Thesis summary
Fidelity National Information Services is a leading fintech company with steady free cash flow generation. Its business is mission-critical to their clients; much of its revenue is recurrent; the switching costs are high; the client retention rate is >90% (for some of the core business, the churn is only 1%-2%). The company has the potential to grow its free cash flows at 8%-10% in the forthcoming five years.
The company acquired Worldpay in 2019 at an unreasonable price in the hope of achieving high growth in the field of global payment. As the growth prospects and integration of Worldpay didn’t play out well as expected, the stock made a round-trip back to its 2014 level (excluding dividends) and the company chose to sell 55% of the stake in Worldpay to a PE company. I consider the company as a stalwart on its way to turn around from the temporary issues.
I will make an educated guess here: if the business keeps growing and the multiple expansion materializes (a terminal PE ratio of 14) several years out (2-5 years), the annualized return on the stock (at a price of $55.86) will be at least in the high teens. Even in the base case, the downside is limited compared with the potential upside. The potential disruptions and value destructive acquisition made by the management in the future are two main long-term risks. I hold the opinion that, at the very least, they don’t pose a genuine threat to the validity of my thesis in the next 1 or 2 years. At an estimated PEGY ratio (my own estimate instead of wall street consensus) of 0.87, the stock could produce a satisfactory return.
Price: $55.86
Market Cap: $33.28B
EPS (Forward): 6.01
P/E (Forward): 9.29
P/FCF: 10.9
Dividend Yield (Forward): 3.67%
Sep 3, 2023
Introduction
I came across the company when I was doing investment research on PayPal. It struck me as another beaten-down fintech company that presents interesting opportunity. Instead of writing a thesis on PayPal, I finally made up my mind to talk about this one, which is going to sell a major stake in Worldpay. I also find its competitors Fiserv (FISV) and Jack Henry & Associates (JKHY) very interesting in terms of business.
Since I don’t have a deep knowledge in business and high conviction in management, for now I kind of view the stock as a turnaround play instead of a buy-and-hold opportunity. The estimated holding period is approximately 2-5 years, until the company resolve the current issues and investor sentiment gets much better.
Background
Company: Fidelity National Information Services is a leading provider of technology solutions for financial institutions and businesses worldwide. It operates through Banking Solutions, Merchant Solutions, and Capital Market Solutions segments. The Banking Solutions segment provides core processing and ancillary applications; mobile and online banking; fraud, risk management, and compliance; electronic funds transfer and network; card and retail payment; wealth and retirement; and item processing and output solutions. The Merchant Solutions segment offers small- to medium-sized businesses acquiring, enterprise acquiring, and ecommerce solutions. The Capital Market Solutions segment provides investment operations and data, lending, trading and processing, and treasury and risk solutions. The company was founded in 1968 and is headquartered in Jacksonville, Florida. (This is an excerpt of company profile from seeking alpha)
Source: Seeking Alpha
While Fidelity National Information Services is a global company and doing business around the globe, most of the revenue is generated by clients in the U.S. The majority of the international revenue is generated by clients in the U.K., Germany, Australia, Brazil and Canada.
Business: At first, I tried to dive deep into details of the business and figure out the trends and outlooks. Later on, when I got overwhelmed by an enormous amount of information, I recalled a fact that Peter Lynch wrote in his book One Up On Wall Street: he started as a textile analyst at Fidelity, even knowing the esoterica of warps and woofs, while it is his wife Carolyn who find L’eggs (Hanes), a multi-bagger before being acquired by Sara Lee. It is fundamentally hard to evaluate every piece of business and then piece together to have a “precise” view for prospects. However, we can observe that the legacy services (Banking Solutions and Capital Market Solutions) are indispensable to their clients, the annual retention rates are constantly >90% (annual retention rates of banking solutions >98%), the backlog remains at $23B (almost 2 years of revenue). These facts speak to the steady demand of the business.
