Tuesday, April 26, 2005

Don’t compromise in investment dating game

April 26 2005 - Financial Times
For a company to find a place in our clients’ port­folios it has to have three crucial ingredients: growth, quality and value. Not compromising, and thus avoiding marginal investments, is a true test of discipline – I would opt to hold cash over a marginal stock any time. As with dating, a marginal stock may prevent an investor marrying a truly good stock when it comes along. First Data is a one of the good ones, the rare stock that possesses all three ingredients. Growth: The company’s largest segment, payment services, represents nearly half of operating income and is carried out under the Western Union name. Although Western Union is one of the oldest and most respected corporate brands, its agent network is still fairly new. When the company bought Western Union 10 years ago it had only 30,000 agents. It now has 225,000 and is still growing. More than 80 per cent of its locations are less than five years old. As with drug stores, it takes at least five years for a new location to reach full profitability. As the new agent network matures, same-store sales should become a very important factor behind growth. There is plenty of inter­national growth left – less than 3 per cent of sales come from the fast-growing markets in China and India – while sales grew by more than 50 per cent in the last quarter. The cost of bringing a new agent online is about $1,500; First Data’s goal to sign up 30,000 agents in 2005 will cost the company approximately $45m, a drop in the bucket considering that its operating income was$1.3bn in 2004. Western Union’s revenues rose a respectable 14 per cent last quarter. However, higher interest rates hit the value of its bond portfolio sending interest income into negative territory and depressing profit margins. Although it is unpleasant, this development has no consequence on First Data’s long-term fundamentals; interest rates fluctuations have neutral impact on profitability over the full interest rate cycle. Western Union’s biggest competitor is MoneyGram, with a network of 79,000 agents. The money transfer business is driven by price and convenience. The network size provides a significant competitive advantage of economies of scale, awarding Western Union the lowest cost structure in the industry. In addition, it allows the company to charge a premium for the convenience of being closer to its customers. Western Union’s operating margin of 34 per cent, about twice that of MoneyGram, reflects its market dominance. The second largest segment is merchant services, processing debit and credit-card transactions, which represents close to 40 per cent of operating income. Last year, McDonald’s started to accept credit and debit cards in its restaurants. Although McDonald’s size will help drive the transaction volume, the benefit to the industry will spill far beyond. It forced all other fast-food restaurants to accept credit cards. More important, it changed the public perception of credit and debit cards. Debit cards are taking market share away from cash and cheque payments. First Data is positioned to ride the wave of this change. Debit card use is up thirty-fold in the last 15 years and growth is not likely to stop. Last year First Data acquired Concord, with its large debit card network, which secured First Data’s key position in the business. The company’s smallest segment, credit card issuing, is the slowest growth segment – with 3-6 per cent long-term growth. However, the spectacular growth of the two largest segments should mitigate its impact on the top line growth. In the long run, First Data is well positioned to deliver consistent and predictable revenue growth. Quality: First Data has a very strong balance sheet, with no net debt. Since its businesses are not very capital intensive, the company generates a very strong and stable free cash flow (operating cash flows less capital expenditures). FDC is returning free cash flows back to shareholders through a small, recently tripled, dividend 0.65 per cent and a massive share buyback, which should help accelerate EPS growth. While I would like to see a higher dividend, buybacks at these valuations make sense. Valuation: First Data is cheap. A discounted cash flow model shows very little growth priced into the stock. On relative valuation, it trades at sizable discount to its past and is significantly cheaper than its peers. With a forward price-to-earnings multiple of 16 and free cash flow of 15 times, I would marry FDC to our portfolios without a pre-nuptial in a heartbeat. Vitaliy N. Katsenelson, CFA


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