Description

eFunds Corporation provides electronic transaction processing, automated teller machine (ATM) outsourcing and decision support and risk management services to financial institutions, retailers, electronic funds transfer networks, e-commerce providers and government agencies. The Company also offers business process outsourcing services to complement the Company's payments business. The Company's services enable clients to reduce their transaction and infrastructure costs, detect potential fraud and enhance their relationships with their customers.

Background

EFunds (EFDS) is a collection of businesses that run the spectrum from marginal to excellent. An overwhelming positive aspect of these businesses is that most of the company’s revenues are recurring with 80 percent of 2002 revenue expected to recur in 2003. At a current valuation of 4.0x EV/ FCF I believe EFDS is a compelling investment.

While EFDS may appear very attractive based on its current valuation there are some significant issues confronting the business. First, EFDS is losing about $45 million in contract revenue in 2003, most of this coming from its high margin transaction processing and professional services segments. Most of this revenue will be replaced by revenue from its ATM Management business but at a significantly lower margin. Second, EFDS restated earnings for 2001 and 2000 by $4 million and $1.2 million respectively. The earnings restatements have led to a formal SEC investigation and a class action lawsuit. While this is an obvious negative, EFDS recently announced that its interim CFO Tom Liston, who has been guiding the company through the investigation and restatements, has accepted a permanent position as CFO so I believe the SEC investigation will reveal little that isn’t already known. Third, Deluxe, the former parent of EFDS has a high margin professional services contract that accounts for about eight percent of EFDS revenue that expires in March of 2005. There is obviously some uncertainty as to whether EFDS will be able to replace this revenue if Deluxe walks away. If that was not enough, EFDS must compete in the transaction processing business against behemoths Concord EFS and First Data Corp.

While the outcome of the shareholder class action is unknown, the risks related to lost contract revenue are, and I believe the competitive risk is mitigated by EFDS product and service offering and recent management changes. While I don’t expect it to be sold, I believe one of EFDS businesses, ChexSystems, is worth in the neighborhood of $189 million leaving an investor the ability to buy some reasonable businesses for nothing that I expect will generate free cash flow of $23 million in 2003.

Current Valuation

Price $6.25 x 46.7 million FDSO = Market cap $291,875,000
Cash = $99,000,000 (actual cash is $119 million but $20 million is required to support working capital for their ATM network)
Enterprise value = $192,875,000

2002 Earnings = $24,554,000 (includes $14.5 million pre-tax charges)
Depreciation = $17,725,000
Amortization = $19,247,000
Non-cash charge = $8,540,000
Capex = $21,536,00
Free cash flow = $48,530,000

EV/ FCF = 4.0x
Price/ Tangible Book = 1.14x
EV/ Sales = 0.35x

Business Segments

Electronic Payments

The Electronic Payments segment includes two businesses, transaction processing and government services. The transaction processing business processes transactions for ATMs and retail point of sale terminals. In 2001, EFDS processed about eight billion transactions. EFDS also develops and sells transaction processing software that is used by banks and some of its competitors who together processed about 15 billion transactions.

This business certainly has some positives with high margin revenues that aren't very sensitive to economic changes. The company also has a shallow moat in this business in that it manages a network of 16,800 ATMs and provides transaction processing for 9,500 of them. The remaining 7,300 ATMs will be transitioned to EFDS transaction processing as existing contractual commitments expire with the current vendors over the next 18 months. Because EFDS manages this network of ATMs it also allows them to retain a larger portion of the various fees that encompass a typical ATM transaction. While not significant, ATM transaction growth is expected to be about four percent over the next five years offering some moderate growth.

The transaction processing business also offers some exposure to the growth area of debit cards. The Tower group estimates that debit card transactions should grow by roughly 16 percent per year through 2010. As of 2001 eFunds had 13,000 bank owned point of sale terminals in place. While the opportunity is significant I am less than optimistic that EFDS will be able to wrestle a significant amount of business away from the larger players, Concord EFS (58 percent share of debit transactions), First Data, Visa and Mastercard.

For what its worth, eFunds was ranked the highest amongst its peer group in terms of customer satisfaction and price by an independent survey of merchant processors. The company’s focus for the year is on ensuring that they are meeting the needs of current customers and increasing service and support levels. While I do not expect significant growth in the Transaction Processing business the company does have some opportunities in front of them. EFDS is offering banks the opportunity to brand EFDS network of ATMs. EFDS is hoping that any partnership in this area would lead to the partner reciprocating with some of their transaction processing business. The company also recently hired Mike Feliciano away from NYCE, a division of First Data Corp, to head up its electronic funds transfer (EFT) business and the company has acknowledged that they are in discussions with a major financial institution for their EFT business. The company also acquired some more business from an existing customer in the fourth quarter. Lastly, there are other opportunities such as offering pre-paid calling card credits through ATMs and the move by employers to issue debit cards rather than cheques to unbanked employees that could provide some future growth.

