03/29/2017

Why we think Total System Services, Inc. (NYSE:TSS) is an attractive investment opportunity

Why we think Total System Services, Inc. (NYSE:TSS) is an attractive investment opportunity

Overview:

Total System Services (TSS) provides electronic payment processing, merchant processing and associated services to financial and non-financial institutions globally. Electronic payment processing services are generated primarily from charges based on the number of accounts on file, transactions and authorizations processed, statements mailed, and other processing services for cardholder accounts on file. These services are provided to issuers of consumer credit, debit, retail and stored value cards as well as government services and commercial card accounts. As of October 2015, TSS had 685.5 million accounts on file in North America and 74.9 million accounts on file Internationally, making it one of the biggest 3rdparty processors in the market. TSS is the #1 North America third party processor, #1 China third party processor (through it joint venture with China UnionPay), #2 in Europe, and is the #2 Prepaid Card program manager in the US. The company provides services in 80 countries with over 2.7million point of sale locations utilizing its network.

TSS divides its services into four segments: North America Services (46% of 2015 YTD net revenue –US$847M), International Services (13% -US$244M), Merchant Services (19% -US$352M), and NetSpend (24% -US$436M). In terms of margins –North America segment is the most profitable (38.4% adjusted OM for 2015 YTD), with International lowest (15.9%) and the remaining segments in between –Merchant at 33.3% and NetSpend at 25%.

The North America and International Services segments are services that TSS provides to issuer banks (i.e. Bank of America when they a Visa credit card to a consumer). TSS provides services from processing the card application to initiating service for the cardholder, processing each card transaction for the issuing retailer or financial institution and accumulating the account’s transactions. TSS also provides optional fraud and portfolio management services. TSS will also mail cardholders their statements. It gets paid from the issuing bank/retailer on a long-term contract basis based on the number of accounts on file plus transaction processing fees (volume based) and non-volume based services (custom programming, value added products, etc.). During the first 9 months –52.1% of total North America revenues were volume based revenues and 47.9% from non-volume based revenues. In the International segment it was 36.7% and 63.3% respectively. Bank of America is a major client of TSS both in North America and Internationally-they executed a master services agreement in July 2012 with a minimum 6 yr. term –and was extended an additional 18 months in May 2015. TSS accounts for its China UnionPay joint venture and Mexico joint venture as an equity investment -it earned US$15M during the first 9 months, relatively a minor amount compared to its other segments.

Merchant Services provides services to acquiring banks (the banks where approved transaction funds are held) and merchants (i.e. the service to approve a credit card transaction for the merchant to obtain the funds from the acquiring banks). Majority of the revenues in the Merchant segment is driven by transactions and dollar volume processed –92.5% of segment revenues were volume based and 7.5% were value added services.

NetSpend manages and provides services for the issue of General Purpose Reloadable (GPR) debt and payroll cards and alternative financial service solutions to the underbanked and other consumers in the United States. TSS has relationships with 6 FDIC insured Issuing banks that handle the money –TSS handles the processing and other value added services that employers or users might want. TSS derived 69%from service fees charged to cardholders and 31% from interchange and other revenues. Service fees are based of active cards while interchange fees are based on dollar volume of transactions. 49% of the 3.1M active cards as of Sep 30 2015 are cards with direct deposits which usually incur more transactions –Number of cards grew by 18% in 2015 while gross dollar volume transacted for YTD 2015 grew by 19% to US$18.6B.

Catalyst:

On January 26, 2016, the company announced the acquisition of TransFirst, a private company, for $2.35 Billion in cash and completed the acquisition on April 1st2016. TransFirst is a large merchant business that specializes in partner-centric distribution model that serviced 235,000 small & medium sized businesses. The combined entity of TSS & TransFirst will be the 6th largest merchant acquirer in the US based on revenue and 3rd largest integrated payment provider. The company will server over 645,000 merchant outlets with approximately $117 Billion in transaction volume.

The company’s Q4 earnings did not meet expectations as the company reported $0.57 per share profit, 0.03 less than what the market expected, though its revenue did beat expectations and its stock price declined 14% that day. The company’s stock price has come back to over the pre-earnings release price. The market will be eagerly waiting for TSS’s revised guidance when they release their earnings on April 26th, however as the acquisition closed after their quarter close, TransFirst will not be included in the GAAP Q1 results, but should be provided in Non-GAAP remarks.

Over the longer term –TSS benefits from the increased digitization and regulations of financial services. Payment processors such as TSS will benefit from this trend as cash will be a less viable option and consumers and merchants will need to use a form of electronic payment such as Visa, MasterCard, etc. Regulations will also lead to fewer potential competitors that have expertise and breadth to break into the processing segment. The digitization of financial services also benefits its NetSpend category as more consumers will need to have access to a cashless form of payment. TSS also benefits from the increased advertising by non-financial companies to use their payment solutions –i.e. Apple Pay, Google Pay and Samsung Pay.

With TransFirst acquisition closing after Q1, we have modeled 50% growth in 2016, 10% for 2017 and 5% thereafter given the factors mentioned above. We modeled flat margins of 25% (lower than historical TSS margins given TransFirst lower margins) though they could increase as TSS scales and many costs are fixed. TSS could be impacted negatively if the government lowers interchange fees or if it loses a big issuer bank such as Bank of America though no single customer is responsible for over 10% of its revenue.

About Value Expectations 18 Articles

ValueExpectations.com, by the founders of The Applied Finance Group is an investment blog that provides institutional quality equity research using AFG’s proprietary Economic Margin framework.

About Value Expectations 18 Articles

ValueExpectations.com, by the founders of The Applied Finance Group is an investment blog that provides institutional quality equity research using AFG’s proprietary Economic Margin framework.