Fiserv, Inc. (FISV) Q3 2018 Earnings Report, Transcript and Summary

Welcome to the Fiserv 2018 Third Quarter Earnings Conference Call. [Operator Instructions] As a reminder, today's call is being recorded. At this time, I will turn the call over to Tiffany Willis, Vice President of Investor Relations at Fiserv.

Thank you, and good afternoon. I'm pleased to be here today in my new role leading Investor Relations. I look forward to connecting with many of you in the future. With me today for the call are Jeff Yabuki, our Chief Executive Officer; and Bob Hau, our Chief Financial Officer. Please note that our earnings release and supplemental presentation for the quarter are available on the Investor Relations section of fiserv.com. Our remarks today will include forward-looking statements about, among other matters, expected operating and financial results, strategic initiatives, the acquisition of the debit processing and related solutions of Elan Financial Services and the impact from tax reform. Forward-looking statements may differ materially from actual results and are subject to a number of risk and uncertainties. Please refer to our earnings release for a discussion of these risk factors. You should also refer to our material for today's call for an explanation of the non-GAAP financial measures discussed in this conference call along with the reconciliation of those measures to the nearest applicable GAAP measures. These non-GAAP measures are indicators that management uses to provide additional meaningful comparisons between current results and prior reported results and as a basis for planning and forecasting for future periods. Unless stated otherwise, performance references made throughout this call are soon to be year-over-year comparisons. As a reminder, the share and per share amounts in the press release, supplemental materials and comments are adjusted for the 2-for-1 stock split completed in March of this year along with adjusting the comparable 2017 adjusted earnings per share amounts in each period for the sale of the majority interest of our Lending Solutions business, which closed in March. And with that, let me turn the call over to Jeff.

