First Data Q3 2007 Earnings Call Transcript

First Data Corp. (FDC)

Q3 2007 Earnings Call

November 14, 2007 9:00 am ET

Executives

Silvio Tavares - IR

Kim Patmore - CFO

Michael Capellas – Chairman, CEO

David Yates - President, First Data International

Ed Labry - President, First Data USA

Analysts

Manish Somaiya - Citigroup

Guy Baron - Credit Suisse

Sundar Varadarajan - Deutsche Bank

Jeff Harlib - Lehman Brothers

Ryder Campbell - Barclays

Presentation

Operator

Welcome to the First Data 2007 third quarter financial results conference call. (Operator Instructions) I am pleased to turn the conference over to Silvio Tavares, SVP and Head of Investor Relations. Silvio, you may begin.

Silvio Tavares

Thank you, Jim. Good morning, everyone. This is Silvio Tavares and I'd like to thank you for joining us. Speaking on the call today is Michael Capellas, Chairman and Chief Executive Officer. He actually became Chief Executive on September 24, 2007 when the company was acquired by an affiliate of Kohlberg Kravis Roberts & Co. Also on the call are Ed Labry, President of First Data USA; David Yates, President of First Data International, and Kim Patmore, Executive Vice President and Chief Financial Officer.

We're very pleased to host this teleconference and webcast. We had another great quarter, and we'll be providing the details of our performance on the call. Now if you will, please turn your attention to the agenda on page 3.

Kim will start by covering the consolidated financial highlights for the company. She will then present the financial performance of our three primary segments: Commercial Services, Financial Institution Services and First Data International.

Next, Michael will discuss the key aspects of First Data's strategy going forward. The remainder of the call will be devoted to answering your questions. The operator will provide you with instructions on how to ask your questions at that time.

After the call is concluded, should you have any further questions, please don't hesitate to contact me at 303-967-8276 or you can just send me an email at [e-mail].

Now go ahead and turn with me to slide number 4 for some important information about this call. Today's call is being recorded. Our comments today include forward-looking statements and I ask that you refer to the cautionary language in the quarterly report on Form 10-Q that we filed this morning with the SEC, as well as the appendix of today's slide presentation for additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements.

During the call, we will discuss items that do not conform GAAP, and we reconcile those measures to GAAP measures in the appendix and on our website in the investor relations section.

All statements made by First Data officers on this call are the property of First Data and subject to copyright protection. Other than the replay, First Data has not authorized and disclaims responsibility for any recording, replay or distribution of any transcription of this call.

Before I hand it over to Kim, I just want to mention an important presentation point. You will recall that our going private transaction with an affiliate of Kohlberg Kravis Roberts & Co. closed on September 24, 2007. The quarterly and year-to-date financial information that we will discuss today is presented on a combined basis. The combined quarterly results represent the predecessor period, July 1, 2007 through September 24, 2007 combined with the results of the successor period, September 25, 2007 through September 30, 2007.

The combined year-to-date results represent the predecessor period, January 1, 2007 through September 24, 2007 combined with the results of the successor period, September 25, 2007 through September 30, 2007.

With that, I'm going to now hand it over to Kim Patmore.

Kim Patmore

Thanks, Silvio. Good morning, everyone. Thank you for joining the call today. Let's move to First Data's financial performance as outlined on slide 6. As you can see on this slide, we had another very strong quarter. Overall revenue for First Data grew 16% year over year; Commercial Services grew 11%; Financial Institution Services grew 10% and First Data International delivered 28% growth. For the year-to-date, I am pleased to say that revenue was $5.9 billion, up 15%. Reimbursables contributed 4% to this growth. Excluding projected near-term cost savings, our year-to-date adjusted EBITDA was $1.8 billion, up 7%.

Year-to-date income from continuing operations was $436 million, down 28% but included $221 million of after-tax merger-related costs, and other costs directly attributable to our going private transaction, which are detailed in footnote 3 on this page. I will collectively refer to these costs as “merger impacts”. Excluding these merger impacts, year-to-date income from continuing operations grew 8%.

I will walk you through the detail behind these adjusted EBITDA figures shortly, but first, let's turn our attention to the business segments, starting with our largest segment, Commercial Services.

Remember, the quarterly growth rates are presented using the combined results for 2007 and are reflected in the column labeled “combined”. The column labeled “combined adjusted” reflects the combined results excluding purchase accounting adjustments and accelerated stock-based compensation expense related to the transaction. The adjusted information is more comparable to how we have reported our financials historically, so those are the results we will discuss today.

