I have been working on this idea for the past few weeks and this will be a much longer article than usual. This one is going in the Fundamental Value bucket (though as usual there is an event/special-sits angle to it to catalyze value). I should also mention, this is a fairly complex business in terms of its reporting (lots of different segments with various jargon attached; lots of add-backs/exceptionals in the accounts); and its recent history. I have done my best to simplify and focus high-level as much as possible (please feel free to ask specific, detail-oriented questions in the comments and I will follow up).
EML Payments (Australia: EML) – last price 42.5c – $1-2mm ADV, $157mm market cap
Thesis summary: EML Payments (EML), an Australian fintech company, trading down 94% from all-time highs and at five-year lows, has been totally and utterly puked by the market. A never-ending regulatory snafu with its main European regulator over the past two years has completely eroded the company’s credibility; and ultimately has led to the destruction of the consolidated PnL, as endless cost escalation in pursuit of regulatory approval has consumed what previously was a highly cash-generative, capital-light set of payments businesses. The company has gone through one CEO; reconstituted the board twice; been sued by its shareholders; and burnt over $500mm of shareholder capital by doing poor acquisitions. At 42c and about a $155mm EV, the market is pricing this business for going concern risk.
I believe the market is wildly, wildly wrong. Whilst the mistakes of the past are very real, the market is yet to realize the new reality, today, at the company is quite different than where we were just a few months ago. The entire board has been reconstituted, and is now effectively led by an engaged, small-cap activist specialist (Alta Fox) who is not only on the Board but owns an 8.5% stake in the company with a cost basis near 50% higher than current levels. This new board, in position for barely a month, has already put the core problem asset, PFS, up for sale and it is my contention that it will either be sold or otherwise excised from the company in short order (under six months). The market has also somehow forgotten that EML as a whole was the subject of at least two reverse inquiry take-out attempts, just 12 months ago, when the situation was not so different than today, at prices 2.5-3x higher than current levels.
Once or if that happens, what is left is actually mostly a high quality business, the majority (>80% of EBITDA) of which is a Gift and Incentive business where comparative multiples are generally well north of 10x EV/EBITDA. Furthermore the market totally misunderstands the power of the new interest rate environment to transform the PnL. I can chop up the pieces two or three different ways and even assuming a huge negative value for the problem asset, still get an implied value for the whole thing of >2x the current price. In reality I think post problem asset disposal, all parts of the business will be up for grabs, and it would not surprise me to see a total value of >3-4x the current price realized here over the next 12 months. I believe the narrative will rapidly shift from ‘this business will be shut down by the regulators’ to ‘this business can be sold in pieces for $1.5 a share’, as and when we receive final resolution on the PFS business – something that should be 2023 business. In sum I believe we are at the moment of peak pessimism and almost any kind of incrementally less bad news regarding the problem asset could see the stock up >50% (this is just levels we were at a month ago, after all).
Normally in writeups like this I like to keep the exposition of the company’s history to a minimum, or at least self-contained discussion. This time, however, we need to go a little into the weeds and thus the ‘history lesson’ will be longer than usual. I think in this case it is especially important to appreciate the extent of management missteps that have occurred in recent years, contributing to the total washout in the stock, and hence our opportunity today. This is because the core of my argument, and what I believe will happen, is simply the disastrous acquisitions of the last couple years will be unwound and we will be left more or less with what existed back in mid-2019.
Back in 2019 – meaning FY19, ie the June fiscal year end – EML was a relatively simple, growing financial services business, based around two key verticals: the General Purpose Reloadable (GPR) business, and the Gift & Incentive (G&I) business. Both of these businesses were growing at strong organic rates of 40-50%, though EML had always been acquisitive and thus had rolled up other businesses into these two core offerings:
As you can see in the above, what I will heretofore call ‘core EML’ – that is, EML before the problematic acquisitions of PFS and Sentenial – did about $100mm in revenues and $30mm in EBITDA in FY19; was still growing at strong rates, organically; and crucially, had no trouble turning adjusted EBITDA into cash flow:
We should examine exactly why this core franchise was, and is, such a high-quality business. Let’s start with G&I. EML’s G&I segment provides single load gift cards for shopping centers and incentive programs around the world. They manage services at over 900 shopping malls globally (by far the most important industry exposure for the group), providing a complete service from issuance, payment processing, reconciliation, and monitoring/fraud. G&I earns fees at multiple levels throughout the issuance and transaction process, including:
- establishment fees (when EML issues the card, either digitally or physically):
- either transaction-based fees (and/or interchange revenues), when a customer uses the card; or alternately a subscription based fee;
- breakage (when the card expires and there is unused stored value left on the card);
- and interest income on the float (the value loaded onto the card held as cash by EML or its partners until it is spent).
Gift and incentive card businesses are, in general, excellent businesses, with high gross margins and minimal underlying capex requirements. This is because breakage runs structurally 2-4% and represents almost pure margin to the program operators; but also because once established and won, client business is generally sticky (it is hard to re-establish extant programs with new providers given the size and complexity of customer information and sharing). Moreover maintenance costs (for established programs) are quite low, leading to high cash on cash returns; and there are generally large cost synergies to acquisitions in the space given the ability to plug multiple new programs onto an existing platform. This is why established players like EML then tend to grow through acquisition; and further explains the historical high acquisition multiples in the space (as we shall discuss).
