Global Payment Systems "Swinging on a Star"
For most of my professional career, I've worked within the Information Technology space. It is a pretty big space, and it keeps growing and changing to the extent that it keeps me busy for the most part. But a few months' past, several readers and my editor suggested that I might like to take a look at the fintech space. Fintech is still tech, to be sure, but tech with some of the rawness and rough edges left off. The companies compete to be sure but they do so in a far more restrained and gentlemanly fashion. One simply doesn't see CEOs bashing each other or bragging about their competitive prowess.
Growth is to be had, either through geographical expansion or through inorganic means, but not primarily through attacking the market share of one's "rivals." Market share gains and losses have more to do with focus areas than with competitive displacements. The secret sauces tend to be less based on technology and more relationship driven and price competition seems a bit, or probably a lot less than it usually is in the IT world.
That can create challenges in evaluating and recommending one company versus another in the space. Most of the differences are more valuation-related although there is fair amount of basic marketing blocking and tackling that is important to recognize.
A few weeks ago, Global Payments (NYSE:GPN) one of the larger competitors in the space was brought to my attention. The reason it was brought to my attention was that it had managed to fall 18% in 5 weeks after what seemed to be reasonable earnings, especially for an initial quarter after a major merger. I pointed out that an 18% move in the enterprise IT space was more or less random - maybe the CEO had a touch of flu, maybe the CFO was seen at a strip club but that is not the case in this space. OK, I decided to take a look and while this is not the most fascinating opportunity I have ever seen, it isn't that bad either.
For those unfamiliar with the name, Global Payments… well far more global than some of its peers. It has just completed a meaningful acquisition of Heartland Payment that has allowed it to bulk up significantly. There are economies of scale to be had and cost synergies as well - although again, the level of cost synergies, which in this case is said to be about $60 million annually from a base of $250 million of general and administrative expense, is less than I am used to dealing with in the information tech space.
In the software world, mergers are generally thought to reduce general and administrative costs by 50% or more, not less than 25% - but then software managements are a bit raw and red of tooth and claw as was once written by Alfred Lord Tennyson.
The company recently reported one of those quarters that the heavens sometimes bestow on businesses - everything went well and exceeded expectations. Perhaps the beat was too modest for some, but it seemed to be a reasonable beat, again in the context of what this company does and where it does it and the fact that it was trying to consolidate with a business of equal size. The only problem was that the shares acted in a contrary fashion, declining by as much as 18% before bouncing a few percent in the last couple of weeks of November.
The cause is said to be concern about the company's organic growth rate. As I will discuss below, management comments during the conference call pretty much said the opposite. Maybe the leaders of this business are thespians. Maybe they thought being transparent was an easy undertaking. But the fact is that even a journeyman like myself heard high single-digit organic growth several times.
And so it comes time to see if GPN, after an autumn in share price purgatory, while seemingly operating at a high level, has reached an inflection point that makes it a good investment. The shares are hardly unknown, they simply seem modestly valued at the moment. The shares are covered by 25 analysts, the last several changes in analyst opinions have been upgrades including those by Goldman, Stifel and Compass Point and the average rating from First Call is a decent, but not unreasonable 2.1.
My take, before discussing the details, is that an investment in GPN seems most likely to produce a portfolio single, but then singles are not all that bad. It is sometimes a relief to enter an earnings day where one is unburdened by extreme emotion and tension.
When one enters the fintech world there are more than a few differences that seem important to mention. Because growth rates are less, so are valuations on most measures. The aforementioned acquisition of Heartland was done for less than 2X revenues despite the fact that Heartland was a profitable and growing company. It is one of those differences that requires a different mindset, and I guess some degree of perspective as well.
Needless to say, there are similarities with the IT world as well. The most obvious is that the fintech space is based on the use of the technology solutions that have been developed by information technology vendors. To an extent, the stock in trade of fintech vendors is the software and the hardware they acquire from the infotech vendors.