For 2002 the Transaction Processing business contributed about $112 million in revenue. The Electronic Payments segment had a 30 percent operating margin in 2002 so this is obviously a good business. However, the first three quarters includes $17 million in revenue from STAR, which was acquired by Concord EFS, that will not recur in 2003. The company did receive some new business in the fourth quarter and had an increased number of their own ATMs on their transaction processing platform. For 2003 I estimate that the transaction processing business will contribute $103 million in revenue and that the operating margin will drop from 30 percent to 25 percent, because of the fixed costs in this business, for total operating income of $25.75 million. I would add that I’m not particularly concerned about EFDS losing any transaction processing business. They have been in the business since 1976, from all accounts have good relationships with their customers and strong track record of retaining business. The business they are losing this year is because of an acquisition not poor execution on the company’s part.

The other business in the Electronic Payments segment is Government Services. EFDS is currently the number one or two provider in this business and while they recently lost two contracts the majority of the losses ($11.6 million) are from Medicaid eligibility services while their focus is on electronic benefit transfer services (EBT). The Government Services business provides electronic payment methods for distribution of benefits under entitlement programs, primarily food stamps, and transitioned aid to needy families. The business also offers Medicaid eligibility verification services. The Government Services business was a tough one prior to EFDS IPO in 2000. The business experienced write-downs of $90 million for loss contracts, asset impairment and legal proceedings from 1994-2000. Because of this Deluxe agreed to indemnify EFDS for any losses in this business that are incurred on contracts engaged prior to the IPO subject to a $14.6 million dollar limit. This seems unlikely given that in 2001 EFDS earned operating income of $14.3 million on revenues of $45 million. The company attributes this turnaround to a combination of cost cutting and higher fees obtained from State governments as they became more realistic on pricing with the previous contract losses. This is a good business providing stable recurring revenues and long-term contracts typically of 5-7 years. For 2002 EFDS generated $50 million in revenue with the same operating margin of 30 percent as the Transaction Processing business (the segment reporting combines these two businesses as Electronic Payments, thus the same operating margin). In 2003, EFDS will lose two contracts that combine for $15.5 million in revenue but have signed new business that should generate $7.5 million for total revenues of $42 million. The operating margin is expected to decline from 30 percent to 25 percent in 2003 so Government Services should generate $10.5 million in operating income for 2003.

Revenue for this segment also includes customer reimbursements of $24 million. This is revenue that is generated from the Transaction Processing business but is returned to the customer who owns the ATM.

ATM Management Services

Through a number of acquisitions made over the last two years, EFDS has cobbled together an ATM network of 16,800 machines. Of these EFDS owns approximately 3,500 machines with the balance being owned by the merchants where the machines are placed. The company also manages a fleet of 10,000 ATMs on behalf of banks. Basically, EFDS will install and provide on-going monitoring, maintenance and service, including call center support, for a customer’s ATMs. While this business does not have the wonderful margins of some of its other businesses it isn’t a bad business has recurring revenue and requires little in the way of capital expenditures. Through consolidation and increased efficiencies EFDS has realized operating margins as high as 8.7 percent in Q3 of 2001 in the ATM business.

The big positive for EFDS is that by managing the ATM network they gain control of the transaction processing fees for the network. I would also note that they haven’t been irrational in paying extreme prices for the businesses they have acquired. Based on the Q3 10q we see that the 7,900 ATMs they acquired in 2002 generated $14.4 million in revenue in Q3, however, this did not include one month of revenue from the largest acquisition CRI. I estimate that total revenue would have been $16 million including this month. Over time I believe that the ATM business will generate at least a 7.5 percent operating margin, so at a 37 percent tax rate EFDS paid 13x earnings for this fleet of ATMs. But this does not include any of the transaction processing revenue from the network that comes with a 25 percent operating margin. As previously noted, EFDS also garners a larger share of the various ATM fees than they would in a bank relationship because they manage the fleet of ATMs. EFDS makes seven to 10 cents for a typical ATM transaction and that number rises to 40 cents or more including EFDS share of interchange revenue and service fees.

