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We are reiterating our Neutral recommendation on Total System Services Inc. (TSS - Analyst Report) based on the current sustainability factor. Although the company has been witnessing improvement in gaining significant contracts over the past few quarters, risks related to operating leverage remains.

Total System reported second-quarter 2012 operating earnings of 35 cents per share that outpaced both the Zacks Consensus Estimate of 32 cents and the year-ago quarter’s earnings of 28 cents per share.

Results reflect consistent growth in revenues across all business segments and increase in overall transaction volume and new accounts. Strict expense control also boosted the results. These positives paved way for escalated bottom line and improved operating cash flow. However, higher-than-expected non-operating and tax expenses partly offset the revenue growth.

Total System’s contract portfolio has got quite a fillip in 2012 with the processing contract attainment for its merchant acquiring services and technology services through the TSYS PRIME 4 card management solutions, VAR Partner Connect Program and Mobile App. In July 2012, Bank of America Corp. (BAC - Analyst Report) also extended its long-term contract for merchant and other card processing services through a new joint venture, thereby driving long-term growth.

Total System’s vigorous efforts of divesting redundant operations and streamlining its overall expenses to execute its international expansion and other efficient client growth strategies have started showing results. Consequently, number of accounts of file, a significant revenue driver, has witnessed spectacular growth in 2011 and so far in 2012.

Financially too, Total System appears sounds with a positive growth in operating cash flow and capital position. With a current ratio of 2.0:1.0, at the end of second-quarter 2012, the company appears well-equipped to meet most of its capital expenditure needs through internal funds, while also indicating disciplined expense management.

Healthy liquidity also paves way for returning wealth to shareholders through dividends and the recently expanded share buyback program, thereby inculcating confidence for future growth.

However, the global payments industry is intensely competitive and Total System faces intense competition from data processing, bankcard computer service firms and third-party software vendors within the US as well as from international processors and third-party software vendors. The company’s prime competitors include Equifax Inc. (EFX - Analyst Report) and Wright Express Corp. , while it also faces operating challenges from MasterCard Inc. (MA - Analyst Report), Visa Inc. (V - Analyst Report) and Discover Financial Services (DFS - Analyst Report).

Total System is significantly exposed to interest rate risk associated with the investing of available cash as well as foreign exchange risk. Moreover, most of the regulatory measures, which were enacted in the US in July 2011, have already been implemented, and could contract credit offerings from financial institutions in the future.

Further, the regulations impose numerous costly new compliance burdens on Total System and its customers, which could lead to increased service costs and legal compliance costs. Even management’s outlook for top line in 2012, which is 0–2% growth over 2011, appears stressful. The ongoing global economic volatility continues to offer ample stress tests to the company, which would have adverse implications on the margins and sustained growth.

Based on all the pros and cons, the Zacks Consensus Estimate currently pegs earnings at 32 cents for the third quarter of 2012, up about 5% year over year. For 2012, earnings are projected to increase to $1.29 per share. This reflects an increase of about 12% year over year, which is in line with the upper end of management’s guidance of 10–12% growth for 2012.

Currently, Total System carries a Zacks Rank #4, which translates into a short-term Sell rating, while the long-term Neutral recommendation indicates no clear directional pressure on the stock in the near term.

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