Fidelity National Information Services, Inc. (FIS) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Rayna Kumar, and I lead UBS' U.S. payments processors and IT services equity research. I'm fortunate today to be joined by FIS' CFO, Erik Hoag. Thanks for joining us today.

Thanks for having me.

Great. So Erik, you've been CFO for about one month now. What are your priorities here? And what would you do differently, if anything, from your predecessor?

Well, first, Rayna, thanks for having me today. It's quite an honor to become the CFO of FIS. We're a big, durable business, high concentrations of recurring revenue. We generate a lot of free cash flow. As far as near-term priorities, focused on our enterprise transformation program, which has got a couple of key goals. Number one, we want to set -- we want to put our margins on a glide path for sustainable margin expansion in the future. We want to reduce the capital intensity in the business, and we want to increase free cash flows. I'm highly focused on driving profitable revenue growth. And from an investor perspective, I'm very focused on ensuring that we are guiding in a way that provides a level of transparency in the underlying building blocks associated with that guide.

You're obviously in a more uncertain economic environment, a lot of concern about a potential recession in 2023. How are you thinking about a potential recession impacting your business? And maybe walk us through the different segments in that answer.

Sure. So FIS is organized in 3 operating segments. We've got a banking business, a capital markets business and a merchant business. Our banking business has roughly 80% to 85% recurring revenues, strong EBITDA margins, long customer contracts that include termination rights and price escalators, we feel, with high barriers to entry with mission-critical software. The business is very durable. What I would say about the banking business is we have seen an elongation in the sales cycle in 2022. We called this out in the second quarter. We talked about it in the third quarter as well. But a durable business. However, we do have a leading indicator with softening sales. Our capital markets business, which is very similar to our banking business, the lines between banking and capital markets are very blurry. We are seeing increased levels of recurring revenue. In the third quarter of 2022, recurring revenue in capital markets was roughly 73%, up from roughly 68% a year ago. We continue to see longer concentrations of -- I'm sorry, contracts with longer terms. We've got high barriers to entry here in capital markets as well. The business has performed very, very well for us over the last 2 years. We feel very good about capital markets. Our merchant business, we've got -- let me break it in, Rayna, into the 3 channels that we operate in. We've got an enterprise subsegment that is roughly 45% of revenue. This is predominantly nondiscretionary spend. This subsegment should perform very well in a down cycle. We've got an eCom business that is performing very well, roughly 16% organic growth in the third quarter, 22% on a constant currency basis. We would expect this business to grow potentially slower. But in a down -- in a choppy market, we'd expect this business to continue to grow. And then our third channel within the SMB book is -- our third channel within merchant is our SMB book, which is roughly 25% of revenue within the merchant business. This is more discretionary spend, a little bit choppier, a little bit more exposed in a down market.

Understood. Okay. So you're one of the largest payment facilitator processors. Do you envision FIS having its own PayFac model? Is Payrix going to be your sole SMB solution?

So our goal is to provide payment capabilities to PayFacs. As new technologies emerge, we would expect that our payment facilitators look to scaled players like FIS to provide innovative solutions. One thing that FIS does bring to bear is a robust set of issuing and banking assets that can ultimately be embedded within Payrix and our Worldpay platform solution. Things like loyalty and issuing AP, AR, things that we can integrate with embedded finance.

Can you talk a little bit about how the economics of that PayFac model is different than your -- or rest of your merchant business?

Yes. Yield on PayFac is significantly lower than all 3 of the subsegments within our merchant business.

On your third quarter earnings call, you and Stephanie pointed a mid-single-digit top line growth in the merchant business. Is a return to high single-digit growth from merchant off the table here?

No, no, it's not. So over the next several years, so as our eCom business continues to grow, as I said, 16% here in the third quarter, it's roughly 30% of our Merchant Solutions segment, the eCom book. Over the next several years, the eCom book will continue to be a larger concentration of the merchant segment. And as that business continues to grow, we would expect that to drag up -- pull up growth rate for the total Merchant Solutions segment, compounded by the Worldpay for Platforms initiative that we have underway that should help reinvigorate growth associated with our ISV book within the SMB subsegment.

