Description

Thesis:  EVERTEC, Inc. (“EVTC” or the “Company”) is a compounding-value company in a transformational market niche.  This transaction processing company has significant scale and growth avenues in a stable industry, high recurring revenue businesses, high margins, and strong free cash flow generation.  However, these characteristics are currently underappreciated by the market, which is focused on concerns about EVTC’s exposure to Puerto Rico’s financial position and demographic trends, its perceived capital intensity required to maintain earnings growth, and customer concentration risk.

With its investment cycle largely behind it, and as secular industry trends (such as conversion from cash to card/electronic payments), portfolio mix shift, and management’s growth strategy play out over the next few years, EVTC is likely to continue compounding earnings and should generate $2.00/share in 2015E EPS which is ~8% ahead of “Street” expectations for $1.85/share.  I am long EVTC with a target valuation of ~15-16x 2015E my estimated EPS, or a target price of $30-32 per share.  I believe my multiple valuation is appropriate yet conservative for this highly scaled niche business – it deserves a premium multiple to peers given its strong compounding growth profile, sustainable competitive position and pricing power, low correlation to macro risks, substantial de-leveraging in process, and significant tax advantages relative to peers.

Company Background: EVTC is the leading full-service transaction processing business in Latin America and the Caribbean.  The Company is based in Puerto Rico (PR) and provides a broad range of services of merchant acquiring, payment processing, and business solutions across 19 countries in the region.  EVTC was privately owned by Apollo Management and Banco Popular until these owners launched the Company’s IPO in April 2013 at $20/share.

Given it is a relatively new public company, here is a brief background on the business model:

• Merchant Acquiring (~20% of revenue; ~70% market share): revenues generated as a fixed percentage of dollar volume processed (net of credit/debit interchange fees) from allowing merchant customers to accept electronic payments (credit, debit and prepaid card transactions).  Management expects organic acquiring revenue growth in this segment in the high-single digits (6-7% in PR, in-line with cash-to-card conversion, and 10-12% outside of PR).

• Payment Processing (~30% of revenue; 80%+ market share): provides financial institutions access to the Company’s proprietary ATH network and other card networks (authorization and processing on the bank side as well as credit/debit card processing on the merchant side).  Revenues are generated mostly on a per transaction basis (on the merchant side) and fee per account/card on file (on the bank side).  Management expects organic processing revenue growth in this segment in the mid to high-single digits.  The most noteworthy feature of this segment is EVTC’s proprietary ATH network, which processes ~70% of all ATM transactions and ~80% of PIN debit transactions in PR.

• Business Solutions (~50% of revenue): provides process management solutions including core bank processing, IT consulting, cash processing, and business outsourcing services for both government and corporate customers.  This segment generates the majority of its revenue (~70%) from a single customer, Banco Popular.  Management expects revenue growth in the mid-single digits.

Bear Case:

• Heavy Puerto Rico Exposure Warrants a Depressed Multiple: The market is concerned about EVTC’s exposure to the economic struggles in PR.  The territory continues to suffer from a high debt burden as well as negative demographic trends such as declines in population, productive workforce, employment, and retail sales.  Since EVTC generates ~85% of its revenue in PR, its growth profile will likely be more moderated than its more geographically-diversified peers’ going forward.  With expectations for a lower growth profile, EVTC should trade at a discount to peers.

• Concentration of Customer Base and Geography Creates Significant Business Risk: Banco Popular accounts for ~45% of EVTC’s revenues and poses a risk to future revenues.  Also, EVTC owns the largest PIN debit and ATM network in the Caribbean, and as a result, they will likely have to continue working with the largest bank(s).  These customer and geographic concentration levels pose significant risks, and any management missteps or contract terminations will lead to substantial downside in the stock.

• Increasing Competition Will Drive Significant Margin Compression: The payments processing industry is highly price competitive.  For example, in the U.S. merchant acquiring market, competition and technological advances are driving acquiring spreads lower across the board.  With EVTC’s EBITDA margins (~50%) well above all of its peers with the exception of VNTV, it is highly likely that well-capitalized U.S. and foreign competitors will invest capital to expand their scale into the LatAm market to capture some of these returns.  Also, although EVTC does not disclose transaction or volume growth, it is safe to bet that volumes growth will slow materially due to this heavier competition.   Given EVTC’s high fixed cost structure, if this decelerating volume growth turns negative, the Company could experience significant operating de-leverage and, as a result, substantial margin compression.  

• Valuation: On consensus estimates, EVTC trades at ~13x 2015E EPS which is a reasonable discount to other payment processing companies (15-16x on 2015E #s) given heavy exposure to PR, high levels of customer and geographic concentration, the high probability of increased competition, and EVTC’s significant debt load.

