Value Investors Club / First Data (FDC)

Description

First Data (FDC) was written up twice in 2016 so I’ll keep the business description brief.

Business Overview

FDC is the largest global payments processor, business operating across three lines of business:

Global Business Solutions or GBS (~65% of total revenues)
- This is FDC’s merchant acquiring business and handles authorization, clearing, and settlement of transactions and related reporting for merchants ranging from SMBs to the largest global enterprises
FDC goes to market across three distinct channels (each ~1/3 of the North American GBS business)
- Partner Solutions – represents integrated software vendors (ISVs), wholesale and retail ISOs, and agents that sell FDC processing services, mostly to SMBs
- Direct – direct sales of FDC services to SMB and enterprise merchants
- JV – An array of JVs, alliances, and referral programs, mostly with large banks. FDC has 8 bank JVs, the largest of which are with Wells Fargo, Bank of America, and PNC
Global Financial Solutions or GFS (~17% of revenue)
- Primarily consists of issuer processing and card issuance for financial institutions worldwide
Network & Security Solutions or NSS (~17% of revenue)
- Consists of network processing through FDC’s STAR debit network, as well as risk management and fraud solutions
EBITDA margins are in the mid-40s for all three segments so profit contribution should roughly approximate revenue mix
A little over 20% of the business is international, spread across Europe, Latin America, and Asia. This business is growing mid-teens and should have long runway for growth given lower levels of electronic payment penetration outside of the US

Investment Thesis

It’s worth quickly revisiting FDC’s history, as numerous factors hindered performance over the past few

years and FDC carries a lot of baggage around with institutional investors who have followed the name.

The company was taken private by KKR at top of the market in 2007 and things went south almost

immediately. As a private company, FDC had 5 CEOs in 6 years, though current CEO Frank Bisignano has

established some semblance of stability with his now 5-year tenure, during which he’s hired many of his

former colleagues from J.P. Morgan to fortify FDC’s management team. The company’s high debt load

also put them on the defensive (leverage topped out north of 10x) as they prioritized debt paydown

over reinvestment in the business while the broader industry was undergoing a major shift towards

integrated payments which FDC basically missed. This was exacerbated by weakness in the

aforementioned bank JV channel spurred by Wells Fargo’s regulatory issues, which caused banks to pull

back on their historical practice of cross-selling products, including acquiring services, into their

customer base. Industry/investor perception was that FDC was a perpetual share donor with an inferior

solution, as evidenced by its below-market growth (organic growth in the all-important North American

GBS segment slowed from ~4% to 1-2% in 2016-2017). This all culminated in 2017 when management

basically conceded that they needed to buy their way into the integrated payments business, spending

$1.6bn to acquire Bluepay and Cardconnect after promising investors that de-leveraging was their #1

priority. By early 2018, shares had dropped back below the IPO price.

So why is this interesting now?

For one, it turns out that the Bluepay and Cardconnect acquisitions were money well spent. FDC’s 2013

acquisition of Clover also looks increasingly smart as Clover has distanced itself from the pack, along

with Square, as a leader in the next gen POS device market (FDC’s SMB direct business has seen

merchant attrition go from 40% in 2015 into the mid-20s today, a change they attribute largely to

Clover). FDC’s position in the fast-growing integrated payments channel has improved dramatically and

our checks indicate that they are at least maintaining if not gaining share in this market segment.

Growth in the North American GBS segment has followed, accelerating from flattish in 2016/2017 to

MSD in 2018 and management is guiding for similar levels of growth in 2019, even with continued

headwinds in the bank JV channel which should eventually subside as FDC’s efforts to digitize this

channel gain traction.

FDC now has a collection of assets which should be able to drive steady MSD organic growth for the

foreseeable future (e.g., 20% of the business is international and growing in the mid-teens). We’d refer

folks to the company’s spring investor day presentation which does a good job breaking down the

business mix and relative growth rates (https://investor.firstdata.com/webcasts-events-and-

presentations/12-06-2018).

