Description

Thesis:
Wright Express (WXS) is an attractive stock because it is being valued on earnings that are materially understated due to unfavorable hedges. As the unfavorable hedges roll off, it will be clear that WXS trades at 11-12x its true earnings power, which is very attractive given high-single digit revenue growth that translates into low-teens EBIT growth because of high incremental margins.

Company Description:
WXS is a leading payment processor for the trucking industry. The company has a proprietary (closed) payment processing network consisting of 180k fuel and maintenance locations (>90% of US locations). The company issues charge cards to trucking fleets to pay for fuel and other products and services in an effort to save customers money by cutting down on improper purchases and by providing better analysis of their operations. WXS earns 2.0-2.5% of the transaction value, a fee which is paid by the retailer. For example, if a customer goes to an Exxon Mobile and buys 20 gallons of gas at $2 per gallon, that is a $40 transaction. WXS pays the retailer $39 and gets $40 from the trucking company. The trucking company also may pay a small monthly fee per vehicle.

The company’s clients include UPS, Pepsi, and Sears and its retail partners include Exxon, Citgo, Shell and other large retail gas outlets.

Value Proposition and Competitive Advantage:
The Wright Express service provides a compelling value proposition. The company’s trucking clients are paying very little or nothing (retailers pay the interchange fee) for the service that saves them 5-15%. The savings come from the information and information technology tools that WXS provides to its clients that allow trucking companies to analyze their drivers’ efficiency and restrict their purchases to operational essentials (not food or other personal items that often get lost in a cash or normal credit transaction).

Why can’t a normal credit card company provide the same value? Because their networks are net set up to capture the necessary data. By having its own closed-network, WXS can capture the driver and vehicle identification, odometer reading, fuel grade purchased, gallons of fuel purchased, etc. It is this data and the company’s IT tools that allow clients to analyze their operations and control spending that is the competitive advantage.

Growth and Market Opportunity:
Excluding the price of fuel (the impacts of which will be covered in detail later), the company has grown revenue, EBITDA and net income at 10%, 15% and 19% compound annual growth rates, respectively, over past three years. The top-line is expected to grow about 8% in the next few years as the company grows its fleet of customer vehicles at that rate. Although the overall U.S. fleet vehicle growth is 2-3%, WXS can grow its customers at 8% because of the large market opportunity for its product. WXS pegs the market for its product at about 24m vehicles. Of those, 20% have their own fueling station so that reduces the opportunity to 19m. WXS has about 4m now or 1/3 of those that use fleet management charge cards. This means that there are a very large number of commercial vehicle fleets that are still using cash, providing the opportunity for WXS to continue its rapid growth. High single-digit rev growth combined with a very fixed cost structure (there is very little variable cost since the network is already built, except the 20 day funding period between when WXS pays the retailer and when the client pays WXS which the company funds with bank deposits) translates into low-teens EBIT growth.

The Opportunity:
At its most simplistic, WXS is taking about 2.0-2.5% of a total transaction that is predominantly fuel. This makes its business very sensitive to gasoline prices. When the company was spun out of Cendant as a newly public company it wanted to assure investors that it would have stable cash flows that investors could count on. To do this, it hedged its gasoline exposure at $1.85-1.95 for 2005 and 2006. So, on First Call, when earnings estimates for this year and next year call for $1.11 and $1.25, they are dramatically understating earnings power relative to the current price of gas which is closer to $3, and even the $2.50-2.60 price implied by the futures curve one year from now.

Every $0.10 move in gasoline is worth about $0.085 in EPS to the company. So, is WXS just a levered play on gasoline? No, because the stock is being valued on the understated earnings making the movement to gasoline asymmetric. On current understated 2006 earnings, the stock trades at 17x, but its comp group (ADS, GPN, TSS, CEY etc) trades at 17x-25x with an average of 20x. If the company’s hedges are stripped out and $2.50 gas assumed (discount to futures curve) it would be earning $1.80 in 2006 instead of $1.25. Earnings power in 2007 is about $2 (assumes $2.50 gas and no hedges – in reality they will be hedged at rates slightly lower and earnings will therefore be slightly less) and if the company traded at a 1 yr-forward multiple of 17x that number it would be a $34 stock in less than a year.

Another positive is that this need not be a theoretical exercise as the company hedges two years out on a rolling basis and as such will lock-in current gas prices. At the end of Q305 it has hedged more than 50% of 2007 and will be fully (90%) locked in for 2007 by 2Q06 (each quarter the company hedges an additional 30% of each of the three subsequent quarters beginning 1 year and a half out – so at the end of Q405 WXS will hedge an additional 30% of Q207 for a total of 90%, an additional 30% of Q307 for a total of 60% and 30% of Q407).

Other growth opportunities:
The company’s growth is not limited to simply growing its core domestic fleet business. It is expanding into service/maintenance purchases (signed up 41,000 locations already including Jiffy Lube, Sears, and Valvoline), the heavy truck market (3m vehicles), and is ramping up its corporate Mastercard offering.

Risks:
Pricing – The processing fee that WXS charges has been declining at about 10bps per year. Management says some of the pricing pressure is just because they have been renegotiating a lot of their contracts with retailers recently and going forward there should be less pricing pressure
Competition – Although there have not been many new entrants, if a large bank decided to address the fleet market with a new offering that could be disruptive
Commodity prices – While the risk is more asymmetric (the market is pricing in the lower gas hedges rather than current prices or even those implied by the futures curve), a major decline in oil and gas prices (say $30 oil) would be a clear negative and reduce earnings power.

Catalyst:
Company makes progress in and is given credit for locking-in 2007 gas prices

Catalyst

Company makes progress in, and is given credit for, locking-in 2007 gas prices