Raymond James Equity Research – Transaction Processing: 2Q11 Review

Fourteen out of the sixteen transaction processing companies we cover beat consensus revenue and EPS projections in 2Q11 and most provided favorable outlooks, which leads us to believe that there may be upside to this year’s estimates. Sector earnings should average 10-15% annual growth as companies leverage a more favorable business environment, generate higher revenues, and execute share buybacks. However, the trend of higher operating expenses, which began in 2H10, continued as companies reinvested in product and services growth after an extended period of cost containment during the recession. Consequently, we think group margin expansion may be muted in the near term because of higher personnel, marketing, R&D, and G&A costs.

The financial metrics of the transaction processing sector are attractive. These include clean balance sheets (cash heavy, debt light), low capital expenditures, strong free cash flow, 80+% recurring revenue, 6-10% organic top-line growth, and EPS growth of 10-15% on 20% operating margin. These outsource service companies operate leverageable business models that expand profitability from processing incremental transaction volume over a fixed-cost infrastructure. The transaction processing industry benefits from a number of defensive growth characteristics, such as targeting large market opportunities with low overall service penetration.

The two biggest topics of discussion in the transaction processing space this quarter were 1) high profile security breaches and 2) the final ruling on the Durbin debit card interchange legislation. In this publication, we provide readers with an overview of payment card fraud and liability as well as some of the measures taken to combat it.

One of the most closely followed storylines in our space came to a head on June 29, when the Federal Reserve introduced a final ruling on PIN (personal identification number) and signature debit card interchange fees that was more favorable to, and less onerous for, the card associations (Visa and MasterCard). The interchange fees will be capped at $0.21 (up to $0.22 including charges for fraud), plus an additional ad valorem 0.05% (5 basis point) fee for fraud losses, about double the Fed’s initial recommendation of $0.12 in December. The updated and final ruling accounted for certain fixed costs necessary to process debit card transactions, which were previously excluded. Under the new ruling, signature debit fees would be down 61% from historical levels of $0.56 and PIN debit fees would be down only 4% from $0.23. The legislation is required to be implemented by October 1, 2011.

The Federal Reserve also determined that debit cards will now require at least two different networks on each card, one unique PIN brand and one unique signature brand, not two different PIN and two different signature networks as was previously considered. The rules are effective October 1, 2011, with card issuers given an extended phase-in deadline of April 1, 2012, to issue/replace newly compliant cards.

We think recent high-profile security breaches, including the compromise of credit card data on Sony’s network and a debit card breach at Michaels Stores, may have affected how banks will be compensated for fraud prevention and protection when the Federal Reserve came to its final decision on the Durbin interchange legislation. Also, Visa’s recently announced domestic initiatives to accelerate Europay, MasterCard and Visa (EMV) and Near Field Communications (NFC) enabled payment adoption shows a continued focus on payment card security in the wake of a number of very public security breaches.

In the core bank processing and application services segment (within the transaction processing universe), we project range-bound revenue growth of low to mid single digits this year and next. Though some companies are indicating a better bank IT spending environment, we still believe annual software purchases and professional service contracts may be delayed by banks, but the demand for outsourced services has remained fairly steady.