Description

Summary

Shares in Evertec, a Puerto Rican payment processing company, have been hammered in the past year due to macroeconomic fears for the Commonwealth.  Shares are now trading at far too cheap for a business of this type.

About the company

Evertec is a payment processing company that derives 87% of revenues from Puerto Rico (the Commonwealth).  Segments as follows:

• Merchant acquiring services - POS and e-commerce systems for merchants to accept e-payments.  22% of revenue, 24% of operating income.  1-year recurring contracts with merchants.
• Payment processing services - enables financial institutions to process debit, credit, ATM and EBT cards. 29% of revenue, 42% of operating income.  1-5 year recurring contracts with merchants.
• Business process-management - core bank processing.  75% of this business is for Popular Bank's payment processing system.  Agreement goes through 2025.  49% of revenue, 34% of operating income.

The company derives its competitive advantage from its dominant position in the Commonwealth.  ATH network is a monopoly in PR, taking 80% of debit transactions and 70% of ATM transactions.  EVTC also the sole payment processor for the PR government's EBT program (dispensary for government aid), and runs BPOP's payment processing back-end.  As such, the Company was under investigation by PR regulators on Feb 4th 2016 for anti-competitive behavior.

The company was spun out of a joint venture between PR's largest bank, Popular Bank (BPOP), and a private equity firm, Apollo Global Management, in 2013.  15% still owned by BPOP, and EVTC is considered a subsidiary of BPOP for the BHC Act.  45% of revenue (though perhaps just 30% of operating income) comes from BPOP.

What happened?

Puerto Rico has been in financial trouble since 2006, when the US withdrew Section 936.  The rule had previously provided the Commonwealth with extreme tax benefits for high-tech industries.  Years of recession and fiscal mismanagement now means that the Puerto Rican government spends almost 50% of tax revenues on servicing debts.  Their General Obligation (GO) bonds were marked down to a "C" grade by Moody's in December 2015, and it seems almost certain that the Commonwealth will suffer in the medium-term as debts get restructured.

Shares of Evertec, as a bell-weather for the general Puerto Rican economy, have been pushed down to very low levels of ~8x NTM earnings.  This compares to 19.5x for Vantiv (VNTV), 21.4x for Global Payments (GPN), 18.7x for Euronet Worldwide (EEFT) and 18.1x for Fidelity National Information Services (FIS).  

Insights

1. The Company has an extremely strong competitive advantage

Evertec's business of payments processing is extremely lucrative for established players.  Margins per single-transaction are extremely low (~25 cents per transaction), so building scale matters greatly.  Costs are mostly fixed, so the larger players are able to offer cheaper rates relative to new entrants.  Also, once a merchant commits to buying a certain point-of-sale system, there is little incentive to replace it with a new terminal.  Thus, barriers to entry are abnormally high.  

2. Credit and debit card spending are less affected by macroeconmic issues

According to I/B/E/S estimates, Evertec's revenue growth rate is expected to reach 2.6% in 2016 and 3.0% in 2017.  This is despite a GDP shrinkage estimate of -2.0% and -1.8% respectively for the Commonwealth.  Two reasons to be somewhat upbeat (despite knowledge that sell-side analysts are almost always too optimistic.  1) Credit and debit card spending tend towards non-discretionary items.  Puerto Ricans may stop buying cars and houses, but most credit card spending is made on apparel, gas, dining, travel and groceries.  2) Penetration of electronic payments is still relatively low in Latin America.  Evertec recently closed an acquisition in Colombia, and expects to expand operations in LatAm for years to come.

3. Evertec is a prime takeover candidate

Merchant relationships are extremely valuable; it would be highly logical for one of Evertec's mainland peers to bid for the Company at the right price to help the acquirer reach ever-greater scale.  Each additional dollar of transaction payment costs virtually nothing to create.

4. Macroeconomic risks can be offset with a short position with BPOP

Popular Bank has ~80% of its assets domiciled in Puerto Rico.  Recall that BPOP also provides EVTC with ~45% of Evertec's revenue.  Thus, a short position in BPOP will cover both issues of macroeconomic and business-specific risk.

Together, these suggest that Evertec's current valuation is too low.  Risks are abound, but payment processors tend to have very high barriers to entry. Fair value of Evertec is perhaps $19-20 at the moment even after adding in macroeconomic risks.

Happy investing!

Catalyst

Restructuring of Puerto Rico's debt will remove over-hang from valuation.