What the Bears Are Missing:

• Company’s Financial Performance is Uncorrelated to Macro Headwinds: While the PR economy remains a financial concern with negative demographic trends, EVTC has maintained at least 5% revenue growth in the territory through a 7-year recession and population exodus, due to the strong and growing tailwinds from cash/check conversion to electronic payments.  Bears are overly worried about the weak PR economic environment; however, the secular shifts from unbanked to banked consumers and from “paper” to “plastic” far outweigh these concerns.  This is evident in EVTC’s financial performance: they achieved adjusted EBITDA growth of at least ~10% in every year from 2008-2012, despite PR GNP y-o-y declines of 0-4% and unemployment as high as ~16%.  Continuation of these trends in EVTC’s growth profile should cause the market’s concerns to subside and allow for multiple expansion.

• Favorable Duration and Contract Terms Mitigate Concentration Risks: EVTC is the sole outsourced provider for Banco Popular through its Business Solutions segment, and there is no evidence indicating that Popular is not satisfied with this relationship.  There is a 15-year master services agreement (MSA) in place with Popular – this contract lasts through 2025 and contains pricing escalators which eliminate inflation risks.  Further, given that the Merchant Acquiring and Payment Processing segments are growing revenue at faster rates with higher operating margins than the Business Solutions segment, there is a positive margin mix shift story playing out.  Thus, it is likely that Popular will become a substantially smaller portion of EVTC’s business (I estimate less than 25%, compared to ~45% today) by the time the contract expires, allowing for natural mitigation of concentration risk over time.  Geographic concentration risk is mitigated by the aforementioned lack of correlation between PR macro risk and EVTC financial performance.

• Niche Strategy, Scale, and Business Model Provide Structural Barriers to Entry and Margin Protection: The market seems to be incorrectly grouping EVTC with larger payment processing competitors in terms of the markets it targets.  The Company’s strategy is actually to target second-tier markets to avoid intense competition in larger markets like the U.S., Brazil, and Mexico.  These secondary markets in LatAm and the Caribbean are under-penetrated and too small for large U.S. players like First Data, and even the more nimble local players often only offer a single product and lack the scale and product depth of EVTC.  These market dynamics give EVTC a defensible economic moat against competitive pressures.

• Valuation: Based on my estimates, EVTC currently trades at less than 12x 2015E EPS but deserves a 15-16x multiple in line with peers, which is conservative given EVTC is a market leader in a rapidly growing niche supported by secular tailwinds, with a strong diversified business model, significant scale, and high barriers to entry.

Key Thesis Points:

• Recurring Revenue Business Augmented by Secular Tailwinds from Electronic Payments Growth: EVTC generates most of its revenue from fees on transaction volumes and sizes under long-term contracts with financial institutions, merchants, corporations and governments.  These revenues are highly recurring in nature, and both secular tailwinds and EVTC’s niche market penetration continue to drive strong growth of this revenue base.

• Contracts in all three of EVTC’s segments are 1-5 years in duration and generate high customer retention due to embedded services and high switching costs.  In 2012, the Company had over 99% customer retention on a year-over-year revenue basis, and of those revenues, approximately 87% were recurring in nature.  Further, Banco Popular (EVTC’s largest customer) remains committed to its 15-year MSA which will last until 2025.  This MSA creates recurring revenue and contains contractual price escalators tied to the U.S. CPI, which should prevent margin compression from inflation within the Business Solutions segment.

• While acquirers in the U.S. continue to benefit from the cash-to-card transition, the opportunity is much greater outside the U.S.  Roughly 80% of the U.S. population has a bank account, compared to just 50% in PR and 30-40% throughout LatAm which are EVTC’s core markets.  LatAm represents the 3rd fastest growing payments market in the world (behind Asia-Pac and Middle East/Africa), and according to The Nilson Report (July 2013), LatAm transaction volumes are projected to grow at a 14.5% CAGR from 2011-2016.  Given its significant scale and market share, EVTC is better positioned to capture this growth than any of its peers.

• Niche Player with Scale Advantages, Pricing Power, and a Strong Moat from Proprietary Network Ownership: EVTC dominates the PR payment processing industry, with 75% market share in the Merchant Acquiring segment and 70% market share of all electronic transactions processed.  As the only player offering end-to-end solutions in Latin America, EVTC follows a strategy of targeting niche secondary markets and defends its market position by leveraging its proprietary ATH network.

• EVTC targets niche secondary markets such as Costa Rica, Panama, and Columbia, where competition is much less intense and often under-penetrated by major payments players like First Data.  Unlike major hyper-competitive acquiring markets in the U.S., Brazil, and Mexico, there are no independent sales organizations (ISOs) and very few payments-focused competitors in LatAm.

