Description

I am recommending First Data. First Data recently announced that it would spin off Western Union into a separate company. My recommendation is based on my view that WU is a wonderful business, a business that the investment world will want to own, and that the market currently allows the creation of WU at an attractive price.

I see certain risks to this investment which I will list up-front. Notwithstanding the risks, I think there is very little down-side to the stock and that the risks could end up impacting the potential for appreciation although I do not believe that they represent meaningful downside risk except in a poor stock market. Stated simply, I think downside risk is low, potential for a nice profit (10-15%) over the next year is high, and that there is some potential for greater profitability.

Once WU is spun-off, “New” First Data’s largest components will be

1) merchant processing which includes its credit card and debit card processing businesses
2) the card issuing business which services credit card issuers (like TSS)
3) First Data International and Integrated Payment (which includes the check outsourcing business which will not go with WU).

I am not going to go into much detail on these businesses as a) much information is available in the public documents and b) the key piece of the equation is the valuation of WU, and I’m going to put a low enough valuation on New First Data where I think there won’t be much downside.

The risks.

1) continued loss of market share to competitors. First Data has invested much less in its systems that has been necessary to maintain market share, a concept we will revisit when looking at valuation.
2) Continued pricing pressure in the business which is not made up for by continued revenue growth. For the moment (as it has for the WU business), price elasticity has worked in the company’s favor.
3) First Data’s card issuing business in particular has been under competitive pressure, which will likely continue.
4) WU continues to see pricing pressure.
5) Valuation. Given the above uncertainties, it could turn out that the stock could be fully priced. Additionally, New First Data has had less historic profit growth than the company is forecasting and the market is expecting.

Stated differently, this investment has more moving pieces than I would ideally prefer.

At the end of the day however, I think WU is simply to fine a business with too much brand value that one can create at a reasonable enough valuation that there is simply a compelling upside-downside calculus.

Let me interject for a moment to compare First Data to Moneygram International (MGI). MGI is trading at roughly 18x 2007 earnings, the peak of what I think one is creating WU for. Its market capitalization is roughly 1/10th of what I am forecasting WU’s to be and it has been growing its transactions almost 1,000 basis points more quickly than WU has, both as a function of working from a smaller base as well as being at a lower price point than WU.

But at the end of the day, WU 3x the number of agent locations. Moreover, WU has recently took an important MGI agent (Travelex) and has been growing its agent base as quickly as has MGI. WU appears to have pre-tax margins north of 30% compared to MGI’s at a bit north of 20%. While WU has grown less quickly than has MGI, MGI is not forecasting EPS growth for 2006. Additionally, WU has no more than 3x MGI’s interest income (comes from float). And WU has over 10x the EBIT of MGI. In other words, as best I can tell, roughly 25% of WU’s EBIT comes from interest income as opposed to to north of 75% for MGI.

So at the end of the day, WU has higher margins, more than 3x as many agents, able to operate at higher pricing (which reflects both its brand and locations), and is consequently the 800 pound gorilla in the business. In terms of agent locations, given its earlier start in the business, WU has a dominant presence in the slums and lower income areas of this country.

On an absolute basis, given the cash up-front nature of the business, WU is essentially a business that needs deminimus capital to operate. So returns on capital are in the high double digits. Operating margins are north of 30%, and despite a gap of transaction growth and revenue growth of roughly 10%, margins remain basically unchanged with EBIT and eps growing in the mid-teens. On the qualitative front (besides having a great brand and being the dominant player which is reflected in the numbers and thus should not be paid for again), there are important secular trends that should continue to lead to unit growth (regardless of what happens on the internet). The world is becoming more global. More people are leaving their homes and moving elsewhere to try to generate more income, and this means more income to send home to families who still do not have bank accounts. These trends should assure substantial unit growth going forward. And this year, FDC is projected a smaller gap between transaction growth and revenue growth as certain price cuts are anniversaried. (I would note that management’s forecasts have been too high.) But overall, I believe this sums to a very valuable earnings stream.

Let’s turn to valuation; and there are a number of ways to slice and dice this one. I am going to base these on 2007 numbers as late this year/early next year is when WU will spin-out, and that is the awaited catalyst.

The stock is $45.41. New FDC earned about $1.00 in 2005. The company is projecting 8-10% growth this year. I am skeptical. I am going to forecast a bit north of 8% growth over the next two years combined, or $1.10 for 2007. I feel that at a 12.5 multiple (any legitimate comparable company is higher), this valuation should be very safe. It is important to note that although struggling, this is still an extremely high ROE business as well. (Virtually all of FDC’s shareholder equity is goodwill.) That is $13.75 a share. Now this business has D&A that is expected to exceed capital expenditures and acquisition of customer contracts (which are capitalized and amortized) by about $150mm a year. This is $.19 a share in excess free cash flow. Most of the D&A is the amortization of the customer acquisition accounts; so it is tax-deductible, but it is also recurring. As I said earlier, I do not think FDC is investing enough. So some of this free cash flow really doesn’t strike me as free but rather should be reinvested in this business. On the other hand, if it were, EPS would likely grow more quickly. So one could put a multiple on this $.19 or assume a higher EPS growth rate for earnings (which would mean both bigger earnings and perhaps a higher multiple. So to the $13.75, I add $2.00 to get to $16.00. This is at the bottom of any street projected value for this business. It is 12.5 GAAP EPS + 10x excess Free Cash Flow or less than 15x earnings that would certainly be too low (and are well below company forecast) if they invested the excess Free Cash Flow and implying no value for the extra $150 million of free cash flow. I believe at this number, this is upside to New First Data once the stock gets fully distributed, both in the public as well as private equity market.

So this means creating Western Union at $29.25 a share. If Western Union grows 15% a year from 2005 to 2007, one gets to a bit north of $1.50 a share. This company has roughly $.08 a share of excess Free Cash Flow, and I believe this is truly free. So for 2007, WU should have cash earnings of $1.60. At $29.25 a share, that is an 18.28 multiple on WU. While maybe not dirt cheap, it is cheap. WU’s Free Cash Flow is growing in the mid-teens, and the business requires no special amount of capital. At a $23bn market capitalization company, is this not going to become a must own stock for any large-cap fund? And while I expect that the existing FDC holders may dump their new First Data, I expect they will hold their WU at this valuation. Consequently, won’t the multiple move to well north of 20 given the company’s financial characteristics? I think WU will trade at a 22-24 multiple, implying anywhere from $6-$9 of appreciation potential from FDC’s current value. In any event, I think the odds of a higher valuation on WU are much greater than the odds of a lower one. As long as WU earnings don’t disappoint (and I think the secular trends are too powerful for this too happen); I think there is sufficient margin of safety in WU’s multiple and in my forecast of New FDC’s EPS estimate (and perhaps valuation as well) that I find it hard to see meaningful downside in FDC.

Catalyst

spin-off of Western Union