Thanks, Tiffany. Nicely done on your first earnings call. Good afternoon to everyone joining us today. We delivered strong financial results, including 5% internal revenue growth in both the third quarter and the first 9 months of the year. Additionally, internal revenue [ has been ] 5% over the rolling 12 months, ending in this year's third quarter. Adjusted EPS grew 23% in the quarter and is up a very strong 26% year-to-date. We remain well on track to meet our financial commitments for the year while continuing to invest in your company. Free cash flow for the quarter was up 22% to $322 million and is over $800 million year-to-date, both of which include the divestiture impact of our lending business. We continue to focus on share repurchase as our primary capital benchmark allocating $438 million in the quarter and, for the year-to-date, have repurchased $1.2 billion. Before we dive into the results, let me provide perspective on the approximately $690 million acquisition of the debit-based assets of Elan Financial Services, which closed today. This acquisition, with annual revenue of over $170 million, extends our leadership in payments, broadens client reach and scale and provides new solutions to enhance the value proposition for our existing 3,000 debit solution clients. We're excited about the opportunity to extend our Payments franchise and welcome more than 300 talented associates to Fiserv. Scale is becoming increasingly important in the payments network and processing businesses. We have spent the last several years quietly migrating more than 1,200 clients to a single debit platform with our most advanced capabilities. We plan to leverage those experiences to successfully migrate the more than 1,000 acquired Elan clients to our platform over the next couple of years. We see revenues synergy opportunities across 3 primary areas. First, we have a number of solutions in our existing card portfolio to make available to the existing clients in areas such as the ACCEL network, enhanced risk, card production and digital capabilities, such as CardValet. The acquisition also provides a couple of new solutions, which are additive to our portfolio and should contribute to internal revenue growth. As part of the transaction, we acquired Money Pass, the second-largest surcharge free ATM network in the U.S. with over 33,000 in-network ATMs. In addition, we acquired a small but strong ATM Managed Services capability, which extends our existing ATM offerings and payments differentiation. The third opportunity is to provide other Fiserv solutions outside of card payments as the substantial majority of the acquired clients are not currently Fiserv account processing clients. Over time, we expect to compete for new revenue opportunities by demonstrating our solution strength and integration advantage. Overall, we believe the synergy opportunity from consolidating to a scaled, market-leading platform will add value to the acquired clients and deliver meaningful cost benefits over the next 24 months. We also believe the revenue synergies to be equally significant but will have a longer ramp given existing client contracts and sales lead times. We generally expect to be at the revenue synergy run rate over a 4- to 5-year period. Given synergy timing, we expect this transaction to be modestly accretive to earnings in 2019 and to grow over time. With that, let's move to our 3 key shareholder priorities for 2018, which are: first, continue to build high-quality revenue while meeting our earnings commitments; next, to enhance client relationships with an emphasis on digital and payment solutions; and third, to deliver innovation and integration, which enables differentiated value for our clients. As I mentioned, we achieved 5% internal revenue growth in the quarter and year-to-date, driven by strong results from a number of our businesses, including card, biller and bank solutions. Internal revenue growth is up 170 basis points versus the comparable 9-month period and is 5% for the trailing 12 months. As you know, we are making and we will continue to make investments to ensure your business delivers sustained competitive advantage and excellence for our clients, balanced against delivering results that are consistent with expectations. To that end, adjusted earnings per share was up 23% for the quarter and 26% year-to-date from a combination of operating leverage, tax rate reductions and capital deployment. These very strong adjusted EPS results were delivered in spite of a 100 basis point decline in adjusted operating margin in the quarter and down 20 basis points year-to-date. The year-over-year decline was due primarily to the lending divestiture, margin-dilutive acquisitions and the investment pool established from tax savings earlier in the year. But for these items, adjusted operating margin in the quarter and year-to-date would have been up 60 basis points and 130 basis points, respectively, compared to the prior year. We continue to believe we will achieve our revenue and earnings commitments for the year, consistent with our first shareholder priority. Our second focus is to enhance client relationships with an emphasis on digital and payment solution. DNA is positioned as the leading charter-agnostic real-time account processing platform continued with 8 signings in the quarter. We announced the addition of CFCU Community Credit Union with over $1 billion of assets to our new Digital Edge solution suite, which is anchored by DNA. In a competitive process, CFCU selected our comprehensive digital-centric platform to provide their members access to our leading digital and payment solutions integrated into DNA. Market interest in Digital Edge is growing, and we believe it will be a longer-term differentiator for the digital-first market. We had 8 DNA clients go live in the quarter and a total of more than 20 since January. We expect nearly 30 DNA clients to go live in the year, which would be a record number of annual implementations. We continue to see important growth both for us and our clients across our digital banking solutions. Mobiliti ASP subscribers grew by 23% in the quarter to just under 8 million. Due to strong demand, we have expended our Architect implementation teams and expect to bring 12 clients live in Q4 alone, which will double the number of go lives for the full year. We anticipate exiting the year with strong Architect sales, a large implementation backlog and continuing market momentum. We're seeing interest in sales activity in platform modernization with our recently acquired Dovetail Payments Platform. We are pleased to sign Union Bank with $160 billion of assets to enable their connectivity to the TCH real-time payments network. We also signed BBVA Compass with nearly $90 billion of assets to help modernize their enterprise payment capabilities in the shift towards real-time settlement. We were recognized in the quarter by IDC for our Real Result Award for next-generation payments for enabling Instant Payments in our Dovetail solution for Intesa Sanpaolo, the leading bank in Italy with a strong international footprint. Our third priority is to deliver innovation and integration, which enables differentiated value for our clients. Zelle continues to garner significant market focus and attention, leading us to sign more than 50 new Zelle clients in the quarter. We were also pleased to bring Dollar Bank, with $8.5 billion in assets, live in the quarter. We expect a continuing ramp of new Zelle clients in Q4 and meaningful acceleration in 2019. We remain focused on ways to accelerate implementation cycles to meet the growing market demand. Zelle transactions were up more than 50% sequentially, and through September 30, are more than 10x the prior year level. Our conviction in Zelle remains high as financial institutions accelerate their focus at the intersection of digital capabilities and real-time money movement. Lastly, we are seeing additional interest in our Immediate Funds solution, which provides financial institutions the opportunity to provide their customers with instant access to deposited funds. A top 10 bank selected our solution in the quarter to address this evolving opportunity and plans to offer this service to their customers across multiple channels. With that, let me turn the call over to Bob for more detail on our financial results.

