First Data is a company with high-margin businesses in very attractive industries but currently trades at around a half of its peers’ valuation. In this article, I will list Mr. Market’s reasons for such low valuation and elaborate on why I believe that despite some valid concerns about the company, the market has been overly bearish and the valuation gap should narrow.
Comparison against its peers
Although there are some competitors listed from First Data’s annual report including Visa, Mastercard,Fiserv,JP Morgan,Wells Fargo and etc, they are ill suited for comp analysis because these companies own other businesses that First Data lack. The companies listed below, also competitors listed from First Data’s annual report, are the best comparison candidates because they almost exclusively operate in the same segments as First Data. Among the comp peers, Vantiv resembles First Data the most because it competes on all fronts with First Data. Worldpay and Global Payments focus exclusively on merchant acquiring which is First Data in First Data’s biggest segment(I will explain all the segments later). Total System Services only competes with First Data in the smaller card processing division.
|Market Cap||Net Debt||Adjusted TTM EBITDA||Net Debt/EBITDA||Forward Adjusted Earning||Forward P/E|
|Total System Services
Market cap, net debt, adjusted TTM EBITDA in millions. Market prices are from Oct 18th 2016. Worldpay’s market cap and debt are in British Pound. Analysts’ forward earnings estimates for Vantiv, Global Payments, Total System Services, and First Data are from Nasdaq.com and Worldpay is from FT.com. Net debt and adjusted TTM EBITDA figures are based on these companies’ earnings releases and annual reports from their respective investor relations websites and further adjusted by subtracting stock compensation.
Why does the valuation gap exist?
- Heavy debt burden. This is definitely the biggest concern. When KKR took First Data private before the financial crisis, the private equity firm loaded First Data with debt and the deal was one of the biggest LBOs (leveraged buyout) in history. As we can see from the previous comp analysis, First Data’s peers have a much lower debt/EBITDA ratio. The market worries about First Data’s default risk.
- Market share loss/stale growth. Because of high interest expenses, the company could not put enough resources into important functions such as R&D and sales and struggled to maintain its competitive advantage. Innovation stopped and growth became stale while First Data’s peers enjoyed very healthy growth.
- High churn in small business segment. The company focused on signing up small merchants but offered very poor support and customer service. As a result, the company has been losing many customers who do not renew their contracts.
- Leon Cooperman insider trading case. This is very recent news. Mr. Cooperman holds shares of First Data and the stock has been suffering since the insider-trading charge against Mr. Cooperman emerged. The market is worried that Insider trading charge leads to possible liquidation and forced selling of the stock from Mr. Cooperman’s fund.
At a glance, the market does seem to have some very solid reasons to discount First Data. Many potential investors probably would turn away right because of the high debt burden. However, it is time to be a contrarian and find out if the situation is indeed as grim as the market fears. First, let us find out what kind of businesses First Data own.
GBS, GFS and NSS — What does First Data do?
Per its 2015 10-K, First Data is “the largest merchant acquirer, issuer processor, and independent network services provider in the world.” It has the following three segments:
Global Business Solutions (GBS): This largest segment mainly includes its merchant acquiring business and its cloud-based point-of-sale (POS) system Clover. For anyone needs a brief explanation on the term merchant acquiring — when customers check out either at a physical store or online with an electronic payment option (credit card/debit card/gift card/PayPal), merchant acquirer acts as the messenger that handles all the communication among the POS, the card issuing bank, and the merchant’s bank. POS takes customer’s payment information and pass this to the merchant acquirer. Then the acquirer figures out which network to use(Visa/Master/Debt/etc.) and routes the processing request to card issuer for approval. Once the issuer reaches a decision, it informs the acquirer and the acquirer relays back the message to the POS. At the end of the day, the acquirer routes many messages in the batched settlement process in which the merchant settles all the daily transactions with various payment issuers. CreditCards.com has a more thorough explanation here. Besides the merchant acquiring business, the Clover business according to management is not yet material to earnings so I will not go into mcuh details. I only will say that this online POS business is in crowded competition against many start-ups and established players.
Global Financial Solutions (GFS): In this segment, First Data enables credit card issuers to offer financial products to their customers. First Data’s clients include some of the world’s biggest financial institutions and big-box merchants and the available services include card issuing/processing services and account support services such as generating monthly statements and posting cardholder payments. First Data charges fees under contracts and the amount of the service fee is dependent on the size of the cardholder accounts under the contract. In other words, the more cardholders are under the contract, the higher contract fee is.
