Chit Chat Stocks - Shift4 Payments (Ticker: FOUR) Not So Deep Dive

Episode Date: June 13, 2023

Shift4 Payments, Inc. (FOUR) is a leading payment processing company that provides secure and seamless solutions for businesses across multiple industries in our cashless society. At the end of the month, we will publish an Arch Capital episode that will cover the company: Airbnb. Listen closely as Brett and Ryan go through the history, financials, and future prospects of Shift4. Enjoy the show! ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (2:23) Industry | (14:13) Management & Ownership | (19:12) Earnings | (26:51) Balance Sheet | (32:52) Valuation | (36:26) Our Analysis | (38:04) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome into Chitchat Money. My name is Brett Schaefer, and I'm joined by my co-host, Ryan Henderson. Today is our Tuesday not-so-deep-dive episode where we analyze

one stock by covering its business model, ownership, financials, basically everything you'd want to cover to get introduced to a company. After going through this episode, we hope you get a better perspective on the company we are covering today. If you have not heard of it before, this will hopefully be a very insightful episode. But as we said last week on the PayPal one, if you know this company extremely well, I doubt it is going to be adding anything extra, adding any little sort of nuanced stuff here. This is really about getting the core overview with the core, um, context for why someone might invest or might not invest in the company. These shows go, uh, are on every Tuesday and you can watch or listen

wherever you want. We have YouTube, Apple, Spotify, just search chitchat money. And we're going to reference maybe some graphics, maybe some charts actually full disclosure. I have not made the charts yet, but they will be out by Tuesday for this episode. If you want to get access to those, it is for free at our newsletter on Substack. You can search Chit Chat Money or hit the link in the show notes. It's a great way to accompany this episode. All right. Today, we are covering a shift for payments, something that isn't covered that much, i would say but is a fairly big business went public what three years ago now ryan and i'll let you get all you know into all that why don't you talk about what they do

why they are maybe different or maybe the same as a lot of these other payments companies and to their history yeah and i'm uh i'm doing great brett thanks for asking but the uh we i I feel like we never have the casual start. We just get right into it. But yeah, Shift4, I don't think it's a company a lot of people are familiar with. They are similar to PayPal in the way that they are kind of a hodgepodge of different payment solutions stitched together. So today, Shift4 is an end-to-end payments processor for mostly enterprise clients, but

they've gotten there through a number of acquisitions. They weren't previously end-to-end. So I'll talk about what that is in a second. But when I'm talking enterprise customers, I'm talking like Caesars Resorts, Hilton, Levi's Stadium, the big restaurant chain, Applebee's, stuff like that. And so historically, Shift4 has focused on being the payments gateway. And if you want to be super confused, I recommend reading the 10K because it provides very little context on what a lot of these payments terms mean. But the gateway, I had to take a lot of time to research this. Hey, Investopedia has a good one, right? I'm sure you read that, right?

I didn't read that one. They have a good definition for a lot of these things. So if anyone is confused, definitely check out Investopedia for a lot of these definitions. All right. Basically, when you think about the gateway, that means when someone pays, let's use that giant resort, Shift4 would collect the payment data, they'd encrypt it, tokenize it, then send it to the merchant acquirer. That is the lower value in terms of what they're actually paid. That's the lower value part of the transaction process. However, I think shift four would argue that it's a higher value, but for some reason they just don't get paid as much for that part.

However, so I guess let me use, there's a quote from a write-up or a blog called Scuttleblurb. They talk about shift four payments a little bit. And I think he gives a really good example. He says, so the payments gateway for, say, a casino resort is embedded in dozens of software systems from the Oracle-owned point of sales used by the restaurant to the Microsoft Dynamics point of sales used by the gift shop or spa. It creates a token that updates the original payment authorization as a guest transacts at different venues inside the property so they can get a single bill at the end of their stay and delivers to the casino resort a consolidated reconciliation of transaction activity across all their software systems. So it's really kind of helping the, that's why I say the enterprise clients where they have a lot of different kind of both types of transactions, different businesses within a business kind of thing.