Thank you, Jeff, and good afternoon. Adjusted revenue was up 1% to $1.3 billion in the quarter and 2% to $4.1 billion year-to-date. Internal revenue growth was 5% in the quarter, driven by strong performance across a number of our businesses, and is also up 5% for the 9-month period. For comparison, our reported internal revenue growth through September would have been 50 basis points higher had we restated our results under ASC 606. Adjusted operating income in the quarter was down 2% to $425 million and, for the year-to-date, was up 2% to $1.3 billion, both of which were impacted by the Lending Transaction. Adjusted operating margin for the quarter was 31.6%, a decrease of 100 basis points, and was down 20 basis points through September 30. The performance in the quarter includes a 160 basis point headwind from a combination of the lending divestiture, acquisitions which closed last year and the impact of a client-focused incremental investments funded through tax savings. This headwind was partially offset by 60 basis points from our strong operational effectiveness performance and operating model leverage. We now expect 2018 adjusted operating margin to expand about 10 basis points, the low end of the range, given a slower ramp of acquisitions, including Elan, which closed today, and high opportunistic in-year investments. Adjusted EPS was up 23% to $0.75 in the quarter and increased 26% to $2.26 to the first 9 months of the year. Based on our strong performance to-date, we expect to achieve double-digit adjusted EPS growth for a 33rd consecutive year. Payments segment adjusted revenue was up 6% to $779 million in the quarter and up 7% to $2.3 billion year-to-date. Strong performance in our card services and biller businesses drove internal revenue growth of 5% for both the quarter and first 9 months of the year. Increased adoption and growing transaction volumes remain important elements of driving high-quality revenue growth. In the quarter, debit transactions were up double digits, and total P2P transactions, including both Popmoney and Zelle, grew nearly 50%. Additionally, Mobiliti ASP subscribers grew 23% to nearly 8 million, continuing to reinforce the importance of digital in the evolving landscape of financial experiences. Adjusted operating income in the Payments segment grew 5% to $260 million -- excuse me, $267 million in the quarter and 7% to $809 million year-to-date. Adjusted operating margin in the quarter contracted 40 basis points to 34.2% and has expanded 20 basis points to 34.9% for the year-to-date. Segment-adjusted operating margin results were negatively impacted by 140 basis points in the quarter from a combination of the headwind from acquisitions and the investments from tax savings, which were included in our guidance shared at the beginning of the year. For the Financial segment, adjusted revenue decreased 7% to $574 million for the quarter and 4% to $1.8 billion for the first 9 months of the year due to the Lending Transaction. Internal revenue growth, which considers the divestiture, was up a strong 4% in both the quarter and year-to-date driven primarily by solid performance from our account and item processing businesses. The Financial segment's adjusted operating income decreased 8% in the third quarter to $187 million and declined 4% to $590 million for the year-to-date, again, due to the Lending Transaction. Adjusted operating margin contracted 40 basis points to 32.7% for the quarter and expanded 20 basis points to 33.2% for the 9-month period. But for the Lending Transaction, segment margin would have been up by 120 and 160 basis points in the quarter and year-to-date periods, respectively. The adjusted corporate operating loss was up $6 million in the quarter due primarily to a difficult prior year compare but fully in line with our plan and consistent with the 2018 run rate. The adjusted effective tax rate for the third quarter was slightly better than our expectations at 19.7% due largely to a discrete tax benefit realized in the quarter. Our adjusted effective tax rate through September was 20.7%, and we continue to focus on strategies to sustainably lower our tax rate. And accordingly, we now expect our full year adjusted effective tax rate to be just below 22%. We continue to deliver significant free cash flow, generating $813 million for the first 9 months of the year. Free cash flow conversion was better in the quarter at 104%, nearly double the rate from Q2, and is now 86% for the 9 months this year. The results for the year have been pressured by combined impact of working capital timing and the impact of ASC 606. Now given our visibility into Q4, we expect to be around the low end of our free cash flow conversion rate outlook for the full year. We repurchased 5.6 million shares in the quarter for $438 million and have returned over $1.2 billion to shareholders through September 30. We have now exceeded, for the first 9 months of the year, the total amount repurchased in all of 2017. We had 34.9 million shares remaining in our share repurchase authorization, which includes a new authorization for 30 million shares approved in the quarter. We had 401 million shares outstanding as of September 30. During the quarter, we issued -- excuse me, during the quarter, we issued $2 billion of new 5- and 10-year notes at a blended rate of 4% and an average maturity of 7.5 years. We used those proceeds to pay off our term loan, retire our $450 million 4.625% interest rate bonds that were due in 2000 -- excuse me, in 2020, and paid down a revolving line of credit. Although interest expense will increase sequentially in the fourth quarter and next year, it was a great opportunity to lock in attractive rates ahead of an upward trending market. Also, because we completed the 2020 note pay-off in October, our balance sheet at quarter's end did not fully reflect the results of the refinancing. Lastly, we extended the term of our revolving line of credit through 2023 and used it to finance the Elan acquisition, which closed earlier today. Our long-term debt, excluding the revolver, is now entirely fixed rate. Our debt to adjusted EBITDA ratio was 2.4x at the end of the quarter, which does not reflect the retirement of the 2020 note. Had that been completed as of September 30, our debt to adjusted EBITDA would have been 2.2x. Now with that, let me turn the call back over to Jeff.

