Does it matter much that FISV is #2 in its space?
Simply put, there have been no signs in terms of operating metrics that the dethronement of Fiserv (NASDAQ:FISV) as the leading player by size in the FinTech space has done anything to slow its momentum. It still retains its crown as the leading supplier of core technology to the space and there is little to suggest that will change in the foreseeable future.
Size can matter in the financial services industry software space. But in this case, being dethroned as the king-pin of FinTech when competitor Fidelity National Information Services (NYSE:FIS) purchased SunGuard a few months ago hasn't mattered a great deal in terms of the competition between the two vendors. It is hard to keep a scorecard on competition amongst core banking platforms and since we are investors here and not analysts of bank software, it really doesn't matter a great deal. The large vendors have several solutions in the same space with different names and apparently somewhat different functionality. One blog that attempts to put the market space in some perspective carries the engaging name of VendorDirt. No, don't all try to open the site simultaneously, there are no steamy pictures or even mysterious confessions. The site calls itself a collection of observations, ruminations, prediction and random thoughts focused on the FinTech space. Its online publication is composed by a group of consultants who specialize in banking software.
Its latest overview article starts off by comparing core vendors (of bank software) to blind dates. "You envision a gorgeous, funny and smart mystery person but really you just hope your date's visible scables scarring is minimal and you don't end up hog-tied in the back of a creepy panel van. We all have high hopes for our blind dates but we have to be realistic, too."
Usually in writing these articles, I try to find some kind of differentiation - be it strategy, product, support - something to distinguish the leading vendors. There are some differences to be sure between FIS and FISV. Fiserv is located in the suburbs of Milwaukee, some 908 miles from here. FIS is located in the heart of Jacksonville, FL, 960 miles from here, but in a different direction. I think I would take Florida over Wisconsin almost all of the time.
A substantive difference is that Fiserv with 22,000 employees is expected to generate about $5.6 billion of revenue. FIS is forecast to generate $9.6 billion of revenues with 55,000 employees. That results in a rather significant difference in revenue per employee in favor of FISV ($254,000 vs. $175,000). Given that the primary cost of a services company is personnel, the core profitability of Fiserv will ultimately be greater than its competitor and that is exactly the case. I will take a deeper dive into what appears to be an anomaly as well as do some quick financial comparisons of this company and its rival FIS later in this article.
But for now, I will just comment that VendorDirt rates the core solutions from both vendors as pretty good. Fiserv, which has 3 core solutions is said to have the most rounded suite within the industry. Fiserv has a strong position in the credit union space. And Fiserv is considered the vendor with the most tightly closed platform in the space - which wins them some vociferous and negative commentary. It is also said to have a woeful loan origination product. Who knew? Those faults haven't seemingly been a huge facto in the company operating results - maybe they would be better if they weren't closed, but percentage growth of the company's core platforms seems to be consistent with growth of the overall market.
FIS is said to be struggling to establish a real identity with its suite of 3 core banking products. That doesn't mean that FIS has been unsuccessful in selling its 3 core banking platforms. It is the ancillary core banking platforms that are basically bought by smaller banks where FIS is said to have had problems.
FIS is said to be nowhere in the credit union space and that is a reasonable conclusion when more than 80% share is divided between FISV and Jack Henry (NASDAQ:JKHY). It is hard to compare CEOs. Inevitably, the CEO who has made the big transformative move, in this case Gary Norcross of FIS, gets most of articles written in recent months. FISV's CEO Jeff Yabuki is not quite as high profile in the industry although he has been CEO of Fiserv for more than a decade after coming from an executive role at H&R Block.(NYSE:HRB)
But at the end of the day, the difference between the core banking technologies offered by the two large vendors doesn't appear to be great. Users are going to decide if one core platform or the other has specific features that suit their specific needs. They are going to decide based on their evaluation of other applications that sit on top of the core platform, they are going to decide based on the quality of the sales effort, and of course they are going to decide based on price.
Overall, at this point in time, it appears that the organic revenue growth rate and the normalized earnings growth rate are more or less comparable, with a minor edge to FISV at this point. The major differences, when they occur, are a function of acquisitions. At the moment, the FIS acquisition of SunGuard stands out as having achieved significant accretion, but at the cost of a very levered balance sheet.