Network & Security Solutions (NSS): This segment offers services that deal with payment security and fraud preventions. First Data owns STAR, one of the nation’s biggest pin-debit network. While big banks might be able to afford its own secure network, other card issuers might not want to. Instead, they turn to First Data or Vantiv who own secure networks and pay for the network usage. First Data collects revenue on transactions routed on the STAR network. Also in this segment, First Data offers services in gift card issuing and processing to merchants.
In terms of geographical breakdown, U.S. is First Data’s biggest market, contributing 5.5 billion of the company’s total 7 billion revenue in 2015. EU is a distant second with a 1 billion revenue. Asia and Latin America each contributed around 260 million.
After getting some ideas of First Data’s businesses, I want to touch on why I think First Data is a great company to own.
Continued shift to a cash-less based society. According to this Federal Reserve survey published in 2015, between 2003 and 2012, credit card, debit card, prepaid card and ACH usage experienced very healthy growth at the expense of checks. The report summarizes the finding as such –“cards significantly increased their share of total noncash payments, from 43 percent in 2003 to 67 percent in 2012…Checks represented nearly half (46 percent) of all noncash payments in 2003, but only 15 percent in 2012.” Moreover, this trend is not just limited to the United States but rather it is a global phenomenon. A separate article shows that globally the number of transactions grew from 269 billion times in 2009 to 390 billion times in 2014 and cites that the Federal Reserve estimates that there will be $616.9 billion in cashless transactions in 2016, up from around $60 billion in 2010. Yet despite the explosive ten-fold increase in cashless transactions, there is still vast room for further rapid growth. This same article points out in the U.S cashless transactions are only around 45% of total transactions, much lower compared to countries such as Singapore, the Netherlands, or Sweden, where about 60% of total transactions are cashless. Germany is even lower at 33% and China, Japan, and Brazil are only in the teens. Cash still accounts for a dominating 85% on global average. These data and forecasts bode very well for the electronic payment processing industry and First Data.
Highly Capable CEO
Past achievements demonstrate high capacity. Many people probably read about First Data’s CEO joined as co-COO from JP Morgan. But who exactly is this guy? Wikipedia has detailed business achievements of Frank Bisignano, First Data’s CEO. In brief, he has over 20 years of experience working in different roles in various big banks including First Fidelity, Citigroup, and JPMorgan. At Citigroup, he increased the revenue for his division from an annual $4 billion to $6 billion and turned a net income loss of $400 million to profit of over $1 billion. At JPMorgan, Dimon trusted him with integrating Bear Sterns and Washington Mutual during the financial crisis. Then he became head of the Mortgage Banking unit and again turned the division’s previous year loss of 2.1 billion into income of 3.3 billion in 2012. Past successes show he is a true turn-around expert, a perfect fit for the CEO role of First Data. Right after he joined First Data, he dissuaded owner KKR from selling the GFS decision, telling KKR that he believed “I could fix it.” After 3 years, the NSS and GFS divisions have experienced healthy growth. In addition, management successfully pushed First Data’s entire debt obligation to the next decade, solving a major overhang of the company.
Attractive businesses to own
Biggest merchant acquirer in the U.S. Even after the no growth period, First Data’s acquiring business remains as the biggest in the States. But why does size matter? Because the domestic industry has increasingly become consolidated and scale helps to battle other big merchant acquirers. Vantiv, the second biggest merchant acquirer in the U.S. right behind First Data, claims to have processed 6.18 billion dollars of transactions in 2016 Q2 and around 23 billion dollars for the whole year of 2015. By comparison, First Data in the most recent quarter reports that it processed 22.5 billion dollars for the first half of 2016, a half year figure that’s almost as big as the full year figure of the industry’s NO.2 player. This shows that what stockholders own is not a company that has fallen completely behind the competition but rather a valuable company that is still very ahead in the game, albeit with a shrinking lead and anemic growth. The main problem in growth, according to management’s earning calls, is isolated in the SMB (Small-Medium Business) space and caused by a high SMB client attrition rate. However, on the hand, the large national clients are actually very happy with the company’s service and First Data bagged quite a few national account wins including Chick-fil-A, Cabela’s, PetSmart, and Toys “R” Us.
High margin businesses. First Data’s Global Business Solutions segment has consistently generated around 40% EBITDA margin over the years. The new management also dramatically reduced the cost basis of the other two segments so that in the most recent quarterly report the Global Financial Solutions and Network & Security Solutions divisions enjoyed 40.5% and 45.4% EBITDA margin respectively.
Fast growing and sticky GFS business: the Global Financial Solution segment, the business that supports card issuers with processing and account maintenance, in the last two quarters grew revenue 12% and 14% in constant currency year over year. A contract with customers last for years and customers are generally reluctant to switch solution providers once they become accustomed to a particular provider’s offering, making this business very sticky. I think growth in this segment could be attributed to CEO Bisignano’s leadership. Customers in this segment are mainly small and mid-size banks. And where is Bisignano from? Bank. Bisignano understands very well these customers’ need and speaks their language.