Thanks, Bob. Sales performance in the quarter was off a bit more than expected, coming in at 69% of quota and declined 29% from the prior year. The sizable amount of the decline came from 2 large long-tenured transactions in the prior year period. Normalizing for contract term only, sales would have been down by 13% in the period. Year-to-date, book sales are down 8% but up 1% when adjusting for the term differential. Quota attainment for the year-to-date was 80%. The domestic pipeline continues to grow and is up 30% over the prior year. We expect very strong sales in the fourth quarter. We continue to make excellent progress on our operational effectiveness initiatives. We achieved another $13 million of savings in the quarter and are at $45 million attainment for the first 9 months of the year. We now expect to exceed our annual goal of $50 million of savings. The financial services environment remains strong, with rising interest rates, positive tax momentum and a benign credit landscape. We continue to see meaningful demand in areas where we have invested, such as consumer and commercial digital, risk management and real-time payments. The Zelle opportunity remains robust as the industry looks to claw back the P2P space and create technology optionality for the future. M&A remains active as financial institutions continue to focus on gaining scale and increasing deposit balances, which we expect will continue for the foreseeable future. As we said upfront, we remain on track to achieve our key financial objectives for 2018, which includes an increase in our internal revenue growth rate to at least 4.5% for the year. As a reminder, for comparison, last year's fourth quarter was our strongest internal revenue growth quarter of the year. We also expect to achieve our adjusted EPS guidance for the year. Given where we are in Q4, we now expect the full year to be in a range of $3.10 to $3.15, strong growth of 25% to 27% over the adjusted $2.48 last year and $0.08 higher than the bottom of the original range of $3.02 to $3.15. You will recall that our full year results anticipate incremental investments funded from tax-reduction savings of at least $25 million for the full year. As Bob indicated, we now expect full year adjusted operating margin to be around 10 basis points, and free cash flow conversion to be about 106% for the year. In conclusion, we're pleased with our year-to-date performance and our progress in building your company. Internal revenue growth is 5% and well ahead of last year's comparable growth rate. Adjusted EPS is up a very strong 26%, supported by operating leverage and operational effectiveness program benefits and also includes incremental investments to further sustain competitive advantage. As important, we continue to allocate capital to build value for shareholders, including a record pace for share repurchase, an enhanced debt structure and the acquisition of Elan's debit assets and a move to deliver incremental value for both clients and shareholders. We also remain committed to a continuous 360-degree view of excellence. Last month, we received the results of our annual associated engagement survey. And after recording a fifth straight year of improvement, have now crossed into the top quartile of associate engagement of the participating employers and their more than 3.5 million employees. And while we aren't done yet, we are grateful to the 24,000 Fiserv proud associates who bring their best every day for the company, its clients and you, our shareholders. With that, operator, let's open the line for questions.

[Operator Instructions] The first question comes from David Togut from Evercore.

I'd like to start with a question about the Elan Financial Services acquisition. Thanks for giving the revenue from Elan. Could you break out what expected EBITDA will be on an annual basis?

Yes, David. Thanks for the question. Good afternoon. Overall, as you heard in our prepared remarks, that business will add about $170 million of revenue to us. We're just now closing as of this morning, so it'll be a nominal impact for the 2018 results in fourth quarter. And when we get into 2019, we'll certainly incorporate that in overall guidance. It's a nice business for us. It's right up the alley of what we do in our debit card processing business today. And as Jeff pointed out in his prepared remarks, gives us some really nice opportunities for synergies over the next couple of years from a cost synergy standpoint as we bring those -- that scale into our existing debit processing platform and, over the next 4, 5 years, to drive some meaningful revenue synergies. So we're looking forward to getting that business online and driving that revenue and cost synergies over the next 4, 5 years.

So David, I -- to the exact question of will we provide EBITDA. The answer is we don't give that kind of a breakdown, as I know you know. But I would say that we would expect that business to maintain margins consistent with our debit processing business, especially as we migrate, as Bob mentioned, we migrate it over to our platform. Over the next couple of years, we're moving from having they run on their own platform, to U.S. Bank, we're going to obviously migrate them to our platform. So we think that there are meaningful cost synergy benefits that will come in. One of the reasons why we're saying it's moderately accretive next year is obviously we'll be moving that forward as we migrate clients over to our platform.

Understood. And then on the third quarter earnings call last year, you gave a preliminary 2019 earnings outlook of $3.50 a share. On a split-adjusted basis, based on what you see in terms of the underlying margin expansion of the business, bookings, revenue trends, is that $3.50 outlook still intact for 2019?

Yes. So I would say, Bob is making sure that he gives me the normal look. I think what we told you is specifically we were not giving guidance. But based on what we could see at the time that we expect it to be in that range. I would say that nothing has changed since we talked about that previously to where we are today. I would say with one exception, and that is, as Bob mentioned, we did a fairly meaningful refinance in the quarter, and that's going to add some additional interest expense, which we expect to cover the same way we cover everything else from an operating perspective. I am not saying we won't be there, and I'm not saying we will be there. But I am saying that that's the one thing that I can think that's a little bit different than it was when we talked last time. Conversely, we've acquired Elan. We expect that to be accretive. So I think when we give guidance, we'll be giving guidance that's consistent with what we have been saying all along.

