Given the current sustainability factor, we have upgraded our recommendation for Total System Services Inc. (TSS) from Underperform to Neutral. This was also based on overall stability that improved client activity and lower-than-expected margin decline due to the First National Merchant Solutions LLC (FNMS) deal.
The company’s second quarter earnings of 25 cents came in a couple of cents ahead of the Zacks Consensus Estimate. Growth from merchant services and transaction volume was partially offset by higher operating expenses.
Although Total System has posted a negative top-line growth trend in the last couple of years as a result of weak macroeconomic metrics, the company swung to growth during the second quarter of 2010 when revenue grew 5.3%, reflecting the subtle effects of market recovery. While revenues from North America have remained weak, merchant acquiring services grew a substantial 58% year over year on increased traction due to market improvement.
This also drove international service revenues and transaction volumes. The revenue recovery is believed to follow slow and steady in North America, although, Total System’s leading technology platform, improved pricing and healthy consumer spending are expected to drive growth once the economy stabilizes to its historical highs.
Total System’s risk free balance sheet along with a strong cash position and modest cash flow generation provides viable scope for acquisitions. We believe new acquisitions and joint venture deals by 2011 or ahead could help pick up growth of the company. Also, its pipeline of international opportunities can help drive growth.
With the completion of the FNMS deal, Total System aims to diversify its portfolio into merchant acquiring and be among the top five merchant acquirers on a global basis in 2 to 3 years. With a bank card portfolio of 3 million accounts on file, the company’s joint venture with the FNMS is expected to be accretive to the earnings in 2011 and beyond.
The ongoing market recovery is regrouping the confidence of the consumers, which in turn is leading to an improvement in client activity. As a result, Total System is also benefiting from a recent spurt in total acquiring services. On year-to-date basis, same-client revenue growth climbed 3.6% and the same-client account-on-file growth improved a modest 8.1%.
Moreover, Total System’s contract portfolio has gotten a boost with the latest processing contract from President’s Choice and Wal-Mart in Canada, Tesco Financial in the UK and CIBC, while being actively involved in negotiations with Bank of America Merchant Services to extend a long-term contract completing in 2010. These high profile long-term contracts are crucial for Total Systems to boost its business portfolio and top-line growth.
However, the declining electronic payment processing services revenues are generated from charges based on several factors, one of which is the number of accounts on file. Accounts on file continue to experience weak trends since the last couple of years. It declined 2.2% from 2008 to $344.8 million in 2009.
The weak growth is attributable to domestic accounts that declined 4.7% year over year to $255.5 million in 2009, a decrease in internal growth of existing clients and lower-than-expected new client growth across the consumer, retail and commercial sectors. The company has significantly high backlog of accounts.
As of December 31, 2009, Total System had a pipeline of approximately 8.2 million accounts, all of which are expected to be converted during 2010. However, timing is an important factor and any delay in the result will adversely affect the top-line and expenses. Overall, given likeliness of ongoing cut-backs at card issuers and slow conversion of accounts in the pipeline, the accounts on file warrants a challenging outlook for 2010.
Further, the growth of credit card industry has been harshly hit by the economic downturn, and signs of improvement remain bleak in the near term. This weakness is hampering the company’s results as credit cards are one of the significant revenue drivers for Total Systems.
Also, regulatory measures enacted in the U.S. in fiscal 2009 are expected to take effect in the upcoming months of 2010, which could contract credit offerings from financial institutions. Further, the regulations also impose numerous costly new compliance burdens on Total System and its customers, which could lead to increased service costs and legal compliance costs.
In all, Total System aims to expand internationally with announcement of deals in the merchant-acquiring space. However, 2010 is going to be a challenging year due to ongoing sluggish growth in the global economy that led to a dip in the client accounts, weakness in the credit card market that has led to decline in the electronic payments services segment, the primary revenue driver of the company.
Moreover, competition, maintenance of operating costs, currency fluctuations, interest risks and pricing pressures have added to the woes. Inefficient cost-cutting and negative growth guidance for 2010 are also among the negatives. Hence, we believe the company requires a vigorous fundamental approach to generate technological advantage.
Nevertheless, Total System is making attempts to tap opportunities in the recovering markets, which is reflected in the growth of merchant services and increased client activity. Therefore, we are upgrading our recommendation from Underperform to Neutral, discerning ample scope for growth in future.