You can readily see this attractive earnings profile in the segment PnL. In FY2019, G&I grew GDV – that is, the amount of money spent on its loaded gift and incentive cards – over 40%, taking 630bps of revenue from this GDV; and reported near-80% gross margins:
In FY19, G&I contributed >70% of the company gross profit pool and I believe more like 80-85% of the EBITDA pool (given the incipient higher margins, etc). That is to say, in mid-2019, before COVID and the unmitigated disaster of the PFS acquisition, the market was valuing EML basically as a gift and incentive business and had decided that is was worth $700-900m, or >25x a rapidly growing EBITDA:
This is simply to provide context on previous valuation perspectives and the perceived quality of the core business historically – I am not suggesting this was the ‘right’ number or what G&I is truly worth, but suffice to say if stripped of all the baggage and history it would be worth far, far more than the EV of all of EML today (about $155mm), probably close to triple when adjusting for the new interest rate environment. But we will come to the valuation discussion later.
Skipping ahead to the most recent period FY period, FY22, and having recovered from the COVID-induced slowdown, G&I is still reporting a similar gross margin and more or less a similar take-rate (note, it is crucial to compare fiscal year to fiscal year end given the huge seasonality in the gifting business around the Christmas holiday period):
Keep in mind, this extant gross profit level has been achieved in recent years largely absent any assistance from interest rate income (as we shall discuss shortly); and whilst the overall profit pool has not grown massively the last couple of years, this was most entirely a function of rolling COVID effects (first total lockdown; then Omicron around the year-end crucial period in 2021-22). It is important to realize that the business is more or less the same core as pre-COVID, in 2019, just with a massive interest rate kicker and not having grown for a couple of years.
Complementing G&I in many ways is the General Purpose Reloadable (GPR) segment, an analogous business that expands upon the use case of single load gift or incentive cards to offer businesses and consumers a more versatile range of services. As the name implies, ‘General Purpose Reloadable’ refers to any card (again, physical or digital/virtual) that can be reloaded multiple times with cash and has no set expiry date; as with gift cards it is simply a prepaid card (ie no credit is provided). As with the G&I segment, EML offers an end-to-end solution, offering issuance, processing, and program management to a wide variety of industries – but with two core offerings (pre-PFS) in Salary Packaging and Gaming.
Both of these verticals demonstrate the use case for GPR to a wide range of industries. Salary Packaging allows employers to deliver wages directly to to their employees in a digital/wallet form, allowing for faster disbursement; easier and fully verified electronic access to funds; and the subsequent offering of incentives/rewards/inducements from third-party merchants. There is a good video summarizing the offering here, which I found helpful in understanding the offering. Invariably employers sign multi-year management contracts, allowing EML to enjoy a growing stream of largely recurring revenues based upon salary disbursement and usage from a growing employee base over time.
Salary Packaging has grown like a weed, and EML now runs many large programs for employers in various industries globally (having started from small scale in Australia); the broad measure of the success of the program is in the growth of its Active Member Benefit accounts (that is, the number of discrete users access Salary Packaging through EML’s platform and services, worldwide) – this number was 112k on launch in 2017, but had grown to 170k by 2019; and as of FY22 is 330k and counting:
Salary Packaging was a big chunk of the GPR business back in FY19, at about 30% of Gross Debit Volume. Whilst its importance to the group has been diluted since the PFS acquisition, it is crucial to understand that this vertical existed, and exists, totally independent of PFS and would thus form part of core EML, if or when PFS is jettisoned to a third party.
Gaming is another important legacy vertical for the GPR segment; you can see a similar video description of some of the functionality EML offers here. The reloadable card model for funding gambling is a well-worn and profitable business: despite the legalization of online gaming in many parts of the US in recent years, traditional financial institutions still are hit or miss when it comes to direct interaction with gaming and gambling firms. EML allows traditional debt and credit card holders to load value onto their GPRs, which in turn can be deposited into gaming accounts, seamlessly and with minimal friction. Whilst this sounds like a vertical that would be in decline as regulatory reform removes the barriers between traditional payments, banking, and gaming, in fact EML’s gaming GDV has progressively grown and shows no sign of slowing down. In FY19 gaming-related GDV was $0.7bn, driven most entirely by strong growth in the mature Australian market:
Since then, with the acquisition of PFS, the Gaming vertical has diminished in importance as a part of the broader group, and the company has only provided qualitative comments on its ongoing performance – but did mention that in both FY21 and FY22 gaming was still growing organically, suggesting no underlying issues with demand for the product.
Turning now to the economic model in GPR, we can see that it is not dissimilar from the G&I business, with the crucial exception that there is no breakage, and instead EML would earn an extra level of fees from card loads/reloads (‘load fees’); as well as account management fees (particularly in the Salary Packaging product). The below slide summarizes the various revenue streams available to EML; I have made some annotations to clarify the differences between GPR and G&I:
To simplify, headline take-rates – recall, the % of GDV that turns into revenue for EML – is a step function lower in GPR than in G&I; but to make up for this GDV is structurally higher (since cards can be reloaded, and there is a wider market use case for GPR than for simple one-off gift cards). Translating this to the PnL we see lower gross margins in GPR on a larger revenue/GDV base and, frankly, far more rapid organic growth (due to the structural tailwinds for digitization of all payments and the implications for a model such as this). In FY19, GPR did ~80bps of revenue conversion and 66% gross margins; in 1H’23, the most recent period, revenue conversion was better (110bps) but margins were sub 60% due to mix shift and higher costs in the business:
We will address some of the reasons behind the gross margin deterioration at GPR, over time, but for now let’s remember that fundamentally – and despite all that this segment has been through, in particular, in the last three years – this is a low-COGS, high-margin product with attractive economics when managed correctly.
