When last I wrote about PAX Global (OTCPK:PXGYF) ((0327.HK)), the latest story was the company's now-former CFO throwing a temper tantrum at a sell-side analyst (Timothy Lam) who had the temerity to be negative on the stock. By the way, not only did that tirade cost the CFO his job, that bearish analyst was right - the stock has fallen more than 40% since then, and a lot of what the analyst pointed out as bearish concerns (a weakening position in China, inflated expectations for developed market adoption, weak service offerings) have become significant issues.
I do have some real concerns about PAX's position in its home market, as well as its ability to penetrate developed markets like the U.S., but I also see solid execution in markets like Brazil as a sign that PAX isn't beyond redemption. I have slashed back my expectations to single-digit revenue and FCF growth, but even those lower projections support a fair value almost 60% higher than today's price. Although this is a very high-risk name, I'm starting to wonder whether these shares have beaten down to a point where they offer a good return on the risk.
Squeezed In China
Although PAX Global is likely still the leader in terms of installed point of sale (or POS) terminals in China, the company has lost a lot of momentum to rivals like Fujian Newland. While the company has shifted its portfolio more toward the middle-to-lower end, the company is getting squeezed both from the low end and the high end in the domestic market. Making matters worse, a change to China's interchange has chilled the market for the past year or so.
The numbers have gotten ugly. PAX saw some growth in China back in the first half of 2016, but since then the company has seen double-digit declines in revenue, with third quarter revenue in China down 43% from the year-ago and down almost 60% from two years ago. With that, I believe PAX's share in China has fallen from around 30% a few years ago to something on the order of 15%. I'd also note that, while quarterly results can be volatile, China now represents less than a third of revenue (with the third quarter contribution diving to 20%).
Making matters worse, the company's efforts to build up its service business haven't really gone anywhere. As the market for terminals has matured, and as payment alternatives have multiplied, companies like VeriFone (PAY) and Ingenico (OTCPK:INGIY) have increasingly turned to services to augment their hardware offerings and expand their addressable market into areas like processing, loyalty programs, online shopping, analytics, security, and so on. PAX bought KaShuo in December of 2014 to help anchor its efforts in building out payment and had expected services to be about 10% of sales by now.
While the company did report strong growth (off a small base) in the first half earnings report, management announced in mid-November that it was writing down its investment in KaShuo. Apparently, WeChat Pay and Alipay have made it very hard for PAX to gain meaningful traction with KaShuo, as these rivals don't charge for their services (and KaShuo/PAX does). I don't necessarily think this is a "back to square one" setback for PAX, but the company clearly hasn't made the progress with its service offerings that management had hoped and planned for by this point.
Overseas Offers Good, And Bad, News
PAX's export/overseas sales have exceeded their domestic sales for some time, and I consider that a good thing - while the Chinese market is large, the competition on the low end is pretty ferocious and there are a lot of other places that PAX can make money. Still, this effort has had mixed success, with the company doing particularly well in Latin America (Brazil in particular), but not gaining as much traction as hoped in the U.S.
In Brazil, PAX has grown from almost no share a few years ago to upwards of 20% share and has become a serious challenger to VeriFone and Ingenico. I believe this success comes from multiple directions - the company's partnership with Cielo (the biggest acquirer in Brazil) certainly helps, as does assembling the systems in the country. I also believe this is an example of "the right products at the right time" - PAX's mobile POS systems are the right mix of features and cost for a market that is developing, but still relatively comfortable with card-based payments (with over 20 terminals per 1,000 people, Brazil is a relatively developed emerging market in terms of card payments).
Although PAX does not break out results by country, sales to Latin America were the largest contributor to third quarter sales (nearly 50%) and have been trending up for some time. Again, quarterly trends can be volatile, but Latin America has become a key contributor to PAX's business over the past two years.
PAX hasn't done as well in the U.S., and sales to the U.S. and Canada typically make up less than 10% of revenue. While a slower transition to EMV may be partly to blame, the reality is that the company's market share in the U.S. is still trivial and the company is nowhere near its prior target of 10% share in 2017. Some of this is probably due to the persistency of VeriFone and Ingenico - they are long-established players in the U.S. and PAX hasn't really offered a reason to switch beyond a cheaper terminal. Moreover, other payment options like Square (SQ) have gained traction quickly, and PAX really isn't bringing anything to the market, in terms of technology, features, services, or price/value that really stands out.
I don't think PAX is doomed with respect to the U.S., but it is going to take time and a lot of market-building efforts. In the meantime, I'd like to see PAX focus on other geographies where they could perhaps be more competitive. India is a small market for PAX, but the country has rock-bottom POS penetration and this could be a worthwhile area to focus on; likewise with Vietnam, Indonesia, Mexico, the Middle East, and Africa. I believe the model that has worked well for PAX in Brazil can be more easily duplicated in these markets than in the U.S. or Western Europe, and I think it would be a better use of management's resources. That said, low-cost competition will be a threat in these markets, and areas like Africa have been adopting mobile banking (phone-to-phone transfers) at a pace that may make it harder for traditional POS systems to really catch on like they have in other markets.
As disappointing as the last 18 months or so have been, PAX may well still finish 2017 with double-digit revenue growth (the company will most likely report fourth quarter results in March). Although I think the company has its work cut out for it in China, I do believe the pace of the revenue erosion should slow as the interchange effect becomes less noticeable and as new products gain some share. I am no longer nearly so bullish on PAX's prospects for gaining meaningful share in the U.S., at best, I think it will be a long, hard slog and the company will have to fight for every share point it gains. That said, I believe the recovering economy in Brazil will help in 2018, and I see a lot of emerging market opportunities where PAX's mix of value and functionality could work well.
I've cut back my expectations pretty significantly, as the company has lost a lot of ground in China and I no longer am so bullish on the U.S. opportunity. I'm now looking for the company's revenue growth to slow into the high single-digits in the near-term and for the company to grow revenue at an annualized rate of about 6% over the next decade. I'm also less bullish on the margin leverage possibilities, but an FCF margin around 10% down the line does support long-term free cash flow growth around 8%. Discounted back, I get a fair value that is around 60% above today's price, with net cash contributing more than a third to that value.
Speaking of that cash, that $300 million-plus balance could be used to reinvigorate the company's service offerings. Acquisitions carry risks, and PAX has made some questionable decisions (including its recent acquisitions in Italy and Korea), but I believe that cash could possibly do more good via M&A if (and that may be a big "if") PAX can find the right service offerings to pair with its POS hardware.
The Bottom Line
Investors are right to wonder when they see sell-side analysts put out "Neutral" ratings when the fair values are well above the current share price, but I kind of sympathize with that right now. Even if PAX were to show no more revenue growth and just replicate its recent FCF margin history, the shares would still look about 20% undervalued.
When looking at stocks, I believe it is just as important (if not most important) to consider the downside risk as well as the upside. While PAX shares look 60% undervalued on my base-case assumptions, there is the risk that the business erodes even further and that the company taps out its opportunity in Brazil without finding new sources of growth. I don't think that's likely, but it's not impossible either - the company's inability to keep its market share in China has to be seen as a risk factor.
The sizable downside risk in a bearish scenario tempers my willingness to call this a "must buy", but I do believe the market has driven these shares down to a level where the reward for the risk should appeal to more aggressive investors.
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