In this weeks’ Sunday Spotlight, we piece together various indicators from bank earnings and industry calls as a read through to our Core Processor and IT Services coverage (FIS/WP, FISV/FDC ACN, CTSH, DXC, EPAM,). Earnings commentary suggests aggregate tech spend among large U.S. banks has maintained a healthy pace as enhancing digital offerings is critical to staying competitive and driving resilient deposit market share, with the ultimate goal of alleviating NIM pressure from the current low rate environment (see exhibits 1-6 below). We see this as a positive read for the Core Processors, which are optimally positioned to support large banks in the effort to enhance mobile banking, card processing, loyalty solutions, bill-pay, payments services, and others. For IT Services, while U.S. bank spend continues to exhibit healthy trends, pockets of weakness in Healthcare and Energy raise questions on aggregate investment trends, particularly in managed services.
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Shares of ADS outperformed in today’s session (7/18/19) (up 5% vs S&P flat) following 2Q earnings, which were released pre-market. Expectations were relatively muted heading into results following a series of restructuring initiatives around its card portfolio and the sale of Epsilon (for proceeds that were below expectations). As such, relatively in-line results (excluding reserve timing and higher taxes), updated EPS guidance to incorporate buybacks and momentum in its shift towards a pure-play growing card business resonated with investors. In particular, credit remained stable and the company’s announced $900mm in planned portfolio acquisitions closed ahead of schedule (previously expected in 4Q). That said, the company also moved $500mm of incremental loans into HFS (claiming terms to renew were below ADS’ thresholds and thus allowing the file to move to a competitor).
Total revenues of $1,349mm (down 3% Y/Y), came in below the Street’s $1,352mm. Core EPS of $3.83 (down 12% Y/Y), came in below our $4.09 and the Street’s $3.94. Adjusted EBITDA, net was $310mm, below our $345mm and the Street’s $340mm. Despite the top and bottom miss, the company raised its 2019 EPS guidance to a range of $19.50-19.75, relative to $18.47 previously, supported by the planned $1.1B in repurchases from Epsilon proceeds and the recent decline in share price. Importantly, ADS closed on $900mm in portfolio acquisitions within the quarter, bringing ending receivables to $17.6B while also pressuring yields ~100bps and causing a reserve build (impacted card margins this quarter). For reference, management previously guided to these portfolios rolling on in early 4Q. Overall we see 2Q as relatively unsurprising and remain focused on the longer-term strategy to accelerate growth within card services and potential strategic actions around LoyaltyOne.
ADS reported its June credit data this morning with NCOs of 5. 8%, down 80bps Y/Y and down 50bps M/M (relative to the 5-year seasonal average of down 38bps M/M). For reference, the Company expects net charge offs to moderate below 6% in 2H19 and result in approximately 6% for the full year (in line with our model).
In this week’s Sunday Spotlight, we look at EMVCo’s 3-D Secure 2. 0 technology and explore its implications for the payment ecosystem. 3-D Secure 2.0 is an effective solution to address PSD2 and Strong Customer Authentication (SCA,) which is scheduled to go into effect on Sept. 14, 2019 in Europe but could be delayed. We note that both Brazil and Australia also have mandates in place which will encourage the adoption of 3-D Secure 2.0 in 2H19.
ADS shares have underperformed YTD (down 1% vs the S&P up 19%) as the magnitude of planned buybacks from the Epsilon divestiture were below investor expectations and portfolio restructuring efforts initiated in 2018 weigh on reported growth. Moving forward, we see focus shifting to the organization and momentum of card services given ADS’ likely positioning the story to become a pure-play card services company. Despite no formal announcement, we expect management focus will pivot towards divesting LoyaltyOne over the next year. Historically low valuation has led to incremental interest from investors, and we look at proforma valuation scenarios with and without LoyaltyOne (see Exhibit 4), which lead us to our PT of $170 (7x our 2021 EPS of $25.44).
In this week’s Sunday’s Spotlight, we take a look at the impact that Boost has had on SQ’s Cash App and how that can impact Venmo. PayPal recently announced that its users were able to earn 5% cash back on eligible restaurant purchases/select merchants (Kroger, Taco Bell, Shell and Walgreens) made with its Venmo Card through 6/30, which we see as a stepping stone to a more encompassing rewards program. Ultimately, we see these programs as encouraging usage and leading to net new adds. Square launched its debit-card rewards program called Boost on May 1, 2018 to encourage users to transact using its Cash Card. The program offers rewards (primarily Square-funded) at specific retailers and we see this program as creating a “Rewards Network” where all three parties (Square, Merchant, Consumer) provide and realize value through engagement/data collection, increased sales, and discounts.
In this week’s Sunday’s Spotlight, we take a look at the private label credit card market and affiliated brands across the top three players including Citi Retail Services (C, covered by Steve Chubak, Outperform rated), Synchrony (SYF, not covered), and Alliance Data (ADS, Peer Perform rated). Over the years, competitive dynamics for loyalty solutions at the point of sale has intensified. According to Nilson, private label use comprised roughly 5% of spend in recent years versus 15%+ 25 years ago. General purpose (including co-brand) cards volume growth has seen a CAGR or roughly 8% over those years, outpacing private label growth by over 400bps. Large bank issuers have offered other reward offerings, innovative payment capabilities, and co-branded programs with retailers. Competition continues to heat up with instant reward programs through digital wallets (for further insight on reward initiatives from PayPal and SQ at POS see: Save a Cow, Use a Digital Wallet: Instant Rewards are the Next Frontier.) Further, installment financing at the POS has been offering additional alternatives to private label, such as PayPal Credit and Square Installments. While not currently offered, ADS has mentioned that extending installment loans at POS is in the Company’s long-term strategy. A recent study by Klarna (private) suggested that 75% of consumers preferred to shop at stores which offered instant financing.
In this week’s Sunday’s Spotlight, we look at the importance and impact of interest rates on ADP and PAYX. Interest rate changes/activity are important for ADP and PAYX given that each company earns close to 100% margin revenue from interest earned on funds held for clients. While PAYX’s earnings power is less resilient than ADP’s as interest rates are falling because of its shorter duration investment strategy, its earnings power rebounds faster when rates are rising, making PAYX the preferred pick by investors in our view during a rising rate environment and ADP a preferred pick in a falling rate environment.
ADS reported its May credit data this morning with NCOs of 6. 3%, down 10bps Y/Y and down 10bps M/M (relative to the 5-year seasonal average of down 26bps M/M). For reference, the Company expects net charge offs to moderate below 6% in 2H19, and result in approximately 6% for the full year.
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