• EVTC’s growing scale advantage is reflected in its recent capital investments and acquisition of long-term contracts with leading banks, enterprises, and governments.  Over the last 5 years, EVTC has invested $130mm in data centers in PR and Costa Rica, resulting in a highly scalable technology platform in local markets.  This platform has high operating leverage with incremental EBIT margins averaging ~65% since 2011, which should allow for significant margin expansion as secular growth trends continue.

• EVTC enjoys significant, sustainable pricing power.  The Company earns higher pricing spreads than its U.S. counterparts because it uses bundled pricing – it is a full-service operator and thus has the opportunity to gain from multiple charges per transaction.  Additionally, its ownership of the largest proprietary ATM and PIN debt network provides further sticky pricing and drives margin expansion as EVTC grows its scale.

• EVTC’s proprietary owned “ATH” network is the #1 largest ATM and PIN debit network in the Caribbean; in fact, the ATH network processes more transactions in PR than Visa, MasterCard, and American Express combined.  This network creates high barriers to entry.  It is virtually impossible for new entrants like Square, Venmo, and other mobile payment companies to enter the PR or most other LatAm markets because EVTC owns the ATH and has rules that prohibit the renting of data bins.

• Shareholder-Friendly Management Team with Proven Expansion Strategy: The executive management at EVTC has significant experience in the payment processing industry, particularly in the LatAm and Caribbean regions, and they have launched a shareholder-friendly capital allocation policy that will drive meaningful equity value creation.

• CEO Peter Harrington, COO Philip Steurer, and several other key executives were appointed during EVTC’s private ownership by Apollo in 2010-2013.  This team has demonstrated the ability to penetrate existing markets, expand into faster-growing regions, and grow revenues and margins across all business segments.

• Management leadership brings aboard significant business development experience in the regions that matter most.  Mr. Harrington was President of Latin America and Canada for First Data Corporation (EVTC’s largest competitor) from 2002-2008 and brings aboard key corporate development experience in EVTC’s core LatAm and Caribbean markets.

• Since EVTC’s IPO in April 2013, management has begun to establish a shareholder-friendly capital allocation policy.  Having recently completed a $130 million capital investment program, they launched a $0.10/share quarterly dividend program in November and completed a $75 million share buyback in December.  In addition to continuing its international expansion efforts, management indicates it will drive shareholder returns through de-leveraging, additional buybacks and/or dividends, given the business now needs minimal incremental capital to harvest earnings in its existing markets.

Valuation:

• Target Revenue: I expect 2014/2015 revenue growth of 9%/10% in Merchant Acquiring and 7%/9% in Payment Processing primarily due to continued double-digit transaction volume growth driven by ramp-up of deals already in the pipeline.  My estimates for Business Solutions are 2014/2015 revenue growth of 4%/5%, driven primarily by a return to stable project growth following a lumpy 2H 2013 as well as contractual pricing step-ups with EVTC’s largest customer, Popular.  This leads to total blended revenue growth of 6%/7% in 2014/2015, conservative relative to management’s medium-term 8-9% target established in June 2013 (prior to recent new international contract wins which management expects will generate their full revenue impact by early 2015).

• Target Earnings and FCF: Assuming incremental EBIT margins of ~60-75% at the segment level (in line with their 3-year averages) and D&A in line with run-rate capex of , EVTC should earn 2015E adjusted EBITDA of ~$217 million (54% margin on ~$405 million of revenue).  Using the current ~3.5% weighted average interest rate and a 2% cash tax rate (conservative given PR’s 4% tax rate and EVTC’s ~$100 million NOL balance), I estimate 2015E EPS of $2.00 and FCF of ~$155 million.  On these assumptions, EVTC is currently trading at ~12x 2015E EBITDA, EPS, and FCF, implying an ~8% 2015E FCF yield.

• Target Multiple:

• P/E: Since the Company’s IPO in April 2013, shares have traded at an average of ~13x 2015E consensus EPS, compared to its closest peers HPY, GPN and VNTV that have traded at ~17x, ~12x, and ~15x, respectively.  Across its entire peer universe, the average 2015E P/E multiple is ~15-16x.  Given its superior and improving growth profile, high margins, and sustainable market position, EVTC should trade at least in line with its slower-growing peers in more competitive markets.  Based on my estimates above, EVTC should generate $2.00/share in 2015E EPS vs. consensus expectations of $1.85/share.  At a multiple of 15-16x 2015E EPS, EVTC is a $30-32 stock, which represents ~25-35% upside from its current market price.  This valuation assumes no EPS impact from potential international acquiring partnerships or licenses, which management has already voiced as being in the pipeline for additional growth in 2014-2015.

