Paysafe Group — Update 30 August 2016

Paysafe is a global provider of online payment solutions – it offers payment processing, digital wallets, card issuing and pre-paid online vouchers. The company’s services are available in more than 200 countries and can process more than 100 payment types in 22 languages and 41 currencies. The recent Skrill acquisition has scaled the business up, resulting in a more balanced geographical and customer exposure and a wider product range. Management is focused on driving growth from the combined processing networks and relationships and will also consider further acquisitions.

On the back of stronger than expected H116 results and raised company guidance, we have upgraded our forecasts for FY16 and FY17 and introduced FY18 forecasts. Revenue and gross margin upside is partially compensated by increased spend on technology development and risk and compliance, but overall, the company is targeting EBITDA margins of c 30% up from the previous 28.5%.

The stock trades at a discount to peers on an EV/EBITDA and P/E basis for FY16e and FY17e. Recent acquisitions have expanded Paysafe’s product offering and balanced out its geographical exposure, while reducing exposure to its largest merchant. Strong cash generation is quickly reducing the group’s net debt position, providing funds for product development and further acquisitions as well as the potential to return cash to shareholders in the form of buybacks or dividends. Our revenue forecasts are relatively conservative compared to the company’s recent underlying growth rates; if ongoing investment enables this rate to be maintained, then we see scope for earnings upgrades.

The following factors could affect our forecasts and the Paysafe share price: 1) merchant failure – mitigated through the use of its risk management tools and by holding rolling reserves; 2) regulatory risk within the online gaming and financial services markets; 3) technology failure, although the use of multiple datacentres and redundancy mitigates this; 4) security breaches – maintaining PCI DSS Level 1 compliance reduces this risk; 5) currency risk – hedged where possible; 6) competition from large, well-funded public companies; 7) customer concentration – one customer made up 20% of Paysafe H116 revenues although this should reduce in FY17e; and 8) integration risk.

The company was founded in 1999 as NETELLER, when it launched its NETELLER eWallet, a secure online payment service for consumers that also offers 100% payment indemnification to merchants. The company listed on AIM in 2004 and, in 2005, bought Netbanx, a UK payment service provider (PSP) founded in 1996. In 2006, the company entered the Asian market with the launch of NETBANX Asia payment processing services. Due to the introduction of the Unlawful Internet Gambling Enforcement Act (UIGEA) in the US in 2006, which banned processing of payments related to illegal online gambling, NETELLER withdrew from the US eWallet market in early 2007. To reflect the revised focus of the group, the company changed its name to NEOVIA in 2008. In 2011, NEOVIA acquired Optimal Payments Inc, a Canadian-based PSP, and changed the group’s name to Optimal Payments plc.

In June 2014, Optimal acquired two US payment processors, Meritus and GMA, and in August 2015, doubled the size of the company through acquiring Skrill1. Earlier this year, the company acquired another US processor, MeritCard. The group now employs more than 1,800 staff across North America and Europe.

In November 2015, the company was renamed Paysafe. In December 2015, Paysafe moved to the London Stock Exchange’s Main Market from AIM and in March 2016 was included in the FTSE 250.

The group offers a wide range of payment-related services. Exhibit 2 shows the operations that fall within each of the three business lines.

Post the Skrill acquisition, the group is now a leading payments provider with a wide addressable market, covering the payments spectrum from pre-funding (digital wallets, pre-paid) and immediate funding (payment processing) to future funding (Payolution). Management’s opportunity now is to take advantage of the scale of its processing networks and merchant and acquiring relationships to accelerate cross-selling and winning new customers.

Paysafe’s mission is “to make every point of the payment experience relevant, secure and simple”. The company has built strong positions in several niche areas (eg, online gambling, processing for medium to high risk merchants, prepaid vouchers) and is keen to build on this success with solutions that serve other niche or neglected areas. These could either be developed in house, or via acquisition.

The company has started work on its next-generation global data platform – this is being designed to enable analysis of data from all parts of the business for the benefit of the company and its merchants. It will also provide unified APIs and SDKs for developers so the platform can act as a single point of integration to the existing processing and digital wallet platforms. The new platform should make it easier for customers to connect to the full range of Paysafe’s services as well as make it easier to cross-sell.

