Description

First Data Corp.

Investment Summary

First Data (“FDC”) offers an investment in an Industry (payment processing) that has strong worldwide secular growth, and in a Company that is the industry leader, has an excellent management team, has a high Return on Invested Capital, and is in the late stages of both an operational and financial restructuring. Buy FDC at $11.01 with an $18.00 price target, with additional upside into the low $20’s for a total return of 63% to 100%.

Company Description

FDC is the leading payments processor with advantages in both scale and distribution. In 2015, FDC processed over 79B transactions and acquired $1.7 trillion in payment volume globally. FDC operates in 3 reportable segments:

·         Global Business Solutions (GBS) - 58% of revenue and 58% of EBITDA.

-    Merchant acquiring, business software, marketing and loyalty programs

-    Total GBS revenue grew 2% yoy and 5% at a constant currency basis.

-    US transactions grew 3.4% to ~45 billion and transaction revenue grew ~ 1% to 2.34 billion from 2.32 billion.

-    Internationally transactions grew a 12.5% to 7.7 billion but revenues declined to 856 million due to currency headwinds.

-    GBS product revenue is primarily sales of the Clover IPOS systems. IPOS bundle payment and software solutions that help small and midsize businesses operate. Clover is important for FDC to effectively compete acquiring SMB transactions, which are expected to represent 30% of total 2017 payment volume. Clover sales have grown double digits the past 3 years and continue to become more popular.

·         Global Financial Solutions (GFS) – 21% of revenue and 19% of EBITDA

-    Credit and private label issuer processing

-    Segment revenue grew 3% yoy

-    Global issuer leader with over 950 million accounts

-    This is generally a recurring revenue business with mostly large clients (credit card issuing banks and retailers). Each contract price will depend on the services provided

·         Network and Security Solutions (NSS) - 21% of revenue and 23% of EBITDA

-    Total segment revenue grew 5% yoy

-    Star Network

§  Consistent revenue growth ~5% yoy the past 3 years

§  Largest debit network after Visa and MasterCard ~15-20% market share

§  Recently introduced PIN-less transactions

-    Closed loop prepaid cards, offers both physical and virtual cards (through the Gyft app)

-    Security (TransArmor) a value add service for merchants to reduce the likelihood of a data breach

Recent History

·         FDC was taken private by KKR in 2007 and saddled with $24 Billion of debt. Due to the high leverage and little free cash flow, FDC was unable to make acquisitions resulting in slower growth relative to competitors Global Payments (“GPN”) and Vantive (“VNTV”). In June 2014 FDC, raised $3.5 billion private placement which reduced debt by $3.3 billion. Continuing to deleverage, FDC sold 160 million shares in an IPO on 10/15/15 at $16 raising $2.56 billion. All the proceeds were used for debt reduction.

·         Private FDC cycled through 5 CEO’s in 7 years and never had a profitable quarter until Q4 2014. Recently, FDC has shown both management stability, profit, and the ability to generate meaningful free cash flow. The current CEO Frank Bisignano joined in April 2013. Mr. Bisignano reshaped his management team with more than 2/3rds of the top 150 executives hired since April 2013. FDC simplified operations by consolidating its processing platforms and closing 15 offices, centralizing management, making FDC leaner and more efficient. Additionally, employee compensation was realigned with shareholder interests by giving all employees FDC shares.

Why does this opportunity exist?

§  KKR control and overhang- KKR and others own 719 million Class B shares, 80% of the economic interest in FDC. The class B shares are super voting shares with 10 votes per share. As a result, KKR will control FDC until it sells down its shares to below 10% of shares outstanding. When sold the class B shares will become standard class A shares. KKR bought FDC in 2007 and will be looking to exit its position in the near term thereby putting an overhang on the shares

§  High Leverage due led to underinvestment in technology, which has affected FDC’s growth rate and competitive position

§  FDC has negative net income – large interest payments and amortization of goodwill have pressured the bottom line.

§  Analysts were disappointed that since its IPO, FDC has not provided guidance

§  Concerns about competition – startup tech companies, such as SQ, PYPL, and Stripe (private) can take market share by managing merchant accounts for the banks

·         Loss of market share - According to data from the Nilson Report, First Data’s U.S. merchant acquirer market share dropped from 41% in 2009 to 39% in 2014.  More importantly, much of this share loss has been the high margin SMB customer

Investment Thesis

§  Strong Management

-    CEO Frank Bisignano: CEO since April 2013 FDC has found consistent leadership after fumbling through 5 CEO’s in 7 years

§  Prior to FDC was co-COO at JPMorgan Chase and CEO of Global Transaction Services Unit by CitiGroup

§  Focused on bringing new talent- replaced 2/3rds of the management team

§  Grew revenue in his first year 3.4% (excluding reimbursable) after slight decline in the prior year

§  Expanded EBITDA margins 2.5% from 32% to 34.5%

§  Mr. Bisignano has expressed a clear plan to grow revenue

§  Industry tailwinds – there is a secular shift from paper to plastic. Global non-cash payments are expected to grow 8.9% outpacing global GDP.  Additionally, recent industry consolidation has helped maintain strong pricing

§  Revenue Growth - FDC has clearly delineated multiple ways they intend to grow revenues and stem the churn of its SMB customers

-    Clover – FDC sees Clover as an opportunity to stem attrition, which according to Morgan Stanley is $300 million per year. Although FDC purchased Clover in 2012, many of the products offered (that are particularly attractive to the SMB client – such as the Clover mini) were launched recently. A key differentiator is Clover’s open eco system allows developers to sell enterprise solutions such as inventory management or seating for restaurants. FDC has observed a “near-zero” attrition rate from clover clients who downloads an average of 8 apps. 

