Gemalto is a France based company that provides microprocessors for personal devices such as smart cards, SIMs, Machine Identification Modules (MIM), e-passports and secure electronic documents.

 SUMMARY:

 Gemalto is a commoditized hardware manufacturer trading as a play on mobile payments (NFC), as well as a beneficiary of the impending deployment of EMV in the United States.  Bulls also point to a burgeoning software and services business that is projected to grow through mobile payment adoption and thus assign the company a valuation in-line with V and MA. 

2 primary tenets of our short call:

1. Gemalto’s success is tied to the fortunes of wireless telecom carriers who will ultimately lose the mobile payments battle to companies like Apple, Google, PayPal, Square, etc

• The carrier’s strategy depends on the deployment of NFC (near field communication, or “Not for Commerce” according to PayPal) and more specifically having the secure element (“SE”) located on the SIM and controlled by the MNO as opposed to embedded elsewhere in the device and controlled by the OEM

• If the carriers lose, Gemalto’s foray as a Trusted Service Manager (“TSM”) is largely kaput; Specifically, Gemalto acting as a TSM is the primary driver behind what the bulls say is an expansion of high margin, recurring software and service type revenues and partially explains the multiple re-rating from its long term average of 12.0x to 20.0x

MOBILE PAYMENTS (47% of Revs, 60% of PFO):

The Mobile Communication segment has two sub-segments: Embedded Software & Products (this is essentially the SIM card business; ~80% of revenues) and Platform & Services (which is mainly TSM contracts).

Historically, the SIM card business has been characterized by double digit unit growth combined with double digit price declines.  This is clear in analyzing Gemalto’s results as hardware (SIM) revenues have declined from €994m in 2006 to €838m through the LTM 1H’12.  With respect to pricing, Gemalto’s ASP’s declined 11.8% annually between 2006 and 2009, at which point the company stopped disclosing unit shipments.  Industry declines have been even worse as emerging Chinese manufactures compete away pricing as they enter developing markets where 2G device deployment is experiencing rapid growth.  Gemalto strategically cedes this share and focuses more directly on developed economies in the process of deploying new wireless standards (LTE). 

As a general rule, 15-20% price declines are common in semiconductor products for consumer electronics.  Component suppliers typically mitigate these declines by adding features and functionality to their products and Gemalto is no different.  In 2006, the company introduced Mega SIM (a SIM with extra memory), then it launched Mobile TV for SIM and in 2009 it began offering products such as software and services in the SIM cards.  

Such innovations have proven ineffective at even maintaining pricing as carriers refuse to pay up for them given that the increased functionality is duplicative to technology being offered by the OS developers and OEMs.  Practically speaking, most consumers don’t use their SIM for much more than storing contacts (if that).  The 2G to 3G migration proved this out as operators refused invest in higher-value SIM cards because the OEMs took the value away from them by building more memory into the phones, while the carriers put more security and identification features at the network level (thus lowering the requirement for added security on the SIM).  Finally, app stores negated the software services offered by the carriers through the SIM as OS developers (Apple and Google/Android) also packaged these items on the phone.

So in short Gemalto’s SIM strategy is centered on constantly driving toward the bleeding edge of SIM technology while surrendering its share of the commoditized product being introduced into the developing world.  The problem is that neither carriers nor consumers have been willing to pay up for the increased SIM functionality developed by the company given that it’s already integrated into the device. 

4G/NFC SIM—“This time is different…”:

After the initial rollout of LTE devices and channel fill from the iPhone 5 in 2012, the bull case on Gemalto contends that the carriers will continue to invest in high-end NFC SIM cards, thus finally driving a sustained ASP increase which when combined with unit growth, should lead to sustained high single to low-double-digit revenue growth for the Mobile Communication segment. 

The second leg to the story is focuses on Gemalto’s transition to a software and services provider for the carriers via its TSM business.  More specifically the bulls see Gemalto as a play on the evolution to mobile payments and more specifically NFC enabled handsets.  In summary, Gemalto wins if the carriers successfully carve out a place for themselves in the new mobile payments landscape.  This is achieved via the carriers controlling access to the secure element (“SE”) which they’re optimistic will be stored on the SIM (as opposed to being embedded on the drive and controlled by the OEM).  As quick background, the SE is a chip capable of securely hosting applications and their confidential and cryptographic data.  It’s where a consumer’s credit card information would be stored on the phone to enable mobile payments. 

