Description

Description

Wright Express Corp. ("WXS" or the "Company") has the largest share of the niche market for payment processing for fleet management companies.  WXS has strong profit margins and high operating leverage and has been able to grow revenues despite increasing price competition through successful customer acquisition and penetration.  The sensitivity of the Company's earnings to fluctuations in the gas price has created volatility in financial performance, which has in turn been exacerbated by the format in which performance is reported.  The shares have declined over 60% since September due in part to the broader market downturn and in part to recent declines in the gas price.  Given the tendency of the Company's method of financial reporting to obscure the true underlying economics of the business, it is likely that WXS is cheaply valued at the current share price relative to future performance, even if gas prices do not resume an upward trend, price competition continues, and transaction volumes stagnate.

Business

WXS operates a payment processing network and provides transaction services to fleet management companies.  The Company's core business is the issuance of credit cards to fleets that are used to finance transactions at fuel and maintenance locations within WXS's closed-loop network.  WXS retains a portion of the transaction amount as a processing fee (currently about 170bps) and remits the balance to the merchant approximately 11 days after the transaction.  Fleet customers have approximately 30 days to remit payment to WXS before finance charges begin to accrue.

WXS's network is attractive to fleets because it captures and disseminates data that allow customers to actively monitor their drivers and control costs.  Such data-which include the dollar amount of transactions, driver and vehicle identification, odometer readings, fuel type, gas station information, and a description of purchased items-are sent to fleet management companies in the form of online accounts and periodic reports managed by WXS.  Fleets can track driver productivity and prevent unauthorized purchases via the WXS network.

The processing fees described above account for over 70% of the Company's total revenue.  The balance comprises: (i) processing fees on transactions involving a MasterCard product on WXS's network; (ii) fees on transactions on WXS's network where the Company does not finance the transaction (i.e., does not act as issuer); (iii) account servicing fees; and (iv) finance charges.  (i) and (ii), like the core processing fees, are paid by merchants, while (iii) and (iv) are paid by fleets.

Revenue

Revenue from processing fees is the mathematical product of four components: number of transactions x gallons/transaction x gas price x processing rate:

In general, the number of transactions has undergone significant growth as WXS has retained existing customers and acquired new ones, while gallons/transactions has stayed relatively constant (due largely to technical restraints) and the gas price has fluctuated (with major increases having occurred over the last few years).  The processing rate has steadily declined, which has been attributed to increasing competition.

Hedging

In light of the impact of a change in the gas price on revenue, WXS has sought since 2005 to hedge approximately 80%-90% of its earnings that are subject to fluctuations in the gas price.  The Company has accomplished this by entering into a "costless collar", where the proceeds from writing a call are roughly offset by the cost of buying a put and where the strike price of the call is approximately six cents higher than the strike price of the put.  WXS on average has entered into hedging arrangements for the following six quarters on a rolling basis, which has provided some visibility into future effective gas prices facing the Company.

The impact from the Company's hedging activities is recorded as "net realized and unrealized losses on derivative instruments" on the income statement, which is further deconstructed into realized and unrealized losses in the financial footnotes.  Unrealized losses are noncash mark-to-market adjustments to the carrying value of unexercised puts and calls.  Realized losses represent cash flows associated with the exercise of puts and calls.  For example, if the actual gas price is above the strike price of WXS's call option, then the Company's counterparty would exercise the call and receive cash payment from WXS.  If the actual gas price is below the strike price of the put option, then WXS would exercise the put and receive cash.  The former would be recognized as a realized loss and the latter a realized gain. 

Because revenue is recognized based on the actual gas price, revenue is overstated (understated) when the actual gas price is greater (less) than the call (put) strike price, since a significant portion of such overstatement (understatement) tends to be offset by hedging-related losses (gains).  As such, a more meaningful measure of true "topline" performance is arguably revenue less realized losses:[1]

Until recently, WXS's goal was to hedge 90% of its earnings subject to fluctuations in the gas price.  WXS has been increasingly transitioning its merchant contracts to hybrid pricing, whereby a portion of the Company's fee continues to be calculated as a percentage of the transaction amount and a portion is fixed.  In conjunction with this, the Company has reduced its hedging goal to 80% of earnings.  In any event, the historical impact of the Company's hedging arrangements can be measured based on actual gas prices, option strike prices, and realized losses.  The table below depicts (i) the difference between actual gas prices and option strike prices and (ii) realized losses per transaction over time.  The "% of price delta" line is simply the ratio of realized losses to the difference between the actual gas price and the option strike price.  Based on gallons/transaction and the processing rate (which are not shown below), the next line shows the ratio of realized losses to the difference between actual revenue less realized losses and what revenue would have been in the absence of any hedging arrangements.  Finally, as the operating leverage on a dollar change in unhedged gas prices is 80-85 cents, the final line measures the portion of earnings that was hedged.  Not least because hedging requires forecasting the behavior of several variables, the portion of earnings that has been historically hedged has varied significantly and has often been below the Company's stated goal.

