Re: PAY – The “Apple” Strategy for Merchant Devices

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

September 6, 2015

Re: PAY – The “Apple” Strategy for Merchant Devices

“It appears your new-product dry spell is over, and you guys are back in the game.Verifone client reported in June 2015

“I want terminal solutions to be network endpoints not just boxes that accept a card payment … which means they need to be as good at broadcasting to the consumer as they are receiving from the consumer. The best way to use that device is connected through a secure commerce architecture where everything is encrypted that touches it, pushes it to a gateway, and that gateway pushes it to the acquirer and makes a connection to whatever is going on online”. PAY CEO Paul Galant May 2015

  • There is an important secular opportunity for PAY as point-of-sale terminals evolve from commodity boxes providing a payments-utility to software-differentiated devices that support merchants in interacting with customer smartphones and hence combining the convenience of a digital shopping experience with the immediacy of an in-store experience. After losing share to Ingenico because of outdated product, PAY’s new management (with Paul Galant becoming CEO in September 2013) has prepared for this market-evolution and in 2016 will globally scale VHQ (which improves terminal reliability by using an IP-connection to monitor and manage asset performance) and launch its app marketplace providing merchants with software to engage customers through screens and on their smartphones via targeted offers and other loyalty initiatives.
  • As merchants use point-of-sale terminals to engage with customer smartphones, the refresh-cycle will accelerate from the current 3-5 years to more closely match that for consumer devices and there will be demand for software to enrich the digital dialogue with customers as smartphone capabilities continue to build. One consequence is that many merchants will shift from purchasing hardware to engaging in service contracts under which terminal manufacturers such as PAY will provide routine hardware updates, bundle in relevant software, and optimize performance through an IP-connection. CEO Paul Galant refers to this as payments-as-a-service and notes “the revenue pool for terminals, globally, is $4bn … the revenue pool for [software] services is 10x that, at least[1].”
  • We expect this expansion of the addressable market to support sustainable organic revenue growth of high single-digits in constant-currency and, along with operating margin improvement[2], mid-teens EPS growth. Accordingly, we believe the stock merits a 10-15% premium multiple to the S&P500 rather than the current discount of ~5% (see Chart below). The discount has arisen because of the stiff revenue-compare created in 2015 when North America revenue, accounting for 40% of PAY’s total, grew 60% as merchants installed EMV-compliant devices ahead of an October 2015 liability-shift date for fraud losses. While this EMV-related refresh cycle will continue for 2-3 years because 40% of terminals have yet to be upgraded, PAY is nonetheless guiding to 3% revenue growth for North America in 2016.

Exhibit: NTM Forward P/E for PAY (red) versus S&P500 (blue)

  • With overseas revenue flat in 2015 in constant-currency (and down on a reported basis so that firm-wide revenue will grow 7% in 2015), investors are wary of downward revisions to 2016 EPS consensus of $2.07. While PAY will not provide broader 2016 guidance beyond that given for North America revenue until December, new-product will provide revenue support. Specifically, as PAY extends its roll-out of new products from the US to international markets, we expect overseas revenue growth to lift to 5-6% in constant-currency as Latin America and Asia Pacific (accounting jointly for ~50% of revenue – see Appendix) catch up to EMEA which is further along the product-release cycle and already at 5% constant-currency revenue-growth. Firm-wide revenue growth will therefore be 4-5% in constant-currency which, after margin improvement, we expect to support 8% EPS growth for a 2016 result of $1.95 versus consensus of $2.07. From there we expect constant-currency revenue-growth in the high single-digits supporting mid-teens EPS growth and a 10% multiple-premium to the S&P500.

Overview

This note focuses on our favorable view of PAY (see heat map of preferences below).

Retail App-and-Mortar Strategies

Mobile phones are changing the way consumers shop and providing physical retailers with an opportunity to deploy “app-and-mortar” strategies that can defend against AMZN by combining the convenience of digital shopping with the immediacy of an in-store experience. Gibu Thomas[3], senior VP of mobile and digital at WMT, articulates the idea as follows “online there have been a lot of innovations using technology and data to give you a personalized, relevant experience that makes it easy for you to find the products you are looking for or even the products you are not looking for … we were not able to bring those disruptions into the store because a customer did not carry a laptop … but now we have the opportunity to transform the [in-store] experience and create a personalized shopping assistant for them using their smartphones”.

Retailer ability to create the convenience of digital shopping in a store environment depends on two capabilities: personally-identifying the customer (so as to curate the experience based on what the customer has done in the past and what similar customers have done) and digitally communicating with the customer through the purchase journey from before arriving in-store (e.g. through browser), to navigating through the store (e.g. through beacon-enabled apps), and at checkout (e.g. through payment terminals). We have discussed identity management in earlier reports but it will require retailers either to enroll customers in their own loyalty programs (a core objective for the CurrentC pay-and-save mobile solution from the retailer payments’ consortium, MCX) or to partner with payments providers, such as PayPal or banks, who have the personally-identifying information or PII of customers. PAY CEO Paul Galant suggests one solution, which PayPal is pioneering in practice, where “a beacon can certainly wake up your mobile banking app and your mobile banking app authenticates you … a major merchant can certainly do a deal with a mobile banking operator and even talk to you through that [app]”.