Fiserv and FIS have remarkably similar levels of share price performance. Fiserv shares are up a heady 6.5X since the market lows in early March 2009. The shares have trebled in the past 5 years and are up 15% year to date. For some time now, with a few minor exceptions, it has been the space, i.e. FinTech and not the particular company that has been far more important in determining the change in share prices. That being said, as I observed in my recent article regarding FIS, woe to the share price of the company that disappoints headline expectations.
Does any of the above suggest the need for readers to purchase the shares of either vendor at current levels? I really do not think so. There are many reasons for the performance of FinTech shares over the past 7 years. But the net effect has been to significantly increase valuation metrics. The space is not a high growth space, although almost all the revenues are recurring and hence very visible for both vendors. And, while organic growth is not at heady levels, acquisition targets have abounded and the targets have offered significant cost synergies and some revenue synergies. The EPS growth rate and the growth in cash flow for both vendors has been much more impressive than top line growth.
But all of that is why the shares of both of these companies have appreciated and is not new news. That is one reason why the institutional ownership of Fiserv shares is 92%. There is nothing more than visibility, predictability and past appreciation that warm the heart of portfolio managers at large institutions who do not want to lose their job pursuing some contrarian home-run possibility and who need FinTech names to keep up with the competition.
On the other hand, it is the reason why the consensus rating of 20 analysts who post their ratings is a hold and the mean price target is $102/share, 6% below the current price. And none of that reflects the industry concentration of this company which essentially sells to one vertical and that vertical has its own problems.
CEO Jeffrey Yabuki commented that "our results were somewhat slow, coming in at 70% of quota for the quarter." This being the FinTech space with its seemingly unstoppable share price momentum that did nothing to really slow share price performance (the shares climbed 6% in the wake of the earnings release and they are up by 10% since May 5th.) Imagine what the impact would be if say Salesforce (NYSE:CRM) announced that its bookings had missed targets by 30% regardless of talking about growing pipelines and a forecast that "we fully expect to reach our sales goals for the year." Besides destroying lots of portfolios and marring the performance of many hedge funds, there would be an inevitable tendency to reassess the credibility of company management. But no matter.
I think investors seeking alpha would be better served in another sector. I think that valuations are stretched. And I think the potential for Fiserv's customers to experience difficult times going forward is still under-appreciated. Fiserv is more than a decent company, but neither its valuation or macro trends are in its favor at this point.
If I want FinTech which one do I pick?
I am sorely tempted to reprise a comment I made on a similar subject in an earlier article, "You pays yer money and you takes yer choice." But since I used that in an earlier article, I am going to have to see if there are enough differences between the vendors in this space that might help investors make a rational choice.
Fiserv is clearly the market leader in terms of its shore of core banking platforms. More than one-third of US banks uses one of the Fiserv core banking platforms. As I have commented in other articles in writing about the two other primary vendors in this space, the issue is that core banking platform revenues are only growing at 3.7%/year. There are very few new name banks or credit unions of size that actually need a new core banking platform. When one observer describes the choice of Bank of the Ozarks (NASDAQ:OZRK) as a great win for Fiserv Premier, it is a pretty sure sign that there simply aren't many other large opportunities about which to brag. The Bank of the Ozarks has an enterprise value of less than $3 billion and revenues this year are supposed to be just above $700 million.
There are 4 vendors in the basic banking software space that divide up the market and have done so for years (Fiserv, FIS, Jack Henry and D+H/Harland in that order with D+H having most recently entered the U.S. market by buying Harland). So, to an extent, owning the largest share in the core space means having a better opportunity to sell additional products that are well integrated with the core platform. Lots of customers complain that Fiserv is not an open platform. They complain but that has done nothing to change market positioning over the years. Fiserv's least capable set of solutions is in the area of loan origination. It has been struggling with that issue for 10 years now, but then so too are its competitors to a greater or lesser degree. If it has slowed down the growth of revenues for the major companies in the industry, it isn't particularly apparent.
If an investor wants FinTech, it ought to be one of the 3 large vendors (D+H which is based in Canada, is not public at this time). Both Fiserv and FIS have huge suites of products that are sold to their user base for specific purposes. The major categories that are sold to users are basically CRM (customer relationship management), various forms of analytics, various payment solutions and various risk and compliance solutions. Fiserv offers 700 discrete products. FIS offers the same set of solutions, packaged and named differently. About the only difference that can be discerned by most observers is that one company amalgamates 2 product buckets. At any given moment in time, one vendor or the other might be ahead in one particular segment or set of solutions - but that seldom lasts long. If a particular solution or set of functionality proves to be popular, it will soon be copied or more likely one of the larger firms will buy a smaller competitor who offers the newly desired capability.
