Download Processing`s Domino Effect

Processing’s Domino Effect
By Jim Daly
Wall Street has discovered consumer electronic payment
transactions, and now, with one deal after another, the
business may never be the same.
Until recently, the electronic payment-processing business was barely known beyond a tight circle of bankers and
processor executives, retailers, techies, and sales guys peddling card acceptance to small merchants. Add in a handful of
analysts and professors who got an intellectual thrill pondering how a process that involves a clerk punching sales
transactions into machines that extract information from a credit card’s magnetic stripe and send it around the country (or
world) could actually have value.
But after a rash of headlines and televised reports over the past three months arising from several multibilliondollar buyout deals, payment processors have emerged from obscurity to become the rage of Wall Street. Privateequity firms awash with money to invest from pension funds, other institutional investors, and banks are taking over
publicly held industry stalwarts such as First Data Corp. and Alliance Data Systems Corp. And more deals are on the
way (chart, page 26).
But private equity, whose boom of recent years extends to nearly every corner of the economy, is only one part of
a sweeping financial transformation of the payments business. A watershed event was MasterCard Inc.’s initial public
stock offering in May 2006. The IPO gave public investors rather than financial institutions, which founded
MasterCard back in the 1960s, majority control of the No. 2 payment network. Since then, MasterCard’s stock has
more than tripled in value and a whole new constituency realizes there’s money to be made by moving electronic
money.
“The economics of this business are much more attractive than people used to think,” says Steve Mott, a former
MasterCard executive who now heads the Stamford, Conn.-based consulting firm BetterBuyDesign.
Cash Flow Is King
While First Data and others are going private, Discover Financial Services LLC, the poor relation of Morgan
Stanley’s investment-banking family (box, page 28), and Metavante Corp., a fast-growing processor owned by
Milwaukee bank-holding company Marshall & Ilsley Corp., are joining MasterCard and going public.
And waiting in the wings for an IPO is the biggest payment network of all, Visa, which plans to consolidate
several of its disparate regions and hand off control from its current financial-institution owners to public
shareholders.
The financial forces that already have toppled some big industry dominoes may prevail for some time yet as some
newly private companies, especially First Data, sell off subsidiaries to sharpen their focus or pay down debt.
Conversely, many observers expect newly public companies with strong balance sheets or stock prices—think
Metavante and MasterCard—to go shopping for companies that enhance their businesses.
Meanwhile, banks that control large processors, most notably Synovus Financial Corp., which owns 81% of Total
System Services Inc. (TSYS), might face irresistible pressure to divest. “There’s really no reason for a bank to own a
processor,” says Brett Horn, an equity analyst at Chicago-based Morningstar Inc, an independent financial research
firm. “The two businesses are fundamentally different.”
Large, publicly held merchant processors such as Global Payments Inc. and Heartland Payment Systems Inc.
could find themselves on tightropes, preferring to stay public but obliged to get the best returns for their shareholders
even if it means going private (chart, page 30). Robert O. Carr, executive chairman and chief executive officer of
Princeton, N.J.-based Heartland, is quite familiar with the tire-kickers.
“We’ve been continually approached for a long time,” Carr says. “I would be insulted if we weren’t approached.”
He quickly adds, however, “we’ve never had an offer yet that we couldn’t resist.”
Paul R. Garcia, chairman, president, and chief executive of Atlanta-based Global Payments, is amazed at the
amount of private-equity money transforming not only the payments industry, but also many others. Indeed, so-called
leveraged buyouts are setting records of late.
Some 32 public-to-private transactions valued at $96.8 billion were announced in the first quarter, reports FTI
Consulting Inc., citing data from FactSet Mergerstat LLC. “It’s getting to the point where these private-equity funds
are like a hermaphrodite worm that can mate with itself—they’ll be self-sustaining,” Garcia quips.
Still, while the trend among some processors is to go public while among others it is to seek private ownership,
there may be a unifying logic in all of these deals. Investors are discovering processing’s solid financial fundamentals,
including strong cash flow and recurring revenues.
For example, according to a recent report from Chicago-based Barrington Research, more than 80% of the
revenue is recurring at Jacksonville, Fla.-based processor Fidelity National Information Services Inc., which bought
check and card processor Certegy Inc. last year. And most of that revenue comes from three- to 10-year contracts.
Morningstar’s Horn summarizes the processors’ inherent strengths as “strong, stable cash flow, and there’s not a
whole lot of capital reinvestment. You have a pretty solid base of free cash flow to service the debt.”
