Important report on this morning FDC upgrade by Bear sterns:
If this is true and there is a higher growth in FDC's ecommerce business than in their normal industry growth(15%), it got to be bullish even for CKFR.
No intentions to be negative on CKFR, cause I am long and bullish on CKFR but we have to keep track of the competitors!!!!
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First Data Corp. (FDC-$31 1/4) - Buy
Upgrading to Buy from Attractive. Payment Processing Powerhouse Getting Back on Track. 15% Long-Term Growth Stock at 19x 1998 Earnings.
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*** We are upgrading the shares of FDC to Buy from Attractive.
*** The shares of FDC have been weak recently in anticipation of a weak first quarter. We believe that the first quarter represents the trough in FDC's earnings growth and that earnings growth will reaccelerate in the second quarter. Ultimately, we expect that FDC will be able to sustain EPS growth in the 15% (plus) range. Accordingly, we believe that the shares of FDC represent excellent long-term value at 19x our revised 1998 EPS estimate of $1.63. We recommend that investors take advantage of the current weakness and any further weakness related to the weak first quarter earnings.
*** Our long term bull-case for FDC is based on several factors:
1) FDC is a payment systems powerhouse, with leading positions in three large, fast-growing markets. The company is the number one provider of cardholder processing services, with over 180 million cards on file. The number two player, Total System Services, provides processing services to customers with approximately 95 million card accounts (the shares of TSS trade at 70x 1998 earnings). In the merchant processing business, FDC processed approximately $260 billion worth of credit card volume in 1997, more than three times the volume of the next biggest competitor. Western Union, FDC's subsidiary in the wire transfer market, boasts an 85% market share.
We believe that the shares of FDC represent one of the best plays on the trend toward electronic transactions. Given the growth opportunities in each one of the company's target markets, we believe that 15% earnings growth is attainable and sustainable.
2) Under new unit management, we are confident that FDC will turn around the under-performing merchant processing business over the next several quarters. In fact, it is our understanding that several of the bank alliances, including Chase, are finally starting to contribute significant volume through the branch networks (as they were originally supposed
to).
Charlie Fote, an FDC EVP, took charge of the merchant business in late October 1997. He is a bottom-line, execution oriented executive. He is responsible for FDC's success in the payment instrument business (wire transfer, money orders, official checks, utility bill pay). As demonstrated by the recent 10% headcount reduction in the merchant processing business, it is clear that Fote is shaking things up to achieve positive, long-term results.
3) FDC is becoming a much simpler story. With the divestitures of several non-core, underperforming businesses, FDC is getting close to becoming a pure-play payment processing company. We believe that a pure-play payment processing company will ultimately trade at a premium multiple.
4) We are confident that FDC will be successful cross-selling its services suite to its large, diverse customer base. The company is intensely focused on cross-selling high-margin, value-added services to its customer base, increasing the revenue and profit per customer (as well as the retention rate).
5) International markets represent a major opportunity for FDC. Less than 10% of the company's revenue is sourced outside the United States. Longer term, we expect FDC to leverage its strength in the United States to move aggressively into international payment processing markets. It is already the number one cardholder processor in the UK. As part of its agreement with HSBC Holdings, FDC will establish a card processing center in Hong Kong.
In the short-run, the shares of FDC may be viewed as a safe-haven domestic play with little international (and essentially no Asian) exposure.
6) FDC's senior management is uniquely motivated to maximize shareholder value, with long-term incentive bonuses determined by the stock's outperformance of the S&P500.
According to the recently filed Proxy, several senior executives were awarded options in 1997 that provide for accelerated vesting if certain EPS targets are achieved in 1998 and 1999. We would also note that Ric Duques (CEO) and Lee Adrean (CFO) have personally purchased stock over the past several months.
7) FDC generates strong cash flow. In 1997, FDC generated EBITDA of $1.69 billion on revenue of $5.2 billion, representing an EBITDA margin of 32.5% -- the highest in our universe. (1997 was a bad year for FDC).
Excluding non-cash write-offs, depreciation and amortization accounted for 13.2% of FDC's total costs and expenses in 1997. The substantial non-cash expenses largely reflect significant goodwill and other intangibles. At the end of 1997, goodwill and other intangibles totaled $4.2 billion (115% of equity).
8) At $31 1/4, we believe the downside risk in the shares is limited. As we have noted in the past, we believe that FDC could make for an excellent acquisition candidate. It boasts three dominant franchises and throws off substantial cash flow. Based on a quick, back of the envelope analysis, ADP could buy FDC at a 60% premium to the current price and make it accretive. We assume no savings (goodwill and other intangible write-offs; telecomm, hardware, data center consolidations, G&A, etc). The shares of ADP are trading at 30.4x calendar 1998 earnings; ADP, in an optimal environment, will grow earnings by 14%. The shares of FDC are currently trading at 19x estimated 1998 EPS; in an extremely difficult environment, FDC will likely grow earnings at 8%-10%. In a more normal operating environment, we expect FDC to grow earnings at 15% (plus).