The lead-in to the introduction comes from a song first made popular by Bing Crosby in 1944. The song was composed by Jim Van Heusen with lyrics by Johnny Burke and won the Academy Award for best original song of that year. Mr. Crosby played a priest in what was a famous movie of the era called Going My Way. I have heard it played all of my life - my mother was a schoolteacher and the concept of the song's lyrics appealed to her.
It has been a hit ever since it was first recorded and has been re-recorded countless times. The specific lyrics basically say that if you study hard and eat your carrots, you will not grow up to be some kind of nasty animal (fishes, mules and a few others). GPN seem to be studying hard and executing well and thus its outcome is that it ought to be "Swinging on a Star."
Was the devil in the details?
Doesn't look that way to me but here the details to be picked apart at the leisure of readers. It should be noted that because of the results of the merger with Heartland, GAAP results do not fairly represent the results of the quarter and should not be considered in evaluating the results of the company. In addition, while GPN pays a dividend, its rate at $.01/share per quarter is derisory and has no real influence in terms of valuation.
The company does generate a fair amount of free cash flow but the company also has a rather significant level of debt, some of it raised to fund the acquisition of Heartland, which cost $3.5 billion. Cash on the balance sheet is a bit short of $1 billion while total debt is almost $4.5 billion. As seems prudent, the company plans to use the majority of its free cash flow to reduce debt and it paid down debt by $44 million in the past quarter as well as repurchasing a minimal amount of outstanding shares.
Before diving into the numbers. I think that in this particular case, it is probably worth quoting from the earnings statement since apparently, investors are concerned about organic growth. "Our fiscal year 2017 is off to a terrific start with organic growth accelerating sequentially across our key markets in the first quarter" said CEO Jeff Sloan. "Heartland continued its strong growth momentum in the US. Our business in Europe performed exceptionally well and our Asia business produced its highest rate of organic revenue growth in several quarters," Sloan concluded.
During the course of the conference call, management was asked the reason why it hadn't raised revenue expectations for the balance of the fiscal year. Here is the specific answer, "Yes Ashwin (the questioner), it is Cameron (Cameron Breardy, CFO of GPN). I will jump in… I think inherently you can think of it (the guide) as an increase because we are now forecasting more FX headwind than we were when we guided in July. So, I think you can essentially look at it as an implicit increase. We are observing more FX headwind on the topline yet maintaining that overall revenue guidance at $3.2 billion to $3.3 billion…So, I think we do see obviously revenue tracking ahead of what we would have anticipated, but we are also currently forecasting more FX headwind …"
And finally, "So I say sitting here since we announced the deal in December 2015 and closed in April of 2016 the opportunities we've had to talk to you guys twice about it Heartland has only accelerated that growth as it relates to new sales over that period. I would say in terms of the health of the merchant base at Heartland that their attrition is running low relative to their own expectations and our expectations going into the deal as well… The only thing I would add Jim is, it is Cameron, is if you look at Heartland's other business outside of the pure payments business, if you look at campus solutions, school solutions, Heartland commerce each of those continue to perform very well also. We see good momentum in those business, we like those businesses a great deal."
Organic growth is an important metric for almost any company in evaluating its performance and valuation. But I am simply baffled that some investors and perhaps analysts as well have particular concerns about this company's growth rate in the wake of the recent earnings report. I have no particular reason to doubt that the company management is reflecting the business momentum that is currently visible.
GPN is a payment processor. To a greater or lesser extent, its revenues are going to track the retail sales of its customers, its acquisition of new customers and the sales of additional services. (Heartland does offer payment services beyond retail but I think in terms of this article and in terms of evaluating the outlook for this company, the correlation with retail sales is quite high.) There is simply nothing in the current environment that suggests that this company ought to be experiencing slowing growth. It certainly doesn't seem as though organic growth ought to be a concern depressing share valuation.
In discussing detailed trended financials most of the data that is provided has to do with Global Payments prior to the acquisition of Heartland. So, there is little value in trying to make comparisons to an entity that has changed substantially.
