Neutral on TSS Despite FNMS Deal - Analyst Blog

Yesterday, we reiterated our 'Neutral' recommendation on Total System Services Inc. (TSS">TSS) given the company's penetration in the merchant acquiring services market, though partially subdued by a negative 2010 earnings outlook.

Besides, the ongoing market recovery is regaining the confidence of consumers, which in turn is fostering improved client activity. Consequently, TSS stands to gain from a recent spurt in total acquiring services. Early this month, TSS acquired the remaining 49% of First National Merchant Solutions LLC (“FNMS”) for about $170 million following a 51% stake bought in April last year.

With a bank card portfolio of 3 million accounts on file, the company's joint venture with and the subsequent buyout of FNMS is expected to be accretive to earnings in 2011 and beyond. The company aims to diversify its portfolio into merchant acquiring and be among the top five merchant acquirers on a global basis in another 2-3 years.

Moreover, TSS' risk free balance sheet along with a modest cash flow generation provides viable scope for share repurchases and acquisitions. With the 3.1 million share repurchase in the third quarter of 2010 and about 6.9 million remaining to be bought back, the company continues to return value to shareholders, inspiring confidence for future growth.

TSS also continues to work vigorously to initiate various cost-cutting methods such as divesting redundant operations, reducing headcount and fixed overheads along with other operating expenses in order to streamline its overall expenses.

On the flip side, the persistent weakness in the credit card industry continues to hamper TSS' results, credit card being one of the significant revenue drivers for Total Systems. Besides, regulatory measures enacted in the U.S. in July 2010 are expected to take effect in the upcoming months of 2011, which could contract credit offerings from financial institutions.

Moreover, the declining electronic payment processing services revenues are generated from charges based on several factors, one of which is the number of accounts on file, which continue to experience weak trends since the last couple of years. Given the likelihood of ongoing cut-backs at card issuers and slow conversion of accounts in the pipeline, the accounts on file warrant a challenging outlook for 2010 and beyond.

The global payments industry is intensely competitive and TSS faces substantial competition from data processing, bankcard computer service firms and third-party software vendors within the U.S. as well as from international processors and third-party software vendors. The company's prime competitors include First Data Resources LLC, Visa Inc. (V">V), MasterCard Inc. (MA">MA) and Discover Financial Services (DFS">DFS).

This implies that TSS has a very dynamic and strong peer group that outrageously competes on various crucial operational factors such as price, system performance and reliability, breadth of features, functionality, disaster recovery capabilities, business continuity preparedness and data security. With weak internal fundamentals, the company is liable to lose edge over competition going ahead.

Earnings Recap

Overall, TSS' third quarter earnings came in a couple of cents ahead of the Zacks Consensus Estimate. Growth from merchant services and transaction volume was partially offset by higher operating expenses.

Despite raising the earnings outlook, management still expects a negative earnings growth for 2010 due to the absence of any major catalyst, limiting near-term growth. Hence, the Zacks Consensus Estimate for the fourth quarter hangs at 24 cents, with earnings release scheduled after the market closes on January 25.

Although management expects to grow inorganically along with a modest cash position and a risk-free balance sheet, the company is vulnerable to competition, currency fluctuation and interest risks.

However, overall market stability and likelihood of a favourable impact of the regulations in the credit card industry will help recover the number of client accounts and long-term contracts in the long run. Hence, we maintain our Neutral recommendation on the stock with a Zacks #3 Rank.

 
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