Evertec: An Under-Valued Cash-Cow

| About: EVERTEC (EVTC)
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Summary

Evertec is a Puerto-Rican company with high operating leverage but a stable stream of cash-flows. Puerto Rico's Popular Bank, on the other hand, is a capital-intensive company.

In isolation, both companies look like highly risky bets on the outcome of Puerto Rico's debt crisis.

Putting the two companies together suggests that investors may have been too harsh on Evertec's outlook and not discerning enough on Popular Bank. Both companies trade at ~7x Fwd PE.

My suggestion is to buy Evertec shares, short Popular Bank shares, and close out interest rate risk with a long investment in a US Bank ETF.

Upside of 15-25%.

About the company

Evertec, Inc., (NYSE:EVTC) is a payment processing company based in Puerto Rico that provides end-to-end transaction processing for retail customers, merchants and banks. The company has three areas of operations:

Merchant acquiring services

Point-of-sale services (POS) and e-commerce systems. These systems are basically the credit card reader that allow merchants to take payments from debit and credit cards. According to the company's 10-K report, they were the largest merchant acquirer in the Caribbean, with 27,500 merchants signed up as of 2014.

Payment processing services

Transaction processing technology solutions. Enables financial institutions to process debit, credit, ATM and EBT cards. 70% of Puerto Rico's ATM transactions and 80% of debit card transactions flow through Evertec's systems. Evertec is also the sole provider of EBT services to the Puerto Rican government, a service that distributes government benefits to its 775,000 participants via a magnetic card system.

Business process-management

Core bank processing technology. The majority of this segment serves the in-house payment platform of Popular Inc (NASDAQ:BPOP), Puerto Rico's largest bank

What's going on?

As a Puerto Rico-based company, the company has a great deal of macroeconomic risk: in 2014, the company generated 87% of its revenue from the Puerto Rican Commonwealth (the Commonwealth).

The Commonwealth has been in a recession since 2006 when the US withdrew Section 936 that had previously provided Puerto Rico with extreme tax benefits for high-tech industries.

As the Economist put it in a November 2015 article:

For decades Puerto Rico, which is poorer than the mainland, enjoyed a special tax status designed to encourage economic development. From 1976 the income of some manufacturers was exempt from both federal and local tax. Investment poured in, notably in pharmaceuticals. But in the 1990s the tax break fell victim to efforts to balance America's federal budget and was phased out. When it came to an end in 2006, the island sank into a deep and protracted depression. The economy has since shrunk by 14%. Employment is 12% below the peak of 2006. As the economy has withered, obligations to creditors have loomed larger.

Source: The Economist

Source: Trading Economics

The situation has recently become dire. Years of fiscal mismanagement means that the Puerto Rican government now spends almost 50% of its revenues on servicing debts. In December 2015, Moody's cut its rating of the Commonwealth's General Obligation Bonds (GO) down to its lowest-possible rating of "C". In short, there is little doubt in the investment community that the Puerto Rican government will be unable to make debt payments due later this year.

Though this is surely bad for holders of Puerto Rican bonds, what does it mean for investors in Evertec?

A bottom-up analysis of Evertec

Evertec's three businesses can be broken down as follows

Source: EVTC Investor Presentation, Nov 2015

Merchant Acquiring

Historically, Merchant Acquiring is a highly lucrative business for established players. This is because processing fees are relatively low and once a business has committed itself to buying the POS hardware (i.e. the cash register), there's little incentive to switch to another provider. To illustrate, the average processing fee for Evertec was US$ 0.248 in 2014, and the churn rate was just 1% for the year.

Despite the incremental rise of companies like Square, Shopkeep and others, the payment processing business remains highly stable; why switch to a new cash register system and still have to pay credit card processing fees.

Source: Shopify.com website

Companies in the merchant acquisition business also tend to be prime takeover targets for private-equity firms because processing fees generate very stable cash-flows. (Evertec itself was previously co-owned by Apollo Management)

These cash-flows, in turn, can be used to pay down debts. This is the holy grail of private-equity investing, but is also a good business for anyone to own given the right entry price.

Payment Processing

This segment consists of two different business lines:

  1. Providing Merchant Acquiring services for other merchant acquirers
  2. Connecting POS systems to card issuers

The second service is much like a utility that routes transactions through the transaction processing chain. This is quite similar to what Visa and MasterCard do in their back-office.

Revenues from payment processing are driven by transaction volume. These have been growing across Latin America for the past decade as people move from using cash to using debit and credit cards.