Source: FY2022 10-k
1) Banking Solutions: The Banking segment is focused on serving financial institutions of all sizes with core processing software, transaction processing software and complementary applications and services, many of which interact directly with core processing software. The predictable nature of cash flows generated from the Banking segment provides opportunities for further investments in innovation, integration, information and security, and compliance in a cost-effective manner.
Given the stability of the core business, growth primarily relies on the upsell of high-margin ancillary services to existing clients and acquiring new clients. In the past several years, outsourcing to third-party core processing companies has largely occurred at smaller banks whereas a majority of bigger banks still relies on in-house and hybrid systems. With the systems gradually became more complicated, bigger banks also have an incentive to outsource more. Since Fidelity National Information Services have a larger exposure to bigger banks compared with competitors Fiserv and Jack Henry Associates, it is well-positioned to benefit from the tailwinds of bigger banks outsourcing.
2) Merchant Solutions (Worldpay): The Merchant segment is focused on serving merchants of all sizes globally, enabling them to accept, authorize and settle electronic payment transactions. Merchant includes all aspects of payment processing, including value-added solutions, such as security, fraud prevention, advanced data analytics, foreign currency management and numerous funding options. Merchant serves clients in over 100 countries. The Merchant segment utilizes broad and varied distribution channels, including direct sales forces and multiple referral partner relationships that provide us with access to new and existing markets. FIS processes over $1.2T in annual payment volumes serving merchants all sizes with a focus on large multi-national enterprises.
Due to its scale of processing volume, Worldpay will be able to drive processing costs lower and maintain a huge database of transaction data. Furthermore, the business benefits from e-commerce and cashless payment tailwinds. The industry has seen consolidation in the past few years and competition is fierce. The Dutch fintech company Adyen might be a disruptive force against Worldpay and other traditional players.
3) Capital Market Solutions: The Capital Markets segment is focused on serving global financial services institutions. Clients in this segment operate in more than 100 countries and include asset managers and servicers, securities brokerage and trading firms, insurers, private equity firms, and other commercial and corporate organizations. Our solutions include a variety of mission-critical applications for recordkeeping, treasury, data and analytics, order management and trading, securities processing and financing, and risk and compliance. Capital Markets clients purchase our solutions in various ways including via a recurring subscription model or software as a service (SaaS). Our long-established relationships with many of these financial and commercial institutions generate significant recurring revenue.
This sector could also take advantage of the increasing trend of financial institutions outsourcing more of their services to third-party providers. In the past, Capital Markets heavily relied on one-time licensing revenues, but it has now largely transitioned to a Software as a Service (SaaS) model, with approximately 80% of its revenues being recurring.
What happened: Before the Worldpay acquisition in 2019, the company mainly provided banking solutions, capital market solutions and some other service. The track record of operating history is amazing, with stock compounded at an annual rate of ~14% between 2003 and 2019 (S&P 500 has an annual return of 8% during the same period).
In the hope of building end-to-end solutions, the company closed the acquisition of the global payment leader Worldpay at a whopping price of $43B in 2019 (LTM EV / Revenue: 9.6x LTM EV / EBITDA: 24.3x; pursuing potential growth at an unreasonable price?). This later became the Merchant Solutions reporting unit of the company. Since Worldpay operates in more than 140 countries with over 120 currencies, it necessarily entails an enormous troop of sales team in order to fulfill the serviced demand. Till now, this mega deal has only led to a painful experience: Worldpay growth slowed down since 2021; costs kept increasing across the board (compared with a ~40% revenue boost from FY2019 to FY2022, the SG&A surged by 71.1%); debt level skyrocketed.
In stark comparison, in 2019 the company’s competitor Fiserv (FISV) also closed an acquisition of First Data, a leader in electronic payment solutions, at much reasonable multiples and expectations.
The purchase price implies an EV/EBITDA of 11.5x on consensus 2019 estimated EBITDA, before synergies, which Fitch believes is near the low-end of deals we have seen in the fintech sector in recent years that have ranged from 10x to more than 25x.