However, in a transaction, as I kind of mentioned earlier, much of the value for the intermediaries is accrued to the merchant acquirers whose responsibility it is to basically process and settle the payments. These often include companies like Adyen, Stripe. JP Morgan, I think First Data is another big one. We'll get to that, yeah, in the industry. And yeah, some others. But because Shift4 has acquired a number of different gateways,

they are now able to offer their big customers merchant acquiring services as well. And so don't ask me how, but apparently because they were able to stitch together these different gateways, they can kind of work backwards in the value chain and also do the merchant acquiring services, which is like, if you're doing end-to-end, so if you're doing the gateway and the merchant acquiring services, it's four times the gross profit apparently, as opposed to just doing the gateway services. So this is really what they're in the process of right now is trying to upsell a lot of their clients to be the merchant so that they can do the merchant acquiring services as well. This is what they call that

end-to-end payments processing from collecting payment data all the way to settling. This conversion from gateway to end-to-end, it obviously drastically improves the revenue they get from their customers. The other thing I'll say here is Shift4 is able to attract enterprise clients better than a lot of these other payments processors because they have more than apparently 500 different integrations with a whole bunch of different kinds of legacy software solutions that these big complex organizations might use. So they've got, you know, if you're at Caesars, there's obviously, it's a big resort, there's people, you know, whether you're at the pool bar, whether you're checking out or cashing in some, whether you're at the ATM or something

for chips, you know, getting food at a restaurant, there's a whole bunch of different softwares that are used. And so because they're able to plug in to all these different legacy software solutions, um it allows them to kind of piece together um those different systems and provide value for the the larger enterprises i guess i have a visualization here um i know that probably pisses people off that listen to the show purely but um it's just it shows the kind of different transactions a big resort would have um and how i guess shift four is kind of the at the center of all that. So that's the basics of the business. They often try to, when it comes to new customers, they'll try to upsell or sell by starting with their SkyTab point of sale system, which they

recently introduced. This is their newest, sleekest point of sales, physical hardware product. And it's been kind of a big point of focus, I think, from management, but really, yeah, the goal here is to provide those merchant acquiring and gateway services for huge enterprise customers? Is that a good lay of the land? I think so. Yeah. At the end of the day, they're just processing payments and now they're trying to do more of it. The end-to-end makes sense. I think any listener will understand this, even if you don't understand what merchant acquiring is and all the back process of that. I don't think really many investors do, and I don't think it's necessary. Basically, they're taking more of the burden. They're doing everything for

the payment process except for you know it's not as strong or it's not as vertically integrated as say an american express uh who is issuing the card but they're basically doing everything but being visa mastercard american express or discover and issuing the card or the ability to pay so everything besides that i think all right let's talk about the history real quick so jared isaac man started what would eventually become shift four. They've changed the name four different times. Um, I don't know. I don't really know what sometimes I think that's a red flag, but when it's a bad name, I got to say terrible name shift for payments. Yeah. I would not be surprised with a fifth name change some point in the future, but, um, he started the business in 1999 when he was

16 years old. Apparently he dropped out of high school. He was working at some, uh, some payments company and decided there was an easier way to do this wanted to do it himself so he's 16 started in his parents basement from what i understand that i guess he's you know he's a really bright individual and kind of was bright from a young age initially the company was called united bank card he said he named it that because he wanted to make it sound more professional because they don't want to you know they don't want customers to figure out oh it's just some 16 year old kid running this um and its primary business was reselling really uh payments processing of another company and i think the reason that he succeeded with it was apparently

back then merchants that were trying to integrate new payments processors were it was like this long laborious process you would have to put in this application it would take a long time and it would take so long to have it up and running he was able to get a lot of these systems set up in a day and just really have really good customer service for their um for the different merchants and then on top of it i think he just undercut or he gave really generous revenue sharing agreements to uh additional vendors so like uh software vendors that you know you might go to the kind of people that i think shift for goes to today. We'll talk about that in a second, but that's really the genesis.