PFS: addressing the elephant in the room
I have mentioned Prepaid Financial Services (PFS) in passing on numerous occasions so far, but it is time to get to the bottom of all the trouble with this company, and that is the acquisition of PFS in early 2020. As I have tried to highlight, before PFS, EML was a suite of attractive businesses, enjoying rapid underlying growth, and valued richly by the market. Perhaps seduced by ‘easy’ past small bolt-on acquisitions, EML management signed an agreement in late 2019 to purchase PFS, a diversified, European-focused FinTech that offered everything from prepaid cards (a very similar product to EML’s GPR offerings) to white-label banking as a service and e-money wallets. EML described the acquisition thus upon announcement; I have underlined (with hindisght-enabled irony) EML’s own assessment of one of PFS’ core ‘strengths’:
The world was different back in 2019: PFS was growing very rapidly (GDV had compounded at near 50% over the last 5 years); opened up Europe as essentially a new market for EML; and provided banking-as-a-service as a core new vertical to attack. As a result the price, as originally negotiated, was extremely expensive, at around 17.5x EV/EBITDA and a total upfront consideration of $450mm with earn outs possible of another $100mm or so:
Keep in mind that at the time EML’s own stock was trading closer to 30x EV/EBITDA and thus management could claim, rightly, that this deal was ‘accretive’ even though funded most entirely with equity.
Then COVID happened, and the price got renegotiated, but management still ended up closing the deal for an upfront consideration of $265mm and a reduced earn-out of up to $76mm:
In retrospect, in some ways it easy to figure out what went wrong. PFS basically tripled the size of the GPR business, as monthly GDV went up 3x overnight:
More than pure volume though was the added operational complexity of operating significant and regulatory-heavy businesses in multiple new geographies. That this happened during COVID, no less, of course made the integration or oversight task near-impossible given closed borders. Worst of all, when EML acquired PFS, (or at least when they agreed to do so) the UK was still part of the EU, and PFS was regulated by the FCA (the UK regulator and one with which legacy EML already had a relationship). But once Brexit occurred, PFS had to find a new intra-European regulator for its (mostly) European business, and it chose Ireland.
Thus its core regulatory relationship became with the Irish financial regulatory body, the Central Bank of Ireland (CBI). Compounding these issues, EML fell into the trap of acquiring another significant business (Sentenial), for >150mm EUR, once again in a largely new vertical (Open Banking), all whilst in the middle of trying to integrate the PFS business.
The first shot across the bow came in May, 2021 – just a handful of months after the operating license at PFS got shifted from the FCA to the CBI, thus implying the regulatory had found immediate and significant problems. The CBI issued a letter to EML, essentially saying, in vague terms, that the general compliance and anti-money laundering (AML) apparatus at PFS was insufficient and would need to be rectified through a significant program of investment (more senior compliance hires; more risk managers; more oversight; better AML and KYC checks, etc) in order for the regulator to allow the business to continue to grow. EML equity fell off a cliff, from the mid $5s to the mid $3s, although management made all the right public statements, promising to shape up and meet the regulators’ expectations.
But then in late July the company disclosed they needed to inject $29mm into legacy PFS card programs that had been (illegally) drawn down, in error or otherwise, under previous management:
Whilst management pinned the blame on the vendors, this was a hugely embarrassing oversight and failure of basic due diligence – something that perhaps would have demonstrated, ex ante, that PFS was a ‘bad actor’ and probably shouldn’t have been acquired. The market’s skepticism only grew.
The CBI came back in late 2021 – this time with a missive to limit growth in the business given the underlying concerns had not been satisfactorily resolved. Despite all this the company was claiming the remediation plan remained ‘on track’; this ‘on track’ language was repeated in a subsequent update (November 2021) that functionally put limits on PFS’ growth for at least 12 months but did not impose broader risk controls or business closure mandates. A class action lawsuit was also filed at this time, for which the company provisioned over $10mm in potential costs.
Despite management’s protestations to the contrary the market had begun to sour on all things high-growth tech, especially so in the face of regulatory scrutiny. EML stock was closer to $3 by the end of 2021, though not much impact had yet shown up in the actual PnL. This changed, rather abruptly, with the 1H’22 report, where, despite reporting ongoing strong growth in KPIs (GDV growth, etc), margins started to suffer, as high-margin setup fees – generated on new account openings and new program launches – fell off due to the regulatory growth limits – and crucially Opex started to ramp aggressively (even stripping out the one-time costs associated with the CBI matter and the class action):
Opex spiraling out of control would now become the dominant theme of EML’s ongoing interaction with the CBI. In each subsequent quarterly update or semi-annual report, opex guidance would be hiked again and again. By 1H’23 – the latest period – the opex footprint for 6 months alone has expanded to a gargantuan $66mm, an annualized $133mm – a cool 3x higher than the FY19 level of $45m, most entirely related to restaffing the organization to meet the endless, insatiable demands of the CBI:
Some of the cost escalation line items have been truly absurd. In 1H’23 the company expensed an incremental $2mm on travel, and $4mm on professional fees – that is, over and above the large numbers they were already paying last year. Note also that these are ‘adjusted’ numbers, stripping out a total of >$30mm in ‘one-off’ total CBI-related costs that have been expensed to date.