One of the biggest debit network operators. According to the aforementioned Fed Survey, debit card usage witnessed the biggest jump in terms of transaction number, increasing three fold from 15.6 billion times in 2003 to 47 billion times in 2012. First Data’s STAR network is one of the biggest pin-debit network in the nation and naturally a big beneficiary of the on-going debit card boom.
Good International exposure. First Data’s Latin America business has been on fire. Revenue from that region grew 44% in constant currency in the latest quarter and quickly becoming a meaningful contribution to earnings. Although inflation is part of the reason to the growth, the company has been adding customers rapidly in Brazil. It also recently entered the Argentina and Columbia markets, two markets with big potential that are still in infancy stage of electronic payments.
Addressing Market Concerns
In this section, I will address the concerns listed in the beginning and explain why I believe they are overblown.
Heavy debt burden and high default risk. None of the debt matures until 2020 at the earliest and the debt maturities span over five years with the latest debt due in 2024, a situation that should be quite manageable. Management has stated that they will use majority of the company’s free cash flow to pay down debt and according to my estimate (detailed walkthrough discussed later), the company should be able to generate over 1.2 billion free cash per year. That means from now until 2024, the company can generate about 8-9 billion free cash and nearly half the current 19 billion debt, making First Data’s Net Debt/Adjusted EBITDA around 4 times which is quite manageable and very close to its peers.
Slow growth caused by high SMB attrition. Management had to deal with myriad of problems and could not solely focus on this issue. However, with many other priorities solved, management should have enough resources to concentrate on this problem. Management stated that this is a very persistent problem and attrition rate remains high as of the last quarter. The team continues to tackle the issue with a multi-pronged approach and things might get better in the future. Based on what Bisignano has achieved in his past positions and what he has accomplished so far in First Data, I believe he has a decent chance of solving the problem. But even if it turns out that management could not fix the issue, it still would not be the end of world for First Data. Because after all, the SMB segment is only part of the acquiring business. The company still has a very healthy acquiring business with large merchants, a fast growing GFS segment and a NSS segment growing at moderate pace.
Cooperman insider trading case. I actually think this is good news. Regardless of the outcome from the insider trading charge, the entry cost for First Data stock decreased, which is great news for potential investors. In addition, this news in no way changes the fundamentals of the company. Is the stock currently cheap enough? I think so. However, I am also cognizant of the fact that based on how the insider charge goes the stock might turn even lower. To prepare for such possibility, or blessing in disguise should I say, investors should maintain some liquidity so that they can buy more on the dip and lower their cost basis.
Future cash flow analysis and stock valuation
In the past twelve months, First Data’s three divisions GBS, GFS, and NSS have adjusted EBITDA (excluding stock compensation and one-time costs) of 1691 million, 622 million, and 668 million respectively. Revenues and EBITDA picked up in GFS and NSS this year while GBS’s growth is a mere 1%. Based on the sticky nature of the businesses, for the forward 12 months, I assign an 8% increase in forward EBITDA for the GFS division(much lower than the recent 30% jump), a 3% increase for the NSS division(again much lower than the 16% and 6% quarterly increase), and no growth in EBITDA for the GBS division, an assumption that seems achievable and conservative.
Recent segment revenue/EBITDA growth trend and forward EBITDA assumption
|16 Q1 Rev increase Q/Q||16 Q1 EBITDA Q/Q||16 Q2 Rev Q/Q||16′ Q2 EBITDA Q/Q||Forward EBITDA growth assumption|
16 Q1 and Q2 figures based on First Data’s 2016 Q1 and Q2 earning releases
Next, corporate cost has been stable at -140 million EBITDA per year, the same figure I use for next year’s cash flow estimate. Depreciation is around 1 billion based on last year’s figure. Interest expense based on the list of debt obligations from latest 10-Q filing and the most recent interest reduction news is estimated at 1,050 million. I use a theoretical 30% tax rate because First Data has sizeable oversea business with lower tax rate than the States. The effective tax rate, however, should be much lower because the company has 3.8 billion deferred tax assets (First Data’s 2015 10-K lists 1.1-billion deferred tax asset and a further 2.7 billion valuation allowance that is likely to reverse in the future). 2017 capital expenditure of 450 million approximates the lowered spending in the first two quarters of this year because management in earning calls has said many growth initiatives have already been put in place and capex will moderate in the future.
