Description

Summary: Monopoly credit card processing network trading at about 14x PE while having a net cash position of about a quarter of the market cap. The market seems to extrapolate the lack of earnings growth over the last ~3 years which I believe is not justified. I expect a low double-digit IRR without rerating driven by earnings growth, and mid-teens IRR with some reasonable rerating with the potential to do even a little better if some of the company’s growth initiatives bear fruit.   

avalon216 has written up Shva about three years ago. It was a good write up, go check it out. His/her write-up explains the business model and some of the history that I will not rehash here. Since that write-up the stock has not worked since and is down about 20%.

What has happened?

Masav separation: Back in 2021, Shva shared a lot of personnel and infrastructure with a sister company called Masav. The eventual decision by the regulator that a full separation was required surprised many investors. Worse, the costs of the separation were revised upwards several times and these incremental costs explain why over the past three and a half years net income is down by close to 10%, while revenue has grown by about 25% (there was also some associated capex; so cash flow looks even uglier). Going forward it seems as though most of the headwinds from the separation are behind Shva and I would expect future growth to fall through to the bottom line again.

Pricing power: Shva charges less for its services than Visa or Mastercard charge for the same service; estimates vary but probably between 80% to 50% less (depending on what you think the rebates are). That gave rise to an expectation of price increases, and they did end up increasing prices in 2023, but by only mid-single digits after not having increased prices for almost 10 years, which was a negative surprise. I think they will increase prices going forward but am not optimistic on price increases much above inflation. First, commercial banks own the majority, and they naturally have a strong preference for low prices. Second, the management team does not own much stock and is therefore incentivized to not push price too much either. Third, unlike Visa or Mastercard there seems to be much stronger regulatory oversight over pricing.

War: The war with Hamas and Hezbollah has not helped sentiment, and it reduces personal consumption expenditures by subduing economic activity. By no means an expert on local politics or the security situation, but I would expect that the current war will resolve itself eventually as pervious similar situations have. What is interesting though is that even despite this headwind Shva seems to be doing rather well with revenues and operating profit up double digits y-o-y in Q2 2024.  

Comps: V/MA are the comps for Shva and their valuation have come down by about 20% since 2021 on the expectation that growth is slowing because the proportion of credit card spending of overall consumption expenditures is getting closer to its ceiling.

What’s next?

The most interesting development is the growth Apple/ Google pay. Both services rely on more complicated technology than normal credit cards for data security reasons; ‘tokenization’ in industry parlance. For tokenization Shva charges twice what it charges for a ‘normal’ credit card transaction, but the variable costs are basically the same (about zero). As more volumes move to these digital services effective prices increase through a mix shift. Apple pay started operating in 2021 in Isreal and today digital wallets including Apple pay and Google pay account for a mid double-digit percent of overall of credit card spending meaning they are growing very fast. I assume that digital in Iseal wallets will grow from the current mid-teens proportion to about 30% over ten years. That effect alone would grow Shva revenues by about 50%. As a reference, Worldpay projects digital wallet penetration of 40-60% globally by 2027 depending on whether you look at physical retail or ecommerce.

And the ‘normal’ business will continue to grow as well. Isreal has favourable demographics (1-2% growth until the middle of the century depending on who you ask), a dynamic economy (GDP growth of somewhere between 3-4% over the mid-term seems to be the consensus though currently slower due to the war) and still quite a bit of headroom for card penetration (2023 credit card spend was about 60% of personal consumption expenditure) and the number of credit card transactions to grow. Note that Shva makes about half its revenue as a fixed payment per transaction rather than a portion of its value. I believe there is still a fairly long tail of small transactions that are predominantly settled in cash that over time will move to credit cards which should be a nice tailwind.

In summary, I expect about 5% revenue growth over the next 10 years without any price increases which translates to about 10% growth in EBIT because the marginal costs of that extra revenue are basically zero (though I do assume about 2% cost inflation).

Valuation

The business model of Shva is similar to a portion of what Visa and Mastercard are doing, so it is tempting to use those two as comps, but I think there are some shortcomings in that comparison.