Source: EVTC Investor Presentation, Nov 2015

The shift to cashless payment has greatly benefited Evertec. Despite the declines in Puerto Rico's economy, payment processing revenues have increased markedly for the company.

GDP Change

Payment Processing Revenue

Growth

2010

96.0

2011

-1.8%

105.2

10%

2012

0.5%

116.0

10%

2013

-0.2%

124.8

8%

2014

-0.9%

132.1

6%

As a warning, however, the company does not disclose the current penetration of credit cards in Puerto Rico, and I have been unable to find reliable statistics on how much further this trend can go.

Evertec's management are apparently aware of this need to find additional avenues for growth. Management has indicated in their earnings calls that their growth strategy would be in targeting second-tier countries to avoid competing head-on against larger payment processors. In December 2015, the company bought a 65.5% share in a Colombian payment processor. As of writing, terms of agreement have not yet been published. But given Colombia's potential market size, this may be a long-term area for growth. We shall see.

Source: Evertec Investor Presentation, Nov 2015

Business-Process Management

This segment includes core bank processing, network hosting and various IT services. This is the slowest-growing and lowest-margin business, but also quite stable due to the business' use of long-term contracts.

Evertec's business-solutions work with its largest customer, Popular Bank, is a 15-year contract with elevator clauses that adjust payments to inflation (though increases are limited to 5% per year). While this introduces some specific risk, which I will get into with valuation, Evertec's business of bank processing technology will also tend to be quite stable over time.

What it all means for investors

So what should the company be worth? Given normal situations, Evertec seems very under-valued relative to peers.

FY1 (2016)

Vantiv

First Data

Fidelity Info

Average

EVTC

Discount

Forward P/E

17.4

16.4

17.4

17.1

7.3

-57%

Forward EV/EBITDA

12.2

10.3

7.0

9.8

8.4

-14%

Source: Thomson Reuters

Being a PR-based company, however, Evertec is in anything but a normal situation. So let us see how Evertec stacks up given the risks.

Business process-management

Let us first examine the more stable aspect of Evertec's business. According to the company's reports, EVTC generated $49.5 million operating income from Process Management in the 4 quarters ending 3Q15.

A quick back-of-the-envelope calculation shows that roughly 75% of this segment's revenue was from Popular Bank. (This number comes from the company's financials: Popular Bank made up 45% of the company's revenue, of which 83% was from business process-management. Simple arithmetic solves for BPOP's revenue)

Assuming that margins are equivalent within the segment (a fair assumption given that so much of the revenue is derived from the Bank), this suggests that Popular Bank's agreement generates $37.3 million in operating profits for Evertec per year. Taxes are assumed to stay at 10% through 2020, then rise to 30% as net operating losses are used up. Leverage is assumed to remain constant, and interest is pro-rated at 33% for the segment, meaning effective taxes are lowered to 7.6% and 23.5% respectively

I use an earnings discount model here since the company's earnings should mirror its distributable cash-flow over time. Also, since the two companies' agreement goes through 2025, a 10-year discount model is used. Finally, a residual value is calculated by assuming some probability that the agreement will be terminated at the end of 2025.

Below is what happens when we use a 7.5% discount rate and assume the residual value at 80% of today's amount.

Real Value

Residual

Discounted Value

2016

34,360

31,963

2017

34,360

29,733

2018

34,360

27,658

2019

34,360

25,729

2020

34,360

23,934

2021

28,503

18,469

2022

28,503

17,180

2023

28,503

15,982

2024

28,503

14,867

2025

28,503

304,030

161,343

Total BPOP

366,857

Below is a sensitivity model for changes in probability of renewal and discount rates.

Probability of Renewal

60%

70%

80%

90%

100%

Discount Rate

6.0%

393,614

420,140

446,667

473,193

499,719

6.5%

369,404

392,765

416,125

439,485

462,845

7.0%

348,402

369,101

389,800

410,500

431,199

7.5%

329,978

348,417

366,857

385,296

403,735

8.0%

313,660

330,163

346,665

363,168

379,671

8.5%

299,084

313,915

328,746

343,577

358,408

9.0%

285,970

299,347

312,725

326,103

339,480

Assuming the remaining portion of the business process management grows at a real rate of 2% per year, taking the same set of assumptions and a 7.5% discount rate yields a value of 163,612.

Real Value

Residual

Discounted Value

2016

11,009

10,241

2017

11,229

9,717

2018

11,454

9,220

2019

11,683

8,748

2020

11,917

168,520

125,685

Total non-BPOP

163,612

I use a higher 7.5% WACC for the whole segment to reflect the greater risks involved, given the Business Process Management's reliance on a single customer. This is a very high WACC: according to calculations by Aswath Damodaran, the average discount rate for non-bank Financial Services companies in the US was 2.39% as of Jan 2016. If you disagree with a 7.5% WACC though, feel free to pick a different discount rate; for reference, Mr. Damodaran calculates the average WACC for US companies at 6.30%.