Source: Fitch Ratings
The management even claimed to expect more synergies than they ever thought. I personally think that Worldpay acquisition is a textbook example of how painful it would be to pay a premium multiple at the time of exuberance, only to find that the reality delivered a harsh blow to them.
Source: Macrotrends
Since Worldpay acquisition didn’t play out well as management expected, the company recorded a goodwill impairment charge of $17.6B related to the Merchant Solutions reporting unit in 2022. The impairment reflects their intermediate-term expectation of lower growth in the segment, particularly related to the SMB sub-segment, which is attributable to the slower economic growth and competitive pressures. Also in 2022, the long-time CEO Gary Norcross handed off the CEO title to Stephanie Ferris earlier than expected. This heightened the level of uncertainty.
Along the way, the FIS stock depreciates by 62.3% from its all-time highs $148.23 on Apr 29, 2021. Since Sep 2022, many institution shareholders and especially fund shareholders dumped their holdings, and many of them just cleared the position. The investor sentiment around the stock became terrible. In the recent five months or so, the stock has been fluctuating in the vicinity of $50-$60 troughs with a current closing price of $55.86.
Source: Tikr Terminal
Source: Financial Times
Amidst the tumultuous environment full of pessimists who lost hope and patience, hedge fund D.E. Shaw and activist investor Jana Partners demanded a review of the company’s strategic plan. Seth Klarman, the “Oracle of Boston”, started to take a position in the stock in 2022 Q3, and made it 6.60% of his portfolio in 2023 Q2.
In 2023, the company announced plans to spin off the Merchant Solutions Business (Worldpay), despite the one-time costs and expense dis-synergies. Then the plans became selling a majority stake to PE firm GTCR, which is expected to close in FY2024 Q1:
FIS announced it has agreed to sell a majority stake in WorldPay to the private equity firm GTCR as part of a deal that values WorldPay at $18.5 billion. The agreement in and of itself was not a surprise. FIS in February announced plans to spin off WorldPay. What changed is WorldPay would become a privately held company; and FIS would retain a 45% stake in the payment processor instead of completely spinning it off as a stand-alone public company. The price was about $1.8 billion lower than Jefferies projections.
Source: American Banker
What will happen: In this stage, the deal is highly likely to be successfully completed as planned. We can expect the management to focus its energy and resources on the legacy business. What follows is that the management will retain a minority stake in Worldpay and come back to focus on its legacy business for now. For the ~$11.7B of proceeds that the company expects to receive in connection with the closing of the transaction, the management expects to use a portion of the sale proceeds to pay down debt to ~$10B, reducing leverage to ~2.5x upon close on a pro-forma basis for the transaction. The remaining net proceeds of ~$2.5B will principally be used for share buyback in order to unlock value for shareholders. After the closing of the deal, Worldpay is anticipated to have a leverage ratio of ~4.5x.
Competitive advantage
Fidelity National Information Services’ solutions and ancillary services are mission-critical (with many of them being non-discretionary) to the financial institutions and businesses they serve. The financial losses and business impact resulting from potential system failures will likely far exceed the cost of solutions provided by the company. Consequently, large clients tend to lean towards choosing companies with a reliable track record and leading market positions, such as Fiserv and Fidelity National Information Services, instead of those start-ups and low-cost operators. We can tell from the historical data (before the acquisition of Worldpay in 2019) that the free cash flows are stable, and the ROIIC (returns on incremental invested capital) is high due to the high fixed-cost nature of business. The legacy Banking Solutions and Capital Market Solutions have a stable end demand and benefit from high switching costs. Because of the high switching costs and multi-year, recurrent nature of contracts, the client retention rate is high (according to Fitch, more than 90% of the clients chose to renew their contracts with Fidelity National Information Services):
A significant percentage of our business with our clients relates to solutions provided under multi-year, recurring contracts. The nature of these relationships allows us to develop close partnerships with our clients, resulting in high client retention rates. As the breadth of FIS’ service offerings has expanded, we have found that our deep and broad access within our clients’ organizations presents greater opportunities for cross-selling and up-selling solutions to our clients.
