The world of internet memes reminds me of financial bubbles. The Harlem Shake Meme was video craze in 2013 where groups would dance to "Harlem Shake" by Baauer. These videos exploded in popularity and proliferated on YouTube. Then, just as suddenly, the internet's attention moved elsewhere -- just like a typical bubble- and bust chart from the stock market.
In business, innovative ideas generate incredible hype yet often fade years later. Unlike viral videos, though, such business ideas sometimes retain profits after the hype dies. Financial technology, or "fintech," is the latest example.
Technology companies promising to disrupt the gigantic and presumably stodgy and inefficient banking industry flooded the IPO market in 2020 and 2021. Smitten investors lavished cash on these software businesses, and stock prices rocketed higher in a hype-driven positive feedback loop. Alas, just like your favorite internet meme from 10 years ago, popularity is fleeting, especially when a newer, shinier meme comes along like artificial intelligence.
Fintech companies suffered a ferocious bear market in August, especially the payment-processing stocks. Payment processors aim to enhance and smooth the process of sending and receiving money both online and in-person. Big money is at stake, given the multi-trillion-dollar size of the market and the inevitable market share movement from "offline" payments like cash and checks to "online" payments like credit cards.
In August, various earnings disappointments with both slowing growth and lower margins shocked fintech investors. Often, when disappointed "growth-at-any-price" investors sell, they must suffer huge gaps in price before value-conscious investors will buy. This adjustment can be abrupt and painful, as shareholders of PayPal Holdings (PYPL), Block (SQ), Adyen (ADYEY), Nuvei $(NVEI)$, Shift4 Payments $(FOUR)$ and Toast $(TOST)$ all learned.
Long-term growth is still likely, albeit at a lower rate than participants previously anticipated.
It isn't all doom and gloom, though. In fact, unlike many of their software-as-a-service (SaaS) peers, fintech payment processors are profitable and growing. They are just growing slower and with more competitive pressure than investors had anticipated. COVID-19 lockdowns and behavior changes pulled forward growth that most mistook for a permanent acceleration.
Investors aren't fully to blame, as fintech management teams became enamored with their own pandemic success, increasing costs and ambitions that left them wrongfooted when growth slowed in 2022 and 2023.
Long-term growth is still likely, albeit at a lower rate than participants previously anticipated, because the industry is still enjoying the massive shift of cash and offline payments going electronic. Looking at the fundamentals of the payment processors, you will find double-digit revenue growth, high margins and attractive returns on invested capital. Yes, the competitive environment is fierce, and slowing growth will only increase margin pressure on these names. Yet the dramatic moves in stock prices have, in some cases, established a "margin of safety" that makes these firms investable from a value standpoint.
PayPal is the attractive mid/large cap of the group. With more than $1.5 trillion gross payment volume, PayPal is one of the largest players in the space, and analyst expectations are for high single-digit revenue growth. Since PayPal stock has been consistently sold off since a peak of over $300 in 2021 to around $60 now, its valuation has retreated from an unachievable 64x enterprise value / EBITDA to its current modest levels of less than 9x.
In my career, investing in a dominant business with good growth, high marginal returns on capital while trading below 10x EV/EBITDA is usually a winning long-term recipe. While PayPal transitions to a new CEO and continues to battle declining margins, investors can take solace in management's projection of $5 billion of 2023 free cash flow on a market capitalization of $70 billion.
PayPal management is also showing their enthusiasm for the stock at these levels, committing to $6 billion of stock repurchases in 2023, or about 8% of all shares outstanding. When I see opportunistic repurchases of over 5% of shares in a one-year period, I pay attention, as I believe this materially increases both earnings per share and future value for shareholders.
On the cautionary side is Toast. This company has $92 billion payment volume primarily in restaurants, with growth expectations in the mid 20% range. Although Toast has declined precipitously since its IPO, the stock weathered August 2023's carnage better than its peers. This in fact should give investors pause, as another shoe may drop should the company report slower growth in the future. Toast still has high relative operating expenses, so looking at price / revenue gives a better idea of valuation.
Once the magic meme wears off, investors must focus on the fundamentals to understand the downside. Fintech companies are no longer sexy. They are ill-equipped to create hype like new forms of artificial intelligence, and as one fintech CEO in the restaurant payments business humorously stated, "There is nothing technologically cosmic about ringing up a cheeseburger."
Still, fintech companies produce something far more attractive for value investors than hype: profits. I think it is worth sifting the wreckage of the bear market in fintech companies for reasonably priced businesses that can grow with the industry as hundreds of billions of dollars or transactions continue to move to the electronic world. Payment processors define their revenue to transaction ratio as a "take rate" but I like to look at it as Warren Buffett's investment idea of a toll booth on a popular bridge. Instead, in this scenario, these companies have toll booths on the trillions of dollars of global payments.
Brian Frank is the portfolio manager of Frank Value Fund FRNKX The fund is long PYPL and NVEI.