The company is further extending the value of their ATM network by offering banks the ability to brand EFDS managed ATM network for a fixed annual fee. They have had some success with this in forming a branding relationship with the Co-op Network, an ATM network formed by a group of credit unions in the southeast. In return, EFDS is hoping that some of these partners will transition the management of their ATMs to EFDS. Based on articles in the trade press, EFDS has been courting Bank of America and their internally managed network of 13,000 ATMs for some time with the hope of winning some or all (including transaction processing revenue) of their business. In what may be a catalyst leading up to this, EFDS announced that Kevin Reager was joining the company as SVP of ATM Solutions. Before joining EFDS, Reager was Senior Vice President, ATM Business Development and Account Management for Bank of America. I would note that EFDS may also have additional insight in to what other banks may be interested in outsourcing the management of their ATM networks because EFDS develops the transaction processing software that banks use to support their ATM networks. Winning a bank’s ATM network management would be a catalyst for EFDS, most significantly if the transaction processing business is included.

The company has also stated that their M & A activity in this segment will be materially different than 2002. Their focus will be on improving efficiencies and operating margins.

For 2002 the ATM Management Services business generated $120 million in revenue with a 4.1 percent operating margin. For 2003 the results will include all the revenue from the networks acquired throughout 2002 and should come in at $132 million. I believe the company can realize a 5 percent operating margin for this business and will generate $6.6 million in operating income in 2003. I believe that the 5 percent margin is conservative and given their previous operating history believe that they can achieve operating margins in the 7-8 percent range longer term.

Decision Support and Risk Management

The DSRM Segment includes two businesses, ChexSystems and SCAN. Both SCAN and Chexsystems are supported by the premier database in the financial services industry. The DebitBureau database contains more than 4.5 billion debit records, including account openings and closings, demand deposit account activity, insufficient funds check-writing histories and check order histories. It also includes credit information and household-specific demographic data.

ChexSystems is undoubtedly EFDS best business with a deep and wide moat. ChexSystems is a provider of new account applicant verification services for financial institutions. It helps assess the risks involved in opening a new account based on detailed account history and other background information of the applicant. Chexsystems is used by 88,000 financial institution locations in the United States giving it a greater than 85 percent market share. Because the relocation patterns of people within the United States are fairly consistent this business has strong recurring revenue. Furthermore, with the introduction of the U.S. Patriot Act it is incumbent on financial institutions to ensure that accurate screening of new applicants is done to try to prevent terrorists from using the U.S. banking system. EFDS estimates that one-third of new accounts opened do not have ChexSystems screening performed on them. If this estimate is reasonably accurate the Patriot Act should provide growth for the ChexSystems business. Another growth opportunity exists in this area in that the Patriot Act may motivate financial institutions to do even more comprehensive customer screening which would allow EFDS to upsell two other products, Qualifile and Fraudfinder, to customers looking for a more comprehensive method to screen questionable customers. For 2002 I estimate this business generated $72 million in revenue with a 25 percent operating margin. For 2003 I estimate that ChexSystems will generate $80 million in revenue with a 25 percent operating margin for operating income of $20 million.

Although I don’t believe it will be sold, I believe if eFunds were to sell the ChexSystems business they would get at least 15x earnings for it. Assuming a 37 percent tax rate on $20 million in operating income gives you a business value of about $189 million. Thus on an EV basis you are paying nothing for eFunds Electronic Payments, ATM Services, SCAN and Professional Services business. Collectively I expect these businesses to generate about $22 million in free cash flow in 2003.

SCAN is the other business in the DSRM Segment. SCAN scans cheques at retailer’s point of sale to insure there are sufficient funds in the account and to query other forms of account fraud or identity manipulation. SCAN is used by 13 of the top 20 U.S. retailers and I should note that this has dropped from 17 of the top 20 U.S. retailers in 1999. While this is a concern, and the company noted on the conference call that further potential losses could be possible, it is not a significant issue from a business standpoint. eFunds generates most of its revenue and earnings in this business from the mass of retailers where there isn’t significant pricing pressure on a transaction basis. This is supported by the financials showing DSRM revenue having grown by 6.7 percent from 1999-2002, the time period in which EFDS lost the major retailers. I would also add that the retailers who have left have not gone to a competitor but have moved to a proprietary method of cheque authorization and they have also continued to provide data to EFDS on cheque writer information. The Tower Group expects the use of cheques to decline by two percent annually through 2010. At the same time, losses from bad cheques and cheque fraud still amount to greater than $20 billion annually. So while this is a business in decline it is not going to disappear imminently. For 2002, I estimate the SCAN business generated about $68 million in revenue with a 25 percent operating margin. In 2003, I estimate SCAN will generate $66.5 million in revenue with a 25 percent operating margin for operating income of $16.63 million.

Professional Services

This business is probably the weakest link in the eFunds family given that almost half of its revenue comes from a pre-IPO contract with Deluxe. The Professional Services Segment provides information technology and business process outsourcing (BPO) services, including accounting operations, help desk, and account management. This segment also includes revenue generated from eFunds transaction processing and call center software applications. While not currently generating any license revenue, EFDS transaction processing software is used by many large financial institutions around the world. In 2001 STAR licensed EFDS software and the value of the license was $18 million. I have not given any value to this product in my valuation but it is certainly worth at least $10 million to another software company in this space.