The Commerce-Enablement Role of POS Terminals

This note focuses on the second capability around digitally communicating with a customer so as to evolve point-of-sale terminals from payments-related utilities to software-differentiated devices supporting customer-engagement and commerce-enablement devices. While investors are focused on upgrades of payment terminals for EMV compliance ahead of the liability-shift date in the US of October 2015, retailers are taking a broader view of the point-of-sale. Their objective is not merely to make the existing one-way receipt of card data more secure (although security is obviously of paramount importance particularly after the Target data breach of November 2013) but to enable two-way, “app-to-app” communication between retailer point-of-sale system and customer smartphone. Commenting on this shift MasterCard notes[4] that the transition to EMV creates an opportunity for a richer feature-set on point-of-sale or POS devices: “the beauty of EMV in the physical world is that it is a much thicker pipe … so not only is it a much more secure transaction but you can add a bunch more data into the stream that can drive things like offers and receipts”.

For terminal manufacturers such as PAY, the significance of this retailer strategy is that terminals need to be commerce-enabling devices that support two-way “app-to-app” communication with customer smartphones capable, for example, of “burning American Express reward points in real time at the point of sale … or being able to convert currency …. [or manage] loyalty, couponing, and targeted offers”. The twin results of this evolution are first that the hardware refresh cycle is going to accelerate (from the current 5 years for terminals) towards the refresh rate for consumer devices, and second that terminal manufacturers, like phone manufacturers before them, will increasingly be in the software business. Paul Galant comments “the refresh cycle on hardware in the merchant environment is going to accelerate dramatically; I think you’re going to see it start to follow closer to the consumer refresh cycle than the traditional B2B cycle … I have terminals out there that are 15 years old; they don’t accept EMV, they don’t have NFC, you can’t send a message to a consumer on the screen or to their cell phone … but it does receive a card payment.”

PAY’s Internet of Terminals

PAY is responding to the opportunity by repositioning from selling boxes to offering payments-as-a-service or PaaS which it characterizes as “an app store connected to a gateway”. As with Apple for consumers, the objective is to deliver function to merchants in the form of apps with PAY focused on providing an integrated hardware/software bundle with the software comprising what amounts to a proprietary operating system (to take care of terminal processing, memory, and connectivity) along with native apps (for performance management as described below) and permissioned-access for developers to allow an ecosystem of third-party apps to evolve. As with iOS, the core of PaaS is a security solution. Specifically, PAY’s secure commerce architecture or SCA encrypts card credentials at the hardware level and routes the raw data away from merchant systems direct to the acquiring processor or gateway. PAY now has 150,000 terminals on SCA after offering the services for only one year, and counts VNTV among its customers.

A difference between iOS and PaaS is that if a customer smartphone dies it is an annoying inconvenience; if a merchant terminal dies, it can threaten lifeblood cash-flow through longer checkout times and lost sales. Like GE and its “industrial internet”, PAY looks to address reliability through an “internet of terminals” where a terminal is identified by an IP address (as well as serial number and location) and can then be serviced remotely with applications for asset performance-management (including, for example, remote monitoring and diagnostics, lifecycle management, predictive maintenance, and operational intelligence). PAY has branded this terminal management system as Verifone HQ or VHQ and, after successful rollout in the US, will globally scale in 2016.

Finally, terminals can provide real-time information about not only their performance but also their interactions with customers and PAY is leveraging this through its LIFT suggestive-selling technology[5] to help convenience stores, particularly those attached to gas station customers, increase sales by up-selling an extra item to a customer basket. Based on the items scanned by the customer, LIFT runs real-time analytics against day-part and the product affinities and marketing calendar of the merchant to generate the best up-sell suggestion and then displays this both to the shopper (on a 17 inch screen) and to the customer-service representative (CSR) on a smaller screen along with an up-sell script. One convenience store, Parkers, reports a 5% increase in sales from using the system as well as better ability to benchmark CSRs performance and assign better-performers to shifts with the greatest up-sell opportunity. As Paul Galant puts it, “if you get to closing the loop on advertising offers … it’s going to be a revenue pool 10x what we’re playing with at least”.

Appendix

Exhibit A1: Geographic Mix of Adjusted Revenue at PAY

Exhibit A2: Geographic Mix of Revenue at Ingenico (excluding online payment)

Final Page

  1. He notes the timing of the revenue is different. In the sale of a standalone terminal, the revenue is booked on installation and there is then negative revenue because PAY underwrites some portion of the warranty. In PaaS, however, PAY may not sell the terminal but rather sell the payments service so that revenue comes in more evenly over life.
  2. The operating margin at PAY is currently 14% and we expect PAY to close the gap with its largest competitor Ingenico at 20%. Ingenico has a 17% share of the US market (amounting in 2013 to 1.8mm units but, given, EMV-related pull-forward nearer 3mm for 2015) versus 51% at PAY.
  3. http://analysis.openmobilemedia.com/commerce-brands/video-walmart-mobile-and-store-shopping-revolution
  4. Mario Shiliashki, SVP US Emerging Payments, MasterCard – May 2014
  5. https://www.youtube.com/watch?v=YVjK1K194a0
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