Transaction processing is the facilitation of electronic payments, such as credit and debit card transactions. For these transactions, there are three essential roles companies in our universe play: (1) a network (e.g., Visa and Mastercard) provides the technological infrastructure for issuers and merchants (or entities acting on their behalf) to complete a transaction; (2) a merchant acquirer (processor—e.g., Vantiv, Global Payments Heartland Payment Systems, and Total System Services) acts on behalf of a merchant to complete a transaction by communicating with the issuer (or an entity acting on its behalf) over a network; and (3) an issuer processor (e.g., Total System Services and Vantiv) acts on behalf of the issuer to complete a transaction by communicating with the merchant acquirer (processor) over a network.
Transaction processing companies typically generate revenue based on dollar- or transaction volume processed. Given less developed economies and technology infrastructures in emerging markets, cash and checks still represent a significant percentage of transactions. In our view, this should result in strong credit and debit dollar and transaction volume growth over at least the next several years, presenting opportunities for companies in our universe with a presence in Asia Pacific, Latin America, the Middle East, and Africa.
Key Themes
We believe that payments and transaction processing are at one of the most critical points in the 12 years that we have covered the industry as a variety of factors are coming together that will not only affect that fundamentals of established players but also the lens through which investors view the industry. Ultimately, we believe that the industry remains an attractive investment vehicle though we would argue that there is likely to be more noise associated with the industry for 2 reasons; (1) The story of the industry is increasingly being driven by international expansion and the various geo-political backdrops are going to affect the industry and share prices.
(2) A wave of innovation is sweeping through the industry and will likely continue for the next several years. Nevertheless, we believe the financial characteristics and growth of the global transaction processing industry will still generate attractive returns over a long-term time frame.
Technology, particularly mobility is reshaping the purchasing and payment experience like at no other time. There are a variety of dynamics taking place with mobile and the mobile Internet that will change the way that a consumer shops and pays for goods and services. There tends to be some initial reaction that the evolution of technology is going to create a whole new set of competitive forces in the payments industry to challenge the incumbents. While this is a logical reaction, we are increasingly believers that what mobile is going to do is create a variety of new players and product offerings that will surround the actual payment for goods and services both before and after a transaction to the benefit of the consumer and the merchant. Specifically, we point to the expected growth of mobile marketing where consumers could receive highly targeted advertisements/coupons/rebates to drive their purchasing decision or the tools that are being developed that help them search and locate goods and services. All of these are what we would describe as “influencing the purchase decision.” On the flip side, merchants will be provided with an ever increasing array of tools to leverage the data inherent in the transactional histories of consumers to better understand how to engage a customer but also better understand the performance of their own businesses. Many of the entrenched players such as the payment networks, banks and processors
Growth remains attractive, though the U.S. market is maturing, placing greater reliance on emerging markets for organic growth. In our opinion, we have crossed into a new phase where drivers of growth will be more driven by the international markets while the US becomes a more mature market. After a 15-20 year run of electronic payments aggressively taking share away from paper-based payments the US payments industry is set to grow at a more moderate rate. As seen in figures #1 -2 the growth rate of payments is expected to remain around 7% credit being in the low-to-mid single digits due to a cyclical rebound while debit is expected to slow to the low double-digits. Overall, we believe that credit is likely to be a low single-digit grower and debit/pre-paid will be able to drive a low double-digit growth rate for the next several years in the United States. However, as a result of the inevitable slowdown in U.S. growth rates, the players in the payments food chain are increasingly going to turn to international markets to drive transaction growth. While the opportunity is clearly obvious when looking at the statistics in various regions of the world such as Latin America or Asia, there are still investments that need to be made and in many cases partnerships that have to be formed, which may limit the trajectory of what seems to be a very obvious opportunity for transaction and volume growth. That being said, we are 7-8 years into the international learning curve and believe that in the next 2-3 years we will see companies make notable strides developing a profit stream that is increasingly driven by international growth.
Exhibit 1. Worldwide Payment Volume Mix, 2010 and 2015E
2010 - $7.831 Trillion
Note: General purpose cards, excluding China Union Pay
Source: Company reports, The Nilson Report, and Wells Fargo Securities, LLC estimates
Exhibit 2. Payment Volume CAGR by Geographic Region, 2005-2010 and 2010-2015E
3%
U.S. C redit U.S. Debit U.S. Asia Pacific Canada MEA Latin America Europe International Worldwide
'05-'10 C AGR '10-'15 CAGR (Est)
Note: General purpose cards, excluding China Union Pay
Source: Company reports, The Nilson Report, and Wells Fargo Securities, LLC estimates
INTEGRATED RESEARCH & ECONOMICS Government intervention has been inserted into the discussion. With the implementation
of the Durbin amendment, it is our opinion that the payments industry in certain respects will be more closely watched by government and regulatory bodies, which will likely try to make their presence known on topics such as pricing structure and market power. Outside of the United States there is also a fair amount of government presence whether that be disputes over cross-border fees in the EU, regulating interchange (as is the case in Australia and parts of Europe) or governments trying to control more of the payment infrastructure such as in China with China Union Pay (CUP) and other governments that are trying to take a bit more active role in domestic payment networks. Ultimately we believe the payment networks and those in the food chain can survive though the legacy economics that are inherent in the US model are likely to be challenged as governments will be more inclined to try and take some control in concert with advancements in technology that will enable a larger set of potential competitors to play in emerging markets as those markets evolve.