With the house now in order, FDC should now be able to refocus its efforts on debt paydown. The

company’s 5.3x net leverage (down from ~6x at the beginning of the year) clearly elicits an allergic from

many investors, particularly among long only investors as evidenced by the lack of representation of the

large mutual fund complexes on the holders list. Management has guided to leverage in the low 4x

range by year-end 2019. We think crossing the rather arbitrary ~4.5x level is an important milestone

and should make FDC shares more appealing to a broader set of investors.

There are also some interesting call options that could work in FDC’s favor. For one, KKR’s ownership

and the related dual-class structure precludes FDC’s inclusion in the key indices. Management has

indicated that both they and KKR have a desire to solve this issue over the medium-term (~2 years). This

could provide a technical tailwind to the extent new classes of investors emerge.

Second, while I won’t spend much time on it because I don’t think it’s necessary to get excited about the

investment, some investors point to the potential value of Clover within FDC. Clover processes a similar

amount of transaction volume, is growing faster, and is just beginning to roll out value-added products

and services in addition to basic payment processing….and Square’s market cap is $22bn vs. FDC’s

enterprise value of $32bn. There are differences in the underlying economics and some of the Clover

volumes are cannibalizing FDC’s legacy business so not a totally fair comparison so file this under option

value.

Lastly, there is a school of thought that FDC is one of the few assets that could be used to create a

proprietary closed loop payment, similar to what JPM has done with Paymentech. This view hinges on

the view that the card networks (V, MA) are over-earning and too dominant relative to the card issuers.

I will dispense with the heresy of criticizing two of the best business models on the planet and just point

out that (a) there is empirical evidence of this in JPM’s actions, i.e., Paymentech has a special deal with

Visa in which it leases capacity at more attractive economics, and (b) FDC tinkered with such an

approach prior to the financial crisis with something called FDNet. Ultimately Visa shut this effort

down…but then caved to JPM a few years later. (Hmm) Under this theory, FDC is a nearly unique

strategic asset that could have great appeal as an acquisition target and/or platform that could be

monetized differently than it is today. In any event, and much like the Clover option case above, you’re

getting this for free, whether you think it has value or not.

Valuation

On 2019 Street numbers, FDC currently trades at 10x earnings, 9.4x EBITDA, and a 11% leveraged FCF

yield (the business converts >100% of earnings into FCF thanks to relatively limited working capital

needs and low capex). The merchant acquiring peer group (WP, GPN, TSS) trade in the 15-16x earnings

and 12-14x EBITDA range. FDC does grow top-line ~300bps slower than these peers so some multiple

discount is warranted, but the current spread simply seems too wide. Even slower growing indirect

comps (FIS, FISV, JKHY) trade a few multiple points higher, though this particular group viewed as more

defensive which inflates the multiple. It’s worth highlighting that all of these business run with leverage,

so while FDC’s current 5.3x is high, they will soon be within spitting distance of the key comps (WP at

4.7x as they delever post Vantiv merger, GPN at 3.5x, TSS at 2.8x). Can they close half the multiple gap

with the low end of the peer group? At 11.5x $3.7bn of 2019 EBITDA (16x earnings and a 7% levered

FCF yield), shares would be worth $28, up nearly 80% from here.

Recent Events and 2019 Set-Up

We could have submitted this write-up this summer when the stock was in the $20s--why is the stock

now at less than $16? Three things: 1) disappointing Q3 results; 2) continued underperformance at

bank JVs; and 3) downward revisions on 2019.

FDC printed 4% organic revenue growth in the North American GBS segment in Q3 (vs. 4% in Q1 and 6%

in Q2). Management guided to MSD for the year but we think there was a contingent of investors that

piled into FDC shares hoping for further acceleration from 6%--instead they got 4%. Management had a

semi-reasonable explanation for why the Q2 number was actually inflated such that the right sequential

comparison was more like 5% in both Q3 and Q4 but investors either didn’t believe them or simply

didn’t care and sold the stock indiscriminately.