To achieve this, the carriers contract Gemalto to act as a gateway that deploys and manages third party access to the SE on the SIM.  Success here is critical to the bull thesis.  Gemalto maintains that increased utilization of the SIM is a key tenet of their ability to maintain pricing power (as opposed to the historical declines).  Even if the company is successful, the MNOs have different plans.  A senior ISIS executive literally laughed at the idea that pricing wouldn’t “fall through the floor” on the SIMs he’s buying from Gemalto. 

In total, the growth in hardware products is expected be complemented by growth in revenue from TSM platforms.  This is especially important to the bulls as it signifies a structural shift in the business from a commoditized hardware manufacturer to an indispensible software and services provider with a recurring, mobile payments driven revenue stream.  Without this shift, valuing Gemalto in line with V and MA cannot be justified. 

I’m clearly taking the opposite view and remain skeptical of Gemalto’s (and the MNO’s) ability to monetize the opportunity.  Similar to past upgrade cycles, I expect handset OEMs and software/app developers (AAPL, GOOG and PayPal etc.) to engineer Gemalto out of the equation.  Ultimately, the consumer will choose and that decision will be a function of creating the most compelling mobile wallet—one that creates a value proposition that exceeds the current choice of swiping your favorite points/incentive based credit card.  So far nobody has come close and mobile checkout (where it’s possible/does exist) is by and large a technology solution looking for a problem. 

Among US investors who have been following the evolution of mobile payments there remains an active debate as to whether NFC will even be a prevalent technology once the dust settles (as compared to a cloud based or other solution).  However, such controversy does not exist among European investors who view NFC as the inevitable winner.  This is in part explained by MNO’s willingness to invest in the opportunity, even if it is as a hedge.  According to management, Gemalto has received orders from carriers in the US (ISIS), Europe (from Orange, Vodafone and Deustche Telekom), Mexico (Mobile payment platform) and Singapore.  In aggregate, this amounts to 35-37 TSM contracts, covering 800m subscribers.  By my estimate this represents ~75% of the global installed base of smartphone users, likely making incremental contract signings more difficult to come by.  It’s also worth noting is that while 800m subscribers are covered through the platform, not even 1% of these subscribers are currently using the service, thus suggesting the carriers will wait to see increased usage before committing to additional investments. 

European MNOs view NFC not only as a mobile payments technology, but as an avenue to expand the handset’s functionality to control a vast array of daily activities including access control (locking/unlocking doors), interactive advertising (where the consumer swipes an advertisement and a coupon is pushed to the device) and transit access (as a replacement for MTA cards for example), just to name a few.  While compelling, all of these things can be achieved by utilizing other technologies that are cheaper, require less infrastructure investment, are more easily upgradable and are more secure.  Cloud based solutions are often mentioned and Starbucks QR code mobile wallet is the best example.  It’s also worth observing that the economics of these NFC business models are even less defined than that of using NFC for payments.  From my vantage this is the primary problem with NFC.  There is no single player who is powerful enough to dictate economic terms for the group, thus delaying the eventual deployment as every competing interest moves in its own direction.  Conversely, this is why QR codes have been so successful for Starbucks—they don’t have to debate economic terms with any of the other players in the supply chain—they can simply build the app/wallet and start transacting. 

Let’s put in context what exactly Gemalto and the carriers are trying to achieve.  The company’s TSM model works as such:

1. Gemalto charges the carriers an initial set-up fee to enable TSM functionality (usually $1-10m)
2. A fee is collected each time a card/application is uploaded to the SE
3. Annual maintenance fees are charged to the carrier on a per card/application basis

