Fidelity National Information FIS W
December 31, 2007 - 10:54pm EST by
sandman898
2007 2008
Price: 41.59 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 8,000 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • IT Services
  • Spin-Off
  • Mortgage

Description

Fidelity National Information Services (FIS) is a high-quality and well-managed transaction processing company trading for 10x 2009E FCF. Shares have recently fallen out of favor due to misunderstood exposure to mortgages. Not only is the business segment related to mortgages likely to outperform in 2008 and 2009 but this segment is also scheduled to be spun-off within six months, providing a solid catalyst for value realization. A more realistic valuation relative to peers would put the shares closer to $60, offering 50% upside over the next year.

Capital Structure
 
Price                             41.50
(x) Shares                     196.5
Market Value             8,150
 
(+)Debt                        4,320
(-) Cash                       (279)
Enterprise Value        12,191
 
2008E ($MM)
 
Sales                            5,500
(x) Margin                    26%
EBITDA                     1,450
(-) D&A                       (525)
EBIT                            925
Interest                         (250)
EBT                             675
(x) Tax Rate                 37%
(-) Taxes                      (250)
Income                        425
 
(/) Shares                     196.5
EPS                             $2.16
 
(+) Purchase Amort.     185                             
(+) D&A                      340
(-) Capex                     (280)
FCF                             670
 
(/) Shares                     196.5
FCF / Share                $3.40
FCF Yield                   8%+
 
FCF is materially larger than reported net income due to purchase amortization and D&A that slightly exceeds total capex. There is quite a bit of debate as to what the company will look like in 2008 and 2009 due to a recent acquisition and a number of moving parts but the numbers above represent my conservative best estimate. The sell-side community is forecasting 2008E EBITDA of approximately $1.5B and 2009E EBITDA of approximately $1.6B. Despite the fact that a bulk of 2008 FCF is modeled to go into paying down very inexpensive debt, FCF numbers for 2009E are around $4.00 per share.

Valuation
 
FIS consists of two individual segments: Transaction Processing Services (TPS) and Lender Process Services (LPS). For 2008, analysts expect TPS to generate roughly $850MM in EBITDA and LPS to generate roughly $600MM. In a recent investor presentation on the company’s website, management pointed out that while FIS was trading at 8.9x 2008E EBITDA, which has since fallen to 8.4x, comps for LPS were trading at 9.0x and comps for TPS were trading at 10.8x. The company also pointed out that TPS was an “industry-focused category-leading outsourcer,” and that other companies that meet this definition trade for 12x+ forward EBITDA. Sell-side analysts are using 9.5-11.0x for TPS and 8.0-10.0x for LPS which result in sum-of-the-parts valuations ranging between $55 to $60 per share.
 
Management’s behavior would confirm that they also believe that the stock is undervalued. FIS repurchased more than 1MM shares in each of the last three quarters of 2006 at prices between $35 and $40. As the stock price continued to advance from $40 to nearly $58 during Q1 2007 and Q2 2007, management did not purchase any additional shares. The stock peaked in late July, right around the time that the eFunds deal was announced. While the price was still justifiable, analysts were somewhat less enamored with the deal based on the belief that the acquisition of a company with larger exposure to core processing would have been more strategic for FIS. The share price began to fall. Q2 2007 results were lackluster as sales were stronger than expected but EPS was “only in line” as margins were held back by large growth investments as well as a mix shift towards lower margin segments.
 
Last quarter, the company missed EPS by a penny, though EBITDA was higher than expected and margins began to show signs of recovery (FIS has beaten EBITDA estimates for the last five quarters). As the stock fell below $50, the stock repurchases were reinitiated. In Q3, the company bought back $80MM of stock (~1% outstanding) for slightly more than $49 a share.
 
Catalysts
 
A spin-off of the LPS segment in mid-2008 should create value as the two segments are likely to receive higher valuations as independent pure plays rather than as a combined entity. The segments have relatively little customer overlap, operate with different management teams, and share very few resources. Both segments are fairly complex, but once independent, each segment should be able to tell a much cleaner story, potentially attracting new investors who may have been willing to purchase only one of the businesses because they were unwilling to analyze both. Furthermore, given the current market environment, removing the word “mortgage” from investor presentations could easily result in a higher stand-alone multiple for TPS.
 
Throughout 2008, FIS should continue to execute on delivering synergies and further cost reductions. Furthermore, any additional default business is likely to come online at a high incremental margin and is likely to surprise analysts. At current prices, it would be fair to expect FCF use to be shifted away from debt paydown in favor of a buyback which should help to support the share price. In addition, a number of large growth initiatives that suppressed margins in 2007 should begin contributing to the bottom line. Finally, the initial $65MM in eFunds cost savings could ultimately be raised to $100MM and additional sales synergies could be announced.
 
