Description

Optimal Payments (OPAY-LN) is an extremely compelling long.  After several name changes and a storied history, Optimal Payments should be entering a period of significant earnings growth and thus sizeable returns for investors.  There is also home-run optionality if online gaming is legalized in the US (which some believe is a matter of when not if) and OPAY is a ripe takeout candidate in a consolidating industry.  Regardless, the business itself is compelling valued with a highly recurring and diversified revenue stream, a significant margin and FCF recovery story post an investment period and tailwinds from being well positioned in an attractive space.  Its not hard to envision a double here within a reasonable time period and greater upside with some more favorable developments.

Optimal Payments used to be Neteller before changing to Neovia and then to Optimal post its early 2011 transformative acquisition.  Any online poker players will remember Neteller well – it was the number one e-wallet player for online gaming in the US.  When the US officially declared war on online gambling, the founder was eventually arrested, a settlement with the authorities was reached for a substantial portion of Neteller’s cash and earnings significantly eroded.  In the ultimate irony – there has been some legislation forming that would allow for online gaming to be allowed once again in the US – which could be a huge windfall for OPAY. 

What is Optimal Today?

OPAY is comprised of a Straight Through Processing segment (68% of revs, 45% margins) and a Stored Value Product (32% of revs, 85% margins).  STP is their Netbanx product which operates in the CNP (customer not present) alternate payment space.  The company targets online merchants for processing online transactions via multiple banking partners.  Growth comes from increased business at its customers and incremental contract wins.  The pipeline of wins is very strong.  Stored Value has an online gaming focus and is basically an e-wallet. 

Why is Optimal a Compelling Long?

Attractive valuation

OPAY is trading at 6.3x 2012 EBITDA and 4.8x 2013 with a low-teens FCF yield, compelling revenue multiples (1.0x ’12 and 0.9x ’13) and a clean balance sheet with net cash even when treating the convertible debt as debt (though it should all convert into equity by Q1 of 2013).  These multiples assume zero benefit from any passage of online gaming in the US.  Takeout multiples have occurred at ridiculously high multiples in the alternate payment space (2-9x revenue multiples, 15-35x EBITDA multiples).  Comps in the space trade at 11x LTM EBITDA multiples. 

Margin opportunity

OPAY has undergone a lengthy period of downsizing to deal with reduced revenue and earnings from its Neteller / US regulatory settlement and exit from the US online gaming market.  OPAY has moved past that stage into a more recent period of system investment and the integration of a key acquisition and is now well positioned to return to substantial revenue and earnings growth.  Personnel have been significantly reduced in Q1 2012 and capex will be greatly paired back going forward. The integration of the acquisition has been completed.  OPAY did $18MM in EBITDA in 2011 and has a $7MM cost savings program (headcount driven/executed in Q1) that will propel results further in 2012/2013.  Though there is a nice recurring stream of revenue, operating leverage is significant here.  Revenues are well positioned to grow across both segments (organically from business growth and new customer wins) as the alternate payment space continues to win share vs. in person transactions.  The revenue, FCF and earnings would get silly if US legislation allowing online gaming were to pass and OPAY could return to its former glory.  Regardless, there is ample room to grow the margins here as this is a highly scaleable model.  The 1H interim results were posted yesterday and showed decent margin progress (1H EBITDA margins were 14.2% ($11.2MM) vs. 11.1% last year ($6.4MM)) and mgmt noted that they expect above market expectations for the full year.  Mgmt sounded very confident in its growth trajectory (given a strong pipeline) and incremental revenue really should meaningfully fall to earnings going forward.

Takeout candidate

There have been many takeouts in the space in the past few years and as noted above, many have come at very high multiples given the attractiveness of the alternate payment space and synergies to the strategic buyers.   Now that revenues have been greatly diversified geographically and away from gaming (OPAY is now 44% non-gaming from 10% in 2010), I think there is more appetite here from buyers.  I think Optimal’s focus near term is improving margins further and increasing scale though at the right price mgmt would be open to a transaction.  There is also a significant shareholder (28.4%) that put up additional capital to help fund the early 2011 acquisition who I think provides significant downside protection and takeout potential – the company views him as a strategic investor given his other holdings/interests.

Attractive space

Industry forecasts in the alternate payment space are compelling given the growth/outlook of e-commerce.  The adoption of smartphones dovetails with the need for retailers to allow for various payment methods.  E-wallet type payments and the processing of risk/fraud while integrated with the back office etc… will continue to be very important for the forseable future.  The company has several high profile wins and looks to be gaining share in North America while looking to replicate its success in the European market.

US likely legalizing online gaming – significant upside optionality

Prior to the DOJ closing the US market in 2006, Neteller used to be the leader in online gaming e-wallet services in the US.  Given its former glory, its not unreasonable to think OPAY could reassert itself in a US market that legalizes online gaming.  There is building momentum for online gaming in the US given the attractive tax revenue that states could generate (in December 2011 ,the DOJ reinterpreted the 1961 Wire Act to narrow its focus on sports betting, thereby allowing states to operate online poker, lotteries and casinos).  Considering OPAY once did $130MM of EBITDA when the US was actively gambling online, the potential here is enormous.  I don’t think you’re paying for any of that upside.   

Risks

There are regulatory risks (in the stored value business) but we’ve been comfortable that there is no US like (almost) death blow lurking – the trends actually seem in the company’s favor.  There is the risk that technological changes occur.  There are other risks that are pretty well detailed by the company but overall, I view the situation as highly attractive risk/reward.

Catalyst

-          Continued margin improvement

-          US legalizes online gaming + OPAY has a meaningful presence

-          Takeout

-          Getting the story out (mgmt plans to come to the US in October)