Mixed Approach On Total System

We reiterated our Neutral recommendation on Total System Services Inc. (NYSE:TSS), the global electronic payment processor and merchant acquirer, based on the current sustainability factor. The company reported second-quarter operating earnings of 28 cents per share, which came in a penny higher than the Zacks Consensus Estimate of 27 cents and climbed from 25 cents per share in the year-ago quarter.

Results reflected increased same client transactions, lower taxes and slight increase in overall transaction volume. However, continued weakness in North America services along with a dip in merchant acquiring services revenue, higher-than-expected cost of services and selling, general and administrative (SG&A) expenses led to the decline in operating income.

Total System has come a long way from the negative top-line growth trend. Since the second quarter of 2010, the company’s fundamentals are screening decent growth in the top line. Although the rate is stuck at lower single digits, the company’s growth drivers lay ample optimism on the performance of the stock in the long run.

The market recovery has also enabled the improvement in new client growth, same-client transaction volumes and accounts-on-file. Going ahead, the revenue recovery is believed to follow slow and steady growth in North America as well with the company’s leading technology platform, improved pricing and healthy consumer spending once the economy stabilizes.

Total System’s risk free balance sheet along with a modest cash position and cash flow generation provides viable scope for share repurchases and acquisitions. The complete acquisitions of First National Merchant Solutions LLC (FNMS) and TermNet Merchant Services along with international alliances are expected to drive the company’s merchant acquiring space and contract portfolio. Meanwhile, the recent expansion of share repurchase program continues to inculcate confidence among investors.

On the flip side, Total System is vulnerable to increased competition from dominant players such as Global Payments Inc. (NYSE:GPN) and Alliance Data Systems Corp. (NYSE:ADS). Moreover, despite the economic recuperation since 2008, operating margin has witnessed a decline from 28.6% in 2008 to 27.2% in 2009 to 25.6% in 2010. It further declined to 17.3% in the first half of 2011 from 18.9% in the first half of 2010. The company even has a significantly high backlog of accounts.

Management’s outlook for top-line growth in 2011 also appears stressful. With weak internal fundamentals, the company is liable to lose edge over its competitors going ahead.

Currency and interest rates fluctuations pose additional risks. Total System is also exposed to sufficient risk from the regulatory measures enacted in the U.S. in July 2010. These are expected to take effect in the upcoming months of 2011, which could contract credit offerings from financial institutions. Any unfavorable impact of regulations could hamper the company’s inorganic growth strategy.

Finally, we believe that the overall market stability and healthy impact of the regulations in the card industry will help recover the number of client accounts and long term contracts in the long run.

Given the pros and cons, the Zacks Consensus Estimate for the third quarter is pegged at 29 cents per share, increasing about 16% year-over-year. For 2011, earnings are expected to rise 11% over 2010 to $1.11 per share.

Additionally, the quantitative Zacks Rank for Total System is currently #3, indicating no clear directional pressure on the shares over the near term.