• P/FCF: EVTC is trading at ~12x 2015E levered FCF, or an ~8% 2015E FCF yield, compared to its peers’ average estimated yield of 6% (note that I calculate FCF more conservatively than management’s “Adj. EBITDA less capex” proxy; I calculate FCF as Adj. EBITDA less capex less change in NWC less cash interest less cash taxes.  Although this is a relatively low working capital intensity business, it is highly levered at 4.0x net debt/EBITDA and has substantial NOLs of ~$100 million, so deducting cash interest and taxes is important to establishing run-rate FCF).  Assuming a more normalized 2015E FCF yield of 6% in line with peers, EVTC should trade at ~16x 2015E FCF per share of ~$1.96, implying a stock price of ~$31 per share.

Risks:

• Economic struggles in PR are the biggest near-term threat to EPS, and despite recent retail sales having held up fairly well, fiscal worries and increased investor concerns could continue to weigh on EVTC’s stock.

• Mitigant: The Street does not seem to have done the work to isolate EVTC’s performance vs. Puerto Rico’s economy over the last 7 years.  However, the Company just released its first full year of results as a public company, and additional disclosures/results in the coming quarters should make it easier to analyze this (lack of) macro correlation, which will alleviate concerns about EVTC’s macro exposure.

• In its recent Q4 ‘13 earnings call, the Company indicated that an international project which was expected to have been implemented by year-end 2013 had experienced delays.  Further delays in this or other expansion efforts may push the timing of their respective revenue/EPS impact farther into the future and cause them to be further discounted, which would likely hurt the stock price.

• Mitigant: The forward P/E multiple discount already more than reflects the risk of a lower future growth profile, and this multiple discount as well as the 1.7% dividend yield should provide an adequate margin of safety in the interim.

• Banco Popular accounts for ~45% of total revenue, and if the bank were to struggle because of the PR economy or any other reason, it could have an adverse impact on EVTC.

• Mitigant: Popular’s contract runs through 2025 and provides longevity to this large and stable revenue stream.  Although Popular’s Business Solutions projects can be somewhat lumpy and cyclically driven, EVTC’s scale and integration along the entire transaction processing value chain is unmatched and makes it a difficult supplier for Popular to replace

• Although EVTC shares trade at a meaningful discount to peers on an adjusted P/E basis, many investors focus on EV/EBITDA multiples which indicate that the Company is actually trading at 12x 2015E EBITDA, ahead of peers VNTV (9x), GPN (9x), and HPY (8x) .

• Mitigant: Adjusted P/E is the more relevant valuation multiple.  EBITDA does not take into account either EVTC’s favorable 4% tax rate in PR (which is guaranteed through 2026) or its ~$100 million of NOLs, whereas adjusted P/E multiples do incorporate these benefits.

• EVTC has a significant debt load (~$708 million net debt, or ~4.0x net leverage on 2013 Adj. EBITDA), and the ability to service this debt may be at risk if earnings growth tapers off.

• Mitigant: EVTC recently refinanced its 10%+ rate debt to an average interest rate of <4% which has reduced interest expense; further, EVTC generates strong levered FCF (~$120 million in 2013) which management can/will use to de-leverage the Company.

Noteworthy Trading Dynamics:

• In December 2013, EVTC re-purchased Apollo’s remaining shares post-IPO on the open market for $75 million (funded with $25 million cash on hand and $50 million revolver borrowings) and as a result, selling pressure has largely abated.

• Since its IPO, EVTC has seen significant accumulation of its shares by several prominent hedge funds, including Glenview Capital (~6%), Steadfast Capital (~5%), Corvex Management (~4%), and Maplelane Capital (~4%).

Catalyst

• EVTC reported its first full year of earnings as an independent public entity (and the first Puerto Rico-based company listed on the NYSE) on February 12, 2014 during its Q4 / FY 2014 earnings call.  However, the Company has not yet released its 10-K.  This release of this filing may carry an important catalyst:

• The FY 2014 10-K may provide greater disclosure on volume growth and other key operating metrics.  By disclosing KPIs, the Company would give the market more confidence about the stability of its volume/price trends and their minimal exposure to Puerto Rico’s macro risks, catalyzing the beginning of a higher multiple re-rating

• In Q1/Q2 2014, EVTC will likely provide a performance update and guidance on the progress of its international growth partnerships which are currently in the works (some of which are quite far along but were just pushed from 2H 2013 into 1H 2014).  As the Company announces progress on existing deals and gives more clarity on their expected revenue/EPS impact, consensus estimates will likely be revised higher. 

• Although not immediate, the market will gradually realize EVTC’s major secular tailwinds, including:

• Increasing penetration of the Latin American market’s significant under-banked population

• Secular migration from “paper” to “plastic” payment methods

• Increased credit, debit and ATH card acceptance by merchants

• Greater outsourcing of card operations by banks