given this modest growth and high levels of FCF, capital allocation will take center stage.  Management has a clear focus on returning capital to shareholders post the WP transaction.  FIS has committed $2.5B of the WP sale proceeds to share repurchases, or 7% of shares.  They have also committed to a 35% dividend payout ratio, a 2.9% yield on today’s price.  But wait, there’s more!  Remainco debt/EBITDA will decline from 3.2x to 2.5x post-transaction, and should be down to 2.0x by FYE24 if FCF is applied to debt reduction.  This is below FIS's target of 2.5-3.0x.  Illustratively, FIS could buy back 14.4% of their shares by taking their leverage from 2.0x to 3.0x.  Given the attractive valuation, low pro forma leverage, and management's focus on capital returns, continued large buybacks are likely IMO. 

Earlier this year FIS announced the Future Forward initiative, designed to improve efficiency and free cash flow.  FIS expects a total of $1B in cash savings at remainco, broken down roughly as follows: 

Capex is down already 13% this year and 2H23 margins are expected to ramp higher as a result of the initiatives.  Next year, the $215MM in cost savings will largely be offset by $200MM in WP dis-synergies.  The remaining $175MM should add ~$.25 to EPS in 2025.  The $400MM capex reduction is equal to a $.73 per share improvement to FCF. 

2023 numbers feel a little bit sandbagged.  FIS appointed a new CEO on January 1st, Stephanie Ferris, who spent no time bringing down 2023 guidance by a huge 11%.  Most of the reduction came at WP where they built a recession into their guidance, which clearly hasn’t occurred.  In the banking segment, despite a flat backlog, account and transaction growth at existing clients continues to drive modest recurring revenue growth, 3% last quarter.  In capital markets recurring revenue growth of 10% in 2Q drove continued margin expansion, again not in guidance.  In all 1Q and 2Q23 beat consensus by 5% and 7%, respectively.  We have a hard time getting to their guided $3.9-$4.0B for proforma remainco EBITDA.  We model $4.06B for ‘23 and $4.25B for ‘24.  This includes WP dis-synergies, which are offset by previously outlined cost savings from their Future Forward program.

Labor cost inflation, which impacted last year’s margins, has been moderating.  FIS cannot reprice long-term contracts so there is a lag effect to capture that inflation in new contracts over the next few years.  Longer-term we expect improved pricing to bring margins back up to historical levels.

Management

FIS's new CEO and CFO are TBD.  CEO Stephanie Ferris was previously FIS’s COO and CAO, responsible for global strategy and the WP integration, among other things.  Prior to that she was the CFO of WP.  Given her time at WP it is interesting that her first move was to undo the WP acquisition and bring back the old WP CEO.  

FIS appointed a new CFO over the summer, James Kehoe.  He was previously Walgreens CFO.

The management turnover is something to watch.  The WP transaction came at a high cost when considering the transaction price, dis-synergies, and tax consequences.  It felt a little bit forced.  However, their message of “get back to a high quality compounder and return capital to shareholders” resonates well.  In the near-term they appear to be taking a very conservative approach to guidance.  

Valuation

As shown below, proforma remainco trades at only 10.3x ‘24e EPS and 7.7x EBITDA.  That is a draconian multiple for a wide moat business.  This is the money shot:

Prior to the Worldpay acquisition FIS traded at a slight premium to the market on both P/E and EV/EBITDA (note the median includes the huge contraction over the last two years).  

On an absolute basis, FIS’s P/E averaged ~18x NTM EPS in the five years prior to the WP acquisition, or ~19x trailing earnings.

Slow growth and competitive issues at WP are the primary culprit behind the multiple contraction at FIS, IMHO.  Now that WP is being sold, we think FIS can return to “high quality compounder” status and trade back to the premium multiple deserving of a company with its superior financial and fundamental characteristics. However, we use a multiple of only 16x in our valuation, reflecting the need to 1) exit their remaining stake in WP and 2) return the banking segment to consistent 3-5% organic growth.  So we have conservatively assumed an almost 15% discount to the market multiple rather than the historical premium.  (As an aside we chose to use P/E rather than EV/EBITDA for historical comparisons due to the significant change in the corporate tax rate which makes EV/EBITDA comparisons less useful.)  16x earnings on ‘24e leads to a one-year expected return of 46%.

Pick your scenario:

Another way to look at valuation is to include the earnings from the WP minority interest in FIS's EPS.  Proforma for the 55% sale of WP, FIS should report total EPS of ~$4.83 inclusive of the WP minority interest.  This puts FIS trading at only 11.1x ‘24e today, and only 15.9x on our target price of $76.75.   

Risks

Risks have mostly already been addressed in the body of this report.  The primary risks are:

Bank industry downturn - Already discussed.  Regardless of the earnings impact to FIS though, the stock tends to trade with the banks (see the trading around SIVB collapse).  If you don’t care about the 1-2 year horizon and are more focused on the long-term you can mostly ignore this risk.  

Bank Segment Growth & Margin Recovery -  Organic growth and margins need to improve.  We expect margin improvement as the Future Forward program progresses, inflation cools, and FIS increases pricing to offset the higher labor costs.  

Higher Interest Rates - Higher rates could have a couple negative impacts.  First, it could make bank client deposits less sticky, moving from traditional banks to online-only banks, for example.  Second, it would increase borrowing costs.  FIS’s current average cost of debt is 3.5%.  That is clearly going higher.  In the extreme case that their borrowing costs doubled to 7.0% it would lower EPS by ~12%.  It would put much more pressure on WP which is levered over 4x. 

Insider activity - Of note, despite the big decline in the stock price there has been very little buying.  Considering how wealthy the board members are, it would be nice to get some confirmation via insider buying.  There has only been an orchestrated token buy so far.

Stay tuned for an analyst day on November 15th.

DISCLAIMER: THIS IS NOT A RECOMMENDATION. The securities described are neither a recommendation nor a solicitation. There are no assurances that securities identified in this note will be profitable investments. The stated opinions are for general information only and not meant to be predictions or an offer of individual or personalized investment advice. This information and these opinions are subject to change without notice. Security information is being obtained from resources I believe to be accurate, but no warrant is made as to the accuracy or completeness of the information. Any type of investing involves risk and there are no guarantees. The author may or may not have material positions in the securities mentioned in this note and will not be obligated to give notice of any changes in their views or positioning. The author makes no representation or warranty, express or implied, regarding the accuracy, completeness, or adequacy of the information. The author accepts no duty of care to you in relation to investments. Past performance cannot be relied on as a guide to future performance.

Catalyst

WP transaction closes.

Banking segment growth and margin improvement.