In 2012, Fiserv sued FIS for patent infringement in the payments area. Both FIS and Fiserv offer payments solutions based on technology - and really products - that were acquired through acquisition. Most recently, in December 2015, the Patent Trial and Appeals Board ruled against Fiserv and said that the patents in question could not be enforced because the patents in question are not patentable. There has been a trend in the world of software patents to declare more and more patented code as unpatentable. The decision leaves the playing field in the payments segment as it had been.
Technology just is not and is unlikely to be a factor that ought to be considered in the investment decision. So it is all down to relative valuation.
Comparative Valuation metrics between Fiserv and FIS
I have chosen the two larger FinTech vendors, FIS and FISV, to compare. That isn't because Jack Henry doesn't have its group of partisans in terms of its future share price performance, but because it is easier to specifically compare specifics regarding two very similar companies. For those readers specifically interested in Jack Henry, I recently wrote an article detailing its positioning and outlook.
Size/Revenue analysis: Fiserv is forecast to achieve $5.6 billion in revenues during the current fiscal year; FIS is forecast to achieve $9.41 billion in revenues. Both companies have a very high proportion of revenues coming from recurring sources. FIS has 48% of its revenues coming from outsourcing. Fiserv probably has a comparable level, although not specifically disclosed on the latest conference call or in the 10k. Fiserv actually has a manufacturing operation that manufactures credit cards for its clients. Nowadays, that is a growth business as banks are moving their customer base to chip cards and will soon be moving customers to contactless cards. Overall, Fiserv software is 96% sold on multi-year contracts which can be typical on-premise deals or can be outsourced deals which is better for vendors and may be better for users as well, depending on their priorities. Outsourcing, mobile, payments and some SaaS growth are priorities for both companies. These are the revenue segments growing the most rapidly.
Profitability: Fiserv's Q1 adjusted operating margins were 32%. The only major adjustment from GAAP to non-GAAP was the gain on the disposal of a business called Stone River. After adjusting for tax impact, the StoneRiver transaction was actually a loss. The company has some costs, after tax, from the amortization of acquisition-related intangible assets which were stable year on year. The non-GAAP tax rate was accrued at 33% although the full-year tax rate estimate is 35%. Fiserv's stock-based comp is small and it is not reported on a quarterly basis. In 2015, stock-based comp, net of taxes was $27 million, which was less than 4% of net income.
FIS had non-GAAP operating margins of 22%. Stock-based comp added $30 million or $22 million net of the income tax impact. That is the equivalent of 8% of reported non-GAAP earnings.
The major adjustment to non-GAAP earnings is the add back of purchase accounting amortization of $154 million as well as the adjustment for deferred revenue and the adjustment for acquisition-related integration and severance costs. Most observers, this writer included, believe that these are really one-time costs and are reasonably excluded from an earnings presentation. The company had a non-GAAP tax rate in the quarter of 35%.
Fiserv had interest expense of $40 million, while FIS had interest expense of $93 million. The rather elevated level of interest expense for FIS relates to the debt that was assumed as part of the SunGuard transaction.
FIS saw outstanding shares increase by 40 million shares, or about 14%, which was part of the purchase consideration for the acquisition of SunGuard.
Overall, FIS' non-GAAP operating margins, excluding the impact of stock-based comp would have been 21%, significantly less than the operating margins for Fiserv.
Pre-tax margins for FIS, were just shy of 19%. Pre-tax margins for Fiserv were about 28%. The relatively large difference in both operating margins and pre-tax margins between the two companies represents the current impact of SunGuard which has historically been far less profitable than FIS. Over time, as FIS realizes the benefits of cost synergies, operating margins are expected to increase by 300-400 bps. That will still leave it below Fiserv in terms of margins and reflects the relatively low revenue per employee of the company. There is lots of room for FIS to improve that metric. but FISV is also on a cost reduction program to trim about $200 million of expenses over the next 5 years.
Fiserv recorded a significant gain of $146 from the sale of its StoneRiver joint venture. This gain, net of taxes was excluded both from non-GAAP earnings and from free cash flow.