The management team has a wide variety of experience in the payment processing market across multiple geographies. Joel Leonoff (CEO) joined via the acquisition of Optimal Payments, where he was president and CEO. Brian McArthur Muscroft (CFO) joined Optimal Payments in January 2015; he was the CFO of Telecity from 2006 to 2014. Danny Chazanoff (COO) also joined with the Optimal Payments acquisition, where he had held COO and CTO roles since 2006.

The majority of this division’s revenue is generated from the existing Optimal Payments businesses (NETBANX payment processing and the Meritus and GMA processing businesses acquired in 2014) with a small amount contributed by the Payolution business acquired with Skrill and the addition of MeritCard, a US payment processor acquired in February.

As a payment service provider (PSP), Paysafe Processing provides a payment gateway specialising in ‘cardholder not present’ (CNP) transactions. This enables customers to pay for goods and services on merchant websites or by mail order/telephone order (MOTO) using a variety of different payment methods. As a PSP, Paysafe manages all the connections to the card processing networks, the acquiring banks, and the merchant’s online shopping basket software. Paysafe’s aim is to enable as wide a range of payment mechanisms as possible to maximise conversion rates, and continues to add new methods all the time. This business has more than 25,000 merchant relationships with more than 42,000 merchant accounts covering a variety of end markets including online retail start-ups, gaming, digital download, travel, subscription, direct marketing and enterprise. In 2015, Paysafe processed more than 170m transactions, worth $17.2bn. Paysafe Processing offers three different services:

The majority of customers are on the bureau model. A large proportion of the business is generated in North America as a result of the Meritus, GMA and MeritCard acquisitions.

Paysafe Processing competes with a variety of processors including BAMS (Bank of America Merchant Services), Braintree (owned by PayPal), Datacash (owned by MasterCard), FirstData, FIS, ingenico ePayments, Chase Paymentech, Kalixa, Safecharge, Stripe, TSYS, Wirecard, and WorldPay.

Once merchants are signed up to use Paysafe’s payment processing service, the business sees very low levels of churn. The main reasons that merchants stay with Paysafe include its good acquiring bank relationships, its technology (eg, risk management tools, chargeback management, recurring payments engine), and its customer service.

As a merchant’s business grows, Paysafe benefits from increased transaction volumes and values. Online retail sales are forecast to continue to show strong growth from the combination of new vendors entering the market and volume growth from existing vendors, as more retail sales shift from on premise or MOTO to online. Data from eMarketer shows that only 7.1% of US retail sales and 14.5% of UK retail sales were made online in 2015 and this is forecast to expand to 9.8% and 19.3% respectively by 2019.

As a growing proportion of online transactions are made from mobile devices, Paysafe continues to develop mobile functionality. The acquisition of FANS Entertainment in May 2015 added mobile platform development skills and the company recently just announced that it will soon be soft-launching new mobile ordering functionality. This will be white-labelled for large merchants and offered as a branded-service to SMEs.

In early 2014, Paysafe was approved as a principal member of Visa Europe and MasterCard Europe, giving it the ability to become an acquirer for Visa and MasterCard transactions in Europe. Paysafe’s acquiring services went live in November 2014. This does not affect the gateway processing part of the business but has the opportunity to change the bureau business. The business can offer acquiring services to new merchants and expects to be able to transfer some existing bureau merchants over from Paysafe’s acquiring bank partners. To build a more balanced portfolio of merchants, Paysafe is targeting lower-risk new merchants for acquiring.

Payolution provides an invoicing service for online merchants, enabling consumers to pay for goods once received, rather than when they are ordered. It pays the merchant at the time the product is sold, and invoices the consumer for the cost once the goods are shipped. The company relies on several banks to provide the funds for the period of time between merchant payment and receipt of funds. Payolution charges the merchant a percentage of the value of the goods. The business is active in Germany, Austria and Switzerland (DACH) and recently launched in the Netherlands. Payolution competes with similar services from Klarna (active in Europe and the US), BillPay (owned by Wonga; active in the DACH region) and PayPal Credit (formerly Bill Me Later).