Just as important, most executives and analysts say processors and networks still have big growth potential as
credit, debit, and prepaid cards as well as niche payments products steadily gain market share at the expense of cash
and paper checks. “These are high-growth businesses,” says Robert B. Hedges Jr., managing director of Mercatus
LLC, a Boston-based advisor to private-equity firms.
On the Block
For Visa and MasterCard, the 40-plus-year-old association structure with financial-institution ownership is headed for
the history books as new technology, competition from nimbler processors, and the emergence of gigantic banks such
as Citigroup Inc., JPMorgan Chase & Co., and Bank of America Corp. force the networks to think in new ways—and
to make more money. “You need to convert them to public [ownership] to get them on a P&L basis to unlock the
value,” says consultant Mott.
Unlocking the value in some publicly held processors, however, may require going private to make necessary
investments that result in short- or medium-term hits to earnings public shareholders wouldn’t tolerate. “You don’t
want to hold [processors] hostage to the industry structure over the past three decades,” Mott says. “That structure is
essentially siloized, bank-based, single-network payment products where one size fits all.”
According to Hedges, some publicly held processors have expanded horizontally—buying a loyalty provider here,
an ATM switch there, perhaps a bill-payment provider or risk-assessment software developer—to such a degree that
they’ve lost their nimbleness. “From a capital-markets, private-equity perspective, there’s an inefficiency in this sort
of payment conglomerate space,” he says. “You’re in lots of businesses, but you don’t have the scale to be the best in
each one.”
That inefficiency is reflected in stock prices. The ultimate example of a processor that may have become too big
for its britches is Greenwood Village, Colo.-based First Data. “The First Data stock price has languished literally for
years,” says consultant Kurt Strawhecker, managing director of Omaha, Neb.-based The Strawhecker Group and a
former First Data executive. “Charlie Fote [First Data’s chief executive who left in late 2005] may have lost his spot
because of that.”
First Data spun off its biggest division, wire-transfer leader The Western Union Co., last year, but this year it will
still generate nearly $8 billion in revenues from its merchant, cardholder, check, and international processing
businesses. In the first quarter alone, First Data reported $232 million in free cash flow.
First Data said it agreed to the $29 billion cash buyout by New York-based private-equity firm Kohlberg Kravis
Roberts & Co.—one of the largest leveraged buyouts ever—to boost shareholder value. The $34-per-share price
represents a 26% premium over First Data’s share price the last trading day before the deal was announced April 2.
After the transaction’s expected close later this year, most observers predict KKR will put at least some First Data
assets on the block. (KKR did not return calls from Digital Transactions.)
High-growth entities in First Data’s vast empire include debit card services and the Star electronic funds transfer
network; merchant processing, including a 49% stake in the hugely profitable merchant acquirer Chase Paymentech
Solutions LLC (JPMorgan Chase holds 51%); and the international division.
But the cardholder-processing unit, Financial Institution Services, is suffering from defections by large banks and
slow growth in its core bank credit card processing businesses. And to rein in expenses, First Data already has
embarked on a $225 million effort to consolidate its 12 U.S. processing centers into three.
Proxy Fight
The Alliance Data buyout of $81.75 per share in cash by Blackstone Capital Partners V L.P. gives shareholders an
even better premium, 30%, based on the stock’s price the day before the deal’s May 17 announcement. In addition to
rewarding the shareholders, “our clients will now have the added benefit of working with an organization that is
completely focused on their success,” said J. Michael Parks, chief executive at Alliance Data, in a statement. “And
our teaming with Blackstone, which has a demonstrated track record of investing in and growing the firms it acquires,
will benefit our clients now and in the future.”
Dallas-based Alliance Data was formed in 1996 on a foundation of J.C. Penney & Co.’s BSI Business Services
Inc.’s transaction-processing operation and The Limited Brands Inc.’s retail card portfolio. The company, which
specializes in private-label processing for specialty retailers and also operates Canada’s largest coalition marketing
program, Airmiles, generated $347.3 million in operating income last year on nearly $2 billion in revenue. Alliance
serves some 600 clients; its store card operation serves 107 million cardholders through 85 retailers.
New York-based Blackstone, which has raised $32 billion through five funds over the past 20 years, has invested
in a wide array of companies, among them Deutsche Telekom and Freescale Semiconductor.
