VeriFone Loses The Tailwind Again

By Stephen D. Simpson, CFA | December 14, 2012 AAA

Something is going on with VeriFone (NYSE:PAY), and it's not good. Not only is the stock well off its highs, but whatever momentum that the company had gained since its fiscal third quarter miss is likely to evaporate with another miss. Although I don't think VeriFone is a fundamentally flawed business, it may well be transitioning away from that phase of its corporate life where investors look past almost any bad news in the pursuit of growth.

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Closing the Year on a Thud
For the second quarter in a row, VeriFone missed analyst expectations on revenue. Moreover, while investors and bullish analysts can point all they like to metrics like "adjusted" margins, the reality is that free cash flow (FCF) was down year on year and the FCF margin has declined for three straight fiscal years.

Revenue rose 18% from last year, but dropped about 1% from the fiscal third quarter. Underlying organic constant currency (cc) revenue was up just 8% (versus a 16% growth in the third quarter), though the Brazilian fire took a couple of points out of the growth rate. Latin America was especially weak this quarter (down 17% on an organic cc basis), but Europe was quite disappointing with just a 6% organic growth (cc).

Margins followed a trajectory similar to revenue. Adjusted gross margin improved significantly from the year-ago period (up almost four points), but dropped more than a point from the third quarter and missed most analyst expectations (by a point or more in some cases). Adjusted operating income rose 25% from last year and was flat with the prior quarter, and surprisingly tight G&A spending delivered a good operating income/margin performance relative to sell-side expectations.

SEE: Operating Cash Flow: better Than Net Income?

North America Still Growing Well
It should be noted that VeriFone reported a 22% organic cc growth in North America for this quarter (though bears have complained about how VeriFone calculates/reports organic growth). Growth was spurred in part by multi-line retail, where wins at Target (NYSE:TGT), Kroger (NYSE:KR) and UPS (NYSE:UPS) helped push revenue growth above 50%. Other categories were respectable as well, with an 8% growth from gasoline sales and an 11% growth in small business.

North America continues to be a good news/bad news market for VeriFone in some respects. While the company saw solid multi-lane wins, VeriFone's decision to exit the micro-merchant acquiring business may be seen as evidence that rivals like Intuit (Nasdaq:INTU) have a better solution for that market. Likewise companies like eBay (Nasdaq:EBAY) and NCR (NYSE:NCR) continue to raise their game in the mobile point of sale (POS) market.

I also wonder if the reported data breach at Barnes & Noble (NYSE:BKS) may be a small blessing in disguise. The breach involved old PIN pads (at less than 10% of stores) and the company wasn't using VeriFone's VeriShield Protect encryption technology. Perhaps, then, this is a good marketing opportunity for the benefits of that technology.

The Market Is Getting More Challenging
Looking at Ingenico's nearly 17% cc growth in the third quarter, it's clear that there's both a lot of growth and a lot of competition in VeriFone's market. What's more, the aggressive ad campaigns from Square and Intuit are at least creating the perception that the traditional POS market really is under attack.

To be sure, this is a competitive market. What's more, with chip companies like Broadcom (Nasdaq:BRCM) stepping up their near field communication efforts (which enables mobile payments), it's pretty clear that the market will continue to evolve at a rapid pace. That said, the traditional POS terminal business is not going away and there's still ample growth potential both in North America and overseas.

SEE: Mobile Payments Could Replace Cash By 2016

The Bottom Line
If VeriFone can boost its FCF margin into the teens (and sustain it), these shares are likely undervalued today. Unfortunately, two straight revenue misses suggests that there's a disconnect between the company and analysts (and/or the reality of the market and management's perception/guidance). It would not exactly surprise me, then, if there was another miss in the works before things get better.

Although I do believe these shares are likely trading below fair value, I've seen what happens when companies transition out of that stage where momentum/growth investors aggressively push the stock. It's not a pretty sight, and I'd probably continue to stand on the sidelines for at least one more quarter.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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