Got it. And then just a quick final question from me. Money20/20, MasterCard debuted new bill pay exchange offering. And I'm just curious if you compare that on a feature-functionality basis to kind of CheckFree's core bill pay offering, how does it stack up? Is this sort of a significant competitive threat or not so much?

Not so much.

And why would that be?

It's not so much -- we -- as you know, that technology has been a market-leading technology for a long time. And the beauty in our technology is the data. Not only can we move money at any speed consistent with what a consumer wants, but we know how to perfect a payment and we know how to manage risk on those payments. And so we are able to take money out of accounts when the consumer wants it because we have a risk model, a patented risk model, that allows us to make smart, intelligent decisions on that basis. But the most important part is we know how to make sure the money goes where it's supposed to go even if the consumer who will occasionally tell us the wrong thing. So we just think it's a more advanced technology. By the same token, we all see a very significant opportunity to electronify the nearly half of the bill payments each year that still are not moving on an electronic rail. So we're glad others are talking about it. But we believe right now we maintain a meaningful and important strategic and competitive advantage.

The next question comes from Dave Koning of Baird.

So I guess, first of all, I'm just wondering, so Q3 revenue is a little lighter than we thought. Was there some periodic revenue maybe that's moving into Q4? Because Q4 seems almost a little better than we thought, and margins in Q3 are a little weak. And usually that periodic revenue carries pretty high margins. Is that kind of what's happening here?

Yes. And we -- you know well that periodic revenue comes in when, to a large degree, it decides it wants to come in. In Q2, remember, we said we had a little bit of a pull from Q3 to Q2. In Q3, we actually have it shifting from Q3 to Q4. And so because of the margins, that also follows. So we do expect -- I think we tried to give a little clarity last quarter when we indicated we expected the first half and the second half to be substantially similar, and we're absolutely on track for that. So no -- nothing other than the shift in revenue -- sorry, the periodic revenue, as you know. And then the other piece on margin, just to add a little bit more clarity. If you look at the last 3 years, Q3 has been our weakest margin quarter, and most of that, to your question, comes from movement of periodic revenue between quarters. And it just so happens that Q3 tends to be an unusually weak periodic revenue quarter for some reason.

Okay. And I guess how much down was it year-over-year in Q3?

It was not down meaningfully in the quarter. To the prior, it was down relative to our expectations for how the periodic revenue would flow through the year.

David, if you think about it, we had a good first quarter. We had a very strong second quarter, to Jeff's point. Some of that was timing of periodic revenue actually shifting out of third quarter. We ended up, in the first half of the year, at 5%. We expected the second half to be similar in growth rate in total versus first half and expect Q3 to be the strong quarter within the half with Q4 being a little bit lighter given the tougher comp in the fourth quarter. That's still the case, but we'll be more normalized because Q3 came in a little bit lighter and Q4 will be a little bit stronger. But it's a shift within quarters. It's not a year-over-year thing, per se.

Okay. And just one quick follow-up. The $3.10 to $3.15 this year includes a little bit, I think, a couple months of the lending business in the first quarter, so you'll lose that next year. Is Elan -- the benefit from Elan, the accretion from that bigger than the lending EPS that you kind of lose next year?

No. The lending income -- operating income in the first quarter of -- excuse me, the first quarter of '18 will be a little bit stronger than the first quarter from Elan in '19. A little bit bigger business.

The next question comes from Andrew Jeffrey of SunTrust.

I actually have a couple, if I may, Jeff, and maybe both of you guys could actually weigh in. You call out sort of investments, and you do so consistently and maybe a little bit more so this quarter than others. Could you just talk a little bit about IRR thresholds or philosophy in terms of how you deploy and when you deploy capital to reinvest in the business?

Sure. So philosophically, the investments that we make, we think more about the capital trade-offs as opposed to maybe a traditional IRR. So if we're going to make incremental investments, we think about how does that compare to share repurchase, just like we would with an acquisition. And how does that end up impacting our competitive position in the market? The problem with IRR is just you can do lots of things with terminal value to make the IRR be whatever you want it to be. And so we tend to stay away from that as a metric, unless we're doing very large incremental allocations of capital, which we are not. The reason why we referenced it in this quarter and maybe a little bit more to your perspective is because the margin was a little bit lighter in the quarter than I think people expected. We were trying to call out this idea that, that $25 million pool, that at least $25 million, the third quarter was the first quarter in which that really started to hit. We'll have an even bigger hit coming in next quarter. And so pointing that out and also looking for other opportunities to invest in a year where, frankly, we're going to deliver 25% to 27% EPS, looking for ways to expedite investments in technology or feature function, we think, is the right way to think about capital overall.

Okay. So in the context of sustained kind of earnings growth and organic revenue growth, I guess?

