Verifone Systems: Eroded Competitiveness


The POS industry was an oligopoly with two major companies competing against each other: Verifone Systems (NYSE: PAY) and Ingenico (OTC: OTCPK:INGIY). However, due to technological advances, the moat has been broken. Barriers to entry are low and the industry has seen many new entrants. In the U.S. alone, there are more than 200 POS companies. The industry has been commoditized. Signs of this are evident: lower margins, slowing growth, falling prices and increasing competition, followed by increasing price competition and industry consolidation. Some recent notable entrants are Square, Shopify, and PayPal.


Investment Thesis

When EMV liability shift was introduced in October 2015, all merchants were required to upgrade their POS devices by October 2017. This was a tailwind for PAY because merchants have the incentives to upgrade their machines. If a merchant hadn’t upgraded and a customer’s card got defrauded, the liability lies with the merchant. If the merchant has upgraded, the liability rests with the card issuer. However, EMV implementation has been delayed to 2020 due to technological challenges. While the three-year delay can possibly give PAY stable earnings, the fact is it will not.


Many of PAY’s large (tier 1) customers have upgraded their POS devices and there aren’t many left. As noted during the Q2 2017 earnings call: “Despite the results in petro, our performance in North America during Q2 was encouraging, our retail vertical grew by 12% sequentially benefiting from several large QSR deployments, onboarding of new payment as a service clients as well as refresh business with early Tier-1 retail adopters of EMV.” This means that there won’t be any significant revenue contributors in the near future.

Other than the lower margin, slowing growth and falling prices, signs of further pricing pressure are evident. PAY depends on a limited number of customers for a large percentage of their revenues. PAY’s 10 largest clients as a percentage of their revenue have been declining since 2011 (from 27% to 20%). PAY is undergoing a switch to a services business from hardware. While this is a positive move because of PAY’s global brand and reputation, the competitive environment has pressured PAY’s services segment’s gross margin — from 43% in 2012 to 40% in 2016.


PAY is losing its competitiveness in key markets to Ingenico. The majority of PAY’s revenue is generated in North America (41.1%) and EMEA (36.6%). Between 2012 and 2016, revenues from these two geographical locations have declined by 8% and 4.3% (CAGR of -2% and -1%), respectively. On the other hand, ING experienced growth in these markets: on an absolute basis 203% and 67%, CAGR of 25% and 11%, respectively. Moreover, PAY revenue’s CAGR is 1.3% vs. ING’s 14%. On top of that, PAY’s five-year average margin of 39% is inferior to ING’s 44%.


The threat of new entrants in the POS industry cannot be underestimated. There are way too many POS companies to track, but if one googles “best POS system,” PAY will not show up. In an effort to maintain its market share, POS has been spending more on marketing efforts (marketing expenses grew faster than revenue growth: 38% vs. 6.8%, respectively). On new and noteworthy entrant into the POS industry is SQ, which has been snapping up market share in the U.S. To make matters worse, SQ has expanded into the loan business (for merchants), which will result in SQ gaining more market share in the SMB market.


In a very competitive environment, it’s crucial to keep up with technology. By that I mean companies have to invest in new technology internally or pursue acquisitions. However, PAY’s high debt level has the potential to limit future acquisitions. Thus, PAY has to increase R&D spending to keep up, ultimately pressuring margins.

Risk

The main risk in this thesis is future technological advancements and regulations requiring retailers to upgrade their hardware (boosting PAY’s revenue). However, it does not seem likely since EMV has yet to be adopted.


Valuation

PAY is currently trading at 11.47x TTM EV/EBITDA, in line with INGIY’s 11.65x TTM EV/EBITDA. PAY should trade at a lower multiple than INGIY.


Source: Created by author.


Conclusion

Both PAY and ING shares have underperformed the market. In a five-year time period, PAY declined by 41.3% and ING increased by 116.52%. The wide gap in relative performance shows that ING is a better company and has better execution. ING’s outperformance is also attributed to its much stronger revenue growth. To mitigate the risk of the oligopoly gaining more market share, I would go long INGIY and short PAY.

Disclosure: I am/we are short PAY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also long INGIY.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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