Forward 12-month cash flow calculation (in millions)
|Income with Tax Benefits(effective 10% tax rate)||640.8|
|Near-term Cash flow||1346.7|
Figures based on First Data’s past four quarter earnings releases. Normalized FCF is calculated based on income + D&A – capex and near-term cash flow is based on income with tax benefits + D&A – capex + stock compensation.
|Discounted current value of 3.8 billion deferred tax asset||2000|
|Adjust market cap/FCF||10.16|
From the above calculation we can see, investors are paying about 10 times the next year normalized free cash flow for First Data, a multiple that is quite low based on the quality of the business, the management, and the prospect of the e-payment industry.
Revenue increase. There are multiple ways for the company to increase its revenue. The most certain revenue increase comes from First Data’s large clients. The company has already won quitea few big contracts from large enterprise and these wins take typically 9 months or more to realize revenue from new clients. In addition, the company showed itself capable of expanding its relationship with large clients and cross-sell more services. However, less certain is the development on the SMB segment and the improvement might not materialize in the near future. I think the chance of a success SMB turnaround is about 50%. Moreover, there are a couple long shots such like the Clover POS business and the Gyft gift card business.
Highly leveraged capital structure will boost earnings. The biggest market concern actually is, at the same time, a blessing in disguise. First, as the company pays down interest, it creates an earning boost on the bottom line. Every billion dollars of debt paid down will give the company between 50-70 million savings on interest expenses, which translates into 35-50 million net income and a 350-500 million in market cap assuming a 10X P/E. And we have shown First Data should be able to pay down billions of debt in the future. The next point is that high debt load will actually make the net income increase look more pronounced compared to a company that is less leveraged. This is a very important yet subtle point and for those who are not familiar with this very concept there is a more detailed explanation in the appendix.
Easy net GAAP income comp in the next three quarters. First Data’s GAAP income in the last 4 quarters was all in the red except the most recent quarter. There were a lot of one time charges, such as IPO cost and restructuring cost, taken in the earlier quarters and the interest expense was much higher than the current level. Going forward, with the much lower interest expense and cost reduction initiatives taking effect, even without a higher revenue, GAAP income comp quarter over quarter should be very easy until second quarter of 2017.
I know this is a quite long article and I appreciated if you have come this far. Much ink has been spilled so let us tie up all the points. First Data is trading at around half of its peers’ multiples based on forward earnings. We also run through a cash flow analysis and finds the stock trades around 10 times 2017 cash flow. Although its peers do deserve a premium over First Data because of lower debt level and faster growth, the market looks overly bearish on First Data’s prospect. First, First Data’s debt will not start maturing until the next decade and our cash flow analysis shows that the company will be able to pay down a lot of debt before debt maturities. Second, there is a decent chance that growth will pick up in the future. In the past, management had to spend a lot of effort on the survival of the company and, after the debt became manageable, the management can now finally concentrate on the growth phase. We already see the growth initiatives bearing fruits on the GFS and NSS segment and there is a good chance for the biggest segment GBS to grow again. Third, despite the market gain of First Data’s peers, First Data still holds many valuable assets. It is still the biggest merchant acquirer in the U.S. by a wide margin and owns one of the nation’s biggest debit network. Under the rein of Bisignano, First Data deepened and expanded many important relationships with its big financial institution and large merchant clients, an initiative that lead to new contract wins and more cross-selling. Fourth, CEO Bisignano has a very impressive background in turning around businesses in different companies and so far, he has done a fabulous job at First Data, a sign that a full turnaround of First Data is quite possible. Lastly, the industry benefits from inevitable shift to a cashless society, a trend that will also help First Data in earning growth.
Because of the above reasons, the stock deserves a better valuation. A 15-16 times forward P/E or a 15 times normalized free cash flow should be fair, implying 40% – 50% potential increase above current stock level. Even at that level, First Data will be at about 2/3 of its peers’ valuation, taking consideration of the higher debt ratio and current slower business growth compared to its competitors. But the current 10-11X forward P/E and cash flow simply feels like there is more than justifiable amount of pessimism on this stock.
Although I suggest purchasing a sizable position at current level, as the 3rd quarter earnings release approaches on Nov 7th and the Cooperman insider charge case still hangs in the air, I also suggest investors keep some dry powder in case of a further stock price drop in the near term.
Capital structure effect on earnings
Assume there are two companies with the same revenue, cost, and tax rate. The only difference is that company A does not have any debt at all but company B does.
|Company A||Company B|
Then revenue and cost increase the same amount for both companies.
|Company A||Company B|
|Net Income % increase||20%||50%|
We can see although both companies’ earnings increased 7, the leveraged company B’s earning increases 50% while company A’s earning only increases 20%.