-    FDC has been investing further in its digital strategy to acquire merchants directly online across all distribution channels

-    Its field sales force is targeting higher life time value clients

-    FDC has been expanding its telesales capabilities to sign up smaller clients

-    FDC has been improving its service model through vertical specialization and expanding its online self-help capabilities.

-    Star Network – network improvements such as PINless transactions led to 20% transaction growth in 2015. Developing signature technology for Star can add over $100 mm in incremental revenue.

-    Brazil – LATAM GBS revenue grew 14% at a constant currency. While the Brazilian economy faces headwinds, FDC has nascent base which it can continue to grow. MS estimates every 1% gain in market share would add ~$65 mm in revenue

-    Large Client - this was the first area of growth cited in the Q4 cc. This is a new area of focus for FDC which can leverage its ability to provide solutions to every aspect the enterprise process. Although large clients are stickier, negotiations can last for months and management gave no time table or revenue growth estimate.

§  Bank Alliances – FDC has over 80 revenue sharing alliances which is an important source of lead generation (and is a barrier to entry for any prospective competitor). Approximately 35% of GBS revenue is generated through alliance leads. Most important, are the 8 bank JV’s because they are hard to create and dissolve. Additionally, FDC has recently put additional focus on these alliances and is leveraging this relationship to grow its SMB customer base

§  Scale and cross selling –

-    Large investment needed to replicate the scale of FDC creates a large barrier to entry.

-    Per Barclays, 25% of FDC costs are fixed, resulting in a high cash conversion from incremental revenue.

-    FDC servicing both banks and merchants allows FDC to sell through value add NNS services to both GBS and GFS clients

§  Deleveraging- FDC used IPO and private placement to pay down debt. FDC also restructured some remaining debt lowering the average interest from 10.23% to 6.36%.  Anticipate that majority of free cash flow will be used to further deleverage.

§  Earnings quality – Investors have been wary of companies like FDC that rely on “adjusted net income”.  However, the actual Free Cash Flow is actually extremely close to the Adjusted Net Income and therefore Adjusted Net Income is a fair metric. Alternatively, actual (not adjusted) FCF is a metric and the one we used for valuation.  Much of the gap between net income and FCF is due to large amortization of goodwill associated with the LBO premium paid by KKR. Removing this 500m of goodwill amortization will cause D&A to reflect the ongoing capital expenditures (inclusive of both CapEx and customer acquisitions) and is therefore a more appropriate indicator of FDC’s cash earnings.

§  Valuation:

-    Based on a 2016 E. FCF and EBITDA multiples, FDC is currently worth $18 a share, with additional upside from execution on revenue growth initiatives and multiple expansion to match peers.

§  Revenue at FDC is expected to growth at 4.2% from 2015 through 2017, exactly in line with expected S&P revenue growth, which makes it deserving of at least a market multiple

§  Free Cash flow is expected to ramp even faster, as FDC will be using FCF to deleverage their capital structure.  We are expecting FCF to grow 22% for the next few years (S&P is expecting 10% earnings growth annually for 2015-2017)

·         FCF = EBITDA – Interest – CapEx- Customer acquisitions – Cash taxes (and does NOT add back non-cash comp)

·         FDC has a $1.2 billion NOL which should reduce cash taxes through 2019.  For illustrations purposes-  If FDC were to start paying full taxes in 2017, FCF would be flat to 2017 and would resume growing at a 20% in 2018

§  Projecting 2016 E. FCF of 948 mm; assuming the S&P multiple of 17x results in a PT of $18

·         Comps GPN & VNTV have FCF that match earnings and therefore their P/E is the same as their P/FCF

·         Since FDC has elevated goodwill amortization associated with its LBO, as explained earlier its earnings are masked by this recurring non-cash expense and is significantly lower than their FCF. Therefore, we believe that using actual FCF (and not adding back non-cash comp) is a better representation of the earnings power of FDC

·         GPN trades at 25.8x 2016 FCF and VNTV trades at 16.8x 2016 FCF

·         GPN trades at 21.4x 2017 FCF and VNTV trades at 15.3x 2017 FCF

-    EV/ EBITDA

§  Currently trades at 13.2x LTM EBITDA

§  Assuming $2.8 Billion of 2016 E. EBITDA and 12.5x multiple EV = $18.31 a share

·         GPN trades at 16.3x 2016 E. EBITDA and VNTV trades at 13.3x 2016 E. EBITDA

·         GPN trades at 13.0x 2017 E. EBITDA and VNTV trades at 12.2x 2017 E. EBITDA

Catalyst

§  First quarter of clean financials in Q1

§  Execution on growth initiatives and on stemming the loss of high margin SMB clients

§  Paydown / refinancing of debt

§  KKR selling down their position