And then during those first 10-ish years, they partnered with a lot of different software vendors. And then in 2008, they launched HarborTouch. HarborTouch was really a point of sale system designed for small retailers and restaurants. This was kind of their introduction of the point of sales business. And then, like I said, it's been this just constant onslaught of acquisitions. So between 2014 and 2017, they acquired a number of other payments processors, including the business that Jared Isaacman worked for before he started Shift4 Payments. Then in 2018, they acquired Shift4. In 2020, they acquired MerchantLink. Apparently, those two combined kind of power the whole merchant acquiring portion of the business as

well um and they've since also acquired just i think probably like four or five different businesses since like 2021 um which some of them have have gone on to kind of drive results for the business but i think a lot of them kind of get swept under the rug i think there was one that was like ways to pay non-profits via crypto that isn't really talked about much anymore Hey, no, they mentioned it on the conference call, but I think, yeah, that was what a hundred million dollar deal and probably just a hundred million dollars lit on fire. I mean, the other part is I understand like it's hard to talk about these individually later on if you're the management team, because they tend to get pieced together with other companies to offer a single product. and so it gets integrated in. I know Skytab, which is their current point of sale system that they're selling was like a combination of four different restaurant payments processing

slash analytics businesses. So if it sounds convoluted and complex, it is. I imagine if you're in parts of the organization, it probably sounds pretty complex as well. But they joined the public markets in June of 2020. They raised $345 million during their IPO. been a bit of a wild ride since i think at kind of the height of the 2021 mania let me check i think they got up to near a hundred dollars the stock did let me check real quick yeah so it got just over a hundred dollars in april of 2021 has it dropped all the way down to 30 dollars kind of june of last year and has since doubled so it's i mean it's up from its ipo but uh kind of down from its high so it's been a bit of a wild ride yep and what do i got here oh i don't know why

are we we're being really bad with our heart tech today yeah today uh using my little dynamic valuation thing i have a share price of 64 but let me move right into industry and competition going through shift four's industry size is very difficult one they keep acquiring businesses two they're expanding to different international markets and three there is not very reliable data or really there is a lot of estimates out there about payments tam and stuff like that and they're all wildly different so the one way i like to do it or the one way i decided to do it for shift for this time is to kind of back through a payment volume opportunity. And remember, when I talk about payment volume, they're going to earn a take rate on this revenue,

or excuse me, on this payment volume. Generally, that is going to be their revenue. And then after that, they have fees that they pay to the other people like the card issuers, Visa and MasterCard, et cetera. But either way, I kind of wanted to look at Visa's payments volume in 2022, and then take their market share and go for a global TAM. And then maybe we can estimate how much of that opportunity shift four is going after. So in 2022, Visa did $11.6 trillion in payments volume. They have approximately 40% global market share. So that turns into $29 trillion in international cashless payments every year, at least in 2022. And it's kind of, I guess it's not kind of, it is steadily growing each year.

In reality, though, Shift4's opportunity is going to be much lower than this, probably significantly lower than $10 trillion in payment volume, because one, they're not in every market, and two, they're not going after every vertical. So if we look at hotels, restaurants, all the stuff that they're doing, it's still going to be sizable payments volume. But for example, they're not really going to have a big presence in online payments at, say, a Shopify-based store. Even though they have a competitor to that, it is extremely small. And I doubt they're going to make a big inroad there. Second, you're not going to be on somewhere like Amazon,

which is processing a ton of payment volume as well. So, yeah, the market opportunity is big, but it's not going to be as big, maybe, as people expect. And when you're going after this volume, yeah, there is a bit of blue ocean opportunity, right? But a lot of the time, you have to compete against an existing offering that is already processing this payment. So I think that makes the industry highly competitive and it's something I think investors should note. For reference, Shift4 did about $71 billion in end-to-end payments volume in 2022. And end-to-end means when they are the merchant acquirer, correct, right? It's hard because they use all these different definitions. So it's $71 billion in end-to-end payments, but I think they have another $150 billion in payments that they process. that is an end-to-end, but the take rate on that is so much smaller.

So I don't know. They didn't really give that out. They didn't give one consolidated GPV number. And I think the reason is because end-to-end is much more meaningful than just general GPV. Yep. End-to-end is more important. Definitely the one to track and it looks like there is still a big opportunity as they try to upsell their existing merchants. And yeah, $71 billion in end-to-end payment volume. That is, you know,

It's a good player. It's not a giant player in this space. But as I'll get to the competitors here, there is a lot of them. And they're big. And a lot of people, I think, have heard of them if they know this industry. So first, actually, we should separate them into two categories. So one are the non-integrated payment processors. This is what they define as their competition.

