Retreat or Treat

(This article originally appeared in the The Motley Fool's Evening News on Wednesday, April 09, 1997)

FOOL ON THE HILL
An Investment Opinion by MF Templar

Retreat or a Treat?

The two-year advance in the shares of credit card and check processing companies was reversed by the recent Federal Reserve-initiated flight from financially related stocks. Bellwethers FIRST DATA CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FDC)") else Response.Write("(NYSE: FDC)") end if %> and NATIONAL DATA CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NDC)") else Response.Write("(NYSE: NDC)") end if %> are both well off of their respective three-year highs, falling at an accelerating pace since Greenspan & Co. saw fit to hike the Federal Funds rate to 5.5%, a 0.25% increase. The risk of further interest rate increases has cooled the ardor of investors for these companies, many of whom incorrectly perceive these transaction processors as potential casualties of higher interest rates.

The Street's appetite for companies in the electronic fund transaction business has diminished from its previous excess in early 1996, when these stocks were perceived as the no-brainer way to make money off of the Internet. More than a year later it has become clear that the advent of the Internet has done nothing in the near-term to accelerate the growth that these companies are enjoying, causing many investors to revisit overly generous assumptions. Now that interest rates are rising, any companies related to the interest rate business are being sharply discounted under the assumption that profit growth will become more difficult.

Although this could conceivably be true for companies that actually make the loans, the companies that merely process the transactions have absolutely no interest rate risk unless they hold some of the loans as well. Given that the only major transaction provider that also holds some of the debt is SPS TRANSACTION <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PAY)") else Response.Write("(NYSE: PAY)") end if %>, this may mean that Federal Data, National Data, FIRST USA PAYMENTECH <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PTI)") else Response.Write("(NYSE: PTI)") end if %> and BA MERCHANT SERVICES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BPI)") else Response.Write("(NYSE: BPI)") end if %> may have been unfairly discounted. Even smaller names like NOVA CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NIS)") else Response.Write("(NYSE: NIS)") end if %> and TOTAL SYSTEM SERVICES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TSS)") else Response.Write("(NYSE: TSS)") end if %> could be unfairly marked down as well, although looking at the numbers alone these two names are more questionable.

Every single time you use your credit card, some entity has to carry the financial information from the point of sale to the bank that holds your credit card. Merchants contract with specific credit card transaction providers to give them an entry into this system, paying a fixed percentage of each transaction. As a result, changes in interest rates affect these companies only in as much as they discourage people from using their credit cards. With most of America still using plastic that charges double-digit interest rates, it is unlikely a 0.25% change is going to staunch their buying habits. Electronic transactions are also growing at steady, double-digit rates as consumers dump checks and cash in favor of credit cards, the panacea for the empty bank account.

Although these companies are not cheap if you look at them from a Graham & Dodd absolute value point-of-view, the valuations are compelling if you look at the margins these companies enjoy. Take First USA Paymentech, spun-off from FIRST USA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FUS)") else Response.Write("(NYSE: FUS)") end if %> on March 25th, 1996 at roughly $30 a share. The company quickly traded up as high as $47 on strong earnings growth, and first fell below its initial public offering price in late February. The company began to sell off almost immediately after reporting second quarter earnings on January 22nd, falling dramatically in the two days leading up to the release. Although the company did recover, you can now buy the shares for less than two bucks more than their 52-week low, about five dollars below where it came public.

So why could 34 times trailing earnings and 4.91 times sales be a compelling price for First USA, especially when you can have industry giants Federal Data and National Data for less? In spite of the dilution from the issuance of new shares, the company is still growing earnings in the 50% range with operating margins of 30.4%, almost double National Data's 15.2% and Federal Data's 20.9%. The only company in the industry with higher operating margins is BA Merchant Services, another recent initial public offering. BA Merchant has operating margins of 33.6%, partially because of its privileged relationship with former parent BANKAMERICA CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %>. BA Merchant Services also only sells for 22 times trailing earnings.

Although many investors are scouring through the traditional financial companies for bargains, looking over banks, brokerages, insurance companies, mortgage companies and the like, it would seem that the credit card processing companies present an interesting investment opportunity here. Almost completely immune from the direct negative affects of interest rate changes, they still allow an investor to participate directly in the growth of financial services throughout the world and online. As the look here has been cursory at best, investors are urged to take the time to do their homework before acting, as each of these companies tends to be a little "unique" in the way that it handles some of the accounting issues, raising the level of risk slightly. Getting the public documents, getting familiar with the basic business model, and crunching through the numbers is, as always, as must.

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