In the last quarter, the company derived about 75% of its revenues from North America. Europe accounted for 18% of revenues and Asia/Pac accounted for the remaining 7%. Asia/Pac enjoyed the highest rate of organic growth last quarter. Europe enjoys the highest percentage operating margins in terms of geos with results last quarter at 48%. That is an important consideration in forecasting EPS as the decline in the GBP and the Euro are significant headwinds to be overcome.
The North American business segment had operating margins of 29% and Asia/Pac had operating margins of 28%. GPN reported non-GAAP gross margins last quarter of almost 56% with selling, general and administrative expense of 26%.(The company backs out pass-through fees on which it earns no margins from its adjusted revenue metric.)
Overall, the company reported operating margins of 29% last quarter. Operating margins as well as revenues have shown significant trends for this company and it will take some time before it becomes feasible to trend results and to adjust for seasonality.
Presumably it is the selling, general and administrative expense bucket that is supposed to yield the $60 million in cost synergies from the Heartland transaction. I would be very surprised if cost synergies, especially in the wake of a sales force that is already consolidated, did not significantly exceed $60 million. Heartland had a base of more than $250 million of selling general and administrative expense. I think it would be surprising if the cost synergies wouldn't reach 35%-40% of that amount over the next couple of years.
The company had a CFFO margin of 19% last quarter. Much of the company's cash flow is a product of both the amortization of in-process intangibles ($80 Million) and depreciation ($21 million). Last quarter, cash flow was depressed by a loss on the sale of an investment that cost $41 million. Stock-based comp. at $7 million last quarter out of a total of $156 million of CFFO is rather modest and it is not growing materially.
In any particular quarter, most of the company's reported cash flow comes from settlement processing asset and obligations, netted. That number was relatively modest this past quarter and was 80% of total CFFO in the prior year's period. There is no real history for capex requirements at the current scale of the company. Last quarter, capex was more than 25% of CFFO. While management is certainly focused on free cash flow generation, it hasn't forecast that metric at this point and I do not think I have enough historical data to trend the results of a single quarter.
I would obviously be more authoritative if I had listened to many years of conference calls by this management - but I suppose listening to the first one that involves the results of Heartland for a full quarter is as good a place as any to start. Again, neither the numbers nor the Q&A during the conference call suggest that there are any hidden land mines or aerial torpedoes on the way. No land mines, decent execution, is basically what investors might reasonably anticipate as long-term trends for this company.
Is there another leg remaining to the company's share price performance?
I guess there are loads of things that most of us would like to do over if the opportunity presented itself. Yes, GPN shares started 2013 at $24. I didn't know the company existed at that point. It was far smaller relatively and back then it was earning about $2/share. So, EPS has increased 80% and because of the Heartland merger revenues are about 50% greater than they were at 3 years ago. Revenues for a mature payments processor simply do not grow at anything like exciting rates and it would be surprising if they did. The company's share price is a product of a high probability of the company achieving moderate growth expectations.
The last 3 years have seen lots of alpha and a pretty healthy increase in share valuation metrics. Yes, I would have liked to take an earlier train, but railroads do not print timetables that anticipate future conditions. (Sometimes the timetables have a hard time in even forecasting when trains might arrive and depart on a given day but that is another subject entirely.)
I think it would be more than a little unreasonable to think that valuation metrics can increase materially from the levels at which they currently stand. That doesn't mean that the shares can't perform decently, just that they can't perform spectacularly.
Basically, a company like this, despite all of the many moving parts, has an expectation to grow a few points greater than the volume of payments being transacted through Visa (NYSE:V)/MasterCard (NYSE:MA). These days that is about 5%+ representing a couple of points of growth in the dollar value of retail sales coupled with some modest movement of payments from cash/checks to credit cards. It is a pretty solid number that has been stable for some years now.
How does a company like this get from 5% growth to 8/9% growth absent acquisitions? It is basically a story of additional service offerings, strong sales execution and the choice of sub-markets that are being emphasized.