Through this dramatic and unprecedented level of cost escalation prior management insisted the remediation program was ‘on track’; and even after the legacy CEO, Tom Cregan, was ousted in a board reshuffle mid last year, the new CEO, Emma Shand, continue to claim to the market that everything was being sorted out on the regulatory front. The truly shambolic nature of these claims was immediately made clear when, in mid-2022, Sentenial – the other acquired asset in 2020 – had its own fraud incident; and then the FCA opened its own investigation into the propriety of EML’s risk management and compliance functions, in late 2022.
By late 2022 the stock was in virtual freefall, plumbing levels in the low $0.60s – 90% off the highs – and the company had basically descended to the level of farce. A shambolic AGM necessitated some kind of board renewal, and this came in early 2023, when three board members (including the Chairman) were shown the door, to be replaced by the company’s second-largest shareholder, Alta Fox Capital, a small-cap activist; and a couple of other high-pedigree new faces (including the former CFO of Afterpay).
The prospect of board renewal and a stop to the bleeding seemed imminent – and yet still the equity found a new low, breaking to the current level (around 40c) when the CBI landed a final, massive uppercut of an announcement by determining that EML’s remediation program was STILL insufficient and that further regulatory action may be needed.
This basically brings us up to speed with where we stand now, so let’s examine the status quo as I interpret it today.
Status Quo: we are at rock bottom
At this stage EML equity is down close to 95% from the highs and is trading at levels that imply significant going concern risk or some unavoidable large negative value for PFS. There is whale excrement on the bottom of the ocean floor, so they say – and then under all that is current sentiment regarding EML’s stock. Basically all sell-side and buy-side investors have given up on the story, such has been the cacophony of bad news and endless disappointment from the company for most of the past two years.
Of course I do not base my investment approach solely on ‘dumpster diving’, but in this particular case I believe the market is missing a number of crucial points:
- there is no going concern risk here at all;
- there is a disclosed activist who has pushed his chips in and gone on the board, and is thus ‘pot committed’;
- there is a disclosed strategic process, that the market is completely ignoring;
- the latest CBI judgement makes any kind of resolution to the PFS issue a near-term, necessary deliverable;
- and there have been multiple disclosed interested parties looking to acquire the business at levels 3-4x current prices.
Let’s examine some of the points in broader detail. Firstly, with regard the supposed going concern risk, normally when equities trade off 95% and at 5 year lows there is some implicit hole in the balance sheet or otherwise some strong suggestion of going concern risk. I do not believe anything close to this situation exists today at EML. The parent balance sheet holds >$70mm cash; has access to near $100mm in immediate additional liquidity; does not take customer credit risk; is only very modestly net levered (under $10mm); and absent PFS the core GPR and G&I businesses are hugely cash generative (as discussed earlier). Indeed it is my contention that, somehow, should the business need capital quickly they could put the G&I segment up for sale and immediately fetch a price multiples of the current market cap, in cash.
Secondly, this is not ‘deep value turnaround story with no catalyst’ type of trade. The market seems to have missed the very salient fact that not only has Alta Fox gotten involved, but that Connor Haley (Alta Fox’s principal) has taken the decision to go on the board, and thus has become ‘pot committed.’ Reputationally it would be extremely difficult for him to leave without finishing the job, and given the ‘playbook’ in small-cap situations like this, I think it is not an exaggeration to say he has risked a lot by undertaking this project, in a new geography and in a very prospective market for small-cap activism (that is, small-cap Australia, something I have commented on previously). It goes without saying that I have immense respect for Connor as an investor, and would not be invested here specifically if he were not on the Board and thus largely calling the shots. This is not to say the investment wouldn’t work without him, but having a like-minded investor essentially deciding what to do with the business and the pieces as they come up for sale (or otherwise), with a higher cost basis and a ton of latent and obvious value, is hugely attractive.
Thirdly, the market appears to have completely missed the import of the latest CBI letter: namely, that it has prompted the company to run a formal strategic process for the PFS business and has already hired investment banks:
Normally when stocks down 95% announce they are potentially getting out of their millstone of a problem business, the stock goes up 20%; in this case the stock fell another 30%. I simply think this reaction, near-term as it is, reflects peak peak pessimism and misses the forest for the trees. One way or another the PFS problem will be solved, and soon – the question is really only how and on what terms it gets done. But my contention is any kind of resolution – even one that consumes some cash – would see the equity trade up aggressively. Frankly I thought the equity would trade to 75-80c on this announcement, not fall to 40c.