Furthermore, most investors, ourselves included, believed the bank JVs would turn from a headwind to

a tailwind in 2018. It became clear during the company’s most recent earnings call that this is now a

2019 event, which has caused some to question management’s ability to sustain current levels of overall

organic growth and the prospects for the bank JVs in particular. Our work suggests management’s

explanation for the delayed JV growth (i.e., slower ramp in marketing spend to support acquiring as they

methodically roll out digital onboarding) is in fact legitimate. Either way, we think the JVs, which

represent ~17% of revenue but generate 50% of the questions during earnings calls, get too much

attention. Management reiterated their belief that the business can grow at similar levels in 2018 even

with the JV headwind and building up to revenue growth based on the mix of business by channel and

the relative growth rates supports this claim.

Lastly, consensus numbers were just too high in 2019. While the JVs are part of the reason, the majority

of the change was related to FX and 2018 divestitures that the sell-side was simply modeling incorrectly.

To be fair, the reset hasn’t been major. 2019 EPS estimates are down ~4% since the end of September

(the stock is down about 35%). We think 2019 numbers are now sufficiently conservative that, barring

major changes in FX, FDC should be able to get back on track.

Risks

We’ve heard rumblings from a few vocal short sellers that the Wells Fargo JV required FDC to make concessions and that the Bank of America JV is “at risk.” FDC renewed two of its three most important bank JVs over the past year (Wells Fargo and PNC). Investors are always fearful that one of the large bank partners will walk away, as Chase did a few years back when they decided to insource merchant acquiring (known as Chase Paymentech). FDC’s JV with Bank of America is up for renewal in 2020. On the Wells Fargo deal, management is adamant that the deal was done on substantially similar terms so I guess they could be lying but for now we are inclined to give them the benefit of the doubt. On JV renewals, we think the Chase example is a bad analogy, as they already had their own processing asset so moving things in-house could be done with minimal investment and client disruption. Bank of America does not and would have to establish their own processing assets if they decided to split from FDC completely, risking client disruption. Alternatively, Bank of America could consolidate the acquiring business, sign an agreement with FDC to do only the processing and pay them a residual. This would likely be dilutive to revenue (but accretive to revenue growth once lapped) but accretive to margins. We think the path of least resistance is a renewal on substantially similar terms given the depth of integration between the two and potential disruption associated with splitting up and the attractiveness of the Clover platform as protection from encroachment by Square into Bank of America’s customer base
We’ve also heard rumblings about FDC’s gas station exposure (10% of revenue) given declining gas prices. From what we understand, FDC is mostly paid by the swipe rather than as a percentage of transaction value (and has never cited gas prices as explanation for quarterly performance), so this doesn’t seem like a major risk
At >5x leverage, a recession scenario is always concerning. However, the company navigated the global financial crisis with higher leverage and an inferior business mix. FDC will generate $1.5bn+ of FCF this year and delever by 1x. Annual interest expense is $865m (70% fixed or hedge) relative to $3.4bn of EBITDA and $600m of capex/JV dividends. The company also recently completed a refinancing of its term loan that extends the maturity into 2023 and they have only one covenant—6x senior secured with no step-downs vs. current ratio of 3.15x
Ongoing secondary sales by KKR, in the extreme short term at least, though this also increases the likelihood that they collapse dual-class structure to enable index inclusion

Disclaimers:

We and our affiliates are long FDC. We may buy or sell shares without notification. This is not a

recommendation to buy or sell shares.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1) Quarterly results

2) Hitting deleverage targets

3) Index inclusion

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			2018	2019
Price:	15.86	EPS	0	0
Shares Out. (in M):	933	P/E	0	0
Market Cap (in $M):	14,800	P/FCF	0	0
Net Debt (in $M):	17,200	EBIT	0	0
TEV (in $M):	32,000	TEV/EBIT	0	0