Magic Formula Stock Review: Total System Services (TSS)
Total System Services (TSS), or TSYS, is a provider of electronic payment processing for both financial and non-financial firms worldwide. TSYS was spun off from Synovus Financial (SNV) at the end of 2007. The company provides banks and retailers the ability to outsource their credit and debit card portfolio management. TSYS handles all management tasks, such as creating and mailing cards and billing statements, processing transactions, and so forth. Revenues are earned largely on volume, based on the number of accounts managed, transactions handled, and statements mailed. TSYS also provides additional offerings to clients such as merchant acquiring services, credit evaluation, fraud detection, and loyalty programs.
The company's business model revolves around signing customers to multi-year processing contracts. In normal economic times, this is a very attractive model. Multi-year fixed arrangements provide TSYS with predictable revenues, allowing management to effectively manage expenses. This is evident from the company's remarkably stable operating margins, which have remained in a tight range between 22-25% throughout the wild economic swings of 2004 through the present. Credit card processing is also a relatively stable business. Cards themselves (both credit and debit) have been increasingly utilized for everyday payments at the grocery store and gas station, and while volume on discretionary purchases may ebb and flow, transactional volume rarely strays out of single-digit growth or loss territory. TSYS is a stable business.
But this firm has taken some lumps over the past few years. Bank consolidation has caused the loss of several large customers. Wachovia, a former client, was acquired in 2008 by Wells Fargo (WFC), who does not utilize TSYS. JP Morgan (JPM) ended an outsourcing agreement in 2007, moving processing in-house using a software platform licensed from the company (licensing is higher-margin but much lower revenue). Morgan then bought the assets of Washington Mutual, another former customer. Even retail customers have not been particularly "sticky". Nordstrom (JWN) moved to primary competitor First Data in 2008, and Charming Shoppes (CHRS - Lane Bryant and Fashion Bug stores) switched to Alliance Data (ADS) in August of last year. With these major customer losses as a backdrop, TSYS's reliance on two customers - Bank of America (BAC) and Capital One (COF) - for 30% of existing sales has to be a major concern, particularly with BAC announcing their intentions to move some processing in-house over the next year. Continued customer "de-conversions" are a risk, and the threat of them has led TSYS to sign contracts at less favorable prices.
Even so, MagicDiligence believes that Total System Services offers good value to long-term investors. Recent customer defections have been largely offset with new additions, particularly overseas where TSYS has been enjoying 20% growth as they sign clients in Asia, Brazil, and Eastern Europe. In China, the company has a 45% stake in China UnionPay Data Services, an entry point into that growth market. Management has not been shy about acquiring payment processors that provide TSYS with an expanded international portfolio, and I expect this to continue going forward. In 2009, the company won every competitive international bid they participated in. With over $200 million in net cash on the balance sheet and over $300 million in reliable free cash flows, there is plenty of money to go shopping with. Some of the customer losses can be blamed on exceptional circumstances stemming from the 2008 financial meltdown that (we all hope) is unlikely to reoccur. Despite all of the defections since 2007, revenue is just about flat over that time period.
Total System also has significant competitive advantages. It is the largest payment processor in the United States, processing about 42% of all credit card transactions, including 85% of Visa (V) and Mastercard (MC) commercial exchanges. Scale is important in the processing industry, as much of the infrastructure is fixed, allowing significant leverage on additional users (each additional user leads to higher profit margins). Their TS2 software platform is considered far and away the best in the industry. These factors should allow TSYS to maintain solid profitability and cash flows for the forseeable future.
All things considered, Total System Services is a good choice for a new Magic Formula position. The one thing holding it back from a Top Buy recommendation is the poor near-term outlook and lack of catalysts. Guidance for 2010 was poor, as customer defections will show up in revenue comparisons and the company invests heavily in their international initiatives. While it may take time to recover, TSYS's 13% earnings yield is about 6 percentage points lower than its historical norm. Those willing to hold TSYS for 2 years or so should see satisfactory gains from current levels.