“I think the most important thing we have learned is there is probably a little more upside in certain businesses than what we originally thought. I will give you the kind of a nutshell reason for that: eFunds was organized on a very, very matrix basis. There really wasn't a continuous business unit that supported a given product. That lack of having strong accountability, in my opinion, hurt some of the revenue growth and some of the profitability growth that they had in that business. That is the good news. We can get in and we can fix that and get that organized the right way.” – Lee Kennedy, FIS CEO, Q3 2007 Earnings Call
 
Background
 
FIS was initially part of FNF and its origin dates back to FNF’s $1B acquisition of ALLTELL Information Services in 2003. In late 2006, FNF merged a portion of FIS with Certegy, and spun-off the remaining shares to investors. Then in September 2007, FIS acquired an electronic payment solution provider called eFunds for $1.8B. Finally, in October 2007 the board approved a spin-off of LPS, which is expected to occur in mid-2008. In the transaction, LPS will take on $1.6B of the combined company’s $4.3B in debt.

TPS Overview
 
TPS provides core-IT systems such as ATM processing, check cashing, bill payment, web hosting, and fraud prevention/detection to financial institutions. These systems are essentially the key operating platforms used by most banks, and because of there mission-critical status, a number of banks have been weary to switch, and instead still rely on outdated, internally-developed technology. In order to get these institutions to adapt, FIS has spent about $2.5B over the last few years researching and assembling the necessary components to offer new architecture based on open-industry standards. The number of core processing vendors has consolidated considerably from over 100 to around 25 over the last two decades. Those that have survived, such as Metavante, Jack Henry, and Open Solutions, have also acquired a number of smaller competitors in order to broaden their product offering and since less than 5% of banks change systems in any given year, acquisitions also enable competitors to quickly grow and expand into new markets.
 
“We believe that large and mid-tier banks will start replacing core processing systems within the next five years. Most large banks are currently operating multiple core systems driven by outdated, 30-year-old technology, which is very expensive to operate and lacks flexibility. We have excellent customer relationships with many of the nation's top tier banks, the majority of which are running on our core processing systems. This puts us in an excellent position to receive strong consideration when the banks move towards new core processing system replacement. Over the past few months, several of the nation's leading financial institutions have launched exploratory core system initiatives with FIS.” – Lee Kennedy, CEO, Q3 2007 Earnings Call
 
Over the last twelve months, TPS generated $823MM in EBITDA or a 25% margin on $3.3B in sales. Contracts are typically long-term and nearly 90% of sales are recurring in nature. This business generates revenue from three segments, 42% from Integrated Financial Solutions (IFS), 38% Enterprise Banking Solutions (EBS), and 20% International. Management previously provided a sales breakdown earlier this year, and thus the numbers below represent a rough estimate of revenue contributions.
 
The IFS segment ($1.4B in sales) provides banking systems to smaller (<$5B) banks that enable them to operate IT systems that are competitive with large, multi-national financial institutions. IFS consists of four segments: 30% of sales come from Credit Card, 28% Item Processing, 25% eBusiness, and 17% Core Processing. The Credit Card segment ($420MM in sales) handles every component of issuing a credit card, to the point that all customers need to do is specify cardholder criteria and fund the cardholder receivables. The Item Processing segment ($390MM in sales) both processes and guarantees checks. The eBusiness segment ($350MM in sales) helps banks offer bill payment and online banking service to their customers. The Core Processing segment ($240MM in sales) licenses the infrastructure needed to setup and maintain account records and online banking.
 
The EBS segment ($1.25B in sales) offers systems for larger (>$5B) banks. Management breaks down revenue in this segment as follows: 45% from Core Banking, 27% from Check POS, 15% from Gaming/Cash Access, and 13% from Specialty. Core Banking ($560MM) offers deposit solutions to nearly half of the top 100 banks in the U.S. and commercial lending services to 20 of the top 25 global banks. Check POS ($340MM) consists of check risk management for banks as well as retailers. While check volumes are declining, the company has been able to offset this with market share gains and the sale of higher-value services. Gaming/Cash Access ($190MM) provides cash advance services to payday lenders as well as casinos. Lastly, Specialty ($160MM) provides auto finance services.
 
The International ($650MM in sales) segment consists of the same services listed above, but targeted to non-U.S. customers. Roughly half of sales come from Card & Payment services, such as a soon-to-be $125MM JV to roll out credit cards for Branco Bradesco and Banco ABN Amro in Brazil, while the other half comes from Banking services. This segment has been growing rapidly over the last few years and in 2006 grew 37% organically.
 