That's right. That's right. Well, sustaining and hopefully increasing, right? Our strategy is to increase this year at 4.5%. It's roughly an 80 basis point increase in internal revenue growth. We are -- based on what we can see right now, we would expect to see some lift in that moving into '19. Of course, that's not formal guidance. But we would expect to see that as we continue to move forward.

Okay. And then if I may, recognizing that Elan is a lot about debit processing, you also, as you mentioned, acquired Money Pass and a Managed Services business. Can you talk a little bit about how you're thinking about ATMs and generally how they fit into sort of banks' priorities and whether there's an opportunity for a third party like Fiserv that outsources just about everything else that community banks do to provide more outsourced services around ATMs?

Sure. I mean, from our perspective, when we hear clients talk about how the digital world, right, will intersect with the physical world, ATMs continue to be front and center in that device-centric type strategy. And so we're still seeing that, and we're actually hearing more people want to add sophistication to those ATMs. For us -- and so given the scale that we have over 3,000 clients who we -- most of them, we drive ATMs for as part of our EFT and debit proposition, we see this to be actually a pretty attractive incremental service, outsourced service, that we can provide. We have stayed away from services like that historically for 2 reasons. Number one, we didn't have the expertise. And number two, it takes a little bit more capital than we tend to use, right, for going out and acquiring the ATMs. But just given how the world is morphing right now, we think it could make some sense, and we'll spend the next couple of years looking to see what can we add in terms of service offerings to those 3,000 clients.

The next question comes from Jeff Cantwell of Guggenheim Securities.

Jeff, you've led this company for many years. You've seen how it performs through various business cycles. Now clearly there's a lot more focus right now on macro risk versus EBITDA 3 months ago when you last spoke with us. So I want to ask you what your thinking is at this point in time as far as how you expect this company to perform if the U.S. economy moderates to some degree in the future. And then what operational levers might you be able to pull in order to manage through the cycle?

Sure. So Jeff, I mean, we are in a period where we are investing significantly in technologies that are linked up with digital -- kind of the digitization of financial services along with the need and soon to be mandate to move to a real-time monetary ecosystem. It's hard for me to see how either of those trends will moderate even if the economy itself begins to slow a bit. So I think that, based on where we are strategically, that will continue to be a fairly strong defensive play as we have been and frankly in all of the other cycles. That said, if in fact, we see a slowdown that starts to negatively impact financial services, I would expect us to be able to take steps such as slowing down the investments. And one of the things -- if you go back and look at our data, you'll see that we've meaningfully increased our level of spend as a percentage of revenue over the last 3, 5, 7 years. And most all of that drives future internal revenue growth. We think one of the beauties of our model is we can pull that back as needed without impacting the current level of internal revenue growth and create incremental flow-through of free cash. So I think we're pretty well positioned. We think about that all the time, as you might imagine. And we like the fact that we have that lever as well as -- I think we've demonstrated for the last 10-plus years, a strong ability to reduce, reign in and restructure our costs overall. We talk about it as operational effectiveness, and I'd expect us to be able to do more of that as well as needed.

The next question comes from Brett Huff of Stephens.

One question on Dovetail. That was an interesting acquisition to us, and it sounds like you guys got a couple of pretty big contracts, and I know that you serve a lot of very large banks, especially in bill pay. Any thoughts on in moving upmarket maybe in specific verticals or maybe even the core account processing. But is there a strategy about moving upmarket? Or is this more about digital and immediate payments, and you're just going maybe where the demand is right now?

It's really a combination of both. I mean, we, Brett, as you know, have a number of large clients who work with us on bill pay. We also have a number of large clients who work with us on digital. And we see that interesting interaction to just open the door to allow us to come in and talk about how the rails are evolving, and that was the back strategy. The other thing that you probably know is PEP+, which is the majority of the ACH in the U.S. goes over PEP+ today, is owned by us, and we see a nice fit between Dovetail and PEP+. So being able to help clients who we've served for years on payments modernized with Dovetail is also part of the strategy. So it's coming together. The market will move at the pace it moves, but we were pleased with the results in the quarter, and the pipeline looks good, and hopefully, we'll continue to make that progress.

Great. And then also there's been a lot more focus, I think, on helping banks or banks looking to do more alternative deposit gathering, not necessarily having to own the deposit-gathering function itself using partners, things like that. Some of those are featured on Money20/20. I know you guys do some of that. Can you just remind us of the various things you do, whether it's alternative lending, things like that? What kind of products, given your digital focus, have you been developing?

Yes. The majority of the things that we're doing are certainly focused on lending. We're doing work, as I mentioned, this is a little bit of an offshoot, but we're seeing more and more banks look to set up separate Internet brands to be able to go out and gather deposits. We do some work with some third parties who are -- who basically are brokering deposits across the -- more on a partnering and integration basis who are moving deposits around the ecosystem. And then, as you mentioned, things around Immediate Funds, which is about attracting noncustomers into branches, things like that.