Overall, and even considering the impact of the margin impact of the SunGuard merger, it appears that Fiserv is a more profitable company and will remain so for the foreseeable future. Fiserv is expecting 5%-6% of organic growth, but is expecting growth in adjusted earnings of 12%-15%. FIS is looking to grow organic revenues by 3%-4%, with a 15%-18% increase in adjusted earnings. Much of that increase in adjusted earnings is coming from the anticipated cost synergies from SunGuard. Much of the difference in longer-term profitability relates to the recently troubled Capco consulting business that FIS acquired a few years past, although that business has started to stabilize at this point.
Balance Sheet/Cash flow
Both of these companies are run more to maximize cash flow and the growth of cash flow. Overall, both companies have done a good job in growing cash flow margins while maintaining decent balance sheets.
Last quarter, FIS generated $385 million of operating cash flow and $338 million of free cash flow. Both numbers grew substantially year on year. Operating cash flow was up by 67% and free cash flow grew by 59%. Most of the growth for FIS in terms of its cash flow came from a doubling of depreciation and amortization and from a trebling of the deferred revenue balance year on year. These sums were significantly influenced by the acquisition of SunGuard. The company is projecting operating cash flow for the current year of about $1.5 billion with free cash flow projected at $1.3 billion. The company recorded an $111 million increase in the balance of capitalized computer software which was part of reported operating cash flow. Of course, spending money on development, capitalized or not, is a real cash cost and while the convention suggests that it not be included in a free cash flow calculation, the cash spent on development is not free. Capitalizing that much R&D reduces the quality of the earnings reported by FIS and influences the comparisons I make in this analysis.
FIS had net debt of $10.6 billion. Debt declined by about $200 million in Q1. FIS has $790 million of deferred revenues, a decent increase in Q1.
Fiserv had net debt of about $4.2 billion and it has deferred revenues of $480 million. Net debt increased by $150 million during the quarter primarily because the company made some smaller acquisitions that cost $265 million.
Fiserv had decent cash flow and balance sheet metrics as well in its March quarter. Operating cash flow reached $509 million, up 47% from year-earlier levels. Free cash flow actually increased by 70% to $437 million. Cash flow growth was essentially driven by the increase in GAAP net income and by balance sheet items.
Fiserv is projecting that free cash flow will exceed earnings. Overall, Fiserv is expecting free cash flow of $1050 million.
FIS has 68% more revenues projected than does Fiserv, but the difference in terms of free cash flow projection is 24%. That will change to some degree as the cost synergies from SunGuard take hold, but overall, Fiserv basically has slightly higher organic growth and significantly better margins.
Summing up the Comparison
Fiserv is growing a bit faster overall and it is both more profitable and generates more cash than FIS does. Fiserv's free cash flow margin is substantially greater than that of FIS.
FIS shares are up more than 26% YTD while Fiserv shares have appreciated by 18%. Fiserv doesn't pay dividends at this point although it certainly could; it has been more focused on share repurchase which has given the company the opportunity to enjoy greater long-term EPS growth than FIS.
FIS has a current yield of 1.43% with a 52% payout ratio. Given that management's goal at FIS is to rapidly de-lever the balance sheet, no near-term dividend increase should be anticipated.
After all of this, I still do not think that the investment merits of one of these vendors as compared to the other is particularly clear. If I were buying either of these names today, it would most likely be FISV. It has a higher organic growth rate that is likely to persist. Its free cash flow margin is much higher than that of FIS. Overall, bookings for Fiserv were only 70% of plan last quarter and yet the company still met or exceeded its earnings and cash flow targets. FIS had a great Q1 that was probably as good as it gets in terms of beating expectations. Fiserv believes that its bookings will significantly accelerate in the quarter that closed the other day. In addition, it will have the revenues from some recently acquired properties for a full quarter. Usually, in handicapping stocks, I like to look for ones with snap-back potential rather than those that are already at the top of their game. Fiserv certainly can have better bookings relative to quota than was the case in the March quarter.
I do not think that there is all that much daylight between the two companies in terms of their investment merits. The fact that FISV doesn't pay a dividend may be an issue for some investors. The balance sheet leverage of FIS may be an issue for other investors. Fiserv appears to have a bit of an edge in payments and mobile software which is most likely why it is estimating organic growth a bit higher than FIS. It offers its clients a service called Popmoney which is essentially comparable to the Venmo service that PayPal (NASDAQ:PYPL) offers. Popmoney is tiny at this point, but it might become big as banks scurry to compete in making personal, instantaneous money transfers.