As you look across your assets in banking, merchant and capital markets, do you see any potential here to better optimize your portfolio?

Well, as the management team, the Board, we're constantly looking at options to unlock shareholder return. Right now, we are focused on some things that are inside our control, such as the enterprise transformation program, ensuring that we're cross-selling all of our solutions across all of our operating segments. But the answer to your question is absolutely yes, that's something that we would focus on.

Can you provide any color on conversations you've had with core processing customers on any early indications for bank technology spend next year? Any hints that the macro environment will cause the pullback in spending? I know you just spoke about some elongated cycles. Do you expect that to improve into next year?

Yes. What we're seeing on the bank core side is cautious buyers. We've got a robust sales pipeline on the core side. But as I mentioned earlier, between the second quarter and the third quarter, we are seeing elongating sales cycles, which will -- which has impacted total sales in 2022. We don't believe that there are new market entrants. We don't believe that we're competitively dispositioned. We feel good about where we're at. And as I talked about earlier, the banking business has got very high level -- very high barriers to entry, long customer contracts, price escalators. We feel like we're positioned very well despite the fact that we've had some softening sales.

Even with the elongated sales cycle in banking, is mid-single-digit growth still doable in that segment going forward?

Yes, sort of. Sitting the macro environment aside and the elongating sales cycle behind, the answer is yes.

Your capital markets growth has remained strong. What is the next step in your multiyear move to a SaaS model? Is mid-single-digit growth here sustainable as well?

So the capital markets business, this was a business that was predominantly acquired in 2015. It was SunGard back in 2015. Over the last several years, we've done a very nice job of converting the business from a license shop to a point solution recurring revenue shop to now a point suite solution shop. So we've got a higher concentration of recurring revenue. Our license fees have effectively remained flat over the last several years. We are attacking that revenue to convert it to recurring. Rayna, I think we're on a very good trajectory. The business has performed very, very well. And we feel like it's positioned well as we head in towards 2023.

Moving on to margin. Are inflationary pressures on wage and vendor costs starting to ease? Or do you believe it will persist through 2023? And then the second part of that question is you have a $500 million cost savings program, how much of that should we expect to hit to the bottom line?

We do expect it to persist into 2023. We do expect cost pressures to persist into 2023. As we talked on our third quarter earnings call, we saw -- we were seeing the cost of employees joining the company versus the cost of people leaving the company at a pretty healthy spread. So we're seeing employee costs go up. We're seeing third-party costs go up as well. Some of those costs we can pass on to customers, some of which we cannot. What we're doing about it, though, in 2023, is we're launching the enterprise transformation program, which the $500 million that you referenced is really just the starting point for us. The goal of the program, as I mentioned in my early comments, really is threefold. Number one, we want to improve and put the margins of the business back on a path for sustainable margin expansion. We want to reduce the capital intensity of the organization. And then number three, we want to drive free cash flow. All of which we believe will unlock shareholder value.

Your medium-term targets called for 50 to 100 basis points of adjusted EBITDA margin expansion. Is that still the right way to think of the business? And is that still the right way to think of 2023 given some of these macro headwinds?

Yes. So on our third quarter call, we pulled our midterm guide. So as you said when we started the call, I've been the CFO at FIS for roughly a month. I took over concurrent with our third quarter call. We pulled our midterm guidance to really to take a step back, to take a breath and really ensure that the midterm guide matches up with how the business is performing. The enterprise transformation program through 2023, we would expect to see sequential improvements in our cost footprint as we move throughout the year. And as we reestablish the midterm guidance early in 2023, we'll be able to talk more holistically around what that midterm expectation should be from a margin expansion perspective.

Should we expect some type of Investor Day or Capital Markets Day where you would address that?

To be continued. With our fourth quarter call, I would expect us to touch on our guide. We'll provide an update associated with the midterm. We have -- we've internally discussed an Investor Day, they're -- more to come.

Okay. But fourth quarter could be when you actually provide potential new medium-term targets?

Potentially. We'll certainly provide an update associated with the 2023 guide. We'll evaluate what the midterm -- how far we advance in terms of midterm.

