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Fidelity Inc. (FIS - Analyst Report) recently announced that it has abandoned its plan of acquiring British financial software company Misys Plc., after the two companies failed to reach a consensus regarding the purchase price. Earlier, in late June, Florida-based Fidelity made a preliminary offer to buy Misys for approximately $2.27 billion. However, Fidelity did not give any reason for the decision.

Moreover, the company announced its intention of repurchasing shares under its existing share repurchase authorization. Fidelity has approximately 13.6 million shares remaining under the existing authorization that was approved by the company’s Board of Directors on February 4, 2010.

Misys, whose clientele comprises all of the world’s top 50 banks, received a revised non-binding offer from Fidelity on July 20, 2011. However, the London-based firm rejected the offer, citing undervaluation.

The sluggish trading environment in the technology sector was primarily responsible for the failure of the deal, according to some analysts. They also believe that the weaker demand may have induced the companies to back out from the deal, after Swiss banking software company Temenos issued a profit warning based on the cautious spending from the banks.

We believe the acquisition would have expanded Fidelity’s business in the European market, thereby reducing its dependence on the US market. On the flip side, we also note that Fidelity possesses significantly high debt levels, and an acquisition of this magnitude would have further aggravated the company’s risk profile going forward.

As of June 30, 2011, total debt (including the current portion) was $4.88 billion; net cash position (cash less debt) was negative $14.33 per share and the debt-capital ratio was 41.5%. Fidelity’s higher interest rates (interest expense soared 241.0% year over year in the second quarter) on its debt are expected to negatively impact its profitability going forward.

Moreover, Fidelity continues to face integration risks. Fidelity’s recent growth was primarily driven by acquisitions such as GIFTS Software, Inc., consulting firm Capco, ValueCentric Marketing Group, Inc., Compliance Coach, Inc., and Metavante Technologies.

Although we believe that the acquisition of these companies will drive both top-line growth and cost synergies with increased operating leverage; we expect this to come at the expense of lower cash flows due to increased working capital requirements.

Last month, Fidelity reported strong second quarter 2011 results, beating the Zacks Consensus Estimate by a penny. The better-than-expected results were driven by strong top-line growth in the quarter. Revenues on a non-GAAP basis in the second quarter increased 13% year over year to $1.44 billion. For further details please see Fidelity Edges Out Estimates.

Recommendation

We believe Fidelity’s expansion into emerging markets such as Brazil, India and China will drive organic revenue growth over the long term. We also believe that Fidelity’s commanding position in the financial services market, increasing international exposure, recurring revenue model, diversified product portfolio, cost synergies from acquisitions and a loyal customer base will drive growth over the long term.

However, increasing consolidation in the banking sector, a challenging environment for the Payments Solutions business and an uncertain regulatory environment are primary headwinds, in our view.

We maintain our Neutral rating on a long-term basis (for the next 6 to 12 months), primarily due to increasing debt and intense competition from Fiserv Inc. (FISV - Analyst Report), and privately held SunGard Data Systems Inc.

Currently, Fidelity has a Zacks #3 Rank, which implies a short-term Sell rating (for the next 1-3 months).

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