9) The shares are currently trading at 19x our revised 1998 EPS estimate of $1.63. The 19x multiple represents a significant discount to the market and the computer services comparables and a modest premium to the 15% (plus) long-term earnings growth that we expect. The S&P 500 is trading at 23.6x the Bear Stearns' operating EPS estimate. Bear Stearns expects the S&P 500 earnings to increase by 6% in 1998. The average computer services stock under our coverage is currently trading at 27x calendar 1998 estimated earnings. We project that the average computer services company will grow earnings by 17% in 1998. Accordingly, the average computer services stock is trading at a 59% premium to expected growth and the S&P 500 is trading at a 290% premium to its expected growth rate.
Our 12-month price target for the shares of FDC is $45 or 24x our 1999 EPS estimate of $1.90. In October 1996, when the market was trading at less than 17x forward 12 month earnings, the shares of FDC traded at 28x. Given our confidence in FDC's ability to execute a successful turnaround and to achieve sustainable 15% (plus) earnings growth, we feel that a mid 20s multiple is reasonable, if not conservative.
*** We estimate that FDC will earn $0.29 per share in the first quarter, flat with the year ago first quarter. We had been looking for $0.30. The weak first quarter reflects several factors: 1) dilution from non-core business divestitures; 2) continued underperformance of the merchant processing business and 3) difficult comps for the card services unit.
*** FDC will report 1Q 1998 earnings on Wednesday, April 22nd, after the close. The company will host a conference call at 8:30 am (EST) on Thursday, April 23rd. During the conference call, we anticipate that FDC senior management will reiterate the earnings guidance that it offered during the 4Q97 conference call and analyst meeting.
In May, FDC will host its annual investor meeting. The meeting will take place in Atlanta on May 20th and 21st. We anticipate that senior management will once again be upbeat regarding FDC's long-term growth prospects.
*** We are reducing our 1998 EPS estimate to $1.63 from $1.69. We are not changing our 1999 EPS estimate of $1.90. According to the company's recently filed 10K, management is still guiding the street to $1.60-$1.70 for 1998. At $1.69, we were the highest estimate. If the merchant business turns faster and holiday spending in the critical fourth quarter is strong, FDC may still be able to achieve the high end of the range. At this point, however, we would rather take a conservative stance.
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MARKET CAPITALIZATION $14,100 (MM)
EARNINGS Q1 Q2 Q3 Q4
Mar Jun Sep Dec Year P/E
Current 1997 $0.29A $0.35A $0.42A $0.45A $1.51A
Current 1998 $0.29E $0.36E $0.46E $0.52E $1.63E 19.2x
Previous 1998 $0.30E $0.38E $0.47E $0.54E $1.69E
Current 1999 $1.90E 16.4x
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Company Background
First Data is a leading provider of payment transaction processing services. Approximately 90% of FDC's revenue is now sourced from the three core businesses - card issuer services, merchant processing and payment instrument processing. In 1997, the company generated revenue of $5.3 Billion. In 1998, we expect revenue to increase only modestly, reflecting the divestitures of several non-core businesses, the underperforming merchant processing business and difficult comps for the card issuer services business. Despite FDC's difficulties, the company generates the highest EBITDA margins in our coverage universe - 32.5% in 1997.
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The shares of FDC have been weak for the past several weeks, giving up $4 « or approximately 13% since March 19th. Year-to-date the shares of FDC are up 7% compared with 15.6% for the S&P500. Since the company released 4Q97 results on January 28th, the shares are up 18.5% versus 14.7% for the S&P500.
We believe that the recent weakness reflects concerns over the first quarter and the company's progress in turning around the merchant processing business. Given these types of concerns, we were surprised by the strength of the stock from February through mid-March. At $25-$26, back in January, we felt that the shares of FDC were irrational (as we noted in the January 20th and 26th Bear Stearns Computer Services Weeklies). However, after the stock jumped with the fourth quarter earnings announcement and senior management's comments regarding the company's outlook, we felt that the stock would languish in and around $30 as the market waited for signs of the turnaround. Helped by a strong market, in general, and a very strong services sector, in particular, the shares of FDC blew past $30 to trade as high as $3513/16 on March 19th.
At $31 1/4 or 19x our 1998 EPS estimate of $1.63, we believe the shares represent excellent long-term value and offer good downside protection. We recommend that long-term investors take advantage of weakness associated with concerns over the first quarter as we believe the first quarter will represent the trough in FDC's earnings growth.
We expect the company to report first quarter earnings on April 22nd. We estimate that the company will earn $0.29 per share for the quarter, which represents no growth over 1Q97. When senior management offered guidance for 1997 earnings in January, it indicated that first quarter EPS growth would likely be in the 0%-5% range. Accordingly, expectations for the quarter should have already been low.
