The stock market is an efficient engine for valuing assets. That is one of the first things taught to students of investment management. What is less frequently taught is the role of sentiment, and algorithmic trading in valuation. Currently, the most popular sentiment gauge remains at highly negative levels, with the latest reading at extremes not seen even during the 2008-9 financial crisis. Algorithmic trading by so-called quant funds is more than capable of destroying the efficiency of markets on a short-term basis.
Most recently, and based on the estimates I maintain for over 150 IT vendors, the correlation between growth and valuation reached an all-time low of 27%. Even when adding free cash flow margins to the mix, the correlation has been less than 40%.
I keep required estimates to calculate the net present value for more than 40 IT names. Even after adjusting for a 200 bps higher discount rate to take account for the rise in yields, the gap between the NPV value of these companies and their current market price has continued to widen. As of the close on April 29th, the difference between the calculated NPV and the current market price had widened to 54% on average. It has only gotten wider since that time as various companies report with stronger than anticipated performance. I don’t have long term historical data on that particular metric, but I think it, too, is in record territory, certainly a record for the past 10 years. It is one of the reasons why analyst price targets imply such massive one year returns, as most analysts do use some form of NPV in setting their price expectations for particular shares.
I am well aware of the concerns that have led investors to throw in their collective towels. Higher rates, of course, but inflation concerns that might pressure consumer spending and corporate profits, a possible recession brought on by Fed policies, concerns with regards to the war in Ukraine-just a whole litany of uncertainties and concerns leading to an overall malaise amongst many investors. To a certain extent, this seems to be a reprise of the Taper Tantrum of 2013, although no analogy is ever a precise guide to current conditions.
With the most recent GDP print being below expectations, some will express the thought that a period of stagflation is impending. Many strategists who felt that the end of the Fed’s asset purchase program wouldn’t provoke a tantrum this time have seen those predictions shredded, although there are plenty of additional factors other than the end of asset purchases by the Fed to account for the back-up in long-term rates.
I am asked sometimes if now is the time to take advantage of compressed valuations. I haven’t a crystal ball, and my view on the concerns of investors certainly doesn’t offer any unique insights. I will observe, as has been said many times, and in many ways, that things are seldom as bad or as good as they might seem at any moment in time. I am writing this article about Shift4 (NYSE:FOUR) - its prospects and its business model. I actually wrote about this company just 5 months ago, when the shares were priced at comparable levels. But in the wake of a recent MS downgrade, and some queries I have had from some subscribers, I thought it might be worthwhile to reprise and update the story. There is far less interest in IT names, and in Fintech names these days then was the case as recently as 5 months ago, and that is one factor that from a contrarian view, actually favors the shares.
Needless to say, despite some puts and takes, the latest quarter reported by Shift 4 was strong and all indications are that the quarter to be reported in early May will be strong as well. Any tech name that hasn’t depreciated in the last 5 months is outperforming by a significant extent and at least some investors have a positive view of its outlook. But it seems appropriate with the shares down 15% in a few days, and a major brokerage analyst rating them as a sell, to restate what I think makes Shift4 shares one of the better fintech names for investors at this price and at this time.
Lately, there has been much discussed and written about the impact of inflation on the operations of various companies. One of Shift4’s specific attributes as a payment processor is that, to an extent, inflation is a growth tailwind, and overall, while inflation will impact opex, the net result of inflation is actually positive on margins. Obviously, as restaurants, and hotels, and stadiums raise their prices, those price increases flow through to Shift4’s revenue. That is going to have a visible impact on revenues as long as the scourge of inflation is with us. I don’t feel that banking on inflation is a reason to own Shift4 shares particularly; inflation is not positive for the economy as a whole and is a stealth tax on consumers. But when investors discuss the risks of inflation on valuation, Shift4 specifically, is a company whose growth and margins will actually be benefited, at least for some time, because of inflationary pressures.
The company is scheduled to report results on May 5th. I imagine, for reasons I will discuss later in this article, that the results to be reported will be quite strong, with payment volume growing above forecast, along with revenue, EBITDA and cash flow. Guidance, I believe, is likely to be increased, but caution and challenges are likely to be noted as well as opportunities. This is a prudent management and it will present a prudent outlook.