This division includes the NETELLER wallet, the Skrill wallet and the Paysafe Card Solutions business.

The NETELLER eWallet service was launched in 1999 and is now active in more than 200 countries. NETELLER is authorised by the FCA as an e-money issuer and has passported its non-UK services on to this authorisation. The Skrill eWallet service received its e-money issuer licence from the FCA in 2002, which it passports across the EEA. While the two brands continue to be marketed separately, behind the scenes the businesses are being integrated with the target of a common technology roadmap.

From a merchant perspective, offering an eWallet as a payment method on its website improves shopping conversions, gives the merchant access to guaranteed funds and chargeback protection, and shifts the customer identification process to the wallet provider. The eWallet has traditionally been used for online gambling as it allows the user to make payments on multiple sites without having to enter payment details each time, it maintains the customer’s anonymity, enables fast receipt of winnings, and has multicurrency functionality. This means that a customer winning on one gambling site can quickly use those winnings to place bets on other websites, without having to wait for proceeds to clear a bank account or be credited to a payment card.

A customer loads up their wallet by transferring money by bank transfer, debit or credit card, direct debit or alternative payment methods such as paysafecard or bitcoin. They can then use the wallet to pay for online products or services anywhere that NETELLER or Skrill are accepted. Both wallets operate loyalty schemes to attract and retain VIPs. To get money back from the wallet, the customer can request a bank transfer, cheque or bank draft. NETELLER and Skrill also offer the option for wallet holders to have a Net+ or Skrill MasterCard-branded prepaid card. This card can then be used for online and offline purchases or to withdraw cash at ATMs.

Both wallets offer a peer-to-peer remittance service charged at 1% of the amount sent and are free for the recipient. Skrill’s Quick Checkout and NETELLERGO! enable merchants to accept alternative payment methods without the customer having to register for a Skrill or NETELLER wallet. Skrill’s 1-Tap allows merchants to offer customers a method to pay for goods with ‘one-tap’ on any device, removing the need to enter card details each time.

Both wallets generate the majority of their revenue from the fees charged to the merchants who accept wallet payments. A merchant will be charged a fee for every transfer from a wallet (typically 2-4%) with a lower charge for a transfer into a wallet. Skrill and NETELLER also earn fees from foreign exchange and pre-paid cards, with the majority of remaining revenues generated from customer deposits and withdrawals.

NETELLER and Skrill operate in c 200 countries, across 40 different currencies and in 18 languages. Certain countries are banned or non-serviced (for regulatory, legal or cultural reasons), and in others illegal online gambling transactions are declined (eg US, Canada, Turkey). Until 2007, the US was NETELLER’s largest market. After the introduction of UIGEA, NETELLER withdrew from the US market. In 2014, Paysafe re-launched NETELLER and Net+ in the US for use in those states where online gambling is legal, supported by a federally insured US financial institution sponsor. The wallet service helps online gambling operators to counter the high rate of credit card rejections: loading a Net+ card using a credit card does not count as a gambling transaction so should not be rejected by a credit card company. Skrill has money transmitter licences in every US state that requires it; the company is in the process of seeking change of control approvals for these licences.

NETELLER and Skrill compete with global digital wallet providers such as PayPal as well as regional wallet providers such as AliPay (China), DineroMail (Latin America) and Yandex (Russia).

This division is authorised to issue MasterCard prepaid cards; it already issues for the wallets, but also offers a white label service for companies wishing to offer their own prepaid cards. Examples of uses include payroll, affiliate payments, currency, loyalty and gift cards. To date, the division has dozens of clients including MistralPay, SEQR, Revolut and Payfriendz.

This division incorporates the paysafecard and Ukash cash voucher businesses, now all branded as paysafecard. The vouchers are used by consumers who:

The vouchers are sold at 500,000 points of sale (distributors) in 43 countries and can be used to buy products or services online from 4,500 merchants, with the code provided on the voucher used as an online payment method. From the merchant perspective, benefits include guaranteed payment (no chargebacks) and security. Distributors benefit from easy integration into existing terminal infrastructure and increased footfall and spend. Online gaming and gambling are the main verticals to date: unique users are split c 50% online games, c 20% sports betting, c 20% online poker, and c 10% other (eg, music streaming, VOIP services).