To defray these costs, the carriers reportedly want to charge “rent” for non-financial product users of the SE, while they hope to collect a portion of the interchange or a per transaction fee for each mobile payment.  This concept strikes me as farfetched considering that there exist competing technologies that are equally if not more effective that don’t force the incumbents to cut the pie into yet another piece.  Thinking through the point on interchange, which player in the payments supply chain is likely to give up some of their portion of the MDR to accommodate the carriers—the issuers (BAC, JPM, Barclays, GE Money, etc), the Networks (V, MA or AMEX), or the processors (First Data, GPN etc)?  If any, I suspect the processors are the weak link in this chain, but they also offer competing TSM services.  For example all First Data issuing clients are pre-integrated with its TSM, enabling the financial institutions to manage a relationship with one TSM rather than with numerous MNOs and mobile wallet owners.  The point is that even if NFC does become the standard, there still remain incumbent players who have better strategic positioning relative to Gemalto.  Evidence of a frail value proposition is beginning to appear as our channel checks picked up that the company is already negotiating on price for both its high-end 4G SIMs as well as setup costs for its TSM services.  In short Gemalto is discounting initial pricing in exchange for increased fees in the future.  It’s hard to imagine how discounting products and services in the 1^st inning of a secular product cycle can be spun as a positive. 

All in, it can probably be argued that there is no problem in payments and there probably isn’t money for those who solve that (non-existent) problem.  If anything the merchants would argue that the problem with payments is that they’re too expensive and collectively they view the shifting landscape as the best opportunity in a generation to drive down fees.  Once again, with that is a back drop, it’s hard to imagine a shrinking pie being cut several more ways to accommodate Gemalto and friends. 

A Timely Short:

As the sole provider for several major product deployments in 2012 Gemalto over-earned its long-term sustainable price and margin potential.  The initial channel fill benefit for those product roll-outs will now have to be lapped in 2013.  Moreover, these roll-outs should be fading in strength as they mature and Gemalto’s market share declines.  This however will be mitigated by increased industry volumes:

• LTE deployments began in earnest in 2H’11 and the company will begin lapping difficult comps, especially in 4Q’12.  As a standard LTE requires that all handsets now have a SIM, while this was not true for prior standards.  Specifically, CDMA did not require SIMs and as such Gemalto is benefiting from an initial channel fill of CDMA customers being transitioned to LTE, thus temporarily amplifying unit growth
  • We’ve also heard that as a novice SIM buyer Verizon has been oversold in terms of SIM functionality and is the only MNO exclusively purchasing 4G chips.  Many European MNOs we’ve spoken to are actually deploying 3G chips (which are ~30% cheaper) into LTE handsets, without loss of speed or major functionality.  This mix should revert back as Verizon’s purchasing habits converge toward industry standards—a negative for Gemalto
  • As the sole 4FF nanoSIM manufacturer for most of 2012, the company benefited from initial channel fill related to the iPhone 5 launch—volume growth should decelerate and pricing decline as competitors ramp capacity
  • As the technological leader in the space, Gemalto is usually first to market.  This grace period is only temporary as more aggressive 4G competition from the likes of Giesecke & Devrient, Oberthur and Morpho has either already or will soon commence, leading to a more normalized share of orders for Gemalto and double digit price declines
  • Initial setup fees for new TSM partners is likely close to becoming fully penetrated and operators aren’t likely to continue to invest without consumer follow through.  Remember that Gemalto has announced 35-37 TSM contracts representing ~800m subscribers.  The developed world (where the company primarily operates) has ~1.46B mobile subscribers—if we assume that 3G/4G is 75% penetrated in those regions (USA: 81%, Japan: 99%, Spain: 85%, Germany: 65%, Italy: 83% and France: 64%), that represents a 1.1B total subscriber opportunity, thus suggesting that the rate of incremental TSM setup fees should decelerate until the use case is born out

SECURE TRANSACTIONS (25% of Revs, 23% of PFO):

The second leg to the Gemalto thesis, relates to a regulatory driven product cycle in the Secure Transactions segment.  In essence, a timeline has been laid out by the payment networks outlining key milestones for EMV deployment in the US, with 10/01/15 being the key date as it represents a shift of fraud liability to the participants in the payment transaction value chain who are not yet EMV compliant.  By way of background, EMV stands for Europay, MasterCard and Visa, and is a global standard for inter-operation of integrated circuit cards (IC cards or "chip cards").  As a standard EMV offers a more secure protocol for authenticating credit and debit transactions, hence the liability shift for non-compliance.

