Focus Stock: Global Payments Rings Up Growth

Atlanta-based Global Payments Inc. (GPN) carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy. Our recommendation is based on our belief that, at current levels, the shares do not fully reflect what we view as the company's positive business momentum relative to data processing and outsourced services peers.

We think that Global Payments and other payments processors participate in a significant and growing market, benefiting from the ongoing secular shift from traditional paper-based forms of payment, such as cash and checks, to card-based and other electronic payments. In developed markets such as the U.S., this shift has been several years in the making, but globally the amount of electronic or nonpaper-based payments as a percentage of all payments is still quite small.

Expansion into international markets is therefore a key driver of growth for Global Payments. Based on data from The Nilson Report (December 2007) and other industry sources, card usage and the number of cards—Visa (V) and MasterCard (MA) credit and debit cards—per person in regions such as Central Europe (0.6 cards per person), China (0.2), India (0.1), and Russia (0.2) significantly trail developed economies such as the U.S. (3.7 cards per person), Britain (2.5), and Canada (2.3). As these regions continue to develop economically, we would expect significant growth to come from these markets as card usage and ownership rise.

To take advantage of this growth opportunity, Global Payments has been expanding its international presence. In February 2004, the company acquired an aggregate 98.3% of MUZO, the largest indirect payment processor in the Czech Republic. In addition to this acquisition, Global Payments has joint ventures with HSBC (HBC) in 10 countries in the Asia-Pacific region and in Britain. We think these joint ventures were a prudent way to expand, since barriers to entry in new markets can be very high. Global Payments benefits both from partnering with a well-known brand and from a 10-year marketing and referral agreement it has entered into with HSBC.

We note that Global Payments primarily serves small and midtier merchants, a segment we consider attractive as it is less penetrated than the market for large national clients. In addition, because they are smaller, these merchants have less pricing power, in our view. We think the company has a competitive advantage over larger financial institutions who offer merchant acquiring services, due to Global Payments' focus on customer service and its technology platform.

Finally, in the current economic environment, we think it is important to note that Global Payments' senior management has what we view as a consistent track record of strong results and a prudent strategy for growing its international presence. The company has a fixed-cost operating model that should benefit from added scale. It also has fairly modest capital expenditure requirements by our analysis (about $45 million in fiscal 2009) and is able to generate what we think are healthy free cash-flow levels, allowing for investment in growth initiatives.

While risks abound in the slowing global economy, we think the shares are very attractively valued when taking into account our view of the company's strong free cash flow, and consistently strong growth rates relative to both the markets it operates in and to peers. At about 14 times our fiscal 2010 earnings per share estimate, Global Payments shares were recently trading at a modest premium to peers, which we believe is warranted.

COMPANY PROFILE

Incorporated in September 2000 and spun off from NDCHealth in January 2001, Global Payments is a processor of electronic transactions and payments. The company operates two main segments, merchant services and money transfer.

The company's merchant services segment offers products and services that allow merchants, financial institutions, and independent sales organizations (ISOs) to accept credit- and debit-card payments. In addition to credit- and debit-card transaction processing services, Global Payments' merchant services include check guarantee and verification and recovery solutions.

The company sells its merchant services offering under two models, "direct" and "indirect." Under the direct model, Global Payments sells a full-service offering (front-end and back-end processing and customer- and other related support services) to merchants through its internal sales force or through ISOs or other sales channels. In any case, the end customer is the merchant. Pricing under the direct model is based on a percentage of the transaction value. Direct sales through ISOs are charged a fee per transaction. The majority of Global Payments' merchant services sales are direct. Indirect sales are to financial institutions who in turn resell Global Payments' services to merchants on an a la carte basis with pricing on a specified amount per transaction. Under both models, Global Payments also charges other fees not related to the number of transactions or the dollar value of transactions.

The company's money transfer segment offers consumer money transfer services, under the DolEx and Europhil brands. DolEx accounts for the majority of money transfer revenues; its services are targeted primarily at Latin American immigrants residing in the U.S. Europhil serves the European market and has receive locations in Morocco, the Philippines, and Central Europe. In fiscal 2008 (ended in May), merchant services accounted for 89% of revenues, while money transfer services accounted for 11%. The company has about 5,300 employees and operations in the U.S., Canada, Europe, Mexico, and the Asia-Pacific region.

INDUSTRY OUTLOOK

According to the Federal Reserve's 2007 study of noncash payments (released December 2007), over two-thirds of all U.S. noncash payments in 2006 were made electronically, including credit cards, debit cards, and automated check handling (ACH) transfers. Credit-card payment transactions grew at an annual rate of 4.6% from 2003 to 2006, and debit-card transactions rose at an annual rate of 17.5% from 2003 to 2006. In contrast, check-based payment transactions fell at an annual rate of 6.4% from 2003 to 2006. Total electronic payment transactions rose to 47 billion in 2006, from 34 billion in 2003 and 15 billion in 1995.