As for the Deluxe contract, Deluxe committed to $43 million in annual software development maintenance and support as well as some BPO services through March of 2005. If Deluxe does not meet this threshold they must compensate EFDS for the profit lost on revenue below $43 million. Clearly Deluxe is receiving some benefit from these services otherwise they would pay the nominal lost profit amount versus the gross revenue number. While it is easy to assume that EFDS will lose some of this business in 2005 I don’t believe that the loss will be total or even significant (>50%). With the declining nature of Deluxe’s business, outsourcing must have some significant long-term benefits for the company.

The Professional Services segment is supported by two call centers, with staff of 1,500 people, and a software development center, with 500 people, in India. While business process outsourcing would seem to be a reasonable idea for many businesses, especially in a slow economy, eFunds has had little success in garnering new business. In 2002, this business should generate about $102 million in revenue with roughly $47 million of this coming from the contract with Deluxe that expires in 2005. Next year the business will also lose about $10 million in revenue that came from services provided to STAR, which was acquired by Concord EFS. They also have a long-term contract with West Teleservices that contributes about $17 million a year in revenue. While eFunds is working hard to grow this business and believes they can get new business as part of a total solution for financial institutions I don’t have any short-term expectations and expect revenue to drop to $90 million in 2003. With the loss of the STAR contract I believe the operating margin will drop from 30 percent to 20 percent and this business should generate operating income of $18 million in 2003.

Future Estimates

With the above analysis here are my estimates for 2003.

Revenue

Electronic Payments $169 million
ATM Management Services $132 million
DSRM $146.5 million
Professional Services $90 million
Total Revenue $532.5 million

Net Income

Electronic Payments $36.25 million
ATM Management Services $6.6 million
DSRM $36.63 million
Professional Services $18 million
Less: Corporate Expense $66 million
Operating Income $31.45 million
Interest Income $1.5 million
Less: Taxes* $10.54 million
Net Income $22.4 million
FD Shares Out ** 47.3 million
EPS 47 cents

*Taxes are calculated at a 32 percent rate as the company receives a benefit of about $2 million from its Indian operations.
** Although the weighted average exercise price of options is above $13 I have added 700,000 shares given all the new management appointments.

Free Cash Flow

Net Income $22.4 million
Depreciation $17 million
Amortization $19 million
Less: Capex $22 million
Free cash flow $36.4 million

Valuation

Current Price $6.25
FDSO 47,300,000
Market Cap $295,625,000
Cash 12/31/03 $136,000,000
EV $159,625,000

EV/ FCF 4.4x

I should note that company guidance is for revenue of $543 million and EPS of 53 cents. At this level of EPS the company is trading at 4.1x EV/ FCF. Given the regulatory and legal issues confronting the company I would hope that their guidance is conservative and that my estimates are extremely conservative.

As previously noted I believe the ChexSystems business alone is worth $189 million. Assuming my estimates for 2003 are correct, you are paying negative $30 million for the Electronic Payments, ATM Services, SCAN and Professional Services businesses. Collectively these businesses should generate at least $22 million in free cash flow in 2003. On an EV basis I have also reduced the cash balance by $20 million to provide for necessary working capital for the ATM Network.

Research

For a detailed report on the industry go to:

http://www.stifel.com/stifelresearchdocs/Payment%20Processors%20120402%20Report.pdf

No pin or password is required.

Risks

The SEC investigation uncovers some skeletons in the closet. With Tom Liston recently taking the role of CFO after serving as interim CFO during the SEC investigation I feel that the investigation is a non-issue.

Large settlement from the shareholder class-action litigation. I do not know how to quantify the risk associated with the shareholder lawsuit.

Loss of contracts without offsetting gains in new business.

Investors value the company on an EPS rather than free cash flow basis.

Even given the risks I have a hard time believing that this company is not worth at least 8x FCF or 82 percent above the current price. Given any positive momentum in the business I believe 10x FCF is reasonable or 127 percent above the current share price.

Catalyst

Resolution of the SEC investigation.

New contract wins in the transaction processing business or ATM outsourcing segment.

Potential stock buybacks. The company has stated that when they get a line of credit in place to cover settlement issues in the event of a system failure in their transaction processing business that they would strongly consider a stock repurchase.

EPS growth above guidance.

Given the company’s low valuation I believe they could be subject to a hostile bid from CE, FDC, NAP or TSS. I believe the likelihood increases with any further decline in the share price.