Fourthly, and building on the point above, is the clear impact of the CBI’s latest missive demonstrates (to me) at least that there is no longer any pathway for PFS to remain within the broader EML umbrella – or at least, not as a public company with the legacy compliance/oversight structure. Having tried – and failed – to remediate this business for almost two years, I firmly believe this is now the CBI telling EML they need to sell up, get out, or sell the whole business to a better owner in the good graces of the regulators. Again, somehow the market took this as an unadulterated negative when in fact it seems to me this is quite a positive as it promotes a near-term resolution to the situation above all else – and just as the new board has been constituted and thus has political cover to execute a sale, either of PFS or the whole company, at much lower prices than 12 months ago.
Fifthly and finally, there have been a number of public reports regarding interested buyers for EML (or its pieces) in the Australian Financial Review (the business paper of record in Australia) in the past twelve months, at levels significantly higher than where we trade today. A number of these approaches have been confirmed by the company (see here and here), although it was not made clear why these entreaties were rejected. Note that the last inquiry, in July last year, specifically mentioned ‘multiple parties’ (the newspaper article mentioned Canadian payments giant Nuvei Corp); and whilst the business has certainly deteriorated somewhat since then, overwhelmingly the issues here are below the line (on costs) and regulatory compliance. Is is so unbelievable to think that a strategic acquirer, already well regulated and at scale in Europe, could look at the cost creep at this Aussie small cap and simply deracinate the cost structure; leave behind most if not all of the regulatory history (by porting the business over to its own compliance and risk management functionality, perhaps with a different regulator and on a different license); and thus extract the white meat of the core businesses left behind? And if said acquirer comes calling with the stock now another 60% below levels it was when those bids were last reported ($1.2 or so), why would the activist-controlled board knock them back? After all their cost basis is around 55-60c.
Putting it all together, then, it appears we have a potential inflection point, if not in the actual business (that comes later) then I believe in how the market will start to respond to new information from here. I expect the discussion on the name – such as it is – to shift from regulatory issues 110% of the time to break-up value and what PFS could be disposed for. Thereafter I expect the street to gravitate towards a reappraisal of core EML or at least begin to capitalize the G&I business at something approaching a more realistic acquirer’s multiple – but we clearly don’t need any of that to win from current levels.
It is often said you make the most money when situations go from being ‘absolutely and utterly hopeless’ to simply ‘pretty bad.’ It is my contention that EML today is a quintessential investment in this mold. We simply need PFS to be cauterized, in one way or another, to make an outstanding return; anything else beyond this will simply be gravy and obviously multibagger territory.. Let me explain why – firstly by considering the impact of the current interest rate environment on the business; and then by conducting a simplified Sum-of-the-Parts analysis.
The new interest rate environment: massive (yet misunderstood) tailwind
Looking simply at what pre-PFS EML earned back in FY19 and assuming that, plus some growth, is the upside case here would be a profound mistake. Due to the nature of its business model, EML is able to earn interest on cash held in custody to back value loaded onto customer cards, as and until the customer redeems the value of said loaded cash (this is called ‘float’). This is why EML breaks out the parent balance sheet from the consolidated balance sheet in its presentations, to demonstrate the size of the float as the overall installed base of cards grows. You can see that, as of the most-recent balance sheet date (Dec’22), the float was about $2.6bn AUD on-balance sheet:
In reality, the actual float is a bit bigger than this, since EML only includes self-issued amounts on-balance sheet – meaning there is additional float generated by its partner banking institutions in jurisdictions where it doesn’t have a banking license (mostly the US). EML does not earn the entire carry on these additional amounts (about $300mm AUD or so), but still participates in some carry on this additional sliver (as they share it with their banking partners). The ‘total stored value’ metric is thus important and most entirely an interest-earning revenue stream; as of Dec’22 this amounted to almost $2.9bn AUD. You can see, incidentally, how it has continued to grow, and grow, despite the many idiosyncratic issues EML has faced in recent years:
Any interest earned on this float runs directly through the revenue line at 100% margin, and is thus pure incremental profit; as such EML is highly sensitive, in theory, to changes in short-term interest rates. The company gives some sensitivity as to how impactful movements in interest rates is, per the following slide in their latest deck:
As you can see, EML is currently (well, as of early January) run-rating close to $30mm in annual interest income, or something like a 1.1% net interest yield (using $2.6bn of assumed float and thus implying the partner-generated balances don’t earn much). This still strikes me as incredibly low, and I think will march much higher, sequentially, for a number of reasons:
- the majority of EML’s float is denominated in EUR (39%) and GBP (33%) balances, where interest rate rises have been commensurately slower than in the US, but are now catching up (see Euribor 6 month rates here, and GBP SONIA overnight rates here). Both EUR and GBP deposits at call should be earning 3-4%+ on a run-rate basis;
- the CBI investigation has stifled EML’s full ability to earn current call or money market-equivalent rates, as banking partners have simply refused to allow them to reinvest in more positive-carry yielding instruments with Irish-domiciled balances (ie the bulk of the European business and thus float) whilst the investigation is ongoing (but obviously this will change as soon as the regulatory impasse is resolved);
- there is a natural delayed flow-through from live market rates to the PnL, given contract and pass-through lag.