Now looking at the results for Commercial Services, adjusted revenue reflects 11% year-over-year growth, or 7% growth excluding reimbursable debit network fees. This quarter's adjusted revenue and adjusted operating profit included incremental contract termination fees of $7.5 million related to our debit business. Our adjusted operating profit growth was 7%.

Compared to the third quarter of 2006, adjusted profit margin, excluding reimbursable debit network fees, stayed relatively constant at 34.6%, compared to 34.5% for the third quarter of 2006. Adjusted profit margin for the quarter was 27%. Merchant transaction growth is a good indicator of our fundamental business growth and came in at very healthy 12%. We continued to see strong transaction growth throughout the quarter.

Now let's turn our attention to Financial Institution Services. Adjusted revenue growth was 10% and excluding reimbursables, growth was 7%. Adjusted operating profit declined 3%, primarily due to anticipated price compression resulting from contract renewals and lost business, partially offset by growth from existing clients and incremental contract termination fees of $7.5 million.

For the quarter, adjusted operating margin excluding reimbursables was 28.5% compared to 31.4% in the third quarter of 2006. Adjusted profit margin for the quarter was 18.6%.

Domestic card accounts on file and domestic debit issuer transactions were up 15% and 9% respectively. Debit issuer transaction growth was negatively impacted by approximately 2 percentage points as a result of three customer deconversions which occurred in the quarter.

Now let's look at our non-U.S. business on slide 9. First Data International achieved adjusted revenue growth of 28%. Adjusted revenue growth on a constant currency basis, excluding acquisitions and divestitures, was 8% in the quarter. This 8% growth was slightly lower compared to previous quarters, due primarily to the deconversion of the Goldfish portfolio in the UK, as well as price compression.

Adjusted operating profit growth was 25% and adjusted profit margin was 9.5%, compared to 9.7% in the third quarter of 2006. Adjusted operating profit included approximately $9 million of incremental investments in platform initiatives, data center consolidation and strategic business development costs related to the Merchant Solutions acquiring partnership. These incremental investments negatively impacted adjusted profit margin by approximately 2 percentage points during the quarter.

Looking at the FDI key performance indicators, we closed the quarter with transaction volume up 15% over the same period in the prior year and card accounts on file up 72%. Point-of-sale locations increased by 19%.

Finally, I would like to walk you through our adjusted EBITDA results on page 10. Adjusted EBITDA is defined as EBITDA adjusted to exclude certain items and other costs. We believe that the inclusion of supplementary adjustments to EBITDA are appropriate to provide additional information to you about certain material non-cash items, nonrecurring items that we do not expect to continue at the same level in the future, and certain items we believe will materially impact future operating results.

Please note that the adjusted EBITDA presented here differs from the consolidated EBITDA defined for covenant compliance purposes in our senior secured credit facilities agreement. Please refer to our quarterly report on Form 10-Q which was filed this morning for a reconciliation to the consolidated EBITDA, pursuant to our senior secured credit facilities agreement.

We will focus on the column labeled “combined nine months ended September 30, 2007”. Please note that the appendix to this presentation contains the adjusted EBITDA reconciliation for the quarter.

Starting on the top line on page 10, income from continuing operations was $436 million. Income from continuing operations included approximately $48 million related to pre-tax royalty; $34 million of those royalties were recognized in the third quarter.

Year-to-date EBITDA was $1.2 billion. The adjusted EBITDA reconciliation presented here is consistent with the description presented in connection with our going private transaction. I will briefly walk you through the significant adjustments on this page.

The adjustment for stock-based compensation was $267 million; $215 million of this was incurred in the third quarter, the majority of which was due to accelerated vesting of all outstanding First Data and Western Union stock options, restricted stock awards and restricted stock units held by First Data employees as well as the related payroll taxes.

Due to our wind down of the Official Check and Money Order business, which comprises most of our IPS segment operations, we have excluded IPS segment EBITDA of $29 million, including the associated pre-tax equivalency of $180 million.

Moving to the next line, we have approximately $51 million in costs related to the data center and technology initiative. Approximately $36 million of these costs are associated with platform and data center consolidation initiatives in the First Data International segment, and approximately $16 million is associated with domestic data center consolidation initiatives. Both are considered one-time projects.