Paysafe is subject to compliance with a variety of regulations covering gambling, e-money, money transmission, anti-money laundering (AML), data protection and the card schemes. We summarise below how it achieves compliance with these regulations. While a meaningful cost to the business, management views its regulatory and compliance expertise as a key barrier to entry.

Paysafe needs to be aware of gambling regulations on a country-by-country basis to ensure it is not providing processing or wallet facilities to customers in illegal markets. It also needs to be registered in certain jurisdictions: in Canada, it is registered with the British Columbia GPEB and is a registered supplier in Ontario. In the US, it is registered with the Delaware State Lottery office and is a registered vendor with the New Jersey Division of Gaming Enforcement.

Paysafe is a regulated money services business in Canada (FinTrac) and the US (state regulators and FinCen). It has a money transmitter licence in the Isle of Man (FSC), is a registered branch in Germany (BaFin), is a regulated financial intermediary in Switzerland (FINMA) and has four e-money licences in the UK (FCA). There remains uncertainty over the status of the UK licences in the EU after the Brexit result (Paysafe passports its UK licences across the EU). It is applying for one or more licences in Europe to counter the risk that the UK licences cannot be passported.

This is primarily a consideration for consumer-facing businesses, ie digital wallets and paysafecard, but also needs to be considered when a merchant signs up. AML monitoring is made up of three stages: know your customer (KYC), transaction monitoring and suspicious activity reporting. When a customer first signs up for a service, Paysafe needs to consider the relevant AML regulations and undertake KYC procedures. Then transactions must be monitored, taking into account the thresholds set in each country. In the EU, new regulations are due to come into force from the beginning of 2017 – the company has already hired extra staff in its Sofia office ahead of this deadline as it expects more customers to fall under the remit of the regulations, particularly in paysafecard (which until now has been able to take advantage of certain KYC exclusions).

Our forecasts and the share price performance are sensitive to the following factors:

Paysafe reported strong revenue growth in H116, with pro-forma constant currency growth of 20% y-o-y and increase in the EBITDA margin to 29.6% (Exhibit 3). The integration of Skrill is now complete, and the company expects to generate cost synergies in excess of the original $40m this year. Exhibit 4 summarises the underlying growth of the three divisions over the last five half-year periods. The UEFA European football championship in June boosted revenues in both Payment Processing and Digital Wallets by low single-digit millions of dollars each. In Payment Processing, the US saw strong growth in volumes and the addition of MeritCard from February. The Digital Wallet business benefited from the introduction of fees for its remittance service. Every division increased its gross margin compared to H115 and H215, despite an increase in bad debts in the Payment Processing division. The take-rate (revenues as a proportion of transaction volumes) decreased in Payment Processing, as MeritCard was incorporated. MeritCard tends to process for lower-risk merchants and hence charges a lower rate. The Digital Wallet take rate increased, partly due to the start of charging for remittances and also because new payment methods went live.

On the back of strong H116 results, the company has upgraded FY16 guidance:

We have revised our forecasts to reflect H116 strength and the raised guidance for the year and we introduce forecasts for FY18. Key changes include revenue upgrades for the Payment Processing and Digital Wallet divisions, gross margin upgrades for all divisions and increased capex forecasts (taking into account accelerated platform development costs). Overall, this drives revenue upgrades of 3.7% for FY16e and 2.5% for FY17e and normalised EPS upgrades of 7.1% for FY16e and 6.1% for FY17e. We continue to expect a rapid reduction in net debt, and forecast a net cash position by the end of FY18. Net debt/EBITDA stood at 1.5x at the end of H116; the company would be comfortable taking this up to 3.0x if a suitable acquisition was identified

Paysafe trades at discount to its peer group on all valuation metrics – this discount is most marked for P/E, reflecting the company’s low tax rate. While some discount is merited to reflect the high exposure to one gambling merchant, this exposure is expected to decrease over time as Paysafe grows the remainder of its business at a faster rate. Strong cash generation is rapidly reducing the company’s net debt position, providing good headroom to make further accretive acquisitions.