Nevertheless, this tailwind is being totally overlooked by the market and its impact on the go-forward earnings power of the business is completely ignored. Back in 2019, when core EML was doing $30mm in adjusted EBITDA and the problematic PFS acquisition had not even been contemplated, the company was earning 30-50bps on their float:
This subsequently dropped to near-zero during COVID and remained there, for most of 2021 and into 2022, due to central bank actions during the pandemic. But today the situation is wildly different: even a much-lower-than-market terminal carry of say 2.5%, on today’s float of $2.6bn (again assuming no further growth), would imply $65mm drops to the EBITDA line, or an incremental $35mm or so even versus what the company says they were run-rating at early this year. Clearly this would double (currently) guided EBITDA and completely change the investment calculus, and while this not made its way through the PnL yet, given some of the factors discussed above, it is realistic to believe it will make its way there in the near term given a likely resolution at PFS and the natural progression of contractual lag through the business.
And crucially, even if we were to perform radical surgery on this business, cutting out PFS and thus assuming a bulk of the float disappears if PFS is sold to a third party, the look-through impact of higher rates for longer on residual EML is still transformative. Disaggregating core EML float from the PFS contribution is a little bit tricky, as the company does not disclose where the float sits on this basis. But PFS sits entirely within the GPR segment, and comprises most all the European assets of the group, so we can take a stab at isolating non-PFS float for the purpose of this analysis.
The FY22 Annual Report discloses that G&I contributed 25% and 38% of interest income in FY21 and FY22, respectively:
Given the native currency interest rates were likely higher in G&I (ie, predominantly non-EUR) than in the GPR float, these metrics likely overstate G&I’s share of total company float (note, for example, that G&I’s share of GDV is only 10-15% of GPR’s contribution in the above). Let’s assume therefore that G&I’s share of float is just 22% of the total consolidated float.
We should also note that core EML includes the Australian business within GPR – a high-quality segment that existed well before PFS and that would remain within EML if or when PFS is excised (this segment contains most all the Salary Packaging business; the Gaming vertical or at least a good chunk of it; and a few other juicy local government contracts). The Annual Report discloses that on a revenue basis – not a perfect proxy for share of float, but something to work with – Australia contributed about 15% the last two fiscal years:
Thus, if Australia is perhaps 10% of float – within GPR but totally outside of PFS – and if the separate G&I segment is 22% of float, we can tentatively conclude that non-PFS (that is core EML) float, is around $925mm today – most all of which should be full-interest earning. As per the below, just a 2.5% carry on this slimmed-down, post-PFS assumed float would generate $23mm in interest income, or an incremental $20mm over what pre-PFS EML was earning through interest alone, in FY19:
The assumptions above are intended to be more illustrative and directionally correct than accurate to the dollar, but they should demonstrate an important conclusion: even if PFS were to be fully and utterly thrown out, core EML would still be earning close to double, at the EBITDA line, what it was earning in FY19, simply through the accretion of higher interest rates alone (ceteris paribus for costs, of course). Absent any other changes or value generation, that would put core EML at about 3x EV/EBITDA, today ($160mm EV today versus $50mm in FY19 interest-rate adjusted EBITDA). That seems ludicrous for a business of this quality.
Taking a stab at a pro-forma SoTP
Since I have a rather strong view that PFS will be disposed of in some form, I am going to continue to think through what residual/core EML could be worth post this exercise; and then modify that number for various scenarios concerning the PFS business. To refresh, this perspective in grounded in the view that the CBI has effectively demanded some kind of change of control transaction for PFS, and that the activists now running the show at EML recognize this is the quickest and best way to cauterize the wound at this point.
In the below SoTP, I have (as usual) made a number of simplifying assumptions, none of which should be considered aggressive:
- What I consider core EML – that is, the non-PFS part of GPR, and all of G&I – is assumed to earn basically FY19 gross margins on LTM revenues (ie no credit for further organic growth);
- credit for run-rate incremental interest income per the earlier analysis;
- $10mm in core opex inflation (ie 12% of total opex inflation ($88mm) incurred since FY19 stays with the core EML business despite essentially all of excess opex inflation accruing at PFS and more recently Sentenial);
- Sentenial gets sold for half of what EML paid for it ie $86mm, despite substantial growth in the interim and reaching positive EBITDA;
- No credit for rest of legacy Digital Payments segment ($8mm of Gross Profit in FY22);
- legacy PFS vendor debt is honored in full and remains at EML, AND treat provisions and residual Sentenial earn-out as debt;
- zero clawback of $27mm injected by EML into PFS cash-deficient legacy card programs (despite ongoing litigation);
- comp multiple (10x) for G&I and 6x for residual GPR.
You can see the below work-up, both at the rough earnings level, and then the SoTP lower down:
None of these assumptions strike me as aggressive, either individually or in total, and yet we get a valuation basically three times the current quote. Of course the obvious corollary is that the market is pricing in an extremely large negative value for PFS – or, using the $450mm in theoretical ex-PFS value here as a guide, maybe $300mm in negative value (being the difference between the above SoTP and the enterprise value today). No doubt the market would not immediately grant core EML a high single digit multiple, nor would it capitalize a mid-$40s EBITDA number (even though this seems eminently achievable, just taking the business back to what it was, at much lower scale, and adjusting for the rates benefit). But I think it remains indisputable that the market is putting some very large negative value on PFS; and thus any resolution to the status quo – even one that carves off PFS at a low headline dollar price – would be taken positively by the market.