Source: NYU

Putting these together generates an enterprise value of around $530 million.

(As a side-note, settling on a discount rate is something I feel people spend far too much time on…better to concentrate on analyzing the underlying business)

Merchant acquiring and payment processing

Onto the more dynamic side of Evertec's business. While payment processors are able to add additional customers with minimal additional expense, this high operating leverage cuts both ways. Because overheads tend to be largely fixed, a decline in revenues will immediately show up on the bottom line.

To illustrate, imagine a software company with fixed expenses of $80/month. If the company generates $100 in revenue, it earns $20 in profit. Increase sales by 20% to $120/month, and profit doubles to $40. But decrease sales by the same dollar amount to $80, and profit is all but wiped out.

Over the past-8 years, Evertec has shown very high operating leverage. Plotting out Gross Profit to Revenue shows an almost 1:1 relationship between the two. In short, an additional dollar generated in revenues costs Evertec next to nothing to produce

Curiously, operating income (after deducting sales, general expenses and depreciation), does not show such operating leverage, suggesting that SG&A hasn't scaled well since Evertec's spinoff from its parent company. Below is a plot of operating income for the merchant acquiring and payment processing segments in millions of dollars.

Using historical data shows that operating leverage has not been particularly strong in practice. Here is a chart showing change in forecasted 2016 revenue and its potential effect on Evertec's operating income.

Historical Operating Leverage

100% Operating Leverage

2016

Revenue

Operating Income

Change

Operating Income

Change

-35%

132,119

56,726

-39%

21,362

-77%

-30%

142,282

61,837

-33%

31,525

-66%

-25%

152,445

66,948

-28%

41,688

-55%

-20%

162,608

72,059

-22%

51,851

-44%

-15%

172,771

77,170

-17%

62,014

-33%

-10%

182,934

82,281

-11%

72,177

-22%

-5%

193,097

87,392

-6%

82,340

-11%

0%

203,260

92,503

0

92,503

0

5%

213,423

97,614

6%

102,666

11%

10%

223,586

102,725

11%

112,829

22%

15%

233,749

107,836

17%

122,992

33%

So how actually sensitive is Evertec's payment processing business to a decline in Puerto Rican spending? The truth is probably somewhere in between the two scenarios. In the extreme case that Puerto Rico's consumption spending falls 25% in the next-2 years, we can probably expect operating income to fall somewhere between the two goal-posts of 28-55%. I'll use the arithmetic average in the next section

Putting it all together

The unpredictability of operating income makes Evertec a very difficult business to evaluate. To illustrate, at the moment, peers have an average of 13.37x EV/FCFF multiple. For the sake of simplicity, I ignore the effects of changes in working capital and calculate Free Cash Flow to the Firm (FCFF) as simply EBITDA * (1 - Tax Rate) + CapEx * (Tax Rate).

Enterprise Value

EBITDA FY1

CapEx FY1

Est. Tax Rate

Free Cash Flow to Firm

EV/FCFF

Vantiv

11,759.1

891.0

94.5

26.0

684.3

17.18

First Data

33,714.2

2,682.6

426.3

2.0

2,637.5

12.78

Fidelity Info

20,661.0

2,885.0

346.8

33.5

2,034.7

10.15

Average

13.37

Source: Thomson Reuters

On average, Evertec has traded at a 10% discount to peers since its listing in 2013. Thus, using a simple EV/FCFF multiple of 12x for Payment Processing (PP) and enterprise value of 508 million for Business Processing (BP), we find the following outcomes using a starting share price of $12.

Change in Sales

Change in Op Inc (Processing)

EV Total

Share Price

Upside

-35%

-58%

1,396,744

9.71

-19.1%

-30%

-50%

1,478,765

10.79

-10.1%

-25%

-41%

1,560,786

11.87

-1.1%

-20%

-33%

1,642,808

12.95

7.9%

-15%

-25%

1,724,829

14.02

16.9%

-10%

-17%

1,806,850

15.10

25.9%

-5%

-8%

1,888,871

16.18

34.8%

0%

0%

1,970,894

17.26

43.8%

5%

8%

2,052,916

18.34

52.8%

10%

17%

2,134,938

19.41

61.8%

15%

25%

2,216,960

20.49

70.8%

(Since Evertec doesn't break out depreciation by segment, I assign 2/3 of total depreciation to processing services)

Suddenly, it becomes clear how linked Evertec's valuation is to the outcome of Puerto Rico's future.

