There are things we can glean from this week's IPO of Square, the company whose devices allow very small businesses to accept credit-card payments on mobile phones, thereby bypassing more expensive equipment.
One is that if you price an IPO at $9 (U.S.) after indicating you planned to sell shares at $11 to $13, you can get headlines like "Square Goes Nuts!" when retail investors bid the stock above the initial estimates. (Business Insider, which provided the "nuts" headline, called the IPO "stellar," which works if the star in question is a falling one that couldn't garner the price it obtained in its final round of private financing.)
Another is that, for now, investors seem willing to buy in to Square's assertion that it's a technology company, with the attendant valuations, rather than a lowly payments-processing company, which would command much lower multiples. Square certainly looks like a tech company, in that it has now achieved a multibillion-dollar valuation while losing hundreds of millions of dollars, as investors accept that the company is, of course, a "growth story."
This brings us to today's question: If Square is a payments-processing company, which it certainly appears to be, why shouldn't investors look instead to the traditional players in the industry, who make money, grow with the economy, and whose stocks are cheaper, to boot?
The field offers a number of options. PayPal, freed from the possession of eBay earlier this year, is a highly visible, consumer-facing online play. First Data Corp., which went public in October, is a debt-heavy turnaround story. Interested in names with better balance sheets than First Data? There are several smaller processors to choose from (see accompanying table).
Many investors eagerly anticipated PayPal's July spinoff from eBay. The argument, apart from separating PayPal's superior growth prospects from eBay's legacy auction business, was that eBay's ownership was limiting PayPal's ability to partner with e-commerce companies (such as, say, Amazon and Alibaba) that viewed themselves as eBay competitors.
Analyst Sanjay Sakhrani, of Keefe, Bruyette & Woods, says PayPal is one of "very few pure-play stocks on the strong growth potential of e-commerce and e-payments," and, right now, the company is "the only real global digital wallet of scale … the power of the PayPal brand is second to none in e-payments."
Mr. Sakhrani, who has an "outperform" rating and $43 target price (versus Friday's close of $36.36), says, however, its long-term positioning in the all-important mobile space is in question, particularly with Apple and Google entering the payments business – while, of course, controlling mobile operating systems.
That's why most analysts are paying keen attention to "Venmo," PayPal's mobile app for money-moving. Right now, it's used mostly by millennials to send funds to friends, a "person-to-person" business that collects no meaningful revenue for PayPal, even though Venmo users sent $2.1-billion in payments in the third quarter, 200-per-cent year-over-year growth.
PayPal's solution is to adapt Venmo for commercial use starting in the current quarter, allowing Venmo users to pay at merchants that accept PayPal, which would allow PayPal to collect fees similar to those at its namesake service.
To Barclays Capital analyst Darrin Peller, this is a huge opportunity. Mr. Peller, who has a $47 target price, currently estimates the company will earn $1.88 a share in 2017, up from his estimate of $1.28 this year and $1.59 in 2016. But he says Venmo, plus PayPal's efforts in money transfers (it has purchased Internet-based money mover Xoom) and offering credit to PayPal users, may mean the company could top his estimate by 20 cents to 30 cents – and that current P/Es are too low. PayPal trades at 25 times forward earnings, according to S&P Capital IQ.
First Data's P/E, by contrast, is less than 13, but that's because it's had an "E" problem for quite some time. Private equity took the highly profitable company off the markets in 2007, loading it up with debt, as is typical for the transactions. Then, the Great Recession hit, crimping the company's core business of processing billions of credit and debit-card transactions in 118 countries around the world. (First Data says it processes 2,300 transactions per second.)
The result is that First Data has been unable to produce enough operating profit to pay for its crushing annual interest payments. In 2005, the company had profit margins of 33 per cent for both EBITDA – earnings before interest, taxes, depreciation and amortization – and net income. However, in the past 12 months, according to Capital IQ, the company had an EBITDA margin of nearly 34 per cent, and a net loss equal to 3.3 per cent of revenue.
That tide may finally be turning. Leading up to the IPO, says Goldman Sachs analyst James Schneider, First Data had just $300-million in cash and $21-billion in debt, with $10-billion of it coming due by mid-2016. The company used $2.6-billion of its October IPO proceeds to retire debt and has refinanced $6.6-billion worth of borrowings. Mr. Schneider estimates First Data's effective annual interest rate on that $10-billion in imminently maturing debt will be reduced from 10.2 per cent to 6.4 per cent by year's end.
Mr. Schneider, who has a "buy" rating and $21 target price (versus Friday's close of $16.36), says this reduction in interest expense will create "outsize" growth in net income, with earnings per share growing at a 45 per cent annual clip from 2014 to 2017. It's not all debt reduction, either: He says that while investors are skeptical about First Data's ability to grow revenue, investments in the company's product portfolio will pay off and increase the top line.
Of course, neither company is expected to grow as quickly as Square, but investors who gave the company a $4-billion valuation may be overrating the newcomer's prospects. Analyst Gil Luria of Wedbush Securities finds that Square's fee structure works best for small businesses with $10,000 in revenue or less a year. When a merchant hits $50,000 in revenue, and their average transaction price is $50 or more, they're better off moving up to a traditional processing company. That means Square can dominate the "micro merchant" category, but may have limited ability to move up the food chain and sign up customers of scale.
Investors may find, then, that the squarest deals in payment processing stocks are the names other than Square.