An Interesting Screen-Deteriorating Operating Margins and Increasing Capital Intensity

As one would expect, deterioration in operating margins will occur in economic slowdowns. Marginal competitors frequently will try to clear inventories at ever lower margins in order to generate cash flow. I am particularly interested concerned if a company exhibits not only operating profitability deterioration but also a build up in working capital intensity (i.e. accounts receivable and inventories may be building and cash is not coming in as quickly as one would like.) Finally, if at the same time, the company is building capital expenditures, free cash flow generation can be impeded.

In this screen, I am taking trailing four quarter observations and comparing these to trailing four quarter observations lagged back one year prior. I have confined my screen to non-financial stocks in the S&P 1500.

There is no attempt to scale the amount of deterioration. For example, in 3M, a company which I continue to like, the operating margin has decreased from 22.57% to 22.53%, hardly alarming. Operating working capital to revenue has increased to 14.1% from 10.35% which still represents significant improvement from working capital levels which hit 20%+ levels of two years ago. Similarly, capex at 3M as it undertakes its international expansion is at 7.52% of revenues versus 6.94% four quarters prior, again, not an alarming pace. Bottom-line, this is a screen which is designed to raise some questions and further analysis, not to prompt an instant sell or a short.

The data is from Cash Flow Analytics, a company founded by Professor Chuck Mulford of Georgia Tech.

Finally, the ultimate test of investment is a test of market price versus intrinsic value, clearly a judgment that each investor should make for him or herself.

You will find the screen in this link: http://tinyurl.com/3oayag

Disclaimer: I, my family, or clients have a current position in 3M

Recurring Revenues and Financial Services- The Competitive Moat of Fiserv

In our last post, we discussed the notion of recurring revenues as it pertains to companies in the industrial sector. The genesis of this idea was a reaction to the prevailing wisdom of many investment strategists to find recurring revenue streams in consumer staple or health care stocks. It is my contention that there are recurring revenue themes across many sectors that remain unrecognized in the marketplace.

As a brief aside, I will mention that our posture on MSC Industrial Direct (MSM) has received some nice support from Mr. Market since our post. Today's earnings release and conference call continue to support our thesis.

Though financial services revenues from a 30,000 foot perspective seem to be one of the last sectors one would consider to have recurring revenues, particularly in light of recent experience, there are some companies whose competitive advantages provide some assurance that business remains relatively stable despite the vagaries of the economy. Switching costs are a major advantage for many companies in this sector. Even small community banks can have a reasonably sacrosanct deposit base and provided that their lending operations remain conservative and sound, they can fit a recurring revenue theme. We think some insurance companies also fit this theme especially when their business is specialized or niche in nature.

Today's post is written by my colleague and friend, John Moran. John joined us as a portfolio manager in January. As a fellow CFA, he brings considerable analytical skill to our firm. Previously with Cohen & Company, he was a portfolio manager and senior research analyst focused on financial services in an alternative asset platform. Between 2001 and 2006, he was employed by Ryan Beck and a predecessor firm (Gruntal & Co.) as an equity analyst in various sectors including financial institutions, consumer products, and healthcare.Before entering the investment industry, John worked for Lucent Technologies in real estate finance and at Chubb Corporation, a leading property and casualty insurance company, where he held various accounting and finance positions.

Here are John's thoughts regarding Fiserv (FISV), in our opinion, a strong moat company in financial services.

Intro.

Fiserv trades at 12.5x 2009 cash earnings and 8x EV/2009 EBITDA. This is a small price to pay for a business that should grow earnings in excess of 15% per year with several sustainable competitive advantages leading to a highly recurring revenue stream. Down nearly 15% since credit issues began to take a toll on its core customers in the financial industry, market price reflects a discount of 30% to the value of the business.

Business Description.