The next question comes from Tien-tsin Huang of JPMorgan.

I want to ask on your comment on the strong sales expectation for the fourth quarter. What type of -- what do you see in the pipeline in being able to replenish the backlog and whatnot? Is there -- I feel like I ask you this every year, Jeff, but is there a concept of budget flush maybe that might be beneficial?

Yes. We do talk about it as we should. We -- you have kind of the year-end budgets. That's always the case. Fourth quarters are always strong. We had some larger sales slip from Q3 to Q4. That's part of the revenue movement from Q3 to Q4 is also due to some of those sales. So we have that. And we have, whether it is around the payment rail transformation, you've got a lot going on there, Zelle, DNA, a lot on the digital front, whether it be Architect or others. So there's -- the same kind of trends I think by -- also connected to the urgency of we've got to get it done this year so we can spin the project up and get going for next year.

Got it. Okay. That's good. So the -- as my follow-up on the margin front, you've covered a lot of it, I know, but just to be clear on my side, is the incremental change in the margin outlook, is it Elan? Because the tax reinvestments, I know you contemplated maybe the timing wasn't contemplated. Just trying to better understand what changed that you're seeing there?

Sure. Are you talking about from being 10 to 30 to going -- to saying it's going to be about 10?

Right. What's incremental to get to the 10?

Yes. There are a couple of things. I would say the biggest one is the acquisitions that we brought in last year as well as the impact of Elan. They're ramping a little bit slower. They've been -- the sales cycle took a little longer. So instead of us signing X deals, we sign Y deals. So things like that around the acquisitions. I would say that's one. Elan will be moderately dilutive as well. And then you've got the incremental investments that was due to tax reform. We've been looking for -- given how the year is progressing, are there some incremental investments we can make that none of them are material by themselves but just a few million dollars here and a few million there, not to diminish a few million, but it adds up, and it has a basis points impact. So it's really those kinds of things.

The next question comes from James Schneider of Goldman Sachs.

Maybe just returning to the question of sales for a moment. I think you talked about some of the slippage from Q3 to Q4, or I think on a full year basis or year-to-date, the quota attainment still feels a little bit light. Is that just the size of the deals? And maybe can you maybe address the whole topic of competitiveness of new deals because some of the sales commentary from some of your peers seems quite robust over the past couple quarters. I just wanted to square those 2 issues.

Sure. So the answer to the first part of the question was really around larger deals were the ones that were slipping. So they have an impact. We mentioned the fact that we had the term adjustment, which had an issue on our comparative sales. I think as a -- it's kind of squaring it, we are seeing a very robust sales environment. Pipeline's up 30% year-over-year, and it's both strong at the late stage as well as in the early stage. I think we probably give a bit more information than others in terms of exact percentages and things like that. So it's a little bit easier to see how our quantitative data ends up playing out. I would also agree that the 80 is a little bit light. But again, we're expecting a very strong fourth quarter and think we'll be quite well positioned for next year.

That's good to hear. And then maybe just on the financial side, free cash flow was actually down slightly year-to-date, and you talked about some of the factors that are driving that and some of the investments, I assume, that are playing into that. Can you maybe talk about as we head into 2019 what levers you're able to pull to kind of get that free cash flow back up to where it normally would be? And is that an issue of conversion percentage? Or is it an issue of lower CapEx as a percent of revenue or maybe some of the factors there, please?

Yes, Jim, it's Bob. We are nominally down just a couple million dollars -- a few million dollars on $800 million year-to-date number. The largest driver of the year-over-year performance is the lending divestiture, and it's a business that generated good cash that we don't have anymore. So it's in our last year numbers. We didn't adjust or make any modifications to last year's actuals. So that's probably the biggest driver. You saw on our third quarter numbers, the conversion rate jumped up very nicely to 104%. We've been a bit behind the overall year-to-date conversion rate. It's not what we would typically expect. And that's really driven by timing of working capital as well as CapEx spending. Some of those investments that we've talked about with that reinvestment of the tax savings is also bringing capital spending. So that will moderate into next year. We expect to have a very strong fourth quarter and hit the bottom end of the guidance range of the 106% for this year and be in good shape into 2019 and beyond.

But just to clarify as it relates to the cash flow itself, it's really a matter of the Lending business, a little bit more CapEx, things that should come back to a more normalized route.

The next question comes from Kartik Mehta of Northcoast Research.

Jeff, as you look at kind of the backlog of the business, the sales you're anticipating in the fourth quarter, what percentage of revenue do -- is already kind of -- I hate to use this word, but in the bag for 2019? And what do you still have to kind of backfill?

