08/23/2017

3 Reasons Why We Like VeriFone Systems, Inc. (NYSE:PAY)

Overview: VeriFone Systems provides payment solutions and services around the world with 30 million devices installed in >150 countries. Its payment solution products consist of point of sale (POS) electronic payment devices, security and encryption software, and certified payment software, as well as other third-party value-added applications. Its services platform consists of equipment repair and maintenance, gateway processing, remote terminal management, end-to-end encryption, Payments-as-a-service, Advertising, couponing, warranty, loyalty and big data analytics, etc. VeriFone has No 1 or No 2 positions in most markets with ~50% market share around the world. Among its $2 billion revenues generated in FY16, services account for 34%. Geography wise, nearly 40% of its FY16 revenues came from North America, 37% from EMEA, and 23% from Latin America and Asia Pacific.

VeriFone is on a multiyear journey of transforming itself from a payment terminal manufacturer to an integrated payment and commerce solution company. In the past 4 years, the company experienced two major setbacks which resulted in massive underperformance of its common stock in some periods. In 2013, VeriFone’s operating results fell well short of expectations when the company was aggressively shifting its business model from hardware sales to services. In that process, management took its eye off the ball on product evolution in a fast changing and complicated global electronic payment environment. The company has in particular under-invested in product localization and customization for country-specific requirements, resulting in big revenue delays and losses. Then in 2016, VeriFone shares took a new plunge, as the company reported disappointing Q2 results and had to lower FY16 outlook. This time around, the culprits were macro pressures in emerging markets and an unexpected EMV (Europay, MasterCard and VISA) adoption slowdown. The EMV adoption slowdown was mostly a result of an EMV certification bottleneck as tier 1 and 2 merchants have complicated payment systems which make certification process slow and difficult. For tier 3 and 4 clients or the SMBs, they need EMV solution help from acquirers first before purchasing new EMV capable terminals and that help was not readily available. To make matters worse for VeriFone, Visa and MasterCard announced the moratorium on chargebacks under $25, which took pressure off small merchants. Visa will also limit the number of transactions issuers can chargeback to merchants and their acquirers until April 2018. In addition, Visa and Master Card also pushed back the liability shift dates for counterfeit card fraud at non-EMV chip-compliant U.S. petro terminals to October 2020 from October 2017. Separately on the macro side, in Latin America and Asian emerging markets, VeriFone experienced more than expected competitive price pressures and worsening economic conditions leading to lower than projected margins in device sales in 2016.

On the positive side, VeriFone has made great progress transforming its business model since 2013. The company has maintained higher levels of R&D than before, or at ~10% of annual net sales, with incremental R&D spent on the next-generation POS hardware and open platform expansion. The company has also simplified its product lineup by reducing the number of products sold by nearly 60%, and brought down the number of operating systems which at once amounted to 13 on its various devices. The efforts to streamline platforms for payment and services will continue, and the company will enable broad e-commerce and omni-technology and partnerships to meet the needs of consumers and merchants.

Long term potential for VeriFone also remains intact. In the United States, demand for EMV upgrade continues to be an important driver though the upgrades will be deployed over a more normalized period of time. There remain more than 5 million terminals that require upgrades to EMV as of the end of FY2016, including roughly half of all SMBs as well as several segments of the U.S. market that are installing consumer-facing payment devices for the first time. Those segments include quick service restaurants (QSRs), pay-at-the-table at restaurants, hospitals, hotels, etc. In addition, there is increasing demand for omni-channel solutions, and continued shift from episodic sales to annuity services. In EMEA, there is continued move towards fiscalization and terminalization, and banks and processors are open to partnerships which will help bring VeriFone’s value-based solutions to under-penetrated and new countries. In Asia Pacific, government mandates in India, Thailand, and Indonesia continue to push demand for devices while moving away from cash transactions, and EMV adoption in Japan and Korea are opening new opportunities.

VeriFone recently announced its mid term outlook from 2017 to 2020, calling for revenue CAGR of 5-6% and EPS growth of ~15%. The company expects payment system sales to grow 4-5% a year and services to grow 7-8% a year. Profit margin will expand, driven by better profitability on new products and increasing mix from service revenues. The company also targets free cash flow conversion of 80% from non-GAAP net income by 2020, up from the current 48%, focusing on working capital optimization and Capex management.

Catalyst:

The 2nd half of 2017 will likely be much stronger for VeriFone than the 1st, as unprecedented launches of new products and services will take hold, ramp, and positively impact VeriFone’s revenue and margin trajectories. The 2nd half of 2017 should also see SMB businesses improve as existing inventories in the pipeline clear out and new growth returns. Lastly, despite continued currency pressure, Latin America and Asia are performing much more strongly than a year ago, thanks to VeriFone’s improved competitive positioning.

1. 2017 is the year VeriFone begins one of the most robust launches of new devices, which will fuel its growth through FY2020. The company has launched Engage Series, E-series (mPOS), Value Series, Carbon (iPOS) Device Services, Payment Services, Commerce Services, Omni-channel services. Engage and E-series provide new solutions to the market segments the company already has dominant share. Value Series will help expand the company’s share in geographies it is currently underpenetrated and are price sensitive. Carbon expands VeriFone’s offerings in the iPOS (integrated POS) segment and is the best iPOS device for SMBs. It will take time for the new products to pallet and ramp, but by the end of 2017, management expects 5% to 10% of VeriFone system solutions to incorporate new products. 75% to 80% of the new product revenue will come in H2, however, suggesting accelerated growth in top line and profitability in the quarters ahead. New products carry better cost of goods sold, and would improve gross margin in H2 for VeriFone.

2. For VeriFone’s SMB vertical, the company is seeing indications that the business has stabilized and the sell-in volumes in North America should improve and normalize in Q2 and start to pick up in Q3 and Q4. Management expects VeriFone to gain market share in the SMB segment once inventory is cleared and growth returns. In addition, EMV installation and upgrades in the hospitality vertical start to take place and will provide a significant boost to the U.S. devices footprint.

3. Despite ongoing macro-related challenges across many parts of the Latin America and some parts in Asia, VeriFone has re-established growth momentum in Brazil and expects flattish growth for 2017 in Latin America. For Asia, China and India will drive strong growth in the region for the company.

 

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