We will come to what PFS should be worth shortly, but firstly a few words on why 10x is the ‘right’ multiple for G&I. I mentioned earlier that these gift businesses are extremely high quality and generally trade for high multiples. If you speak to one of EML’s direct North American competitors, BlackHawk Network, they will tell you directly these businesses tend to trade at 10-12x EV/EBITDA and there is invariably a bid at that level due to the underlying high cash-generation of the model; and the huge cost synergies available upon consolidation to the acquirer. BlackHawk itself was formerly listed on the Nasdaq (in 2013) and after rolling up segments of the North American market was acquired by Silver Lake in a $3.5bn LBO in 2018 at 15.5x LTM EV/EBITDA:
Notably, BlackHawk at the time carried >4x of net leverage; pro-forma for the PFS separation, G&I would be totally unlevered. We should further recognize that with 80% gross margins and – even back in FY19, before interest rates moved – >30% EBITDA margins, the core G&I business at EML appears in many respects a superior asset to the broader BlackHawk group. Whether BlackHawk or someone else, be it strategic or PE, I am quite comfortable G&I is saleable at minimum 10x EV/EBITDA in an auction/breakup scenario. That realization alone essentially underwrites more than a double from here (assuming such a sale would be pursued).
But what is PFS worth?
This brings us, of course, to the thorniest of questions – and that is, what is PFS worth today? The answer is of course, ‘it depends.’ To EML today it is of profoundly negative value; but it should be recalled that this business as recently as 2020 was sold for $330mm (after being price cut due to COVID) and a health mid-teens EV/EBITDA multiple, apparently after a competitive auction process. The business, pre-EML ownership, was growing rapidly; still generated mid-60%s gross margins; and (before the regulatory snafu) was racking up high 20s % EBITDA margins as it grew:
I believe it is a near impossibility to put a precise number on what PFS is worth today, since so much depends here on who the acquirer is; what the new regulatory relationship looks like; and how much of the explosion in costs in the business at EML can be ripped out by the new owner. But perhaps we can speculate as to what a potential acquirer could see in the business.
Let’s approach this from the perspective of Nuvei, a Canadian listed FinTech specifically chosen because they were mentioned in the AFR as an interested potential acquirer of EML (and thus, perhaps, willing to underwrite the PFS risk). It seems to me the core problem facing EML in managing PFS is a lack of scale, particularly in Europe – here, Nuvei appears to check all the boxes. Total payment volume last year was $128bn, or 10x the size of EML’s entire GPR business (within which PFS obviously sits). Nuvei is highly profitable and already at scale, boasting >40% adjusted EBITDA margins and converting 90% of EBITDA to free cash:
Nuvei operates in many if not most all the same verticals as PFS: digital banking, cross-border payments; digital e-money wallets; prepaid cards. Moreover it already has a significant and growing European presence, with 55% of group revenues coming from the region:
Within the rubric of EU regulation, Nuvei appears to have two operating European subsidiaries (at least at the licence-holding level), neither of which sits in Ireland. These are Nuvei B.V. in the Netherlands, and Nuvei Limited, in Cyprus:
Without speaking to the strength or weaknesses of Nuvei’s regulatory engagement, the simple fact remains here is a payments business handling 10x the volume of EML; growing extremely strongly, both through acquisition and organically; and regulated, within Europe, outside of Ireland. Moreover it is a cashed-up, highly valued listed company (>25x EV/EBITDA) with zero leverage that has (apparently) already engaged with EML in recent months on a potential change of control transaction. Is it so beyond the realm of possibility that Nuvei could buy PFS; port over the licenses to its Holland/Cyprus entities; cut a whole bunch of costs that EML stuffed onto the business in their error; and make an absolute fortune?
On the contrary, it seems this is exactly what they would do. What, though, would they pay for such a privilege? At current valuations on the EML equity it doesn’t really matter, as long as PFS is sold for some net non-negative number (and in reality I think Nuvei would probably be more interested in acquiring the whole company, including G&I, than just PFS alone). Still, for the sake of argument, if Nuvei could cut PFS-related opex by 33% – that is, from say $70mm to $47mm; and grab the additional benefit from restriking PFS’ $1.9bn in float closer to market rates, I think acquirer’s EBITDA on PFS alone would be something like $62mm:
To be fair, some of these synergies (at the COGS line through better vendor terms; and at the opex line of course due to duplication of systems, etc) are available only to a strategic acquirer like a Nuvei. And we should also probably assume some budgeted cost for integration, or firing all the unnecessary hires that EML installed. Finally, perhaps there is some meaningful cost to reincorporate the issuing entities now sitting in Ireland into new geographies (or a costly relicensing process). But the fact remains – PFS is clearly worth something, potentially a very meaningful something, to certain acquirers. The number above are hardly aggressive and yet $62mm EBITDA would increase Nuvei’s total EBITDA by 20%. Nuvei has a $8bn CAD market capitalization today, supported by $350mm of adjusted EBITDA; surely they would pay a few percent of this market cap to grow EBITDA another 20% minimum at a stroke?
It is hardly my intention to get too bullish with regard to PFS outcomes, but I simply want to re-underline that 1) PFS is not worth zero, let alone a large negative number; and 2) there are certain outcomes here (a $200mm or $300mm sale) that could see our EML equity literally 3x overnight. In reality, I doubt Nuvei would bid against themselves and there will certainly be some deep discount for regulatory uncertainty. But even so, simply putting a line under PFS and getting something modest like $100-150mm in cash would, I believe, send the stock straight to $1.5-2 a share. With no balance sheet risk (in my view), those are the kinds of odds I can really get behind.
