In this weeks’ Spotlight we look at ADP and PAYX’s PEO businesses (~30% of ADP revenue and ~20% of PAYX revenue pro forma for Oasis and ex. Insurance Services) and the impact that the faster than company average growth of these businesses has on margins. While both companies present PEO revenue net of certain direct costs that are passed through to the merchant such as payroll wages, payroll taxes, and more, other costs such as state unemployment insurance and health insurance benefit premiums among others are not always netted out. The effect can leave PEO revenue looking higher than it otherwise would if it were reported net of all pass-throughs and margins much lower than they would otherwise be. See exhibit 4 for ADP margin estimates ex. pass throughs.
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Entering 1Q earnings, ADS remains one of the most debated names in our coverage. While some see upside potential from strategic optionality, others question the accretion math around the sale, as well as whether card services will return to high-teens growth and late-cycle credit concerns. In our view, shares of ADS are appropriately valued at current levels and believe Sunday’s announcement of the divestiture of Epsilon may drive slight accretion on 2020 EPS (see Exhibit 4). We continue to believe that an appropriate mix of debt repayment versus share buybacks is important given a proforma entity that is much more reliant on bank earnings. In this note, we adjust our model to reflect recent credit data and performance in the non-lending businesses. Given the final Epsilon proceeds were below our previous estimates ($3.5B vs $4.5B, see our prior note from 4/7, ADS/Epsilon: Our Analysis Suggests Modest Accretion Potential Given Leverage), and incremental adjustments to our model, we lower our YE19 price target from $175 to $170, (7x our 2020 EPS of $24.67) and maintain our Peer Perform rating.
In this week’s Sunday Spotlight, we attempt to disaggregate Square’s Subscription & Services segment and provide a deeper analysis on 1) Cash App Debit Card, 2) Square Business Debit Card and 3) Caviar demographic and penetration details. The company’s existing guidance calls for 41%+ adjusted revenue growth and we have received a significant amount of questions surrounding what could drive a beat/raise type of year. The company will be lapping Instant Deposit’s strong 2018 volume growth and price increase (consumer went to 1.5% vs. 1.0% at end of 1Q18) in 2019, however, we expect continued tailwinds in the segment by virtue of cash app growth. We also suspect that the Cash App Debit Card will further penetrate its 15mn active user base and see its business debit card resonating with sellers. Additionally, we see continued adoption of ancillary services to its seller base as only 50% of large sellers use 2+ of SQ’s products today and only 30% sell through multiple channels with Square. See exhibits 3-7 in the report for more info.
ADS reported its March credit data this morning (4/12/19) with NCOs of 6. 2%, down 10bps Y/Y and down 10bps M/M (relative to the 5-year seasonal average of down 12bps M/M). For the three months ended March 31st, charge offs were 6.4%, slightly above the 6.3% in our model.
In this week’s Sunday Spotlight, we provide an overview of ADS’ strategic initiatives around Epsilon and an accretion/dilution analysis based on a hypothetical selling price of $5B (10. 5x LTM EBITDA). Our math suggests that to maintain a well-capitalized financial services entity post-spin, a significant percentage of the sale proceeds would need to be earmarked for debt repayment versus buybacks, limiting accretion potential (see Exhibit 4 for base case analysis). Many have often questioned the strategic fit of ADS’ business lines, and we’re constructive on the Company’s efforts to divest the non-lending assets and simplify the corporate structure. Over recent weeks, headlines have indicated the Epsilon process is nearing the finish line with multiple strategic /sponsor-led bidders and purchase price approaching $5B (10.5x LTM EBITDA). Following a hypothetical sale of Epsilon, we suspect ADS would begin a process for LoyaltyOne as well.
In this week’s Sunday Spotlight, we look at contactless payments in the United States. With 1) 78 of the top 100 merchants now accepting contactless payments, 2) 95% of all new terminals being contactless ready, 3) over 60% of “face-to-face” transactions occurring at contactless enabled merchants, and 4) issuers representing ~66%+ of network volume expected to begin issuing contactless cards by 2020, we expect contactless to become a dominant form of payment in short time within the U.S. Visa also set a goal to get 100mn cards to be contactless in the U.S. by the end of 2019 (vs. ~1.4bn total according to The Nilson Report with ~875mn being Visa). We highlight that 55-60% of U.S. PCE is carded with ~$6.1tn of payment volume hitting credit, debit and prepaid cards in 2018 (up 10.5% Y/Y).
In this week’s Sunday Spotlight, we look at mobile banking adoption, including penetration rates, reasons behind the lack of adoption, and the revenue/attrition benefits of mobile users. Coming out of the recent Wolfe FinTech Forum, it has become more evident that digital adoption by consumers in the U.S. remains under penetrated (~35-45%), as evidenced by our fireside chat with CEO of FISV, Jeff Yabuki as well as some industry estimates. Our recent day of meetings with FIS and WP CEOs, CFOs and IRs also confirmed this. Despite retail mobile banking being ubiquitous, with ~90%+ of Federal Reserve FI respondents estimated to be offering mobile banking services, eMarketer’s analysis suggests that only ~45% of the U.S. population is estimated to use mobile phone banking services. Importantly a Federal Reserve analysis suggested that >80% of banks and credit unions rely on core deposit processors (FISV, FIS, JKHY, etc.) to deliver mobile banking services.
In this week’s Sunday Spotlight, we look at the evolution of cross-border payments and the impact from large banks becoming increasingly selective on emerging market operations and scaling back investments in the correspondent messaging network, SWIFT. The FSB reported that from 2011 to 2017, the number of active correspondents declined by 15.5% and active corridors by 7.3%. The World Bank found that 27% of 300 global banks surveyed reported a drop in total correspondent banking relationships. As eCommerce continues to open more businesses to global trade, demand for more efficient and transparent cross-border payment solutions has increased. At the same time, AML, KYC and other country specific regulations are becoming increasingly costly and complex for banks to manage efficiently. This is particularly true in remote locations viewed as higher risk. Considering the EU continues to add more countries to its tax haven blacklist (10 new countries were recently proposed), we do not expect the cost of doing business in these regions to abate near-term. This friction has created increased demand for tech-based payment solutions, which either build around the existing SWIFT infrastructure or circumvent the network altogether. On page 2, we illustrate the decline in correspondent banking, existing challenges, and initiatives of FinTech aiming to reduce cross-border friction. We expect this shift coupled with strong eCommerce trends to drive outsized growth for innovative private companies such as Payoneer, Transferwise, Remitly, and public incumbents such as V, MA, PYPL, WP, WU, and others.
ADS reported its February credit data this morning with NCOs of 6. 3%, down 60bps Y/Y and down 30bps M/M (relative to the 5-year seasonal average of down 12bps M/M). While February’s M/M change was ~20bps better than seasonal averages, this improvement is partially attributable to a higher than expected January NCOs of 6.6%. For the two months ended February 28th, charge offs are trending to 6.5% for Q1 vs. the 6.3% in our model.
On March 12th and 13th 2019 we hosted the Wolfe FinTech Forum in NYC. Nearly 60 public and private companies across the space presented and/or hosted meetings. The event was filled with both broad thematic and company/stock specific takeaways (page 3).
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