Skipping down four lines, adjusted EBITDA, excluding projected near-term cost savings, is $1.8 billion, up 7% year-over-year. We believe this number better approximates the underlying liquidity of the business, and shows our clear ability to meet our obligations and invest in the business for the future.

Finally, moving to the next line, you see projected near-term cost savings of $150 million. The annualized figure of near-term cost savings is approximately $200 million, which we are on track to complete in 2008. This represents an acceleration of our original plan of $150 million in near-term savings.

Before I hand it over to Michael, there are two quick points which I would like to briefly mention. With respect to our IPS Official Check and Money Order business, in October we completed the repositioning of the investment portfolio from long-term municipal bonds to short-term municipal bonds. We expect to transition our short-term municipal bonds to short-term taxable securities beginning in the first quarter of 2008.

Finally, I did want to update you on our capital expenditures during the quarter. Our CapEx was $213 million for the quarter and $399 million year-to-date. Our capital expenditures this quarter included $98 million related to the buyout of synthetic leases, as required by the change in control. So excluding synthetic lease buyout costs, our year-to-date CapEx was approximately $300 million.

Now let me hand it over to Michael Capellas.

Michael Capellas

Thanks, Kim. I certainly would also like to express my thanks to all of you for joining the call as well. My comments will be brief because as Silvio mentioned, I've only been officially on the job since September 24, but associated with the company since early July. I do want to spend just a few minutes discussing some of my thoughts on the company and on our strategic positioning.

First, our position in the fast-growing electronic payments industry is second to none. For example, together with our alliance partners, we are the largest merchant acquirer in the U.S., acquiring approximately half of all U.S. credit and debit card purchase volumes. In the third quarter, we saw 12% growth in our domestic merchant transactions, despite the downturn in other parts of the economy.

We maintain a highly diversified, predictable and stable business. Over half of our domestic merchant transactions come from what I would call commodity purchases. These are transactions from merchants in the grocery, gas station and quick service restaurant industries, which tend to grow predictably even through difficult economic cycles.

Our card businesses are healthy. In the quarter, adjusted consolidated organic growth on a constant currency basis was 11%, or 8% excluding reimbursables. In addition to our core business, we have significant opportunity in new adjacent markets such as mobile commerce, prepaid cards, security, loyalty and analytics. These are all very attractive multi-billion dollar markets.

The company clearly has significant potential for structural cost savings. We are already executing initiatives to capture those opportunities.

Finally, we continue to generate strong cash flow. Over the past several years, our P&L has reflected about $1 billion in annual expense on information technology, which demonstrates our commitment to technology leadership. However, we have low capital expenditures and modest working capital requirements, resulting in significant cash flows.

In order to build on First Data's inherent strengths, we've laid out a five-point strategy for the company going forward. First, our focus will be on generating continued organic growth through improved sales effectiveness. Substantially all of our U.S. sales operations are now under the leadership of Ed Labry. We have heightened our focus on cross-selling First Data's portfolio of services.

Secondly, accelerating new product innovations will generate substantial incremental revenue. Our product development organization is under the leadership of Tom Bell, our new Chief Strategy Officer. We are establishing centers of excellence to execute against the opportunities in the areas of mobile commerce, risk and fraud solutions, loyalty and analytics.

Next, internationally we have the opportunity to expand the business in a more targeted fashion. This means consolidating our number one or number two positions in key international markets as we build scale, increase organic revenues and improve margins. Acquisitions will be deemphasized. David Yates is the new President of First Data International. He manages the majority of our international business with responsibilities for all of our European operations.

Fourth, we will continue to reduce structural costs. We've simplified the structure of our U.S. operations by combining Commercial Services and Financial Institution Services under Ed Labry. We now have one face to the customer and as a result, we are much easier to do business with. We are on track to achieve approximately $200 million in annual savings in 2008. Most of these near-term savings will come from the reduction of corporate and business unit overhead spending, including headcount reductions of approximately 6%.

Finally, we will focus on significantly improving our technology delivery. First Data is fundamentally a technology company. There are a number of areas we have identified that will increase the impact of our technology through product innovation and the efficiency of consolidating our platforms.

So in summary, we have a clear path and are already executing it. As I've been meeting with the First Data team around the world, I sense a real excitement and an enthusiasm about the future.

I'll now hand it back to the operator for questions. With me today on the call is the entire management team. I've already mentioned Ed Labry, President of First Data USA; David Yates, President of First Data International; Tom Bell, Chief Strategy Officer; and Kim Patmore, Chief Financial Officer.