Shift4’s valuation exists in the context of the overall market. After months of compression, valuations for most fintech companies have declined substantially. Actually, Shift4’s decline thus far in 2022 of 12% has been less than most other fintech vendors. That said, the shares have lost 50% of their value since their high in late June 2021. It would be naïve on my part to suggest that Shift4 shares will appreciate in any meaningful or sustainable fashion until the market for tech stocks returns to some semblance of stability and valuations show some less aberrant correlations with growth and profitability.
The other day, Qualtrics (XM) announced a very strong quarter and provided strongly positive commentary and upside guidance. Qualtrics is more expensive by some measures than Shift 4, but the shares have fell by more than 10% on the day after the earnings release, and they are at an all-time low.
The other week, CrowdStrike increased its estimate for its multi-year CAGR from 30%+ to nearly 45%. Several analysts raised their rating and for a few days the shares responded. But the shares were down by more than 10% last week, and are lower now than when they increased their forecast.
When shares are trading on a set of indeterminate fears and aren’t overly correlated with either growth or profitability, the impact of an impending profit report on share valuation is hard to handicap. But I am trying - hard as it is at this point - to look out over a year and not overly concern myself with the reaction of Shift4 shares to its impending quarterly earnings release. I have owned the shares of Shift4 for a while now and from an operational point of view this company has delivered, and I expect that to be the case for the foreseeable future.
As mentioned, recently, an analyst at Morgan Stanley wrote a report downgrading FOUR shares. It is hard to say exactly what the impact of the downgrade was on the share price. The shares were down by about 4% on the day of the downgrade was published, i.e. April 19th, and they lost 15% last week. How much of that was the impact of the MS downgrade, and how much was a function of the overall market pullback is hard to determine. The tech/software ETF, IGV, lost 5.6% last week, while the ETF that encompasses more high-growth IT names, the WCLD lost 9% and the FINX, the Fintech ETF lost 7%. So probably the downgrade cost the shares about 7% on a relative basis.
The MS analyst maintained that the company was overvalued because of its less than average cash conversion margin. I will comment later in this article about that specific misperception which the company addressed as part of its conference call presentation. But regardless of that specific, I think on a relative basis, that Shift4 shares are materially undervalued. The company has been and is likely to continue to gain substantial market share in its historically significant verticals, restaurants and hospitality, and it has been entering new significant verticals as well. It has maintained its take rate despite moving “up-stack” in terms of the average size of its customers. The company has forecast a substantial increase in EBITDA margins as well as its cash conversion metric. I use the company’s net sales metric, i.e. gross sales less network fees in terms of valuing the shares. On that basis, the EV/S is now down to less than 4.5X. Shift4 is profitable on a non-GAAP basis and it is generating cash. I have estimated that its Rule of 40 metric is close to 50. The logic behind the MS downgrade is extremely faulty in my opinion.
Payment processing probably seems like a mundane application with few barriers to entry or differentiation between vendors. That is simply an inaccurate assessment of the competitive landscape in this space. Some enterprises have far more complex payments requirements than simply taking a credit card from a customer. Shift4 started its life as a payment gateway, and it still offers that functionality. Of course payment processing does include that function, but it Shift4's differentiation lies within what the company calls its end to end platform.
The company's end to end platform offers many functional advantages and in addition, as users migrate from a payment gateway to this platform, Shift4 enjoys a 3X-4X uplift in gross margins. Some investors appreciate the end-to-end focus of Shift4, and how the end to end offering substantially impacts the company’s growth and profitability.
But the fact is, that not everybody focuses on that part of the company’s business. What this has meant, however, is a rather compressed valuation for Shift4 shares that belies the reality. The CEO of this company, Jared Isaacman, is passionate about 2 things; one is space and space flight but the other is actually payment processing. As some readers will know, Jared actually founded what is now Shift4 in the basement of his parent's home when he was still in his teens.