So on balance, our recurring revenue is in the 80% to 85% range, depending on what year you're in. So I think that's a reasonable proxy to say certainly, that's -- using the notion of in the bag, I think that's a fair way to think about it. But we also have line of sight into a whole bunch of additional revenue below that -- I'm sorry, above that recurring revenue number. So it's a fairly small number. Ultimately, that is kind of in the go-get category. But if it's -- even if it's 5%, it's 300 and change -- 300 million and change. And because 10 million is 1.25 points roughly, Bob's going to tell me it's really 12 million, but it's in that range, you can have those shifts just because of the 25 million to 30 million a month that is in that 5% range.

And then, Bob, just the tax rate for 2019, do you anticipate it to be similar to 2018? Or are there things that might change for 2019?

No. We came out with the original guidance of 22% to 23%. And I would think that as kind of a more normalized rate. This year will dip just below that given some of the discrete tax items we had. But of course, we're always looking for that. In fact, I think it's one of the things we pointed out in the prepared remarks. That's an expense line that we look to manage, but 22% to 23% is kind of a long-term normalized rate for us.

The next question comes from Ashwin Shirvaikar from Citibank.

You guys gave a lot of good color on sales, appreciate that. I guess larger deal slippage, I mean that happens. Larger deals also tend to be competitive in many ways. So I guess the question is if the deals and ramps push out more or if you suppose don't win, can that affect your internal growth rate? Or do you believe this year's internal growth rate is sort of a good assumption thinking ahead into future quarters?

Well, that -- I'm pausing because, sure, these larger deals and smaller deals tend to have a competitive element. The pipeline that we're talking about that is up 30% is actually weighted on the basis of our belief that we will prevail or not. Now things happen, and sometimes you lose transactions that you don't think you're going to lose. And certainly, if we lost a bunch of things that we were expecting to win, it could have an impact on revenue this year and, frankly, next year. I think that's always the case. We feel pretty good about where we are right now and that we'll achieve the, at least, 4.5% internal revenue growth. But to sustain that over time, obviously, we have to continue to win. And we'll make sure that we're doing what we need to do from a product and a go-to-market perspective to ensure we will win.

Got it, got it. And then on the debt, I mean, paying up to ensure a fixed rate would -- to me, it's sort of a -- in some ways, a bullish sign because it kind of probably implies that you kind of think that can continue to improve. And that would imply things for the spending environment. Things like that. I guess is that a fair hypothesis in terms of kind of as you speak with bank executives with regards to what you're hearing about spending intentions for technology and so on and so forth. And then a quick question at the end of that, what is the new cost of debt?

So let me take the -- even though I know the answer to the last one, I'm going to let Bob take that, Ashwin. Yes. The spending environment is quite bullish. I mean, right now, everyone in financial services knows that technology investments have to continue to be made to keep up with what's going on, on the digital transformation front. So there's lots going on there. There's still a ton going on around cyber, other kinds of risk and then, in this whole -- the whole notion of this payments revitalization. So there's a lot of that going on. Most of those "decisions" have been made to do things. Now it's a matter of finding the right partner, making the decision, making sure they have the right resources in their own shops to get this done. That is one of the -- one of the constraints is do the financial institutions have resources on their own side, not just us, but to pair up to be able to get things done. But there's a lot of energy and focus. And in fact, I would say that there is a higher level of motivation now to get things done because people can see what's on the other side of the wave. And what's on the other side of the wave is this intersection of digital and payments, money movement, new financial experiences, all of that. And we haven't even begun to talk about cognitive technologies, RPA and where that's all going to go. And in order to do that, you have to get some of the other legacy systems cleaned up. So it's pretty good. From that perspective, pretty bullish overall.

And let me just answer your question on the cost of debt. After this refinancing, we're just under 3%, about 2.9% after tax.

Got it. Pretty good. Can I just squeeze one last one in, just to get a fuller explanation on? You mentioned the acquisitions have had a slower ramp. Is that -- I mean, was that a product issue? Or what led to that slower ramp?

I'm sorry, Ashwin, which product are you talking about?

No, no. When you said the acquisitions that have had a slower ramp...

Oh, sorry, acquisitions. I'm sorry. I thought you said something. I thought you said activations. It's all about sales cycles. So it's about how long -- so we announced a couple of Dovetail Payments Platform transactions. It's about the how the sales cycles have gone in terms of how long it took for people to get comfortable that we were going to continue to invest and win. And then just the cycles on the client side took a little bit longer. So that idea is the main slowdown that we've seen relative to what we expected to happen. Does that make sense?

That makes sense. Yes. Yes. Got it.

Thank you. And thanks, everyone, for joining us this afternoon. If you have any further questions, please don't hesitate to contact our Investor Relations team, and have a great evening.

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