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Fundamental Focus: A Look Inside FDC

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The devil is in the details.

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I wrote a more structured piece on First Data Corp (FDC) in Financial Times several months ago; here are just follow up thoughts on FDC and its second quarter performance.

  • Merchant services performance was impacted by one time items and tough comparisons with last year. Last year FDC got out of the adult business - stopped processing transactions for porn sites.

  • Lost contract of payment processing with Intuit (INTU) - it will start processing its own transactions.

  • Last year the company sold iPayments portfolio resulting in $100m gain.

  • Last year FDC took a $48 million gain in its bond portfolio which accounted for all of its income in the quarter. As interest rates edge higher its large bond portfolio is likely to produce more losses. All these items shaved a couple of percentage points off merchant services growth.

  • Telecheck - as check usage continues to decline this business will decline as well, however, to FDC's credit, they have managed this business accordingly as the margins increased, and profits actually went up in the quarter despite decline in revenues.

  • Discovery Credit Card - if Morgan Stanley (MWD) decides to spin off its Discover card unit, FDC would like to partner with a bank where they would operate (own) the network and the bank would own the receivables.

  • Vigo acquisition - a very interesting acquisition. Vigo is a money transfer business, competing with Western Union. However, its focus has been on ethnic groups, mostly outbound (from US) money transfers. It has 3,500 locations in US, in the areas with high concentration of ethnic minorities. Outside of US it has 45,000 locations. FDC's game plan is to keep the Vigo brand and to grow it, expanding further into Latin America, Africa etc... FDC should be able to raise margins in that business as it plans to integrate Vigo transaction processing on Western Union's platform (network).

  • The Expanded Access to Financial Services Act - will allow non-credit union members to send and receive money at credit union locations. Though on the surface it appears to be a negative for Western Union, it may turn into a positive. If (a big IF) Western Union is able to sign up credit unions as Western Union agents. If Western Union fails to sign up credit unions, the downside to its business is still very small as a very large portion of transfers are outbound to the United States. Also, FDC is a global company and it has a very large presence outside of United States.

  • Card Services business - it faced tough times recently due to the Chase / Bank One merger as Chase will be doing its own card issuing. Consolidation in the banking sector definitely adds uncertainty to this segment. In the long run this not a positive development for the segment as consolidated entities will have more bargaining power. And as happened with Chase/Bank One they may decide to issue credit cards in-house. On the brighter side, retail cards are getting more popular, though it is a lower margin business, this business should be growing nicely in the long run. This business is managed mainly for cash flows and requires minimal capex.

  • Western Union's market share - according to Western Union's (not unbiased) analysis, its market share has grown 2% over the last two years, from 14-16%. It definitely has competetive advantages (see FT article) in place to grow market share further.

  • Food for thought, MoneyGram positioned itself as a lower price alternative to Western Union, but it doesn't have the low cost structure to compete against Western Union. (Western Union's operating margin of 34% is almost double that of MoneyGram's 19.2%. Its ROA lags Western Union's by a large margin as well.) Interestingly, this business is extremely price sensitive, if Western Union decides to compete with MoneyGram on price (lower prices) it will likely crash it as its volumes will increase substantially.

  • Long term expectations for segment growth:
    · Western Union - 12-15% - mostly driven by network growth and same stores sales producing nice gains.
    · Merchant Services - 8-10% - credit / debit card growth should be a nice tail wind in this segment. As telecheck's revenues shrink it will become a lesser negative to the top line growth.
    · Card business - 0-5% - growth will depend on future mergers in the banking industry as it may create a sizable headwind.

Performance in the second quarter was unexciting to say the least, but if adjusted for tough comparisons and one-time items it was acceptable. It appears that long-term fundamentals are still intact. Also, it is reasonable for any business to suffer short-term setbacks and public companies are not an exception. Second half of the year should be a lot better for FDC as one time items will phase off and business kicks in into a higher gear.

Position in FDC.

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