We think the trend has been driven by the convenience, safety, and fraud protection features increasingly featured by card-based and other electronic payments, as well as loyalty or benefit programs such as airline miles and rewards or cash-back programs. According to The Nilson Report (August 2007), a consumer payments industry publication, there were 42.7 billion credit- and debit-card purchase transactions worldwide in 2002. It projects that these transactions will rise to 133.1 billion in 2012, a compound annual growth rate of 12%.

In developed markets, particularly the U.S., we think credit and debit cards are used for nondiscretionary spending as well as discretionary spending and despite the slowing economy. Amid recent reports of declining revolving consumer credit, we think transaction volumes will hold up, with nondiscretionary spending providing an underpinning. Historical data regarding U.S. Visa and MasterCard purchase volumes support this view, in our opinion, and we note that the purchase volume rose during the last two recessions (7% in 1991-92 and 16% in 2001).

In view of Global Payments' focus on consumer-to-consumer money transfers in the U.S. to the Latin American corridor, we note that the addressable market opportunity (i.e., the number of immigrants from Latin American countries in the U.S. and overseas) is significant. According to the World Bank's Migration & Remittances Factbook (2008 edition), there were nearly 191 million immigrants, representing about 3% of the world's population, who remitted more than $318 billion in funds worldwide. The majority of this volume originated in the U.S. In 2007, the Inter-American Development Banks estimated that $66.5 billion in funds were transferred to Latin America. Of this amount, $46 billion was estimated to be sent from the U.S. While growth for this segment has slowed due to the weak U.S. housing market and economy, pricing pressure seems to have abated.

EARNINGS OUTLOOK

We expect revenues to rise about 23% in fiscal 2009, to $1.57 billion, reflecting organic growth resulting from an anticipated increase in credit- and debit-card transactions, acquisitions, and contributions from Global Payments' recently formed British joint venture with HSBC. We expect growth in Global Payments' money transfer business to remain pressured by competition and the weak economic environment, although we think pricing has stabilized and comparisons will not be as difficult in fiscal 2009. We forecast revenue growth of about 8% in fiscal 2010.

We anticipate operating margins widening about 60 basis points in fiscal 2009, as well-controlled operating costs for the company's British joint venture are partly offset by unfavorable currency movements, most notably the strengthening of the U.S. dollar relative to the Canadian dollar. We look for Global Payments to remain focused on operating efficiencies internally and within its joint-venture operations, although we believe they will take time to materialize. We see modestly wider operating margins in fiscal 2010. We estimate EPS of $2.18 in fiscal 2009, rising to $2.50 in fiscal 2010.

VALUATION

Our 12-month target price of $42 is based on a blend of our P/E and discounted cash flow (DCF) analyses. We apply a peer-premium P/E ratio of 15 times our fiscal 2010 operating EPS estimate of $2.50 to derive a value of about $37. We think Global Payments warrants a peer premium (to the S&P 500 Data Processing and Outsourced Services sub-industry) due to what we see as revenue, transaction, and, at constant currency, earnings growth above the peer average. We also note that the P/E ratio of 15 times is below the low end of the five-year range for Global Payments of 16.9 to 27.1 times. Our DCF model yields an intrinsic value of $46.

CORPORATE GOVERNANCE

We have a generally favorable view of the company's corporate governance policies, although we think the company could strengthen its corporate governance by separating the roles of chairman and CEO. We also note that the board of directors is classified. We view favorably the company's separately designated committees for audit, compensation, and governance and nominating. In addition, no member of the compensation committee has ever served as an officer or employee of the company or its subsidiaries. Officers of the company who are also on the board of directors are not provided any compensation for sitting on the board. A review of the company's most recent proxy statement indicates that of the nine current board members, only current Chairman and CEO Paul Garcia is an officer of the company—all other members are non-employees, and appear to be independent.

INVESTMENT RISKS

Risks to our recommendation and target price include the broad-based slowdown in the global economy. Global Payments processes credit- and debit-card transactions. And while we would argue that the use of these payment methods will grow, even in recessions, the current slowdown has already caused high levels of job losses and will likely contribute to future declines in the level of consumer spending. The economic slowdown has also had an adverse impact on retailers and restaurants. These types of merchants are customers of Global Payments, and a significant rise in bankruptcies or business closures would likely have a negative impact on results.

The malaise in the U.S. housing market, the related decline in construction, and lack of a clear resolution to domestic immigration policy has had a negative impact on remittance volumes from the U.S. to Latin America. This has dampened growth for Global Payments' money transfer business, which has declined as a percentage of total revenues to 11% in fiscal 2008 from 13% in fiscal 2006. Finally, we note that while Global Payments has benefited from international expansion, there are risks inherent in this strategy, including exposure to foreign geopolitical problems as well as the potential for volatility in reported financial results due to currency fluctuations.

Other risks we see include the potential for customer losses, increased regulation, and the potential for a negative impact from changes in interchange fees charged by card associations.