Since my last write-up on PAX Global (OTCPK:PXGYF) (0327.HK) in January of this year, the shares have more or less marked time, though there was a nice run heading into fourth quarter earnings in March that ultimately faded away. Relatively speaking, though, that's not such a bad performance in what has been a tough payments technology space - while Square (SQ) has done very well so far this year, Ingenico (OTCPK:INGIY) has had a tough run (down 20%) and VeriFone (PAY), too, was drifting lower before receiving a buyout bid.
The shares remain a challenging call. While PAX is doing quite well in Brazil and surprisingly well in Europe, I do have concerns that there are long-term fundamental shifts in the market working against PAX, exacerbating its lack of a value-added service business. Likewise, the company's home market (China) remains quite difficult, and management has trading gross margin for market share across multiple geographies. If PAX management can stabilize the business and report a few clean quarters, though, I believe there's enough underlying fundamental value here to merit a closer look from more aggressive investors.
Brazil Is Driving The Bus
PAX Global's last earnings report drove home yet again how important the Brazilian market has become for PAX. Part of the "Latin America and CIS" segment, this unit saw 117% revenue growth in the fourth quarter and contributed more than 40% of sales. At the same time, sales in China fell another 16%, bringing PAX's home market contribution to revenue down to almost 25% for the quarter and down to 28% for the year - almost half what it was in 2015.
The good news is that I believe Brazil (and other Latin American countries) can continue to drive good growth. PAX continues to build on its approximately 20% market share and boasts high-quality partners like Cielo (CIOXF) and PagSeguro (PAGS), with the latter quickly gaining share (from low-single digits in 2016 to low double-digits early this year) by focusing on the micro/SME merchant segments. One of the keys to PAX's success has been its skill in developing and introducing low-cost mobile POS terminals that cost half to two-thirds as much as rival systems from Ingenico and VeriFone. While a focus on "simple but functional" has helped control costs, so too has local assembly.
Looking ahead, I think Brazil can continue to support above-average growth. Brazil is somewhat mature among emerging market peers in terms of the penetration rate of terminals, but the overall penetration rate is still low next to developed markets and only about 29% of household consumption is paid for with cards (versus close to 50% in the U.S. and almost 70% in the U.K.). Looking a little further ahead, I could see PAX replicating some of this success in other LatAm markets with relatively low card penetration like Peru and Mexico, where only about 13% of household spending is done with cards.
Market Shifts Are A Real Risk
Brazil/Latin America isn't the only place where PAX is seeing above-market growth; the company also saw 49% yoy growth in Europe in the fourth quarter and over 120% growth in the U.S., albeit off a very small base. With growth in mature markets in Europe moving into the low single digits, I believe PAX is gaining share and is benefiting in part by targeting markets like Turkey and Russia. In the case of both Western Europe and the U.S., PAX also has the benefit of growing off of a very small base, as its market share in these regions is almost rounding error for Ingenico and VeriFone.
I do worry about what changes in the market may mean for PAX in the coming years. Western Europe and North America (ex-Mexico) are pretty well saturated with POS terminals, and it is largely a replacement-driven market. At the same time, new payment options like Square and other phone/tablet-based payment technologies are taking share away from traditional card payment systems. Growing use of QR code payment methods has already had a significant negative impact on PAX's business in China, and I believe this is a risk in developed markets as well. Although PAX does sell terminals that handle these payments, I see a real risk of ongoing disintermediation for traditional terminals.
PAX also still suffers from a lack of service offerings. The company wrote down KaShuo and has struggled to figure out a model for offering ancillary services - particularly in its home market, where WeChat and Alipay have offered these services for free. Without value-added services, particularly in mature markets like Western Europe and North America (ex-Mexico), I think PAX runs a real risk of seeing its core business become a low-growth near-commodity.
It's no surprise or secret that PAX has been forced to trade margin for market share. Gross margin fell about two and a half points in 2017, and the midpoint of management's 2018 guidance would represent another 500bp of gross margin erosion (albeit on a revenue growth target of 15% to 25%). Although PAX's gross margins are in the same ballpark as VeriFone and Ingenico, and I believe lower GMs are a sector-wide risk factor, this is going to be an ongoing challenge particularly with falling ASPs in Brazil.
Management is not giving up on China and has created a new business unit focused on accelerating product development (particularly smart POS and low-end mPOS systems). Management has also apparently decided to try to put a stake in the ground with respect to margins and elected not to chase business (for instance, not participating in the first round of bidding with a large bank).
I believe PAX can continue to pick up some market share at the expense of Ingenico and VeriFone, and I believe PAX does have a good understanding of how to compete in emerging markets. That somewhat offsets the risk of technology-driven changes in the market, including new payment options in developed markets and the risk that many emerging markets largely bypass payment terminals in favor of phone-based payment systems.
I'm still modeling long-term growth in the neighborhood of 6%, with high single-digit growth over the next five years, driven by markets like Latin America. I think generating higher margins over the long term is going to be more challenging though, and I now believe that FCF margins will likely peak in the high single digits and drift lower over time (due to gross margin pressures), pushing FCF growth below revenue growth.
Discounting those cash flows back at a low teens discount rate suggests a fair value (including cash on the balance sheet) more than 40% above today's level. I would note that liquidity for these ADRs is low, and investors may wish to consider the Hong Kong-listed shares.
The Bottom Line
Management credibility isn't the best with PAX, and the market doesn't seem to believe their projections for revenue growth in 2018 (though the market is willing to believe the margin pressure story). Delivering on that 15% to 25% revenue growth guide would be a major positive driver for the stock, as would signs of market share stability in China, ongoing growth in Brazil, and real progress in the U.S. market. This is still a very risky call, but I'm finding the potential opportunity here harder to ignore.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.