There are other members of the core senior team: David Money, General Counsel; Peter Boucher, EVP of Human Resources; and Grace Chen, EVP of Communications. I'm quite proud of the senior team we've assembled. We have a rich and diverse set of skills and certainly, continuity of experience. As we move forward, we'll add new talent as appropriate.

Once again, thanks for joining us and I would now like to open it up for questions.

Question-and-Answer Session

Operator

Your next question comes from Manish Somaiya - Citigroup.

Manish Somaiya - Citigroup

I'm sure this is going to come up as we go through the Q&A, but let me just ask this anyway: do you have any updates on Chase Paymentech?

Michael Capellas

Certainly, that was a question we anticipated. Obviously, just to put the facts on the table here, everybody knows that this is a joint venture with JP Morgan. JP Morgan has 51%; we have 49%. Obviously, the merchant acquiring business has been in place since the late '90s.

Under the clause and terms of the merger agreement, they had the right to, after 30 days of the transaction being closed, to terminate. There are some specific provisions relative to how the dissolutionment of that JV would go about. So those are the facts.

As probably many of you heard me say when we were out on the road, that agreement to continue negotiations can be extended at any time by the two parties. Relationships with JP Morgan are quite good. We are in continued and active constructive dialogue with them about the go-forward position. I don't have anything new to report today, other than we continue to talk at the highest level of this company. They are constructive dialogues, and neither side feels any terrible pressure to force to a conclusion that is not in the best interest of both parties and our customers.

Bottom line here to net that out is we continue to talk, they're constructive talks, we can extend it at any time we like. We're just going to make sure that we go through something that's really helps us win in the marketplace.

Manish Somaiya - Citigroup

Essentially, Michael, you're saying that there is no deadline in terms of getting a final resolution?

Michael Capellas

The way it works in very, very practical terms is that we can extend at any time between the two companies. That extension can be as simple as we both say “let's take another 90 days”. We agree to take another 90 days; the lawyers paper it, and we go forward. It's very practical. At a very practical level, there is no real deadline -- at a practical level.

Manish Somaiya - Citigroup

The second question I had was on the international business. I think you commented in the press release that the growth rate on the international side had slowed down a bit. I think it was about 8% compared to the target rate of around 11% to 12%. Can you just give more details on the pricing pressure that you're facing on the international side? Is it more, less than domestic or what you have seen in the international marketplace before?

Secondly, the lost business in the UK, what was it? Why did you lose it? If you can just provide some clarity on that.

Michael Capellas

I would be happy to. I think you have to segment the market into a couple of places and not look at it -- because you actually have different characteristics. I actually am going to answer this question quite specifically.

If we take the UK and Germany, this has the characteristics of what we have seen in the U.S. issuing business. This is a smaller number of very large accounts, and there was pricing pressure in the traditional long-standing issuing business, sort of like we saw with the issuing business a few years ago in the U.S.. So there's a very similar parallel.

The pricing pressure is in the UK and Germany in the traditional issuing business, and that's with the large customers, as you would expect. In many cases, we have extended our relationships with those key customers, but at the cost of some price pressure. That's pretty similar to what we've seen elsewhere.

The second piece of the market would be where we're starting to expand into new markets, which would be by and large, either the smaller countries or into emerging markets. Naturally, that is more of a blend of the issuing and the acquiring business, and the pricing pressure is much less. But obviously, it's a smaller piece of the business at this point.

In terms of lost business in the UK, this primarily relates to one particular contract, which I think we've already announced. Did you want to comment?

Kim Patmore

Yes, that was one that we had announced probably about a year ago, and it took them about a year to deconvert. It was the Goldfish Portfolio primarily; again, related to the issuing business.

David Yates

To be specific, this was a portfolio that used to belong to Lloyds TSB that was sold to Morgan Stanley, and Morgan Stanley decided to convert this onto their own platforms.

Michael Capellas

Thank you, David.

Operator

Your next question comes from Guy Baron - Credit Suisse.

Guy Baron - Credit Suisse

Now that we're halfway through Q4 here and as we head into the holiday season, can you talk about what you're seeing in terms of volumes? How much of a spike would you typically witness towards the end of Q4?

Ed Labry

Overall, we have not seen any volume declines associated with the economy, as some people anticipated. Of course, we're just now beginning to see gasoline back over $3 a gallon so we'll see how that impacts us. We believe that everybody is anticipating a great Christmas season so it's not any additional anticipated revenues for the Christmas season, it's just the nature of the business is your fourth quarter is primarily your largest quarter.