So what should an investor do?

An investor with insight into Puerto Rico's economic future should consider investing in Evertec's shares based on his or her superior knowledge. I, however, claim no special insight into how Puerto Rico's economy will perform beyond what is already widely broadcasted in the news.

Thus, despite a seemingly wonderful upside to Evertec's shares, an investment in the company becomes a bet on Puerto Rico's economic future. Remember, despite Evertec's international expansion plans, 87% of 2014's revenues still came from Puerto Rico. So a disintegration of the Commonwealth's economy will no doubt irreparably harm Evertec's operations. For a bottom-up investor, I feel this is an unacceptable risk.

Buying call options is also not appropriate in this case. Given Evertec's small size of less than US$ 1.0 billion market cap at time of writing, the options market is simply not liquid enough to support a meaningful investment. As shown here, the longest-dated options expire in August 2016 and open interest on calls is negligible anyway.

Source: Nasdaq.com

Thus, I would propose an unusual long-short strategy in this case: go long Evertec, short Popular Bank and long a US Bank ETF.

Popular, Inc

Popular Bank is Puerto Rico's largest bank with 44% of the Commonwealth's market share. The company has 82% of assets in Puerto Rico and operates just as any commercial bank would by taking deposits and lending it out to fund businesses, real estate and personal loans. As a reminder, this is the same Popular Bank that makes up almost 50% of Evertec's revenues.

Source: Popular, Inc Nov 2015 Investor Presentation

Like virtually all US-based banks, returns for Popular Bank has suffered greatly following the 2007/08 financial crisis. Lower gearing ratios mean that despite notching a 1.0% ROA in the past-12 months, Popular has only managed 7.1% ROE.

Basel III regulations effectively limit the amount of risk-weighted assets banks can carry for given levels of equity, and so leverage ratios have come down throughout the US banking sector. While return-on-assets may increase as interest rates rise, the contribution to ROE from leverage should be muted at best.

Finally, Popular Bank's balance sheet looks relatively average, although real-estate makes up a worrying large portion of the pie.

Valuing Popular, Inc

In valuing banks, a decent rule-of-thumb is to take a company's forward ROE and divide by 10 to find the warranted price-to-book. For instance, if you have a bank that is expected to earn 10% ROE next year, it's price-to-book today might be around 1.0.

The rule generally works well for large banks with limited growth potential. Here is the graph of the ten-largest commercial US banks relative to the rule-of-thumb.

Data source: Thomson Reuters

Purists will certainly balk at this gross oversimplification; growth potential adds a very large component to valuation, and this method completely ignores the quality of assets…not to mention hundreds of other factors. Here is the same graph as above, reproduced with all other US banks with market capitalizations greater than US$ 1.0 billion.

As shown in the graph, investors are generally willing to pay a greater sum for smaller banks. How much more, exactly? Currently, on average, investors are willing to pay an additional 0.345x book value. This means the average mid/large-cap US bank with a forward ROE of 10% might expect to trade in the neighborhood of 1.3 -1.4x BV.

This puts Popular Bank in a strange situation. Because it is so dominant in Puerto Rico, should it be considered a "big" bank, despite having only a $2.50 billion market cap?

Source: Popular, Inc Nov 2015 Investor Presentation

As far as growth is concerned, I would argue that the truth is probably somewhere in between. Looking at growth alone, Popular is probably worth more than (ROE * 0.1), but less than (ROE * 0.1) + 0.345. Asset quality, however, is a different matter. Fully 61% of Popular's book is backed by real estate, so a shock to the Commonwealth's financial system would certainly have far-reaching effects to the company's asset base.

Already, the company's credit quality lags that of other US banks. In Sep 2015, Moody's downgraded Popular's issuer rating to B2 (5 notches below investment grade) and assigned a negative outlook.

BPOP

Sector Peers

Loan Losses % Gross Loans

115

6

NPA To Gross Loans

423

108

Source: Credit Suisse

And so, despite a consensus estimate of 7.1% ROE, Popular Bank trades at just 0.6x Price to Book. It's fair-value is unlikely to be far off given Puerto Rico's current fiscal situation.

The Long-Short Of It

Popular Bank is therefore a high-potential candidate for helping reduce risk for an investment in Evertec. Banks tend to be capital-intensive and are thus limited in their growth potential. Payment processors, on the other hand, are asset-light and can therefore grow much faster.