Source: FY2022 10-k
On the Merchant Solutions front, while many hold the opinion that Worldpay benefits from the differentiated scale that leads to lower processing cost per transaction, I am suspicious of that as a solid argument of long-term competitive advantage. Even though global payment processing market is so massive that even future winners couldn’t take all, we already saw intensified competition in the sector and truly disruptive force like Adyen, a payment gateway, service provider, acquirer, and processor for online and brick-and-mortar commerce. Below is an illustration of Adyen’s business:
Source: medium.com
Adyen has a disruptively low and transparent fee structure compared with its competitors like PayPal, Stripe and Worldpay. In the long run, Worldpay’s competitive advantage could be turned into competitive disadvantage, if it fails to adjust to the industry dynamics. The good news is that even if the new and disruptive business model finally dominates the industry, the process will still take years and even decades to materialize. Another good news (or bad) is that Fidelity National Information Service will only hold a 45% minority stake after FY2024.
Financials
In my opinion, the balance sheet is still in good shape, especially when considering that the company has a strong track record of generating stable free cash flow. Cash conversion ratio of adjusted EPS is high (sometimes >100%). It is amazing to see that the company has increased the dividend for 45 consecutive quarters through thick and thin.
Debt level: After the completion of the Worldpay deal, the anticipated leverage will be ~2.5x. I think that this level is good for a company that has recurrent revenue base and constantly generates free cash flow.
Reconcile GAAP and non-GAAP: It is interesting to see a huge gap between GAAP and non-GAAP results. Generally speaking, I prefer GAAP numbers as measurements closer to the reality. However, for Fidelity National Information Services, I would pay more attention to free cash flow mainly because of two reasons 1) the GAAP EPS may not reflect the real economic nature as the depreciation and amortization are much higher than capex spent on PPE and software. I believe that this is largely due to the accounting of high amortization of customer relationships, which in fact does not deteriorate at such a fast clip 2) the GAAP EPS becomes choppy since the company recorded assets and goodwill impairments.
ROIC: ROIC data doesn’t screen well in the data base. It once annoyed me a lot when I found that the ROIC is almost always in the single digit even before the value destructive Worldpay acquisition. The ROIC is even lower than WACC (weighted average cost of capital; N.B.: I am not a fan of WACC though) in many years. I ask myself: “If this is indeed the case, how on earth could the company be a 10-bagger from 2008 to 2020 and consistently generated free cash flow?” When using free cash flow to substitute NOPAT (Net Operating Profit After Tax) in the formula of ROIC, I found that Cash ROIC fluctuates around 10% in the past decade. Even though this is not ideal in the eyes of quality investors, it is still not bad given the low effective interest rate of debt overall (1%-2%).
Source: Tikr Terminal
Management
Incentive plan: Long-term incentive constitutes most of the total compensation. In response to shareholder feedback, the Compensation Committee made changes to the 2023 long-term incentive program, including using PSUs with a relative TSR (Total Shareholder Return) metric over a single three-year period and utilizing premium-priced stock options. The other 2 metrics for long-term incentive program are Annual Organic Revenue Growth and Annual Margin Expansion. From my perspective, those metrics altogether will incentivize the management to do more share buybacks in the future to boost the adjusted EPS (and also the share price) so that they can fulfill the TSR metric and exercise stock options. They have a strong motivation to cut costs as well.
Source: FY2022 10-k
In 2022, Stephanie Ferris became president and CEO. As a 28-year industry veteran with significant expertise in payments and financial technology businesses, she seems to have the ability to take over. However, without track record it is hard to say whether she will be a great business operator and capital allocator or not.
Capital allocation
Dividend: The forward dividend yield based on consensus adjusted earnings is 3.67%. This is untypically high for a fintech company, largely due to the plunge of stock price in the past 2 years. The management targets a payout ratio of 35%, which I think is healthy given that free cash flow easily covers dividends by a factor >2.5x.
Capex: In general, the company only needs a moderate level of maintenance capex. Even with growth capex included, the total capex only takes up ~34% of the free cash flow in the first half of FY2023.