And these non-integrated ones would be Chase, Payment, Payment Tech, Fiserv, FIS, which, again, I get confused between Fiserv and FIS because they sound so similar, and then Global Payments. And then there's also integrated payment providers that I believe do either very similar or the exact same process at its core as a ship for product. that would be Shopify, Square, Toast, Adyen, competitors like that. Again, they're not doing the exact same thing. They might be attacking different verticals. They might be in different markets. They might be going for more online versus in-person. But in general, the payment process is, again, doing everything except what Visa and MasterCard do and the card issuers, okay, the bank. And in the newsletter, I'm going to have an operations map. It pretty much just shows they are in Europe, North America, and Japan, but they plan to expand, as they mentioned in

the last conference call, to a lot of different countries. All right, let's go to maybe the most fun part of this episode, or maybe the most disappointing for me, which is management and ownership. For this section on this episode, I want to hit three topics that I think are very important for any investor that's going to consider shift four. One, how Isaacman, who again is the founder, controls this business. Two, the executive incentives. And three, some related party transactions and governance red flags. So first, Shift4 has three classes of common stock, A, B, and C. The B and C shares have 10 to 1 voting rights. And Isaacman owns all of the B and C shares, therefore giving him 82% voting power as of the latest proxy. So

He has full control of this thing. It is a dictatorship, and there's no risk of him losing control anytime soon. It's not like he's down at the 50% range or the 40% range that would make it so someone could have the potential of mounting an activist campaign. Now, if we look at the compensation and the incentive here, 99% of the CEO compensation, which again is Isaacman, is in restricted stock units. The question I have, as a 32% owner of the business, and now his economic stake is 32% from my quick calculations versus his 82% voting power, he has 32% ownership of this business with a market cap of $5.4 billion. does it seem necessary to incentivize him with more rsus in order to do a good job i'm curious

your thoughts ryan is this a major red flag when you see this or kind of just a little bit irks you as a potential outside shareholder i've never understood it um why when you're a big shareholder like this you own a huge chunk of the business it's your basically your business your net worth is tied to the share price aren't you more shouldn't you care more about like the long-term value of those shares than getting some grant this year in rsu's like it just it's not going to move the needle for his wealth it's not going to move the needle for his life oh yeah it just doesn't make sense to me if but we we see this all the time so i i'm kind of thinking like what's my ideal structure my ideal structure would be something like this where he

owns a huge chunk and he just gets paid you know whatever cash salary that's good for that year and good enough for him to live on in the short term and doesn't need to sell stock in order to finance his life or you can sell stock but you can get a buffet like salary of a hundred thousand or something like that to make it irrelevant. Because again, I don't really care if you are selling shares to fund your life, as long as you still have a huge ownership stake in the business.

But giving these RSUs does feel a bit greedy and strange. If you look at the other cash bonuses that the other executives can get, they are based on an incentive targets. One is payments volume. Shoot, I should have mentioned, or I should have looked if it's end-to-end payments volume. Either way, they're incentivized

grow their payments volume they're incentivized on another target to grow their gross revenue less network fees which i'll probably just call net revenue which is again the gross revenue they subtract out the network fees they pay to say visa and mastercard and the other the card issuers uh like you know bank of america and then they're also uh targeting adjusted ebitda levels i think looking at these three things it should be no surprise then to see them be a heavy acquirer of other companies and using stock-based compensation a lot, because I can choose the adjusted EBITDA. And if you acquire a lot of companies, well, that's an easy way to grow your payments volume. Now, there were a lot of strange things I saw when reading the proxy

filing and annual report that from a governance point, either if I was looking at this company, I would want to investigate further to make sure it was my concerns were say, maybe misguided, or to say they weren't misguided and say, I don't really like this management team and this board and this executive. First, there was a strange note about a multi-billion dollar payout to a stepsister. Never liked that.

Second, the company pays $1 million a year to use Isaacman's plane. Just to be clear, it kind of sounded like you said multi-billion dollar payout to the stepsister. Oh, multi-million. Yes, it was like $3 million. So not really relevant in the long term, but again, slightly strange, not something you want to see.