This sounds like a match made in heaven. Buy the fast-growing cash-cow, short the slow-growing money-hog. What can go wrong?

The single biggest risk factor is that interest rates rise faster than expected. As a moderately levered entity with floating-rate debts, Evertec stands to lose $6.9 million per 100bps rise in interest rates. This comes to around 5.2% of 2016's estimated net income. Popular Bank, on the other hand, stands to gain approximately $35 million from net interest margin per 100bps rise in interest rates. This comes to 9.5% of 2016's estimated net income.

Putting together some rough figures, here are four potential scenarios

Puerto Rico's Scenarios

Detroit (Fix the Problem)

Status-Quo (Kick Can Down Road)

Greece (-30% GDP growth)

Argentina (-30% GDP growth and a financial-run)

Evertec

10% gain PP revenue relative to estimates. Remove 10% discount from PP, BP discount rate to 5%. FV of $25.9

-5% decline in PP revenue relative to estimates. FV to $16.2

-30% decline in PP revenue relative to estimates. FV to $10.8

-30% decline in PP revenue relative to estimates and BPOP into receivership. FV to $4.0

Popular

ROE moves to 9%, PBV to 0.9, FV to $46.6 (0.9 * 51.76 book value per share)

Estimates of 6.5-7.0% ROE prove correct, but asset base remains impaired. PBV of 0.6 FV to $31 (0.675 * 51.76 book value)

PBV cut to 0.35x of today's value. FV to $18.2 (0.35*51.76 book value)

Bank in receivership → FV to $0

Evertec Return

116%

35%

-10%

-67%

Popular Return

94%

29%

-24%

-100%

Outcome from a 1:1 Long-Short

22%

6%

14%

33%

This seems good at first glance: you win in all 4 scenarios. An instant 100bps rise in interest rates, however, will wipe out any potential gain in all but the scenario where BPOP goes bankrupt. Assuming an increase in Popular's net interest margin doesn't change liabilities, the following happens when using a 28% tax rate on the Bank's potential income.

Scenario

Detroit (Fix the Problem)

Status-Quo (Kick Can Down Road)

Greece (-30% GDP growth)

Argentina (-30% GDP growth and a financial-run)

Outcome +100bps

-3%

-10%

4%

32%

Therefore, an offsetting investment in a US Bank ETF would help reduce the interest rate risk from shorting BPOP. Bank of America, for instance, stood to gain $3.685 billion in additional net interest margin for a 100bps gain in interest rates. This is equivalent to 22% of its 2016 estimated net income.

Put another way:

Personally, I feel an investment in Bank of America (NYSE:BAC) or JP Morgan (NYSE:JPM) would be an acceptable alternative to investing in a market-cap weighted US Bank ETF. The two companies are valued at relatively reasonable rates of 8.1 and 9.3x forward earnings respectively, and both have very stable franchises that are likely to withstand negative shocks to the broader US economy. A separate article should be written for these two companies though. Too much detail here would detract from the primary thesis.

Data source: Thompson Reuters

If you feel this is too much, a simple position in a US Bank ETF would do the same in creating a completeness portfolio to close out part of the interest rate risk.

Conclusion

As you might be able to tell, I have a dim view on trying to be too precise in measuring fair-value. Small changes in discount rate assumptions can have enormous effects in the perceived fair-value of a company. Thus, it's far more important to understand the underlying industry dynamics and why the market might be wrong.

To round out the key points:

1. Evertec is a company with high operating leverage but a stable stream of cash-flows. Given Evertec's total interest payments of US$ 23.8 million in the trailing twelve months, solvency is unlikely going to be an issue even in a poor-case scenario where Puerto Rican spending does fall by 25%.

2. Popular Bank, on the other hand, is a capital-intensive company. Super-normal growth is difficult to achieve without lowering credit standards, and the Bank has already started showing some issues with credit quality. Valuation at 0.50x book seems fair, given forecasts of 6.5-7.0% ROEs in 2016/2017.

3. Putting the two companies together, however, suggests that investors may have been too harsh on Evertec's outlook and not discerning enough on Popular Bank. Both companies trade at around 7x forward earnings, yet Evertec requires only ~$30 million in capital expenditure to sustain $130 of net income, while Popular Inc requires major amounts of core capital to make risky loans. Evertec also has a larger avenue for growth, given its easy-to-leverage technological base and growing adoption of electronic payment methods in Latin America.

4. Finally, closing out interest rate risk with an investment in US Bank companies rounds out the risk reduction strategy.

Happy investing!

Disclosure: I am/we are long EVTC, BAC.

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.

Additional disclosure: I am also short BPOP