Valuation/Investment Considerations
Capital deployment will continue to increasingly factor into the valuation creation equation. Historically, the payments industry has been one that has been characterized by margin expansion, no balance sheet leverage, and copious amounts of free cash flow. However, as the industry has matured and organic growth rates have moderated, the allocation of capital is figuring more into the equation as opposed to during the prior phases of the industry life cycle when strong EPS growth alone was the major driver of shareholder value creation. We look for investors to be more discerning among the names in our universe and try to understand who is allocating capital efficiently among various geographies, (i.e., taking capital out of the maturing United States and investing in emerging markets), partnerships and acquisitions. We also look for companies to continue to be diligent about share buyback, and we look for dividend payout ratios to move higher.
We point to names in our universe like JKHY, TSS, WU, and V as companies that are very actively returning capital to their shareholders.
Exhibit 3. Dividend Growth and Payout Ratios
Year Average Median Average Median
2005 27% 22%
2006 27% 21%
2007 15% 20% 23% 21%
2008 17% 11% 26% 21%
2009 0% 0% 23% 13%
2010 33% 0% 26% 15%
2011 37% 8% 26% 17%
Year-Over-Year Growh Payout Ratio
Source: FactSet, company reports, and Wells Fargo Securities, LLC estimates
We look at a variety of valuation yardsticks with the transaction processing companies. Historically, P/E ratios and the P/E ratio relative to the market were the primary tools (and most likely still are), but we increasingly sense that investors are using EV-to-EBITDA ratios (to account for more leverage on balance sheets while a variety of definitions of “EPS” cloud that equation). We also look at the PEG ratio.
Exhibit 4. Transaction and Business Services Valuation: NTM PE
0 5 10 15 20 25 30 35 40 45
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
NTM PE - Average NTM PE - Median 5-Year Average
Note: Companies include all companies under coverage excluding MGI and VNTV plus CKFR, CEFT, EFD, FDC, GDOT, ACIW, DST, FISV, ORCC, SDS, HEW, CEN, and NSP
Source: FactSet Research Systems and Wells Fargo Securities, LLC
Exhibit 5. Transaction and Business Services Valuation: Relative P/E Ratio
0.0 0.5 1.0 1.5 2.0 2.5
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Relative NTM PE (S&P 500) - Average Relative NTM PE (S&P 500) - Median Historical Average
Note: Companies include all companies under coverage excluding MGI and VNTV plus CKFR, CEFT, EFD, FDC, GDOT, ACIW, DST, FISV, ORCC, SDS, HEW, CEN, and NSP
Source: FactSet Research Systems and Wells Fargo Securities, LLC
INTEGRATED RESEARCH & ECONOMICS Exhibit 6. Transaction and Business Services Valuation: PEG Ratio
0.0 0.5 1.0 1.5 2.0 2.5
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
PEG - Average PEG - Median 5-Year Average
Note: Companies include all companies under coverage excluding MGI and VNTV plus CKFR, CEFT, EFD, FDC, GDOT, ACIW, DST, FISV, ORCC, SDS, HEW, CEN, and NSP
Source: FactSet Research Systems and Wells Fargo Securities, LLC
Exhibit 7. Transaction and Business Services Valuation: EV/NTM EBITDA
0 3 6 9 12 15
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12
EV/NTM EBITDA - Average EV/NTM EBITDA - Median 5-Year Average
Note: Companies include all companies under coverage excluding MGI and VNTV plus CKFR, CEFT, EFD, FDC, GDOT, ACIW, DST, FISV, ORCC, SDS, HEW, CEN, and NSP
Source: FactSet Research Systems and Wells Fargo Securities, LLC.
Flow Charts for Payment Transactions
Exhibit 8. PIN Debit Transaction Flow
8 Authorization and Settlement Information 7 Authorization and Settlement Information Network
3 Message 4 Message
Acquiring Processor Issuer Processor
9 Authorization and Settlement Information 2 Message 5 Message 6 Authorization and Settlement Information
POS Terminal Issuing Bank
10 Completed Transaction 1 PIN
Card
Source: FRB Kansas City and Wells Fargo Securities, LLC
Exhibit 9. Signature Debit and Credit Transaction Flow
8 Authorization Information 7 Authorization Information
Network
3 Message 4 Message
Acquiring Processor Issuer Processor
9 Authorization Information 2 Message 5 Message 6 Authorization Information
POS Terminal
10 Completed Transaction 10A Signature 1 Card Swipe Card
Issuing Bank
Source: FRB Kansas City and Wells Fargo Securities, LLC
Exhibit 10. Settlement for Signature Debit and Credit Transaction: 1 of 2
1 Transaction Info 1 Transaction Info
Processor 2 Net Debit And Credit Processor
Information
Network's Bank
5 ACH 5 ACH
4A Debit Fed 4B Debit Fed
Account For 3 ACH Account For
ACH Credits File ACH Debits
Originated Originated
ACH Operator Network
Source: FRB Kansas City and Wells Fargo Securities, LLC
INTEGRATED RESEARCH & ECONOMICS
Exhibit 11. Settlement for Signature Debit and Credit Transaction: 2 of 2
Processor
1 Net Debit And Credit Information
Merchant Processor Clearing Bank Cardholder
5A Post Credit 3A Debit Fed 3A Credit Fed 5B Post Debit
Account For 2 ACH Account For
Member FI ACH Credits File ACH Credits Member FI
4 ACH ACH Operator 4 ACH
Source: FRB Kansas City and Wells Fargo Securities, LLC
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INTEGRATED RESEARCH & ECONOMICS