Shift4 shares are hardly valued as a hyper-growth company these days, but the fact is that it is a share gainer in its space and I expect to see those gains persist for the foreseeable future. Over the last several years, Shift4 has achieved a 51% CAGR in payment volume for restaurants and a 140% CAGR in payment volume for hospitality. It started its effort in hospitality as recently as 2018, and that vertical has grown to about 20% of the company’s revenue. Obviously it is unlikely at the company’s scale that it can continue to achieve those kinds of CAGR’s in its core verticals on into the future. The company has also entered several new verticals, particularly including sports and entertainment, gaming and E commerce.
There are a variety of ways to measure market share, since the payments market is rather amorphous, and there is not one standard definition. One way is to compare the growth of Shift4’s payment volume to that of Mastercard (MA) and Visa (V). By that measure, most recently, Shift4 has grown its business four times as fast as those other two companies, even though both Visa and Mastercard reported strong quarters for volume growth. Then there are anecdotes to relate such as the consistent growth the company has achieved in terms of net new customers. The company is having material success in converting its gateway customers to its end to end platform which has material implications for gross margins.
The company currently offers 425 software integrations which can be a key competitive advantage for some potential customers. It has an integrated platform that ranges from POS hardware, analytics, and mobile payment technology. The company is able to deal with complex payment requirements from a single end-to-end platform which is a significant differentiator, so far as I can determine when potential users evaluate payment vendors. The company has a vertical focus and indeed it has the largest market share in the restaurant space in terms of payment processing. It has been focused on a vertical strategy for hospitality with strong results, and recently it has expanded into new verticals including sports and entertainment venues, gaming and eCommerce, The company has been very successful in moving upmarket and its average customer size has grown at a 30% CAGR over the last several years.
In sum, the company’s market share gains are a function of its broad range of integrations, its unified platform that is mostly internally developed, its specific domain expertise in dealing with complexity, its vertical focus, and its strategy of moving upmarket to larger customers. In terms of market share gains the numbers speak for themselves.
At the end of the day, the basic reason to recommend and to own Shift4 shares is that the company has been a consistent share gainer for years and it has done so in the context of maintaining its take rates, and improving EBITDA and cash flow margins.
When Shift4 last reported its results the world was emerging from the latest manifestation of Covid-19, the Omicron variant. Apparently the impact of Omicron had a material impact on the company’s payment volume, although by early February the impact had ended and prior trends in terms of rapid growth had reemerged. Overall, the company’s gross revenues less network fees last quarter were $147 million, up 65% year on year. I have typically used gross revenue less network fees in calculating EV/S and margins for this company. Within that net revenue growth metric, processing fees rose 79% and SaaS/software revenues rose by 38%.
In terms of profitability, the metric of most relevance is that of “spreads.” Spreads do vary from quarter to quarter depending on mix. Spreads have fallen over the past year mainly because the lodging vertical, which has far more revenue per site than restaurants, has doubled as a percentage of revenue. Actually, the spread within the restaurant vertical rose by 10% and the spread within the hotel vertical rose by 6%. Overall, in the quarter, the company’s EBITDA rose to $44 million, up 65% year on year, but about 10% below expectations. Some of that was expense pull-forward, and some of that was volume related, The adjusted EBITDA margin for the quarter was 30%.
The company does generate adjusted free cash flow, although its free cash flow margin last year was somewhat constrained. That is the metric on which the MS downgrade was focused. The company’s business has been very sensitive to the impacts of Covid on the travel/hospitality/restaurant verticals. Because of the different measures taken by both enterprises and various government agencies, some of the year over year comparisons are not totally meaningful.
That was even true last quarter because the 65% gain in revenues is being compared against the high point of the impact of the Delta variant on travel and restaurant spend. Nonetheless, while the full year of free cash flow was $18 million, the free cash flow in the last 2 quarters of the year was actually $27 million, or an EBITDA to cash conversion rate of 27%. The company actually generated $29 million in operating cash last quarter, and free cash flow was around $21 million.