Unit Economics

WXS typically remits payment to the merchants within 11 days of the transaction and provides 30 days of free financing to its fleet customers.  Hence, the Company is required to fund its customers' transactions for approximately 19 days, which it facilitates through the issuance of brokered certificates of deposit at its banking subsidiary and through a credit facility that resides at the parent company.  On its income statement, WXS distinguishes between "operating" and "financing" interest expense, where the former is located above operating income and represents interest expense on liabilities at the banking subsidiary (CDs as well as federal funds) and the latter is located below operating income and represents interest expense on the parent company's credit facility.  The implicit suggestion seems to be that only the banking subsidiary provides funding for advances to the merchants (i.e., the core operating activity), but based on the Company's weighted average interest costs and its days funding, it appears as though nearly all of the Company's interest expense has been utilized to fund merchant advances.[1]  Below is a per-transaction income statement, adjusted to reflect realized losses as a deduction to stated revenue and the consolidation of operating and financing interest expense.

[1] This is meaningful to the extent that the business is valued on an operating income basis.  The sell-side as well as parts of the investor community appears to view the Company at least in part on an operating income basis, despite the problems with this approach, including the fact that the Company's stated operating income is after "operating" interest but before "financing" interest and realized losses. 

Pros

• WXS has demonstrated steady and significant growth in transaction volumes by adding new customers and retaining existing ones. There is clearly a sustainable demand for the data capture that is the core of the Company's service offering and high switching costs have helped to retain the installed customer base.
• The Company has the largest market share and remains small relative to the addressable market, much of which has yet to be penetrated by WXS or its competitors.
• High operating leverage combined with topline growth has roughly offset declines in the processing rate to sustain healthy pre-tax margins. Credit costs, although currently elevated, continue to be manageable.
• Although the fate of this business is inextricably linked to the path of gas prices in the long run, there is significant short-term visibility into the impact of gas prices on financial performance.

Cons

• WXS's processing rate has steadily declined over time as competitors have matched the Company's level of data capture, which has prompted increased price competition. Although recent efforts to transition merchants to a hybrid pricing model may mitigate this negative trend, the ultimate equilibrium price for the Company (and the industry) remains an unknown.
• A deteriorating economy is likely to place downward pressure on transaction volumes and upward pressure on credit costs, thereby reducing profits. Although credit losses have remained relatively under control, WXS is exposed to the risk of a customer bankruptcy in which the Company holds a large quantity of potentially uncollectible receivables. (This risk is acute as the Company's receivables are large relative to its sales.)
• Unless the Company's pricing becomes completely fixed, gas prices will continue to have a major impact on financial performance irrespective of the hedging policies that are put in place. Hence, a long-term position in these shares is willy-nilly a position on gas prices.

Conclusion

At $12 per share, WXS is trading at 5.6x LTM EPS of $2.13, pro forma for unrealized losses and a payment to the Company's former parent in satisfaction of deferred taxes.[1]  Q3 performance adjusted for Q4 gas prices suggests that Q4 run-rate EPS is approximately $1.25, which would imply a P/E of 9.6x.  The Company is hedged through September of 2010 at an average gas price of $2.61 for Q1'09 increasing to $3.63 for Q3'10.  To the extent that gas prices remain at their current levels, WXS would be entitled to larger payments on its put options over time.  In fact, assuming gas prices remain at their current levels, transaction volumes stay constant, and the processing rate continues to decline until bottoming out at 150bps, WXS could generate more than $1.45 in run-rate EPS by Q3'10 in light of the contribution from realized gains.  On the other hand, should gas prices resume their upward trend, earnings would be supported by higher revenues that would only be partly offset by hedging-related losses.

Earnings could naturally decline from current levels if gas prices move lower than their recent nadir, and credit costs will in any event continue to exert pressure on profitability during the current economic slowdown.  However, to the extent one achieves confidence in the proposition that gas prices are likely to remain constant or increase in the near term, then WXS would appear to be meaningfully undervalued at its current share price. 

[1] WXS was spun off from Cendant in 2005, at which point certain assets of the Company were marked (up) to market.  Cendant is entitled to a majority of the savings generated by the resultant tax shield.  See a writeup by jet551 from December of 2008 for a useful discussion of the relationship between WXS and Cendant.

Catalyst

simply time thru the cycle so investors can understand the hedging and accounting under different scenarios