Buy the stocks of Total System Services Inc. (NYSE: TSS)

Summary: 

Total System Services is slated for long term growth given its superior performing NetSpend business. Also TransFirst acquisition will place the company’s merchant acquiring business in top position in the market. Moreover its diversified and restructured portfolio, strong network alliances, strategic acquisitions and technical competence are some of the other positives. Nevertheless, stiff competition, regulatory challenges, low interest rate, foreign exchange volatility and high leverage are some of the headwinds. During the first-quarter earnings beat expectation and improved year over year. Though revenues increased over prior year quarter, it failed to meet expectation. 

 Reasons To Buy:

*The acquisition of NetSpend in Jul 2013 has made Total System the 2nd largest program manager of dollars reloaded in prepaid cards as per the Mercator Advisory Group, thereby enhancing its footprint in the U.S. prepaid card industry and bolstering long-term growth through a diversified portfolio. With over 3.2 million accounts, 500 retail distributors and 130,000 reload locations; NetSpend has a wide distribution network for its prepaid cards and card solutions that are offered through its strong online, mobile and direct marketing channels. NetSpend covers less than 5% of this field of payments, which is further expected to double over the next 4 to5 years, laying ample scope of growth for Total System and stimulating conversion of a large chunk of its pipeline accounts in the next two years. Additionally, NetSpend’s top-line CAGR was 22% in the last five years until 2012. The company also expanded its relationship with Walmart which will sell NetSpend card in more than 1100 Walmart money centers. NetSpend also partnered with Ingo Money, Inc. which will enable card holders to receive immediate access to funds from approved checks iOS and Android devices. The company also signed a 3- year distribution agreement with RiteAid, extended distribution relationship with InComm for 5 years and signed agreement with Capital One. With these initiatives NetSpend is poised well for long term growth. NetSpend delivered another solid performance for the first quarter with record revenues, Gross Business Value (GBV) and operating income. The company also exceeded 100,000 distribution locations and employers in the same period.

*The company’s merchant acquiring services have consistently been in focus given the growth in direct businesses and higher sales productivity. The company’s strategic plan has been to reduce the contraction of the indirect business in the segment. The merchant acquiring portfolio continues to be bolstered by the acquisitions of FNMS, TermNet and Vanguard Payment Systems. Also the acquisition of TransFirst, which focuses on partner-centric, vertically specialized distribution will accelerate the segment’s growth within the highly attractive integrated payments space. Post closing, this specific distribution model will comprise approximately 20% of the revenue of the combined businesses. Based on an analysis by First Annapolis Consulting, on a pro forma basis, this would make Total System the third largest integrated payment provider in the U.S. The transaction with TransFirst strengthens the company’s sales and distribution network with the addition of over 1,300 partners and more than 350 sales professionals, enhancing its access to high growth, strategically attractive vertical markets such as healthcare, business to business and not for profit. The transaction is financially attractive from both an earnings and valuation perspective. The acquisition will also enable the segment to generate 80% of the revenue from direct business. Through the combination with TransFirst, the company will service more than 645,000 merchant outlets, process approximately $117 billion in annual volume and leverage over 2,300 distribution partners. The TransFirst acquisition was completed on Apr 1, 2016,. Moreover, Total System anticipates acquisitionrelated growth in its results from the deal going ahead. Based on the completion of this acquisition and better-than-expected performance in the first quarter, Total System raised its full-year consolidated guidance. The company currently projects the total revenue growth to be in the range of 50–53%, net revenue growth of 20–24%, and adjusted EPS ranging between 13% and 16% in 2016. 

*The company boasts of a strong acquisition story. The acquisitions of ProPay and a 75% stake in CPay in 2012 have enhanced Total System’s growth prospects within the small-, medium- and micro-merchants market. Acquisitions of FNMS, TermNet and Vanguard Payment Systems, NetSpend also ramped up its growth profile. Overall, total acquisitions added 2.9% to top-line growth in 2011 and 1.8% in 2012, followed by significant 16.7% in 2013 and 15% in 2014. The recent acquisition of TransFirst, a leading U.S. acquirer of payment solutions for $2.35 billion will place this business in a leadership position in the acquiring market. Management expects acquisitions to contribute further to the financials going forward. 

*The company has a strong record of generating favorable cash flows. In the first quarter, free cash flow was $101.4 million. With the addition of TransFirst, net of the additional bond expenses and one-time items, the company now expects free cash flow between $510 million and $540 million in 2016. While cash flow declined in 2015 we need not worry as the company expects to churn out higher free cash flow in 2016. The company’s prioritize utilizing its strong free cash flow over the next two years to de-lever its balance sheet so that it becomes possible to revert to the long-term target leverage ratio of the low-to mid-two times range. This growing level of free cash flow is another strong indicator of the health of the business and the ability of the company to generate strong free cash flow. 

The company also stays focused on effective capital deployment and thus envision returning about 75% of the free cash flow to its shareholders via share buybacks and dividends. To that end, the company paid back 94.4% and 92.3% in 2014 and 2015 respectively. 

Risks: 

• Total System will see an increase in debt level due to the funding of the TransFirst acquisition which is valued at $2.35 billion. With the closing of the aforesaid acquisition the company debt level came in at around $3.8 billion, in line with the company’s expectation. The debt to EBIDTA ratio increased 3.8x. The strong cash flow generation of the business will enable the company to get back to its long-term target leverage ratio of the low to mid-two times range within 24 months of closing. The reduction of debt will, however, limit its share buyback and acquisition. A cut back in share buyback might drain the company’s bottom line. 
•  The global payments industry is intensely competitive and Total System faces intense competition from data processing, bankcard computer service firms and third-party software vendors within the U.S. as well as from international processors and third-party software vendors. This implies that Total System has a very dynamic and strong peer group that aggressively competes on various crucial operational factors such as price, system performance and reliability, breadth of features,functionality, disaster recovery capabilities, business continuity preparedness and data security. Moreover, the direct and indirect businesses within the merchant acquiring segment faces headwinds from price competition and consolidation within the global market. This is evident from the sluggishness that has crept into the segment over the past few quarters. Given the volatile macro-economic factors, regulatory challenges and sluggish fundamentals, the company could lose edge over its competitors going ahead. Further, the regulatory measures enacted in the U.S. impose numerous costly compliance burdens on the company and its customers, which could lead to increased service costs and legal compliance costs.