Fiserv gets most of its earnings from the US banking industry. While it does not break out foreign revenues specifically, it reported that 97% of its tax payments went to US and state governments and the 10K states that substantially all of the company's pre-tax earnings are derived from domestic operations. The company has some high profile international customers, including Allied Irish Banks (OTCPK:AIBSF), Credit Suisse (NYSE:CS), Kuwait Finance House, Lloyds TSB and ING (NYSE:ING) to name a few of many.
FIS currently gets about 25% of its revenues from off-shore sources. It has a significant operation in the UK. It has operations of some significance in both Argentina and Brazil.
Interestingly, Goldman Sachs (NYSE:GS) recently recommended both FIS and FISV because they already paid high tax rates and had relatively low international exposure. Basically, the recommendation is based on election concerns and the populist statements of the candidates.
Does it make sense to buy FISV shares now?
Simple Answer - I don't think this is the optimal time to buy the shares. Fiserv shares made an all-time high last Friday. Technical analysis would rate the outlook positively I believe. Kudos to current holders. And Fiserv's absence from international markets is considered by many as a blessing.
Since 2009 at the depth of the financial crisis, Fiserv's revenues, buoyed by acquisitions, have grown from $4.1 billion to $5.3 billion last year. That is a CAGR of just over 4%. More important, the EPS CAGR over that same period has been 13%. EPS has increased for this company for the last 30 quarters. Operating cash flow growth was just above 10% for the period. Capital spending has ramped significantly over the years, constraining the growth in free cash flow to a degree. But none of these metrics comes close to comparing with the 6.5X in share price over the same period. Valuation metrics have stretched significantly over the years. That alone is a troublesome background for a positive recommendation.
But at the end of the day, Fiserv's customers are banks (and credit unions). To them, most FinTech solutions are capital expenditures. While, for the most part, Fiserv doesn't sell to the absolute largest banks, it certainly has customers whose operations will be affected by any banking crisis that may come or by a decline in overall economic activity. Many of this company's contracts are usage based - usually a good thing but not in a recession. Some large US customers include JPMorgan Chase (NYSE:JPM), Bank of New York (NYSE:BK), Bank of America (NYSE:BAC), PNC Bank, National City Bk and Wachovia. These are customers in just the vertical of financial crime and risk management.
The Italian banking crisis is smoldering without any likely resolution short of recapitalizing Italian banks. Almost all of the large customers Fiserv serves, have some relationships with some Italian financial institutions. In addition, the impact of Italian bank restructuring on the rest of the European banking system is not likely to be inconsequential. CEO Yabuki said that "even as banks prognosticate (about macro trends) we are seeing an important bias to action in driving online and mobile solutions. Customer expectation are ratcheting up, and that translates to opportunities to further differentiate our broad catalog of solution…" That may have been so in May. I have to wonder if Mr. Yabuki will be so sanguine with regards to his customers not paying attention to macro factors in their acquisition of banking software. It is, I believe, simply a risk not worth taking in front of the company's earnings release and conference call.
For the record, I imagine that bookings did bounce back last quarter and that overall, the company showed a faster rate of revenue growth compared to Q1 and that its EPS was probably a beat. None of that will mean anything for the stock if guidance is not reaffirmed, and reaffirming guidance probably will not be enough to keep the shares on their current price trajectory. I would draw similar conclusions in analyzing the shorter-term outlook for FIS shares.
- Fiserv is one of the big two with regards to the banking and credit union software market.
- Its shares have enjoyed an exceptional run since 2009, far outpacing the growth in company revenues, earnings and cash flow.
- The company probably has a small advantage compared to its principal competitor FIS in terms of core market share and organic growth.
- The company is significantly more profitable than FIS and boasts much greater revenue per employee.
- The company has a far less levered balance sheet than FIS and its cash flow generation is significantly greater relative to its size.
- The company has a relatively modest international exposure and pays a high tax rate making it less vulnerable to political pressures.
- The company's current valuation, and the looming issues of another banking system crisis do not allow me to recommend the shares at this time.
- I am afraid, that while results for the June quarter will show a nice snap back from the poor bookings of the March quarter, management will prove to be conservative in setting forward guidance which would weigh heavily on the shares.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.