Some brief thoughts on Sentenial (Digital Payments)
I have spoken very little about the third of EML’s segments, that is Digital Payments – the business unit that encompasses the acquired Sentenial/NuaPay open banking business as well as the legacy VANS business. The business did $15mm in gross profits last year, having grown revenues at near 100% (and at 85% gross margins) as the NuaPay open banking business scales rapidly (and reached EBITDA breakeven). EML paid close to $175mm in total (cash upfront plus earnouts) for the bulk of this business in mid-2021, and despite the ongoing rapid growth and apparent move towards profitability, it took a large charge against goodwill for the acquired business last year due to declining tech valuations and EML’s own tanking stock price. I will not pretend to be deep in the weeds on NuaPay’s specific edge as an open banking platform; nor do I have deep multi-year DCF demonstrating this segment will be worth many multiples of what EML paid, in the future. That is because I do not believe this segment will drive equity returns here (good or bad) and frankly is maybe the fourth or fifth thing to think about, in terms of priority, when it comes to this investment.
Thus, for valuation purposes, I am simply taking a pretty chunky haircut against what EML paid in an open-market, competitive transaction – admittedly a totally different market environment. It is my understanding that given the nature of the business, and its recent acquisition, it would not be too difficult to carve it out and sell it independently, should the new board decide that is the best path forward. If you are worried $86mm is too aggressive a marker here, you could always cut it another 50% or so – it doesn’t change the valuation argument, as SoTP drops only 10c as a result (and recall I am giving no benefit for the legacy VANS business which still contributes >50% of segment gross profit):
So all in all I am clearly imprecise on my valuation of this segment but feel quite comfortable at an $85mm or so number give or take, for now.
Risks: what should we be concerned about?
When the valuation and set-up is this bombed out, it is perhaps natural to wonder what more could it take to really get hurt. This is a bit of a different case in that, whilst the break-up/asset value appears many multiples higher than where we trade and thus covers our purchase price many times over, there is of course still risk regarding the actual execution and disposition of some of the assets. Perhaps the worst outcome from here would be a failed sales process for PFS – that is, simply no one wants to inherit the regulatory headache that would potentially come with the business. Whilst I don’t think this happens, as per our discussion above, if it did, I believe EML would be forced to essentially put PFS into run-off: something that sounds scary but frankly would, in theory, generate cash in the interim given the huge size of the float and interest rate earning power; the ability to run-down staffing levels, consulting spend; all the extra layers of organization building that are currently being expensed in the pursuit of a sustained growth business; and of course by cutting any and all growth and new-program related spend. Indeed it is quite remarkable that even with the regulator throttling PFS so massively over the last year in particular, the business has continued to grow. But if it could not be sold, and the regulator could otherwise not be appeased, putting it in runoff does not strike me as a horrible middle-ground and maybe not something that would ultimately cost cashflow at all (and certainly not the multi-hundred million implied negative value being priced today).
Another risk worth considering is the G&I segment’s sensitivity to broader macro and in particular to consumer spending (65% of the business derives from shopping mall programs, after all). During COVID GDV at the segment did get hit, somewhat, although the fall was cushioned by 1) growth in non-mall volumes; 2) overall volume growth due to client wins and take-up of the product; and 3) higher breakage due to the effects of COVID, effectively pulling forward a bit of revenue that would otherwise have been recognized in future years. In fact, looking at the below, G&I performance during the heart of COVID was quite incredible:
In an elongated and ‘regular’ recession, perhaps, the impact would be more strident: you would see less elevated breakage (ie no tailwind for EML), but simply less GDV as consumers spent less. The business is highly seasonal with a big chunk of GDV/revenue being generated over the holiday period, so if the global economy goes into the tank in the second half of this year, that is a real risk, and one I am cognizant of. At this point I simply feel the valuation more than compensates for the risk and the interest rate tailwind is such that it would offset a huge drop in GDV volumes without impacting earnings too much.
A final risk to think about here – and why this position size should be considered carefully – is the ‘black box’ nature of some of the regulatory matters at hand. It has never precisely been spelled out, what exactly EML did wrong. Since the CBI found these issues, the FCA has also chimed in, suggesting EML’s standards are not what they should be. Whilst it has been quite a long period of time now that the regulators have been interacting and examining the company – defraying our risk here considerably – there still remains a non-zero chance that some further regulatory infraction comes to light that risks another portion of the business (the highly profitable Australian GPR business, perhaps). I view these odds as quite low, and believe in any case the problem business will be sold in under six months – but it is worth thinking through.
Still, given all of the above, and with a base case of a 3x upside to vanilla SoTP value, before even considering potential sales proceeds from a PFS disposition, this seems a very fat pitch indeed. I believe if, or more likely when, the PFS is finally sold or otherwise totally derisked, this will near immediately be an 80c stock – and more if there are actual cash proceeds from any disposal transaction. With a new board and activists aligned, gunning for a similar outcome and with a cost basis closer to 60c, this is about as juicy as it potentially gets in small-cap land. This is a top five position in my book.
Disclosure: long EML.AX