Global Payments Still Feeling An Uncomfortable Squeeze

By Stephen D. Simpson, CFA | April 03, 2013 AAA

Life still isn't easy in the narrow space between merchants and banks. Regulators have taken a much sharper pen to the fees that many players along the way can charge and earn, rivals continue to bludgeon each other for market share, and new entrants like Square threaten to upset the entire apple cart. That's led to less-than-spectacular performance from merchant acquirer and processor Global Payments (NYSE:GPN), as well as long-term concerns about the sustainability of what had previously been a pretty high-margin/high-return business model.

Challenges Aplenty In Fiscal Q2
Global Payments certainly absorbed more margin pressure this quarter, and would have missed expectations by an even wider margin (about four cents) without a favorable tax rate.

Revenue rose more than 8% as reported, more or less on target with the average estimate. Revenue in the U.S. was up 11%, while Europe was surprisingly strong and up 13%. Canada remains weak though, and revenue declined another 6%. Revenue from Asia-Pacific picked up 2% and still represents less than 10% of company revenue. I do believe it's also worth noting that revenue was down about 2% sequentially, and down sequentially in every market except Asia.

Margin pressure has been a key issue for the company as spreads, transaction volume, and security remediation costs have all done their damage. For this quarter, cash operating income (a non-GAAP metric) was up only 1% and fell about 9% on a sequential basis, leading to a 140bp fall in margin to 18.3%.

Will Easing Pressures In Canada Be Overrun By New Challenges In The U.S. And U.K.?
Global Payments continues to groan under the pressure of spread compression in Canada, though the magnitude of the pressure did abate a little. At the same time, though, the weaker transaction volume growth (up 2% versus 4% in the prior quarter) could mitigate some of the benefits as the company gets to a point where the spread compression becomes “like for like” on the annual comparisons.

At the same time, U.S. volume seems to have lightened a bit. Now, we'll have to see how rivals like Heartland Payment (NYSE:HPY), Vantiv (NYSE:VNTV), and U.S. Bancorp (NYSE:USB) fare, but I'm still a little nervous that this sector is vulnerable to further share loss to rivals like Square and Intuit (Nasdaq:INTU), particularly those companies like Global Payments that focus on smaller merchants.

Global Payments may also have something to fear in the new agreement between Visa (NYSE:V) and JPMorgan Chase (NYSE:JPM) that will effectively allow Chase to develop direct relationships with merchants and negotiate directly on price. At a minimum, I would think it would increase the pressure on companies like Global Payments, Heartland, and Vantiv to get more creative about merchant loyal programs.

Last and by no means least is the risk of increased regulatory scrutiny and new rules in the U.K. The ultimate impact of these rules could be to increase price competition (and shrink spreads), but Global Payments management seems to believe that companies like Visa and MasterCard (NYSE:MA) will see most of the brunt.

The Bottom Line
I'm still broadly optimistic about Global Payments' future. While it's true that the North American markets have changed in pretty fundamental ways, I believe there are still meaningful profit and growth opportunities. Likewise, I like this company's international exposure and the opportunity to grow in emerging markets like China as card payments become even more commonplace. Still, don't sleep on the risk presented by companies like Square and other non-traditional electronic payment options.

I've lowered my long-term profitability estimate a bit and shifted it some as well. While I believe Global Payments could still generate mid-to-high single-digit revenue growth and mid-teen free cash flow margins, I have to acknowledge that the payments world is changing and there's probably more risk to these numbers as a result. In any case, I still believe Global Payments can support a $60 fair value. The recent underperformance (and growing worries about spreads and long-term sustainability) will probably keep this stock in the “show me” penalty box for a time, but risk-tolerant investors looking for increasingly scarce bargains may find something to like here.

At the time of writing, Stephen Simpson owned shares of JPMorgan.

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