First, Visa and Mastercard are essentially unregulated with regards to pricing (yes there are some regulations on interchange, but Visa and Mastercard do not directly benefit from the interchange). The regulator seems to have much more influence on Shva’s pricing. Moreover, a good proportion of Visa’s and Mastercard’s revenues are tied to the dollar value of transactions on their networks such that revenues increase automatically with inflation. Shva on the other hand charges mostly on a fixed amount per transaction which is not quite as good esp. with higher levels of inflation and political pressure.

Second, of all the activities of Visa and Mastercard I would argue the payment network is the weakest. Sure, there are some network effects, but you can route the payments through an alternative network (and merchants do have the right to do that in some countries including the US). The competitive advantages on the issuing side are much larger in my view; you can’t issue a Visa/Mastercard branded card that will be accepted globally without their approval.

Third, Shva’s payment network is not as good as the payment network of Visa or Mastercard because of the number of participants is much smaller and less fragmented. Isreal’s top 5 banks control something like 90% of the market depending on how you want to measure it. Visa/ Mastercard have 15,000 banks participating in their networks. Establishing a new entrant is therefore a very different proposition in my view. That said, I don’t think the Israeli regulator would allow the local banks to band together and establish a new payment processing network after having just forced the separation of its predecessor. As a side note, much has been made of Visa and Mastercard having been invited to establish a rival payment processing network in Isreal but declined. One possible interpretation is that V/MA thought it not economical to do so. However, my take is that V/MA realized that pricing in Isreal would be much lower which would be somewhat awkward in price negotiations elsewhere.

Fourth, capital allocation is much worse. When quizzed on why Shva holds so much cash the company gives nonanswers. My take is that a large cash balance is effectively mandated by the regulator as Shva has been designated critical infrastructure and some maybe earmarked for acquisitions. Shva’s business model is very cash generative, but they can’t buy back stock, so there is some tax leakage as well. However, the large cash position gives me hope that future cash flow finds its way into the pockets of shareholders. 

So what to do? I think V/MA are reasonable starting points, but you need a sizable haircut on the multiples. You could argue that Shva does have better growth prospects but that is only true if they can increase prices (which seems too uncertain for me to assume) or if one of their growth initiatives works out (I think they have reasonable chances of making them work, but I would not want pay for them). Absent those two factors growth looks pretty similar. So, what is the right haircut? I would be happy with a third, but that is admittedly arbitrary, and I don’t have an elegant way to justify the number.

I don’t think using enterprise multiples makes a ton of sense given that cash balance isn’t really excess cash so I would either focus on price to earnings or price to free cash flow which in practice are very similar given how capital light the business is (the last two years being an exception).

Shva currently trades at 14x LTM PE. Without any multiple uplift I expect low double-digit IRRs based on earnings growth and about 3% post tax dividend yield. V (the cheaper of the two networks) trades at 27x NTM PE, less a third is 19x. If it takes 10 years to rerate to that multiple you get to mid-teens IRR, if you get there in 5 years you end up with high teens with additional upside from new initiatives and pricing.

Risks:

Displacement of credit cards: Lots of initiatives out there to make digital payments work without credit cards. Fednow is a prominent example. Technically these are viable alternatives, but there are two problems. First, there is a lot of consumer inertia esp. without a reason to switch (your merchant can save some money probably does not cut it for most). Second, credit cards are not that expensive. Sure interchange is high, but most of that goes to fund rewards consumers love. The actual cost of the system are maybe 20-30 bps given the massive scale. That seems pretty difficult to undercut while still making returns commensurate with a start-up. Time will tell.

War: One of the most unstable regions globally. A significant attack on Isreal is conceivable in which case this is not an investment that will prosper.

Culture/ management: Run like the monopoly that it is for a long time. The newish CEO seems not bad, but cultural changes are difficult and Shva needs to change if they want to be successful esp. with their growth initiatives. Not so fond of the rest of the management team.

New entrant: Theoretically it’s possible to start a new network in Isreal. In practice, the problem is that most of the costs to do so are fixed and identical to Shva’s. If you divide Shva’s revenues evenly between the new entrant and Shva you would end up with two companies somewhere between barely profitable to loss-making. Not an exciting prospect for a new venture. However, with price increases and overall market growth that calculus could change.

Shareholder structure: I don’t think the banks care about returns from their investment in Shva very much. Neither does V or MA. Together these shareholders represent 60% of the register. I think the business is good enough that you can live with suboptimal governance but it’s not ideal.

Catalyst

Earnings growth 

End of the war in Isreal