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Processors Feel Customers' Pain Only Indirectly

Core processors will feel only limited pain from the financial crisis.

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The term data processor encompasses a fairly wide range of companies, from payroll processors such as  Paychex (PAYX) to prescription drug sales tracker  IMS Health (RX). In this article, however, we will focus on two types of processors tied to the financial industry: core processors (or bank technology companies) and credit card processors.

Core processors serve the banking industry, and the market has found them guilty by association. While struggling customers are not a recipe for success for any company, we think the negative effect of the financial crisis on core processors will be limited and that three core processors we cover ( Fiserv (FISV),  Jack Henry (JKHY), and  Metavante (MV)) look attractively priced. Core processing refers to the day-to-day systems banks use to track customer transactions and balances. Given the mission-critical nature of these systems, banks almost never switch vendors. Excluding cases where customers are acquired by banks, customer retention rates are typically on the order of 99%. Core processors take advantage of these essentially captive relationships to cross-sell other products such as Internet banking and electronic bill payments, which is why the term bank technology company applies as well.

But with the banking industry under severe stress, why shouldn't the core processors also suffer? First, no matter how poorly a bank performs, as long as it doors stay open it needs to pay its core processor. Without the technology to process transactions, no bank could operate. Industry leader Fiserv, for example, estimates that 85% of its revenue base is recurring under long-term contracts. License sales will take a hit as banks cut discretionary spending, but pointing again to Fiserv, license sales make up only 5% of its revenue. Also, the customer base of the core processors skews heavily toward small and midsized banks, which have largely avoided the losses their larger peers have incurred this year. Finally, diversified client bases limit the effect of specific customer failures. Certainly, there is a greater risk of bank consolidation as the industry shakes out, but consolidation is a trend the core processors have been living with for a long time without issue. So far, these companies' results support our opinion of a limited impact. Fiserv, which had been growing at a mid-single-digit level for the last few years, saw flat sales on an organic basis in the third quarter, and the other core processors also saw a slowdown in growth, but none of them experienced a revenue decline. We expect similar results in 2009.

But while core processors will have a bite taken out their growth in the near term, a long-term trend toward increased technology needs for banks remains in place. For example, not so long ago, Internet banking was considered an optional perk to draw in depositors. Now, it is something that customers expect. We think the cost effectiveness of customers handling their own accounts will continue to drive the move from branch visits and paper checks to online transactions and digital funds transfer. One lesson we would expect financial institutions to take from this crisis is the attractiveness of stable deposit funding. And if you're trying to attract deposit customers, you're going to be at disadvantage if your systems are outdated.

We expect the recession to have a greater impact on the credit card processors. While card issuers like  Capital One (COF) work to sign up consumers, card processors work at the other end, setting up merchants to accept credit and debit cards. Two processors we cover,  Global Payments (GPN) and  Heartland Payments (HPY), focus on the small merchant niche. Global and Heartland present an interesting contrast, with Global sticking to an old-school approach, using confusing billing statements to mask its fees from clients. Heartland, on the other hand, sets itself in opposition to industry practices that it feels are unfair to customers, committing itself to clear pricing. It may seem paradoxical, but we think both approaches work, although Heartland has more potential upside if it's successful in upsetting the industry apple cart.

The small merchant space is the most attractive in the long run, as it is still not fully penetrated and small merchants have less leverage to push down fees. But small merchants are also the most exposed to a recession. In the near term, the economic trend will battle against the secular growth trend. Heartland, for instance, was able to increase revenue organically 14% in the third quarter, despite a 2% decline in same-store sales, as it continued to sign up new clients. We're less concerned with same-store sales declines, however, than with a spike in attrition rates, as small merchants can be expected to fail in large numbers during a recession. Although near-term risk is present, we think both companies are worth consideration at the right price, as we like the fundamentals of the industry and expect both to remain profitable.

Brett Horn does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.