Buyback: After attaining the target leverage, the management is expected to use residual proceeds from the Worldpay deal and free cash flow to make a massive buyback.
Acquisitions: The acquisition of Worldpay has cause many pains. It is worth monitoring whether the new CEO clings to a proper playbook of disciplined acquisitions.
Amateur’s edge (opt.)
Insider trading: The stock has experienced intensive insider selling activities since 2019, but this changed in 2023. Given that the total amount of insider buying is insignificant and the purchases (new CEO and 5 directors) happening in February appears to be actions to reassure shareholders, insider buying may not be a valid signal of stock being undervalued as some analysts claimed. It is a positive sign though.
Source: secform4.com
Valuation
I would always like to be conservative but keep it simple for my valuation process. John Maynard Keynes said: “I would rather be vaguely right, than precisely wrong.” For such a fintech giant, a seemingly precise valuation based on many assumptions (remind yourself of Occam’s Razor: Entities should not be multiplied unnecessarily/ Pluralitas non est ponenda sine necessitate) may turn out to be a defective one. Having gone through hundreds of thousands of stock pitches, I remembered seeing innumerable cases when investors (even value investors) make a complicated valuation model in which they assume a “base case scenario”, only to find the reality turns out to be even significantly worse. Carvana and Zoom are good examples.
Therefore, I will make it conservative but simple. First, exclude the potential influence of Worldpay deal for convenience’s sake. At the moment, the forward PE ratio is 9.29 based on adjusted EPS and the free cash flow yield is 9.17%. This is already low for a fintech company that generate stable cash flows. The company’s P/S ratio is at a very low level compared to historical (10 years) and industry averages. Assume that the company uses ~25%-30% of the free cash flow to buy back stocks after paying down debt to $10B, the annual buyback yield will be ~2%-3% (if multiples remain at a depressed level). Even assume that the stock price appreciates by 50% in the near future, the estimated buyback yield will still be 1.5%-2%. Based on the consensus estimate, the adjusted EPS and free cash flow will have growth rates between high single digits and low teens in the next 3 years. Assign more conservative 5% adjusted EPS and free cash flow growth rates for the stock and a 2.0% buyback yield, the PEGY (PE ratio/(EPS growth + yield)) will be 0.87, which is still at a good level. The Worldpay deal doesn’t change the numbers and the bigger picture much.
But obviously we should not forget about the restricting costs and dis-synergies from the separation of Worldpay. However, it is hard to quantify the benefits and the costs of the deal. Since the company’s legacy business has highly recurrent revenue and a considerable backlog, this signifies that the downside from here is limited in the next several years. I have full faith in the future dividend payment, which I think will be well covered by future cash flow generation. In order to have margin of safety, just assume that from now on the company achieves 0% organic growth, 0% inorganic growth rate, and neither raises dividend per share nor makes share buyback, we will still roughly break even if the 5-year terminal PE ratio is >8.
An educated guess: I assume that in the forthcoming 5 years 1) the free cash flow per share and adjusted EPS grow at 6% 2) dividend payout ratio keeps the same 3) the company reduces the shares outstanding to 92% by stock buyback 4) the turnaround materializes and the stock trades at a terminal PE ratio of 14, which is conservative for a leading fintech company. In this case, the estimated annualized return is in the high teens. If the outlooks turn out better than expected or the turnaround is quick, then the estimated return could be >20%.
Why this opportunity exists
- The painful experiences linked to the acquisition of Worldpay in 2019
- The investor sentiments changing from exuberance to extreme pessimism
- The concerns about disruptive forces
- Lack of track record for the new CEO
- The gap between GAAP earnings and free cash flows
Risks
- Possible value destructive acquisition in the future
- Disruption from competitors like Adyen
- Consolidation in banking industry which may lead to the decline in revenue
Catalysts (opt.)
- A massive share buyback at low multiples
- The turnaround of investor sentiments
- Potential insider buying at a significant amount