I don't propose to do a deep dive into all of the company's product offerings. I think the net is that it has what it needs to be competitive but it doesn't have some super-special secret sauce that will allow it to break through to double-digit organic growth. Investors are getting what they are paying for but this is no hidden dusty corner of growth.
The company's basic solution is known as OpenEdge after being re-branded a couple of years ago.. It provides its users with all of the modern payment processing bells and whistles particularly including security and "decline minimization" technologies. It is hard to identify any specific moats or competitive advantages in the payment processing space. There are obviously some newcomers to the space such as Square (NYSE:SQ), Stripe (private) and PayPal (NASDAQ:PYPL), which offer newer capabilities such as mobile and online payment processing and are growing significantly faster than companies such as this with valuation to match.
But overall, this company has been able to execute and target well enough to continue to achieve high single-digit growth. It is hard to imagine a scenario in which organic growth rates accelerate materially. On the other hand, the ability this company has to grow a bit faster than the dollar value of retail sales, has been proven for many years now and there is little reason to believe that organic growth numbers are going to change anytime in the near future.
Valuing a company with a moderate but predictable growth profile is quite a bit different than looking at any kind of software or IT services company. The visibility and the stability are just so much higher. When investors and commentators talk about the high valuation in the fintech field and for this company particularly, the objection simply ignores the differences between a steady stream and one filled with boulders and waterfalls.
Less excitement equals lower expected returns. The company currently has a market cap of just greater than $11 billion. The company has net debt of $3.5 billion, much of it a product of the acquisition of Heartland. That yields an enterprise value of $7.5 billion and an EV/S of a bit more than 2X. Reasonable enough.
As mentioned earlier in this article, the company increased its reported earnings target to $3.45-$3.55 per share. The P/E on current year numbers is 20X. The EPS consensus for the following year, as the cost synergies and some modest level of revenue synergies are realized, is about $4.20, which yields a P/E of 17X. I think that $4.20 is a reasonable number although it could be exceeded if synergies are greater than forecast. Again, cheap enough, if not the absolute cheapest name on the block.
As I have written elsewhere on more than one occasion, my favorite valuation metric is free cash flow yield. There are obviously readers who might criticize that metric because it includes stock-based comp but I find it useful in measuring the overall performance of subscription-based companies. In any event, as mentioned earlier, last quarter was the first quarter in which GPN reported its financial results including the full quarter impact of its acquisition of Heartland. It seems likely that CFFO for this company, over the extent of a full year, is going to closely track non-GAAP earnings.
Last quarter, reported non-GAAP earnings were $134 million and the company reported CFFO of $151 million. The major difference between non-GAAP earnings and CFFO was a $30 million credit for settlement processing assets and obligations net, offset by prepaid expenses and accounts payable. That metric can and has had a major variation in quarters throughout the year on a random basis. Overall, balance sheet items seem likely to normalize over the course of a full year.
As mentioned earlier, stock-based compensation is not a meaningful component of this company's cash flow. This past quarter, the tax benefit from stock-based comp. actually was greater than the recorded expense. I think it is reasonable to forecast that CFFO for a full year will equal GAAP net income + depreciation, amortization and stock-based comp. Based on company guidance, that will come to about $475 million this current fiscal year.
CapEx this past quarter was at $41 million. It was significantly higher in prior quarters before the Heartland merger. Despite its importance, at this point, the management of Global Payments has not chosen to forecast capex and so far as that goes, it hasn't forecast CFFO either. I think using a cash flow expectation of more than $200 million is reasonably conservative and provides a free cash flow estimate of $250 million. The free cash flow yield based on that expectation is just a bit greater than 3%. It suggests to me that there is lots of improvement that this company needs to achieve in order to generate a satisfactory level of free cash flow.
When I look at Global Payments, I see a company with a set of valuation parameters that are reasonable but not overwhelmingly cheap. High single-digit organic revenue growth, modest improvement in operating margins and a share value that has recently compressed significantly. I think that is the formula for moderate, although not extraordinary positive alpha over the next year.
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.