Scottsdale, Ariz.-based eFunds Corp., meanwhile, is saying little about the review of “strategic options” it
disclosed May 9. The alternatives publicly held eFunds is considering include remaining independent, going private,
or merging with another company, according to chairman and chief executive Paul F. Walsh. In a brief investor
conference call at which he did not take questions, Walsh said eFunds had been approached before during his five
years at the helm to explore possible “business combinations,” but wanted to remain independent as it focused on its
growth plans.
“Today, though, we cannot ignore the fact that our industry is undergoing great changes, as evidenced by the First
Data and Metavante announcements,” Walsh said. He also cited continuing consolidation among banks—payment
processors’ core customers. Change in the financial-services industry “is inevitable and will accelerate,” he said.
EFunds traces its origins to Deluxe Data Systems, a debit card processor and check-services provider owned by
check printer Deluxe Corp. that became independent in 2000. Under Walsh, the company has shed slow-growing
ATM businesses, expanded internationally, added transaction-security services, and entered the fast-growing prepaid
card market with its acquisition of WildCard Systems Inc.
EFunds reported first-quarter earnings of $11 million, flat with the year-ago quarter, on revenues of $134 million,
down 4% from $140 million in 2006’s first quarter. The review announcement, however, produced a 12% boost in
eFunds’ share price.
One of the most recent private-equity deals is the proposed $5.3 billion buyout of Ceridian Corp. by Boston-based
Thomas H. Lee Partners L.P. in concert with insurance processor Fidelity National Financial Inc. of Jacksonville, Fla.
Bloomington, Minn.-based Ceridian’s main business is payroll processing and related human-resources services, but
its Comdata Corp. fleet card, prepaid card, and payment-processing subsidiary is more profitable. The buyout
announcement made no mention of breaking up Ceridian, but management already was facing a proxy fight with a
hedge-fund investor agitating for change.
Deadly Debt?
The high profile of private equity in payment processing is inevitably drawing fire. Some blogs and newspaper reports
assessing the First Data buyout have dwelt on the possible job losses and the unsavory reputations buyout firms
gained in the leveraged-buyout craze of the late 1980s.
In Omaha, where First Data has more than 5,000 employees, the Omaha World-Herald started its April 3 story
about the First Data-KKR deal with, “Thirty years ago they were called corporate raiders or, in the best-known book
on the subject, barbarians. Today they are called private-equity firms, and one of the biggest, Kohlberg Kravis
Roberts, Monday offered $29 billion for Omaha-founded First Data …” (KKR was immortalized in the book
“Barbarians at the Gate,” an account of the 1988 leveraged buyout of RJR Nabisco.)
Indeed, to many observers the arrival of a private-equity firm means little equity for the target company but a
whole lot of debt piled on through that notorious tool, the leveraged buyout. And a close look at recent Securities and
Exchange Commission filings from First Data and Metavante parent Marshall & Ilsley does show debt plays an
important role in their ownership changes.
“It’s definitely going to be more debt than they are carrying on their books at this time,” says Barrington Research
vice president Gary Prestopino. “One can assume they’ll be more highly leveraged.”
While KKR and a host of investment banks will pony up $7.17 billion in equity, First Data’s buyout involves $24
billion in debt financing, including up to $8 billion in high-yield senior unsecured notes and senior subordinated
notes—junk bonds.
At Metavante, the planned $4.25 billion “sponsored spin,” in which M&I shareholders would own 75% of the
independent company and private-equity firm Warburg Pincus LLC would own 25%, would provide M&I with $1.67
billion in new capital, but it also would put $1.75 billion of debt on Metavante’s books.
But several analysts and executives say processors are better equipped than many companies to handle debt
without literally mortgaging their futures. “It’s not inherently a problem,” says Mercatus’s Hedges. “It’s a responsible
financial-structure move if the cash flow is strong. The good news in the payment business is the cash flow is strong
because there is annuity-like revenue streams.” He adds the high debt loads in LBOs enable private-equity firms to
post high returns on their invested equity.
Randall J. Erickson, M&I’s chief administrative officer and general counsel, says liabilities at Metavante are
“certainly moving up, but at a prudent level.” He notes that the spinoff would leave both M&I and Metavante well
capitalized and better able to grow their respective businesses.
Metavante’s recent growth—17 acquisitions totaling $1.6 billion since 2003—has strained M&I, which as a
regulated bank-holding company must meet minimum capital levels while it also tries to expand its banking business.
“With two businesses growing, we think it’s better to split up,” says Erickson.