Drilling down a bit further, the cash flow metric was constrained by a rather substantial change in operating assets and liabilities. Stock based comp. declined for the year. Last year, the largest factors leading to the strength in back-half cash flow were the improvement in operating profitability and a material increase in depreciation and amortization. The company CFO has forecast an EBITDA conversion rate of between 35%-40%, or free cash flow for the year of about $100 million. I think when considering the components of operating cash flow for this company, this is an estimate that can be substantially exceeded. I have used a free cash estimate for the year of $120 million, both because of my expectations with regards to the balance sheet, as well as stronger profitability based on higher payment volume.
At the time the company held its conference call, and despite the early quarter impact the company had experienced from constrained payments volume, likely due to the Omicron variant of Covid, Shift 4 had recorded payment volumes of $8.2 billion through the first two months of the year. The company also indicated that it was then setting record weekly payment volume, and had its first ever day of $200 million in payment volume. Over the course of March there were signs of an acceleration in travel activity, particularly involving the strong quarterly reports of Delta (DAL), United (UAL), American (AAL) and other airlines. To an extent, there has been a noticeable, although not exact, correlation between Shift4 payment volumes and the health of the travel space. Because of the strong trends in the travel space, I expect that transaction volumes in Q1 will surpass expectations, and perhaps reach more than $13 billion. That would be growth of a bit more than 60% for payment volume, and with take rates stable, I think revenue growth of 60%+ for the quarter seems likely.
The company presented a rather detailed bridge analyzing the methodology that was used in developing the estimated for payment volume for the current year. In my view, the volume bridge is remarkably conservative. In particular, it only shows a 5% increase in volume due to the travel recovery, and that metric is clearly rising at a much faster rate. In addition, the estimate for the impact of net new wins on transaction volume only calls for a 15% gain in that metric. Given recent results, that kind of an estimate seems unduly conservative.
As mentioned earlier, I use gross revenues less network fees in analyzing valuation. The company guidance calls for that revenue metric to reach $705 million. Because of the specific factors cited above, I have used $740 million as a revenue estimate for 2022, which would be growth of 40% year over year. Much of the difference in my estimate to that of the company projection is a reflection that the travel recovery component of the bridge which I think is highly likely to be more than the $3 billion, or 5% of last year's base shown in the bridge.
The company forecast a 300 bps increase in non-GAAP EBITDA margins. That metric is quite volume sensitive as was seen last quarter. I think volume above the company forecast will be a significant tailwind in terms of EBITDA margins, particularly those in the core of its business. I assume the company will choose to invest some of the likely upside in augmented spend to ramp growth for its newer verticals. That said, overall, I think EBITDA margins will be above the forecast the company provided last quarter.
A little more than a year ago, Shift 4 bought a relatively small company called VenueNext for $72 million. At the time of the acquisition, VenueNext’s revenues were apparently $7 million. Since the acquisition, Shift4 has been able to utilize its far larger sales engine to drive substantial new customer acquisitions. Individual stadiums and arenas are self-evidently far larger than restaurants or even most hotels in terms of their contribution to payment volume. Of course revenues from stadiums can include tickets to events, usually sold in conjunction with a Shift4 integration, Last quarter, VenueNext was adopted by the United Soccer League as its official payments solution. There were several major stadiums involved in that partnership. Another recent major win was the T-Mobile arena in Las Vegas. Perhaps a poster child of the kind of success VenueNext has been able to achieve was the acquisition of the Staples Center in LA as a user. The Crypto.com and the United Center venues also use the VenueNext offering and are using the company’s newest POS devices as well.
VenueNext offers a variety of mobile, commerce, and loyalty solutions as these relate to payments, and Shift4’s integration with the on-line ticket vendors is a significant advantage to a potential user looking for a single payments platform. Shift4 hasn’t broken out the revenue contribution from its different business lines. In its volume bridge analysis, the uplift in payment volume from new markets in total, which include stadiums, and other VenueNext opportunities as well as volumes from its forays into gaming, transportation, and the non-profit vertical, are estimated to be just $3 billion. It certainly seems that the volume of wins that have been announced could readily lead to a revenue upside in that category of a noticeable amount.
