Global Payments Looks Too Cheap Today

By Stephen D. Simpson, CFA | January 08, 2013 AAA

Merchant processing firms such as Global Payments (NYSE:GPN) run relatively simple businesses - a customer swipes a card at a store, Global Payments sees that the money goes where it needs to between the banks, and it takes its cut. While there's ample competition to sign up (and retain) merchants and data breaches are an ever-present threat, these can be very profitable businesses with good returns on capital. In the case of Global Payments in particular, this not only looks like a profitable, growing business, but it's also one with an undemanding valuation and good global growth prospects.

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Solid Second Quarter Results
Global Payments did a good job in its fiscal second quarter of 2012. Revenue rose 11% and was modestly higher than analysts had expected. Revenue in the United States (the company's largest revenue generator) rose 16%, while revenue in Europe rose 14%. Canada was down 6%, while Asia-Pacific was up 1%.

On the margin side, the company saw some gross margin compression, but operating income rose 21% on a reported basis (and about 5% on an adjusted basis). On the reported number, operating margin improved about 160 basis points, comfortably ahead of analyst expectations. While profitably was a little less impressive in North America (operating income down 5% against 11% revenue growth), the international business did quite well (an operating margin of about 32%, with 21% growth on 11% revenue growth).

A Slightly Deeper Dive
While Heartland Payment Systems (NYSE:HPY) has been fairly aggressive with prices in the post-Durbin world, Global Payments seems to be doing fine anyway. Transactions were up 13% this quarter, suggesting that the company continues to do well with its share and business mix.

I was also a little surprised to see the strong European results continue. Apparently, results were quite strong in Russia, and even Spain saw transaction growth. On the other hand, the company mentioned weak macro conditions as the principal source of the weakness in Asia. In Canada, the company continues to see the impact of spread compression (transactions were up 4% in the quarter), but the company is close to the point where it will anniversary those changes and reported results should start looking better.

Plenty Left to Do Overseas
Global Payments is a pretty small player in the United States. While it's a more significant player in the small merchant space that it targets, its overall share is only about 4%. That's more than respectable against the likes of Wells Fargo (NYSE:WFC) (4% share), Heartland (about 2.5% share) and Total System Services (NYSE:TSS) (also about 2.5%), but I'm a little concerned about the potential for more competition from the likes of Square in the small merchant category. While Global Payments could arguably look to move up-market, that comes at the cost of smaller spreads.

I do believe, however, that there is ample overseas growth potential. Global Payments operates in a "triopoly" in the United Kingdom with WorldPay and Barclays (NYSE:BCS) and is part of a joint venture that is the largest processor in Spain. The company also has an important foothold in Russia, and I believe the company could do more deals in Europe to build the business. Asia could be an even bigger long-term opportunity. The company chose to pony up for the rest of its joint venture with HSBC Bank Canada (NYSE:HBC), and credit/bank cards are still an emerging payment option in much of Asia today.

The Bottom Line
I get a little paranoid when I see a well-known and well-followed company trading too cheaply, but that would seem to be the case for Global Payments. I believe the company can continue to grow revenue at a mid-to-high single-digit rate, and I see no reason why the company cannot generate average free cash flow margins in the mid-teens.

That said, I don't expect this to be a necessarily smooth ride. Like Heartland, Global Payments has experienced an expensive and embarrassing data security breach (though Global Payments' was smaller), and there's no guarantee that it won't happen again. What's more, this company has had a somewhat erratic history with respect to margins and free cash flow, and that adds to the risk.

I do believe the company is undervalued on the basis of free cash flow, and fair value could be in the $60 range. Accordingly, that makes it a worthwhile stock to consider at today's prices.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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