Description

Recommendation: Short Ingenico SA

Quick Thesis: Trading at a ~5% Adjusted Unlevered FCF yield, Ingenico (“ING”) is significantly overvalued for two reasons. First, the market is treating recent market share gains as a new sustainable earnings base, but these share gains are likely revert over the next one to two years. Second, the current valuation does not reflect new competitive risks that threaten to commoditize the payment terminal market over the long-term. This long-term thesis is not predicated on Square dongles on iPhone’s displacing traditional payment terminals. I actually think the Square dongle threat is mostly limited to smaller merchants. Instead, other new payment form factors (e.g., tablet, cloud) are the largest threats and will likely reduce the profit pool of the terminal market over the longer-term.

Long-Term Competitive Threats: The electronic Point of Sale (“POS”) payment terminal market is effectively a duopoly. Ingenico and Verifone (“PAY”) each have a roughly 40% market share, with small local players making up the remainder of the market. The main barrier to entry for a payment terminal is a lengthy certification process in each country that until recently was tightly controlled. As a result, Ingenico and Verifone enjoyed relatively stable market share and healthy operating margins despite offering what was essentially commoditized magnetic swipe hardware. To put it another way, Ingenico and Verifone relied on a competitive moat provided by payment networks and financial institutions rather than their own technology. The certification process, however, has been less tightly controlled as new competitors have begun to gain traction in new payment form factors that are more or less substitutes for traditional POS systems. Bulls have said that the EMV certification (the chip on card instead of mag swipe) is more difficult for new competitors to obtain. However, one source indicated that it only takes 18 months and a couple million dollars to become EMV compliant. The result is that there will be increased competition in the emerging technologies that are cannibalizing traditional terminals, such as tablet-based POS terminals and EMV-capable mPOS devices with PIN pads. While the chances of traditional terminals being entirely displaced are low, some portion of terminals will likely be replaced by tablets and other technologies, in which Ingenico has a lower share. In addition to having a lower share in newer technologies, increased competition is commoditizing newer technologies resulting in fewer dollars per device. For example, the average price for a traditional Ingenico payment terminal is $400, while tablet-based alternatives sell for $100 or less.

Near-Term Market Share Reversals: Over the last year, Ingenico has temporarily benefited from operational missteps by its largest competitor Verifone. There have been no structural changes to the competitive landscape. Verifone simply had sloppy execution in a couple key geographies where it competes with Ingenico. In Brazil, Verifone did not receive certification on an upgrade and was temporarily shut out of the market there. In the Middle East, Verifone terminated a relationship with a distributor who was selling into an embargoed country and, as a result, has to rebuild its business with new distributors in the region. In Europe, Verifone did a poor job of integrating its Hypercom acquisition, laying off many of its direct salesforce to rely on a less effective indirect sales channels (ISOs). All of these issues are fixable, and Verifone should be able recover the market share over time. The prior CEO resigned earlier this year, and Verifone hired a new CEO on October 1^st. While it is difficult to estimate the precise impact of these share shifts, it could be as much as €45 million in gross profit or about 20% of 2013E Ingenico EBIT.

Valuation: ING is currently trading at ~6% Unlevered FCF yield including recent share gains as ongoing earnings. However, assuming share gains are temporary and likely to revert over time, ING is currently trading at a ~5% Adjusted Unlevered FCF yield. I have heard that ING’s multiple is inflated due to the scarcity of tech names in France for local funds to hold. While this dynamic could persist for a while, I believe that over time it should revert to a more fundamentally appropriate level. PAY provides the most obvious comparable for a business with a similar risk profile, not distorted by any obvious geographic ownership biases. PAY is currently trading at a 6% unlevered FCF yield off what is arguably a trough earnings number. It is widely understood that PAY will benefit from the upcoming EMV upgrade in the U.S., which will expand the U.S. market size. Ingenico has a small share in the U.S. and will not see a material benefit from this EMV upgrade opportunity. Adjusting for the PV of the EMV upgrade opportunity using numbers that are pretty well publicized, PAY is currently trading at a 7.5% Unlevered FCF Yield. A 7.5% Unlevered FCF yield for a European payment hardware business with declining barriers to entry seems reasonable, if not generous. If ING were to trade in line with PAY’s multiple, that would represent over 30% downside. As the longer-term commoditization risks materialize, there could substantially more downside.

Risks: Continued execution difficulties at Verifone, delay in new competitors’ products, stronger than expected growth in Emerging Markets, successful execution of new transaction processing strategy, high short interest

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