Shift4 has been working to introduce a new POS product, the latest version of SkyTab, as part of its overall offering. The product is actually already in use at more than 3k locations, including restaurants such as Shoney’s and Church’s. Restaurants remain by far, the largest single vertical for Shift4, and Shift4 appears to have the largest market share in the restaurant payment vertical, with 125k locations, about 3X the number of locations using Toast (TOST). These days, many restaurants acquire their payment devices as part of the process of choosing an integrated payments platform. Sometimes the POS terminal is bundled as part of an overall end-to-end payment sale.
The new SkyTab release is scheduled for general availability this quarter. The company has already reported a fair level of pre-GA acceptance with usage in 3000 restaurants and stadiums. It is part of an overall refresh the company has spoken about in the restaurant space over since its analyst day in the fall of last year. I wouldn’t want to put too much reliance on the release of a single product, or family of products. That said, I think the new terminal, and the overall product refresh is likely to provide a demand tailwind not really recognized in current guidance. Overall, the company has forecast that the revenue impact of net new wins and conversions of gateway customers to the end-to-end platform will add about $8 billion, or 17% of last year's base, to revenues for this current year. The potential to exceed that forecast seems significant, based both on the introduction of the new products, and dare I say it, of inflation, which has a meaningful impact on payment volume.
Finally, without much in the way of fanfare, Shift4 has accelerated its presence in the eCommerce vertical. The company bought 3dcart, which was a small eCommerce platform in early 2021. There are, no doubt, a substantial number of eCommerce platforms, and lately, the granddaddy of them all, Shopify (SHOP), has seen a great deal of skepticism with regards to its growth prospects. The Shift4Shop platform has apparently been able to expand its user base quite dramatically and now has 70k online stores, an increase of several time the count of shops in the time Shift4 has owned the service.
Is Shift4Shop really going to be a Shopify killer? I have linked here to an article that might suggest that. I doubt that many investors are going to consider Shift4Shop as the service that dethrones Shopify. That said, Shift4 Shop has certain inherent advantages they may not be fully realized by some readers. In particular, on-line stores need to process payments, and of course, that functionality is built into Shift4 Shop. Indeed, Shift4Shop basically provides users with the tools to build their eCommerce platform as part of an overall bundle of services in return for contracting to use the Shift4 end-to-end payment platform. When comparing costs between Shopify, and Shift4Shop, users find a rather substantial difference in cost, particularly considering the fees that Shop Pay charges. Again, given the size of the opportunity, and the apparent advantages that Shift4Shop brings to the market, it seems that the company’s eCommerce vertical could be a significant upside compared to the modest estimate in the company’s current volume bridge.
In addition to those 3 potential areas of significant 2022 upside, the company made two acquisitions that have lots of promise, but which probably will not have a huge impact on results this year. The company has acquired a business called the Giving Block for a total consideration of as much as $300 million, although much of that is a potential earn-out. Giving Block is a company which essentially allows donors to use crypto as well as card based payment methods to give to non-profits. The company entered a customer relationship with St. Jude Hospital late last year. St. Jude is a well known non-profit hospital and this acquisition is intended as part of a strategy to develop the non-profit vertical, which has total payment volumes of $450 billion. Giving Block’s principle distinction is its ability to accept donations using crypto as well as cards-a strong trend in that market but still in its infancy. The company expects that revenues in 2022 will be about $10 million +, although it also anticipates some cross-selling opportunities toward add 2022 revenues.
The company also has also announced an agreement to purchase Finaro for an upfront consideration of $525 million, 62% stock and 38% cash with an additional potential $50 million in stock through an earn-out provision. The transaction is not scheduled to close until the end of the year. It has been forecast to add about $15 billion to payment volume and $30 million to EBITDA in 2023. Much of the raison d'etre of the merger for Shift4 is that it has some significant global customers, and expects to have more, and the acquisition of Finaro will allow Shift4 to capture this low-hanging fruit. In particular, Shift4Shop and the company’s the new SkyTab solution are likely to see substantial demand from overseas businesses. I see the acquisitions as building blocks in an overall strategy of expanding Shift4’s total footprint into high growth verticals within the overall payment space.