Analysts speculate about a TSYS spinoff from Synovus for the same reasons. Synovus did not respond to a
Digital Transactions query.
On Edge
One merchant-processing executive who speaks highly of his experiences with private-equity firms is Andrew Rueff,
senior vice president of corporate development at Dallas-based TransFirst Holdings Inc. TransFirst was sold for $683
million this spring by one private-equity firm, GTCR Golder Rauner LLC, to a larger one, Welsh, Carson, Anderson,
& Stowe—the firm that created Alliance Data.
Rueff says GTCR got a good return on its investment (he refuses to disclose it). Perhaps more important, the
acquisitive TransFirst will now have access to a bigger pool of capital for growth. Under Welsh Carson, “we will be
looking at acquisitions in the future, a little bigger than in the past,” says Rueff.
When will all the restructuring end? Garcia of Global Payments says there’s nothing fundamentally different
about the processing business now compared with five years ago. “What’s changed is the massive amount of privateequity money,” he says.
Garcia predicts that this money flow, or “private-equity bubble,” will come to an end when “somebody
overextends.” In the meantime, Garcia, like Heartland’s Carr, is doing his best to keep his company’s stock strong
enough to ward off unwanted suitors. “I can categorically say that Global Payments is not for sale,” he says, though
he acknowledges his fiduciary responsibility to present a takeover offer to shareholders.
Public shareholders, however, often can’t resist a good premium despite uncertain prospects for a company postLBO. And that,
despite the advantages of private ownership in some circumstances, is leaving many processing
executives
on
edge.
Changes Ahead?
Processor
Current Owner
Total System Services Inc. (TSYS)
(81%)
Possible Future Owners
Background
Synovus Financial Corp. Synovus shareholders,
private-equity firm, or an
outside company.
gets big enough to stand
alone.
Global Payments Inc.
but not
Public shareholders Private-equity firm,
Heartland Payment Systems Inc.
Profitable and growing,
large competitor.
for sale.
Public shareholders
large competitor.
Private-equity firm,
Source: Company reports, Digital Transactions
Feelin’ Free at Discover
Like a 21-year-old finally allowed to drink legally, Discover Financial Services LLC at last is on its own. The No.
4 payment network’s New York City-based parent company, investment-bank powerhouse Morgan Stanley, was set
to spin Discover off to its shareholders June 30.
Retailer Sears, Roebuck and Co. developed Discover as part of its financial network in the 1980s, taking Discover
national in 1986. But Sears’s dream of offering everything from Dean Witter brokerage services, Allstate insurance,
Coldwell Banker real-estate services and Discover general-purpose credit cards didn’t quite work out as the company
struggled to maintain its core retailing business against the rising, big-box discount stores. Sears spun off the
brokerage and card businesses as Dean Witter, Discover & Co. in 1993.
Morgan Stanley, meanwhile, thought it might be good to add a retail component to its tony investment-banking
services and bought Dean Witter, Discover in 1997. Though Morgan Stanley always presented Discover as ballast
countering the waves that swept down Wall Street, most observers saw Discover as an odd fit in the company from
the beginning. John J. Mack, Morgan Stanley’s chairman and chief executive, finally reached that conclusion too,
though he said so in a polite way.
“We believe the spinoff of Discover will enhance value for the shareholders of Morgan Stanley, and position both
companies for continued success,” he said in a June 1 statement announcing the spinoff. As a well-capitalized
company with an independent board of directors, Discover will be able to build on its strong brand and significant
scale to execute its growth strategy. At the same time, we believe the spinoff of Discover will position Morgan
Stanley to continue accelerating our growth and building on the positive momentum we have achieved across our
securities businesses.”
Discover chief executive David Nelms piped in that “Discover will be even better positioned to create long-term
value as a standalone company. We have a clear strategy to increase profitability by continuing to grow our cardissuing business and realizing the substantial opportunities in the fast-growing payments business. We believe we are
well-positioned to build on the success we have achieved as part of Morgan Stanley.”
Long differentiated by its cash rebate, Riverwoods, Ill.-based Discover nonetheless has had difficulty getting even
a 10% share of the U.S. market dominated by Visa, MasterCard, and American Express. In recent years, Discover has
launched a number of new credit cards, moved into debit cards with its acquisition of the Pulse EFT network, struck
deals with bank card merchant acquirers to sign Visa and MasterCard merchants to its network, and expanded
internationally.
The next chapter of its life will tell whether being independent rather than part of a larger company will help move
the needle its way.