First quarter results are being adversely impacted by divestitures of non-core businesses, difficult comps for the card services unit and continued underperformance of the merchant processing business.
During 1997, FDC divested four units -- GENEX, First Health Strategies, First Health Services and Nationwide Credit. These businesses (and EBP Life which was deemphasized) accounted for approximately 6% of the company's revenue in 1997 and 12% in 1996. In January 1998, FDC announced its intent to sell First Image and sold its NTS transportation services unit. These two businesses accounted for 6% of total revenue in 1997.
The difficult year over year comparison for the Card Services unit reflects a 45% increase in domestic cardholder processing revenue during the first quarter of 1997. Excluding acquisitions, the unit posted revenue growth of 32%. In the first quarter of 1998, we expect only single-digit growth in Card Services revenue. Compounding the difficult comps in the card services business is a significant ancillary services contract that was brought in-house. PNC Bank which had outsourced customer service, collections and other ancillary services to FDC as part of a comprehensive card processing contract decided to insource many of these ancillary services. We believe that this was low/no-margin business for FDC.
As the year progresses, we expect an acceleration in card revenue growth but this will largely depend on successful cross-selling of higher margin ancillary services, including credit application processing, fraud management, behavioral scoring, and cardholder database analysis.
The merchant processing business is the key fundamental variable to getting the stock going in 1998, in our opinion. We do not expect to find much evidence of a turnaround of the merchant business in the first quarter results. We expect merchant revenue to be flattish, at best (excluding revenue associated with the Comdata Gaming acquisition). The merchant business is being negatively impacted by several factors. First, the dramatic change in the merchant distribution model over the past couple of years as FDC moved away from direct sales (by NaBanco and CES) to a Bank Alliance Model. The change has clearly been more challenging than expected. The alliances have not ramped up production as rapidly as FDC had anticipated and merchant volume that has not been contributed to alliances has been declining at a fairly rapid pace. Second, third party merchant processing revenue continues to be weak. Finally (and less relevant, in our opinion), pricing pressure and a slowdown in overall MasterCard and VISA volume.
Over the next couple of quarters, it is critical that FDC's alliances demonstrate improved productivity. The alliances, which include Chase, Banc One, NationsBank and Wells-Fargo, should be able to grow north of the industry's rate of growth (15%), reflecting the use of the alliance partners' powerful bank branch networks as a distribution channel, coupled with strong direct sales (old CES and NaBanco salespeople working with the alliances); cross-sales of ancillary services; and higher client retention (low single digit attrition versus hi-single, low double digit attrition). As Ric Duques (FDC CEO) indicated during the fourth quarter conference call, "1998 is show-time for the alliances". Based on recent conversations with FDC senior management, it sounds as though the Merchant Alliances are starting to kick-in in a meaningful way. Again, it is not clear whether we will see much evidence of this in the first quarter results.
It is also important that FDC contribute the unallocated merchant volume to current or new alliances over the next several months in order to stem the fall-off. This volume relates to FDC owned and managed accounts. Revenue associated with this merchant volume has been declining. We estimate that it accounted for approximately $250 million or 20% of FDC's domestic merchant processing revenue in 1997. To get back to historical growth rates, FDC cannot afford to have 20% of its merchant processing revenue declining, especially given that another 12% (revenue associated with third party merchant processing) is not growing.
As FDC's alliances improve production and the unallocated volume is contributed to existing or new alliances, we expect the company's merchant revenue growth to accelerate sharply. Given the unit's new management, we are confident that we will start to see signs of a turnaround in the merchant processing business over the next couple of quarters. Charlie Fote, an FDC EVP, took charge of the merchant business in late October 1997. He is a bottom-line, execution oriented executive. He has been responsible for FDC's success in the payment instrument business. It is our understanding that he is shaking things up to achieve positive, long-term results.
We note the following risks associated with FDC:
1) Year 2000. According to FDC's recently filed 10k, most of the company's business units are faced with Year 2000 remediation issues. "Failure to achieve timely remediation of business units' computer systems that process client information and transactions would have a material adverse effect on the company's business, operations and financial results". After spending $32 million on Y2K in 1997, the company expects to spend $75-$90 million and $35-$45 in 1998 and 1999, respectively.
2) Bank/Card issuer consolidation.
3) Potential slowdown in consumer spending.
4) Slowdown in card growth; increased delinquencies; bankruptcies.
5) Western Union lawsuit. Along with MoneyGram, Western Union was named in a class action lawsuit that was filed in November. The Plaintiff claims that Western Union charges an undisclosed "commission" through foreign exchange fees. The plaintiff alleges damages in excess of $1 billion. Western Union has filed a motion to dismiss the plaintiff's Federal claims. |