Great. Very helpful. In October, the Federal Reserve finalized updates to its role around online debit routing effective in July 2023. Can you talk about the opportunity to gain greater share of online debit routing and whether FIS needs to make any additional investments to take advantage of a more openly competitive debit routing environment online?

Yes, broadly speaking, I think regulatory change is a tailwind for FIS. As regulation changes occur, both merchants and financial institutions look to FIS to help solution some of these things, particularly scaled players to help solution some of these regulatory changes. We believe our debit-routing capabilities are best-in-class, and I don't expect any material impact to FIS associated with potential regulatory changes.

So the NYCE network right now could actually do the routing for debit online without any need for additional investments?

I don't anticipate any additional investments associated with that.

Are there any other regulatory changes that you foresee where FIS would see that as an opportunity? For example, the emergence of FedNow, which is anticipated to be launched in mid-2023.

Rayna, I don't think I can provide any level of specificity around FedNow.

Okay. On your third quarter earnings call, Gary and Stephanie made some comments regarding the return to M&A during a stable macro environment. While not in the near term, what would you anticipate would be the main issues or solutions FIS would be solving for when assessing an acquisition in the future?

Right now, we're focused on the enterprise transformation program. I think your question around a stable macro environment would certainly be key. But right now, we are very focused on launching the enterprise transformation program, rightsizing the cost footprint of the company and wrapping up the 2023 plan. We'll evaluate options around M&A as they unveil themselves. But right now, we are not focused on M&A. We are focused on rightsizing the cost footprint of the organization.

Great. If anyone has any questions for Erik, feel free to input it in the app. Everyone on their table has a QR code you can scan. And once I get those questions, I will read it to Erik. So in the meantime, Erik, can you discuss your capital allocation strategy and thought process about how you prioritize capital return versus growth investments, both organic and inorganic?

Yes, sure. So from a capital allocation perspective, number one, we want to invest for growth. And I'd say, in 2023, we're more focused on organic investments for growth. Number two, we want to maintain an investment-grade balance sheet. Number three, we want to return a reasonable dividend in 2023. We'll increase our dividend roughly 20% as we move towards a payout ratio of roughly 35%. And then lastly, we want to return excess free cash flow to our shareholders. Rayna, one slight nuance in 2023 v 2022 is we aren't going to continue to lever up, up to 2.9 turns for share repo. We're going to naturally let our EBITDA drift down as EBITDA grows -- our leverage ratio drift down as EBITDA grows.

Understood. Okay. A good question from the audience. What are the main initiatives you're taking to reduce capital intensity and improve free cash flow?

Yes. From a capital intensity perspective, we're ensuring that we are investing in the right products and the right projects within the right products. So we're bringing a true quantitative approach to ensure that we're generating the appropriate ROIs, ROICs associated with the initiatives where we put our capital dollars.

Okay. Do you anticipate providing any more metrics going forward in your earnings reports?

Yes, great question. So one of the things that I aspire for in my new role as CFO is to provide additional disclosure and clarity associated with the underlying building blocks of our guide of our actual results. So yes, Rayna, the answer to your question is an absolute yes. In the third quarter call, we did provide slight -- some slight incremental disclosures associated with the performance of our enterprise business split between the U.S. and the U.K. So we would -- I would certainly expect us to provide more quantitative statistics around the underlying performance of the business.

How would you characterize the U.K. market now? Are you seeing it worsen versus 3Q, relatively the same for 3Q?

I think it's generally relatively the same.

Got it. And remind us how large the U.K. business is of your merchants?

Yes. The U.K. business is roughly 15% of the merchant segment. The U.K. business sits within the enterprise subsegment within our merchant business, roughly 15%.

What are you most excited about as we enter 2023 for FIS? And what are you most worried about? What keeps you up at night?