In 2008, International should continue to be a growth engine. The company has also announced strategic review of both the check risk management and gaming cash access business, arguably the two least attractive, as it continues to streamline operations.
 
LPS Overview
 
LPS provides processing services to nearly 60% of all mortgages in the U.S. The company offers a number of different services and major customers include Bank of America, Washington Mutual, Wachovia, JP Morgan, Countrywide, Citigroup, ING, etc.
 
“If you went to obtain a new mortgage from Bank of America, depending on the channel, they would rely on Fidelity for credit information on you, appraisal services on the property, title insurance, and closing services. Once the loan was closed, they would utilize Fidelity for servicing and securitization technology, tax information, network services to connect with other business partners, and default management capability. In short, Fidelity lender processing services would have touched or enabled virtually every step of the process.” – Dan Scheuble, President, FIS Mortgage Processing Services
 
Over the last twelve months, TPS generated $560MM in EBITDA or a 33% margin on $1.7B in sales. Contracts are typically long-term and nearly 90% of sales are recurring in nature. This business generates revenue from six segments, 32% from Default Services, 26% Processing, 22% Property Valuation, 11% Origination Services, 5% Tax Services, 4% Other. Default Services ($540MM in sales) includes loss mitigation, foreclosure publishing, bankruptcy, field services, property management, and even disposition. EBITDA margins are now in the 25%+ and should scale upward as additional volume takes advantage of a leveragable cost base. The business has a 30% market share in the U.S., and with foreclosures expected to hit record levels, provides a very strong counter-cyclical exposure to the mortgage market.
 
“We have a very, very full pipeline of large institutions that traditionally have operated their default programs in-house. And as they are experiencing increasing volumes, they started to talk to us about handling some of the overflow and some of the business they normally would do within their own institutions. That business is really a very, very good business for us and it's going to continue to be so well into the future.” – Lee Kennedy, CEO, Q3 2007 Earnings Call
 
Processing ($440MM in sales) provides the accounting, customer service, regulatory reporting, and other services for a bank’s mortgage portfolio. The company charges approximately $1+ per month per mortgage and benefits from nearly 40% EBITDA margins. Property Valuation ($370MM in sales) includes everything from automated valuations to sending out agents and EBITDA margins tend to run around 15%. Origination ($190MM in sales) includes title search, documentation, packaging, and closing services. Tax ($90MM) generates revenue over the life of a loan and is typically associated with sub-prime mortgages. EBITDA margins in these segments are around 25% and both are heavily cyclical. The Other segment consisted of the recently divested Property Insight business.
 
At this point, Default Services is large enough that the combined LPS business is arguably slightly counter-cyclical. In fact, sales are up more than 10% for the first nine months of 2007. Margins in the segment were negatively impacted when the mix shift began away from Origination and Tax and towards Default Services but this margin compression has reversed and margins are now expanding. During the company’s analyst day as far back as March, management had said that the only real risk to the top-line was due to two independent clients who were under pressure, and these two combined represented, “slightly less than 2% of total revenues.”
 
It is likely that a number of homes stay on the market for a prolonged period of time, but the good news is that a stagnant market environment will not exist forever. Eventually these homes will be refinanced or foreclosed and mortgages as a concept are unlikely to go away. As things get worse, LPS should actually do better, with the Default Services segment adding new business at a high incremental margin and the Processing segment growing as additional customers move their mortgage processing over in an effort to save money.
 
“Looking beyond the past couple of months and perhaps the next couple of months, we think FIS will actually come out of the recent mortgage-related turmoil in an even stronger competitive position as mortgage volume market share is likely to accrue to the larger industry players, which is FIS’ sweet spot. A number of second and third tier players have ceased operations or scaled back substantially and those companies with larger balance sheets and the ability to hold mortgages rather than immediately selling them appear well positioned…if the economy were to actually pick up, then we think the origination piece of the business has the potential for explosive growth given market share gains that have been more than offset recently by volume reductions.” – Merrill Lynch, November 29, 2007
 
Risks

The sell-side community has done a decent job pointing out the short-term integration risks as well as the long-term risks to the business model, particularly the erosion of the check business which the company is attempting to sell, so I will not elaborate too much on those here. I will however, point out that as management gets closer to the spin-off date there is some chance that LPS segment frontloads costs in order to issue equity in the new business at a lower basis and/or provide a financial cookie jar with which to show strong performance post the separation. While this risk is somewhat mitigated by the high-quality of management, it remains a real risk to anyone limited to a one year time horizon, and can only be fully eliminated by taking a longer-term view.

Catalyst

Spin-off of LPS in mid-2008, additional cost synergies, growth of default services segment, potential sale of check segment, and continued stock buyback.
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