Fiserv Inc. (FISV) is a leading provider of IT services to U.S. banks, thrifts, and credit unions. The company also provides administrative support services and processing to the insurance industry. The business was repositioned late last year through the sale of selected nonbanking businesses and the $4.4 billion acquisition of CheckFree, the market leader in electronic billing and payment (EBP) market. Just over 80% of Fiserv’s 2008 sales will come from its main business of core processing and related products for financial institutions and CheckFree. The balance will be derived from the company’s insurance service segment, which provides policy, rating, and claims administration as well as billing and reinsurance services.

Core Processing.

Core processing is the nuts-and-bolts infrastructure that allows checks to be posted, payments to be tracked and processed, and accounts to be managed. The company’s products and services form the backbone of its client’s back-office systems and are critical to conducting business – they are not discretionary in nature. Moreover, changing core processing systems is costly and time consuming in implementation and employee training for customers. System changes also increase the risk of potential interruptions and service issues. Clients are therefore unlikely to leave due to a modestly cheaper or slightly superior product – once a contract has been added, the client relationship tends to be fairly sticky and pricing is reasonably inelastic. Longer-term contracts with early termination fees are the norm and renewal rates consistently run 90+%, leading to a revenue stream that is highly recurring and reasonably predictable.

The high switching costs for core processing, arguably the company’s best sustainable competitive advantage, is a double edged sword since the company’s competitors also benefit from installed bases. As such, Fiserv’s biggest challenge in this segment is generating organic sales growth. The company controls 34% of the core processing market, more than 2.5x its nearest competitor. Cost advantages from this scale position combined with a diverse and tightly integrated product set positions Fiserv better than many of its competitors to win new business. This is evidenced from the company’s 40% win rate on new core processing deals – exactly 2.5x greater than its nearest competitor according to the 2007 Automation in Banking report. Organic revenue growth has averaged just over 5% over the last five years and the business has generated operating margins near or above 20% on a consistent basis.

Consolidation among core processing companies has led to a concentration of larger players and several smaller competitors that are increasingly disadvantaged due to limited product sets and scale. The market is dominated by six major competitors with a combined 75% share down from 24 major companies in 1987 and 55% of the market is now controlled by the top three companies. While there are few compelling or willing acquisition candidates remaining, there are still some 15 independent processing companies with a little less than 25% market share – some are owned by their customers and some are small segments of larger companies. As industry dynamics continue to shift toward an oligopolistic structure, it seems highly likely that smaller competitors will either exit the business or lose clients to larger competitors due to service, product capabilities/breadth, pricing, or some combination thereof. Moreover, consolidating competition has intensified barriers to entry and should lead to higher marginal returns on incremental business for the companies that remain.

Electronic Billing and Payment (EBP)

Fiserv repositioned its business late last year and early this year by selling certain nonbanking businesses and acquiring CheckFree for $4.4 billion. The strategic rationale for moving away from businesses where the company lacks scale in nonbanking businesses (Fiserv Health, Investment Support, and two mortgage/lending services related businesses) and moving more aggressively into higher growth businesses where it does is compelling. The acquisition also reinforces Fiserv’s position as the leading provider of technology solutions for financial institutions and proceeds from the sales of other segments will be used to pay down debt.

CheckFree is the market leading electronic bill payment and Internet banking service provider and one of only three scale providers in a growing industry. The company was an early mover in the EBP market and has a 27% market share – more than 3.5x the share of its nearest competitor. Like the company’s competitive advantages in processing, CheckFree benefits from high switching costs and has a marked cost advantage due to scale economies of the EBP business. Also like FISV’s core processing business, more than 90% of revenues are recurring in nature.