I opened this article commenting about some of the valuation anomalies that have emerged in the IT sector as a result of extreme risk-off sentiment on the part of investors. I call them anomalies, there will be others who say they were the bursting of a bubble. Having lived through, and experienced about the worst of the end of the dot com era at the start of this century, I will state again, that this episode of market turmoil is very far removed from what I saw then. From my perspective the reason why some market commentators believe this to be a bubble is simply an inability or an unwillingness to understand that IT particularly, is seeing an extended period of growth far above past trends. There simply haven’t been sizeable businesses that have been able to enjoy profitable growth at 30%+ for 5-10 years. The share of GDP going to IT is growing, and that growth is accelerating, and this is not changing in 2022 despite all of the well-known fears and uncertainties that have plagued investor sentiment and valuation. The results of many companies reporting thus far in the IT space suggest that the IT space is alive, and well and vibrant.
Shift4 is, of course, a fintech vendor, but the fintech world is one experiencing increasing digital transformation tailwinds as well. The basic investment case for Shift4 is simply that it offers a set of technologies through its end-to-end platform that provide users with cures for many pain points in the word of increasingly complex payments channels. Shift4's differentiation, which includes the vast number of software integrations the company has built is why the company has gained share in its key verticals for years, and why I believe it will continue to gain share. In addition, the company has entered several interesting verticals, such as that of Sports and Entertainment , E-commerce and Non-Profits amongst others. It is preparing to launch its next-generation POS family, with potential significant positive impacts on its business in its core restaurant vertical as well as in the Sports/Entertainment space.
Shift4Shop has a unique cost advantage that has given the company surprising momentum in a crowded space, even against such a powerful vendor as Shopify. For many businesses, Ship4 Shop is a better and less expensive solution. The e-Commerce opportunity is probably under-understood by many investors.
Shift4 is one of the more inflation resistant tech businesses around. Its revenues will inflate as the price of all of the merchandise and service for which it processes payments rises as well. Its operating costs, which of course will also inflate, are quite a small percentage of adjusted revenue.
Shift4’s profitability and free cash flow have been impacted by the variability of its revenues that have been susceptible to the impacts of Covid. In addition, the company has deliberately chosen to make substantial investments in new verticals to accelerate/perpetuate its rapid growth. It is important to note that despite the company's strong pivot to larger customers who invariably enjoy a better pricing tier, the company’s take rate has remained stable. The company has forecast a substantial increase in its free cash flow margins this year, and as some of its initiatives in terms of product come to fruition, I expect its free cash flow conversion margin to continue to improve.
As mentioned, and despite the overall rerating of most IT shares, Shift4 still has favorable valuation metrics. I currently use 52 million shares in evaluating the company’s enterprise value because that is what the company reports and what is shown in Yahoo Finance. There are about 5 million class C shares shown in the latest annual report and these do have the same economic value as the outstanding Class A shares. The company’s Class B shares have no economic value, so they can be ignored for the sake of valuation analysis. Using 52 million shares outstanding, the company has an enterprise value based on the current market price of about $54/share of $3.35 billion. As mentioned earlier, I use a sales estimate based on revenue less transaction fees, and my estimated EV/S ratio is currently about 4.5X. Even with the overall valuation compression, that kind of EV/S ratio, and an estimated 3 year CAGR of 33% shows almost a 40% discount below the average valuation of IT shares. The discount to average is even greater when looking at the company’s rule of 40 metric to growth. And FOUR shares have an NPV, based on my latest estimates, that is more than 60% above the current market price, even when adjusted for a higher weighted average cost of capital.
I think that Shift4 as a company, has gotten much less coverage and attention than its rapid progress ought to warrant. While after 5 months of bloodletting I am not about to suggest that Shift4 shares are going to rise in the absence of some stability in the IT space in terms of share price valuation, my belief is that when investors return to this space as they search for growth in a low growth environment, Shift4 will be one of the names considered. I own, and have owned a position in the shares and I do expect that the company will continue to achieve positive alpha.
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Disclosure: I/we have a beneficial long position in the shares of FOUR either through stock ownership, options, or other derivatives. 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.