Written by: Tyler Ventura, CFA | Diamond Hill Capital Management
The financial services industry continues to find itself under assault by technological change
. The term financial technology, or “fintech,” has taken on new meaning, as it has evolved from a descriptor of back-end processing systems to representing startup companies focused on innovation, automation, and disruption. Nearly every area of financial services is battling with nimble, well-capitalized, digital fintech startups capitalizing on inexpensive, distributed computing power, and changing consumer preferences. Keeping abreast of the changes in financial services is more important now than ever before.
An analysis of our investment in Fidelity National Information Services (FIS) provides a concrete example of how companies are expanding amidst the shifting sands. Additionally, a look at an unlikely partnership demonstrates just how much the landscape is changing.
Scale Begets Scale
In April 2016, I wrote about technology driving innovation and disruption in the payments industry and highlighted the opportunity we found in Vantiv, Inc. At the time, we lauded management’s track record of utilizing acquisitions to enhance its technology offerings, turning threats into opportunities, and building critical scale in an attractive industry. In July 2017, Vantiv announced the $10.4 billion acquisition of Worldpay, Britain’s largest payment provider. The combined company took on the Worldpay name and operated a significant global platform with strong capabilities in the growing e-commerce business. In March 2019, amidst a period of industry consolidation, FIS announced the acquisition of Worldpay for an enterprise value of $50 billion, in what was reported to be the largest-ever fintech deal. In announcing the deal, FIS CEO Gary Norcross, who will lead the combined company, stated, “scale matters in our rapidly changing industry.”
FIS: Fintech Leader
On July 31, 2019, FIS completed the acquisition of Worldpay, creating a global leader in financial services technology with software, services, and technology outsourcing capabilities critical to the industry. Most financial institutions abandoned home-grown technology solutions over the last couple of decades, and firms like FIS stepped in with dedicated systems to run a variety of critical and strategic applications (check imaging, online bill pay, mobile banking, etc.). The combination brings together FIS, the largest financial institution technology provider, with Worldpay, the largest merchant payment processor. FIS has relationships with over 14,000 financial institutions globally, including 45 of the global top 50, in over 130 countries. Worldpay processes over 40 billion transactions annually, supporting more than 300 payment types across 146 countries and 126 currencies.
The scope of the new combined firm’s capabilities extends across retail and institutional banking (money center banks, regional banks, credit unions), payments, capital markets, asset management, and wealth and retirement markets. The firm’s size and extensive global footprint is an important competitive advantage, allowing for the cross-sell of FIS’ and Worldpay’s capabilities via a massive distribution network. Security and fraud prevention, data and analytics, global e-commerce solutions, and commercial and B2B payments are areas of growth for the new firm. This unique combination of scale and global presence is critical to the firm’s expansion plans and necessary to fund the level of innovation required to compete at the forefront of technology. As FIS CEO Norcross stated at the time of the deal, “there’s a lot of innovation going on, there’s a lot of modernization going on, and our clients need to continue to look to compete in this very aggressive market. You’ve got disruptors coming in.”
FIS Revenue and Cash Flow
FIS’ revenue is principally derived from a mixture of technology and processing services, professional services, and software license fees that are recurring in nature and delivered under multi-year contracts. The relative stability of the recurring revenue stream is attractive and many of the services provided are critical to client operations, making provider changes relatively difficult. There are also aspects of the recurring revenue base derived from transaction processing fees that fluctuate with the level of accounts, card transactions, or other variables (commercial, consumer or capital markets accounts and/or activity). The business exhibits significant revenue and cash flow generation capability with pro-forma combined year-one revenue of over $12 billion, approximately $5 billion in EBITDA, and $2.4 billion of free cash flow. Over the next three years, management expects organic revenue growth of six to nine percent. Combined with revenue and cost synergies, free cash flow is expected to nearly double over that time frame to over $4 billion. We like the strong secular growth profile that the payments business adds to FIS and agree that high-single digit revenue growth is feasible going forward. Management has a multi-decade history of maintaining a strong, flexible balance sheet and balancing acquisition needs with shareholder-friendly capital allocation (dividend payments and share repurchases).
A Wall of Funding, Startups Expand
One trend we are closely watching is that of fintech startups disrupting traditional financial services. In many cases, disruption boils down to new entrants developing better alternatives for customers who are willing to try alternative solutions. According to KPMG, global investment (including M&A and buyout activity) in fintech doubled to $112 billion in 2018 from the prior year and almost half of the top 50 global fintech companies are valued over $1 billion. While the industry adage, “the battle between every startup and incumbent comes down to whether the startup gets distribution before the incumbent gets innovation” rings true, we would also add that “capital is king.”
Stripe, a privately held San Francisco-based internet payments company founded in 2010, just completed a funding round valuing the company at $35 billion. Stripe processes billions of dollars a year for millions of businesses worldwide and is now the largest private U.S. fintech company. Capitalizing on its growing scale in internet commerce, Stripe intends to expand into small business and corporate credit card lending, both of which are huge profit centers for legacy banks. Two public companies that followed a similar path, PayPal and Square, now have ever-expanding financial service ecosystems and possess market capitalizations of over $120 billion and $24 billion, respectively.
Apple and Goldman Sachs, What’s Next?
Of course, it is not just well capitalized startups that are encroaching on profit centers for legacy banks. Wall Street and Silicon Valley are closely watching the August 2019 launch of the Apple Card, a joint mass-market credit card venture between Apple and Goldman Sachs. Many years ago, one would be hard pressed to imagine either of these firms launching a retail financial services initiative, much less collaborating on one together. In the last few years, Goldman Sachs has moved into retail financial services, utilizing its $945 billion balance sheet to build a consumer-facing digital bank called Marcus, which offers personal loans and online savings accounts. Apple, meanwhile, continues to promote its Apple Pay capabilities while expanding services that generate loyalty and engagement among its massive global device ecosystem. The Apple Card product has a relatively familiar cash-back incentive reward structure with no fees, but the technology integration, user interface, and daily cash back features stand out as truly innovative. The product was designed from scratch, and Goldman Sachs CEO David Solomon stated that the “Apple Card is big, but it’s also a beginning. With no real legacy technology or a longstanding consumer business to defend, we are positioned to innovate unlike many others in the industry.” While the ultimate success of the venture is yet to be seen, there is a lot at stake for the financial services industry, as there are other massive technology companies likely looking to enter the fray.
Finding Opportunity, Avoiding the Fallout
As investors, one way to find investment opportunity
, and avoid the fallout that inevitably comes with technological change, is to identify companies that possess a management team with a proven track record and a superior ability to execute. At Diamond Hill, we also rely on our investment philosophy, which emphasizes remaining patient, being wary of fads, focusing on the preservation of capital when balancing risks and opportunities, and fundamental analysis. This philosophy allows us to remain even-keeled in our examination of whether rising competition and evolving industry dynamics simply requires talented management, or if it presents an existential threat to the businesses we follow.
Related: The Two Big Issues Bank CEOs Have with FinTech