Historically, Fiserv’s clients tended to be small and mid sized institutions that had limited internal technology groups and contracted for a fairly wide range of its services. While it maintained client relationships with larger institutions, the top 25 banks tended to buy only a handful of Fiserv’s services. With CheckFree, the company has increased exposure to larger bank clients and, as the CheckFree products are fully integrated with its existing offerings, FISV might have the opportunity to sell a broader range of existing services to larger institutions. These upstream sales opportunities are likely somewhat limited – besides which, incremental sales to top 25 banks would likely come with pricing concessions and increased customer concentration risk (pro forma for CheckFree, we estimate that Bank of America is the largest customer at somewhat under 5.5% of combined revenues). However, the company appears to have a tremendous opportunity to increase penetration of CheckFree’s bill payment and internet banking solutions within Fiserv’s core client base, where 52% of customers have yet to install an EBP solution and 25% use a competitive product.

Also, CheckFree has a reasonably long runway in the bill payment and internet banking space. Consider the following:

- Just over half of the 70 million U.S. households with access to internet banking are actually using it; customers appear to be fairly early in the adoption cycle.
- Of those 36 million households that use internet banking, only 13.4 million households (or just under 40%) currently pay bills online, suggesting that online bill payment is even earlier in the adoption cycle.
- The vast majority of those that have adopted online bill payment are served by the top 25 banks.
- CheckFree has historically grown revenue at 16% compound annual rate with high teen operating margins and 30% EBITDA margins.

Insurance.

The company’s insurance segment focuses on transaction processing and administrations services for the life, property and casualty, and workers’ compensation segments of the insurance industry. It is the largest third party administrator of flood insurance policies and claims in the U.S. and a leader in workers’ comp processing. Outside the flood insurance platform, the company’s competitive advantage in these businesses is somewhat limited as compared to the core processing and CheckFree businesses and competition is more intense. Organic revenue growth in the insurance segments had averaged well more than 5% with operating margins low teen operating margins until the last few years, when internal growth was 0% to slightly negative and operating margins for the business collapsed to a bit under 8%. The segment has faced headwinds as higher margin flood claims processing revenue decreased and lower margin workers’ compensation businesses increased. The 2007/2006 decline in flood claims processing revenues created comparability issues that should not be a factor this year.

Financials.

Full-year 2008 internal revenue growth is expected to be 5% to 7%, with the financial segment at the upper end of the range and the insurance segment at the lower end of the range. This is possibly conservative given that 25% of the financial segment will now be comprised of revenue from the faster growing CheckFree business. Moreover, downstream revenue synergies that could begin materializing in the back half of this year could increase the revenue growth rate.

Fiserv has completed nearly150 transactions since its inception in the mid 1980’s, with acquired companies historically operating their businesses more or less independently. CEO Jeff Yabuki, now entering his third year at the company, has focused more on centralization, cross selling, and operational efficiency. Last year that focus yielded $50 million in incremental operating income or about 130 bps of operating margin ($30 million from integrated sales and $20 million in operational efficiencies). The company has more opportunities in this area and potential cost saves from the CheckFree acquisition should accelerate operating margin improvement – management guides to savings of $100 million, about 24% of CheckFree’s existing cost structure, which strikes us as achievable by the middle of 2009. Moreover, the company will not be up against difficult comparisons in the insurance segment this year. All things considered, the 75 basis points in operating margin improvement that management is currently guiding to for this year appears reasonably easy to achieve and the company should be generating operating margins of about 20% by 2009.

Over the next two years, the company will generate in excess of $1.1b in free cash flow, with the majority being used to pay down debt. By the end of 2008, EBITDA should be at a run rate of $1.5+ billion and the earnings run rate should be in excess of $4/share. Returns on invested capital will be depressed for the next few years due to the increased debt taken on in conjunction with the CheckFree acquisition, but should ultimately revert back to historic low/mid teen levels, well in excess of the company’s cost of capital. Financial technology and outsourced processing businesses with sustainable competitive advantages have traded for between 9.5x-12x EBITDA (on an enterprise value basis) and between 15x-20x earnings – seemingly reasonable for FISV given the competitive landscape. On either basis, the current market price looks like it provides a comfortable discount to underlying value of a high quality business.

Disclaimer: I, my family, or clients have a current position in FISV and MSM.