Well, in terms of what I'm excited about, I'm excited about just the company itself. As I said at the very start of the interview, FIS is a big business with global distribution, with lots of -- with a high concentration of recurring revenue, with a lot of very marquee customers. So I'm very, very excited about the opportunity that I've got in front of us. In terms of things that I'm nervous about, Rayna, we've got a really uncertain macro. And the macros impacted us rather materially in 2022. I am excited about launching the enterprise transformation program. I'm excited about providing some guidance associated with how much of that contribution will impact '23 versus '24 and the mix between operating expenses and capital expenditures. I'm cautious associated with our sales performance in our banking business. But broadly speaking, I'm very excited about the new leadership between myself and Stephanie Ferris, who assumes the CEO role on January 1 as FIS moves forward.

How crucial is the merchant business to your long-term strategy? This is a question from the audience.

That's very important. It's very important. We do have an initiative underway called Project Amplify, which is an initiative really to unlock the white space across the organization. So within our capital markets segment and our banking segment and our merchant segment, we've got products and services that fit all of those customer bases. So for example, we've got embedded finance that we can sell to our merchant customers. And we've got capital markets solutions, for example, our treasury services that we can sell to Merchant Solutions. We can use Merchant Solutions to plug into our banking customer base. We've got a tremendous amount of unlock that can happen associated with the white space of the organization together. So merchants at its foundational is banking and capital markets.

How have the -- so since -- so in 2019, when you acquired Worldpay, the biggest synergy that Gary would speak about was just the Banking Solutions segment serving as a referral channel for merchant. How has that played out?

Yes. So the bank channel sits under our SME book. It continues to perform well. But in addition to that, right now, we've got synergies associated with our loyalty business. As I mentioned, we're selling treasury solutions into our merchant business as well. To your point, we are plugging in, acquiring to our banking core base. We've had some very robust success associated with revenue synergies across the Worldpay deal.

Okay. Take another one from the audience. In merchant, you mentioned SMB is about 25% of segment revenue. Can you give us a breakdown of the different parts of your SMB business? How are they performing? And what strategies are you taking on to improve growth in these subsegments?

Yes, good question, thank you for asking it. So within the SMB book, which is roughly 25% of the merchant segment, we've got 3 predominant channels. Number one, we've got an ISV book, which is roughly half of the SMB subsegment. We have got an ISO book, which is roughly 1/3. And we've got the bank channel piece, which is roughly 20%. As I mentioned, the bank channel business is continuing to perform well. The ISO business, I mean, it's an ISO book. It's sort of bobbing around at 0. And then we've got the ISV channel, which we are deliberately attacking with our Worldpay for Platforms strategy to enable card-not-present technology for these ISVs and give them the ability to compete.

Got it. Okay. You're often compared to new entrants in the market, like Adyen and Stripe. What capabilities do you think FIS needs to invest in so that it can be more competitive against some of these newer entrants?

Well, I think we are competitive in these new entrants. And I might take it a step -- I may come at it a little bit differently, Rayna. We have got existing capabilities that others do not. So when we talk about -- maybe I'll pause on embedded finance for one second. So within our eCommerce business, within Payrix for Worldpay for Platforms, we've got existing assets within our banking business. We've got existing assets within our capital markets business that can further enable these customers. As I mentioned, whether it's issuing or credit or loyalty, we've got assets that can further and more quickly enable embedded finance to ensure competitiveness with the companies that you mentioned.

Since we're reaching close to the end of this conversation, final question is, what do you think, if anything, investors are missing about the FIS story?

Well, FIS is a big, durable business. We generate a lot of free cash flow. I would say that there's a lot of focus associated with our SMB book. You know if -- Rayna, if I go segment by segment, the banking business, as I mentioned, large concentrations of recurring revenue, strong margins, generates a lot of free cash flow. The capital markets business continues to perform very well, and it only gets -- it's only continuing to improve. The merchant business, we've got an eCommerce business that is growing very well. We've got an enterprise book that provides a level of insulation and durability in a choppy environment. And we've got an SMB book, which has got 3 subcomponents that I previously mentioned that the bank channel business is performing well, the ISO book. I would say the one piece that I might say, Rayna, is that the ISV book, it's a subcomponent of the broader segment. The FIS business is big, it's durable. We've got a consistent pattern of growth, and we've got a consistent pattern of margin expansion.

Great. Well, Erik, thanks for joining us today.

Thank you very much.

It's great having you.