Michael Capellas

Just to add to that, the reality is in the third quarter we anticipated to see some slowdown, and we didn't see it. So we're all doing exactly the same thing as you are doing, which is trying to triangulate all this data whether it's same-stores coming out of Wal-Mart yesterday or some of the indices that came out this morning.

We cautiously continue to have believed through time that the pattern was that the secular growth towards electronic transactions has overlaid any slowdown on particular elements, and the fact that the businesses we are in tend not to slowdown. All we can say at this point without trying to predict this economy, which I'm not sure anybody can, is we just haven't seen it yet.

Operator

Your next question comes from Sundar Varadarajan - Deutsche Bank.

Sundar Varadarajan - Deutsche Bank

A couple of housekeeping questions if I may. Your cash on the balance sheet was a little stronger than what we had seen as pro forma at the end of the transaction. Is there any stuff that you need in terms of refinancings that didn't get done in the quarter? Could you give us some more color as to what we should look for? What should we take away as a more normalized cash balance here?

Kim Patmore

If you look into the 10-Q in the liquidity section, we do speak a little bit about that, because about $700 million of those cash balances were really just still cash on our balance sheet at the end but it was just the payout of the stock options, primarily to employees. So it was just cash in transit, but still cash on our books at that time. I think in general you can think about between $500 million and $550 million or so of cash on the balance sheet going forward.

Operator

Your next question comes from Jeff Harlib - Lehman Brothers.

Jeff Harlib - Lehman Brothers

Good morning. In Financial Institution Services, I'm wondering if you can address a couple of things? One, on the customer deconversions, is that pretty much behind you, and is there some more fallout from that?

Second, Wells Fargo, it sounds like it's unclear whether that business will be going in-house or staying with you; if you can just address that.

Lastly, the margin pressures in that business in the quarter and just going forward, can you talk a little bit about that?

Ed Labry

I think that the deconversions were relatively small and anticipated in the first part of the quarter. I think that we've seen great success over the last six to eight weeks in renewing customers, three or four specifically. Just for competitive reasons, I'm not going to talk about specific names of other customers on the deconversion list.

As it relates to the margins, of course when you renew these longer-term agreements, which are typically in this business five to seven years, you're seeing price compression associated on card, and a little bit higher than that on signature-based debit processing.

Michael Capellas

Ed, do you want to go back on the Wells question?

Ed Labry

On Wells, I think that we had previously announced that Wells was bringing their signature debit processing in-house. I believe we announced as part of this release, or in the Q, that that business has not yet deconverted. As anticipated, that it would by the end of this year. We are working with Wells Fargo for a longer-term renewal of that business.

Operator

Your next question comes from Ryder Campbell - Barclays.

Ryder Campbell - Barclays

First, just a little more clarity perhaps on the cash balance -- actually, the $720 million that's earmarked for the former shareholders. Is there anything else that might have happened between September 30 and today, perhaps related to transaction fees that might bring that cash balance down to below $1.1 billion or $1 billion that it would be, minus the $720 million?

Secondarily, it looked like your revenues from product sales had a pretty good boost in the quarter. I was wondering if you could just talk a little about that and maybe give us some color whether that's a new kind of level that we should be looking at going forward, or if there are some kind of one-time sales in that quarter that you don't expect to really continue, at least on that level.

Kim Patmore

On the cash balances, keep in mind also that we had a drawdown on the debt on the short-term revolver piece which was about $200 million, which you will see in the fourth quarter; we will repay that. So again, we probably had a little excess cash at the time that we closed and not knowing exactly all of our cash needs, we did have that draw on September 24^th so you'll see that as also a large piece of the paydown.

And then we did have some of the transaction fees that were actually paid post September 30^th. So I think with those combinations in general, again you'll see us closer to that $500 million or so.

In the product sales and other, the largest piece there was that patent royalty piece that I referred to earlier, which was $38 million. You can see the patent income, that is something that we think over time is winding down because the patents are coming to a close. That was the primary larger piece in there, along with those contract termination fees that I mentioned earlier.

Operator

This does conclude today's Q&A session. I'll turn it back to Mr. Tavares for any additional or closing remarks.

Silvio Tavares

Thank you all for joining the call. You know where to reach me if you have any follow-up questions. 303-967-8276 is the number to reach me. Thank you very much. Have a great day.

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