Following Visa’s summer 2011 announcement regarding US EMV migration and the “soft” 2015 deadline, the bulls were modeling 70-100% penetration of EMV cards in the US by 2015.  These expectations are aggressive to say the least, considering that EMV was rolled out in 2005 in Western Europe and penetration is ~81% on a card basis.  To be clear, this is not a mandate.  The only mandate pertains to the processers updating their infrastructure, so that merchants and issuers can achieve transaction compliance should they choose to comply (without the infrastructure and EMV card or terminal wouldn’t work). 

With respect to pricing, some analysts were modeling an ASP of several dollars per EMV card which is ridiculous considering it sells in Europe for ~€1.  There is implicitly some expectation that NFC/EMV cards, which are more expensive, represent some of that mix, but those volumes will be de minimisly low until the use case for NFC is proved out.  SunTrust has been planning their EMV deployment for ~3 years (putting them significantly ahead of the industry) and recent checks with product managers there revealed they will be paying less than $2 per card.  Specifically, they plan to roll out cards on a very limited basis to high net worth customers who frequently travel abroad.  The contact further noted that they’re deploying the most stripped down possible version of the product, primarily focused on easing international transactions for their customers.  Contacts within JPM Card Services have further substantiated these prices, quoting EMV card costs at $0.80 per unit, well below the bull case of $3-4.00+. 

As a result of this aggressive modeling, the Street expected revenues to accelerate for the segment in 2012.  This did not happen. Instead, the Secure Transaction division saw a steep slowdown in organic revenue growth from ~17% in 2011 to low-single digits in 2012.  Despite management’s guidance, that the US EMV cycle won’t be material for the company until at least 2014, the Street continues to model low teens revenue growth for the next 2 years.  This is in the context of an industry with mid-teen unit growth, offset by >10% annual price declines. 

There further exists a more sinister view that US EMV deployment may be delayed past the 2015 deadline if it happens at all.  It’s worth pointing out that EMV adoption was legislatively mandated in almost every geography where it’s currently deployed and that dynamic has yet to play out in the US.  Moreover, there is a conspiracy that the issuers are disinterested in reducing fraud (as EMV would do) given that they: 1. get a tax benefit from the write-off and 2. Use fraud to justify charging some of the highest interchange rates in the world.  Durbin enables the Fed to periodically review interchange rates and if EMV drives a significant reduction in fraudulent activity, it’s possible (likely) that interchange will be forced lower once again.  Finally, from a technology perspective, there is nascent speculation that EMV could be leap-frogged by other technologies given how long it’s taking to deploy in the US. 

Given the excessive length of this analysis thus far, I’ll refrain from doing a deep dive on the accounting issues and instead highlight them as points to be considered:

• Wide gap between adjusted PFO and numbers reported on an IFRS basis
• Frequent changes in reporting segments
• The discontinued disclosure of ASPs and units
• Increases in unbilled revenues in accounts receivables:

• Adjustment of PFO for the capitalization of R&D—also the commencement of capitalizing R&D
• Deteriorating cash conversion rate:

There is further reason to believe the company is stuffing marginal costs into discontinued operations.  Specifically, revenues from discontinued operations (held for sale), declined in the 1H’12, while operating expenses were stable (R&D and SG&A costs increased).

Finally, in mid-December, CEO Olivier Piou sold almost half of his holdings for ~€50m or around €74 per share, nearly top ticking the stock.  While bulls defended this action as having been planned for tax reasons, the magnitude is alarming. 

VALUATION:

In 2012, Gemalto’s forward PE multiple expanded from its long-term average of 12x to 20x as excitement surrounding the company’s mobile payments prospects continued to build.  This enthusiasm overshadowed the previously mentioned earnings quality and free cash conversion issues. 

Given the somewhat questionable P&L adjustments and other aggressive accounting tactics, I view free cash flow as the most appropriate valuation measure.  A 5% yield feels conservative for a commoditized hardware manufacturer and represents >50% downside from current levels:

2012 earnings and guidance call in March.  Further delays to wide scale deployment of NFC based mobile payment projects.