A third, Isaacman, again, the founder, his dad is on the board. And then fourth for me was this confusing hold co-structure where there is a deal where all the tax loss carry forwards get paid to an entity called Shift4 LLC, which is not the stock you're actually buying. It is listed in the related party transactions. if you're really interested in this, you can try to analyze the three to four paragraphs of crazy lawyer legal speak that was very confusing. I'm not going to try to spend 10 minutes explaining all this and the dense lawyer paragraphs, and I probably would get some things wrong anyways.

But I never like seeing these things because when I do see that, I get a little confused and I say, wow, why are they doing this? Why do they have this whole co-structure? If the capital structure is extremely confusing and opaque, I always want to ask why. Why are you doing this? Why are you paying this out? And they have, I think, around $400 million in tax loss carry forwards. That could be a good asset for this business, right? But it looks like 85% of that, according to this thing I read, is going to get paid, not to you, but this LLC thing. Again, could be totally wrong on this, but yeah, generally came away very disappointed in the proxy statement and ownership structure. And it's something that would be a big concern for me because I do not like this dual class stuff where the founder, as Ryan's going to mention later, he is a rocket scientist that goes on missions. it's just a lot of uncertainty and it seems like he can do whatever he wants yeah i mean if it comes to like voting in the interest of the minority shareholders or

uh jared isaacman where where do you think his dad's gonna vote you know yeah that's also sticky yeah i think the biggest one for me though was the private plane they're paying a million dollars a year to use his private plane and he's the one that's going to be using the plane listen if you take every one of these things independently they're not the end of the world maybe i mean the tax loss assets i i don't think we know it intimately enough to say it's a huge deal yeah it's just something to investigate further when there's a page and a half of related party transactions it starts to feel like they're using this as a their bank account yeah and you get concerned about that. I also get concerned that nothing's based on a per share metric.

Again, especially with a heavy acquirer, they can be, I'll go through some of the math here on how they're really not generating cash right now. But yeah, anything else on that, Ryan, or do we want to move to earnings? When WestJet first took flight in 1996, the vibes were a bit different. People thought denim on denim was peak fashion. Inline skates were everywhere. And two out of three women rocked the Rachel. While those things stayed in the 90s, one thing that hasn't is that fuzzy feeling you get when WestJet welcomes you on board. Here's to WestJetting since 96. Travel back in time with us and actually travel with us at westjet.com slash 30 years. Let's move to earnings. I think the two most important top line figures to pay attention to

are, Brett kind of mentioned this, end-to-end network volume and gross revenue minus network fees. Gross revenue minus network fees. I would just think about that as their actual cut. So their revenue because they have to pay out a big chunk to the issuing banks and the card networks and stuff like that. But the end-to-end volume was $72 billion. That was up 53% year over year. They've done a really good job converting traditional gateway customer volume to end-to-end. So that's been a big driver of growth for them. So kudos to them on that. And then the gross network minus or gross revenue minus network fees was 700. Basically their revenue is $730 million, a little under. That's up almost 40% from last year. These are all the 2022 numbers. I didn't

include Q1 just because it would probably not be that big of a difference and I wanted to use annual figures. But that year they also did $290 million in adjusted EBITDA. But frankly, that doesn't mean anything for this business because for one, you X out stock-based comp, you X out acquisition and integration costs, which is fairly meaningful. They had a network outage that they're currently paying back a lot of the customers for. So you X that out, you X out basically all the, there's interest expense that I'll talk about the balance sheet here in a second. And they're getting into hardware. There's some depreciation there as well. So there's a lot of expenses that are X'd out in adjusted EBITDA that are really true,

meaningful costs for this business. Free cashflow has been a little hard to come by for them, which it's never exciting to see. But if you exclude all the acquisition costs, which you shouldn't, but maybe they stopped, let's say they stopped acquiring on a go-forward basis, and you X'd out the settlement timing, because apparently I think that's like a working capital dynamic, about 46% of their EBITDA would convert to free cashflow. So their theoretical kind of free cashflow here, I'd call it $133 million for 2022. That's about 18% free cashflow margins on that gross revenue figure that I used. If you use the total revenue, it's going to be significantly less, but that's kind of the way to think about it. It's worth noting though,

that right now they're acquiring a lot of their third-party distributors. And the third-party distributors, I've worked at something like this before. It's basically just this middleman software vendor that you go through. I think they're called ISOs on the 10K. They're buying a lot of them, which I do find a little bit weird. And there's a sort of a popular short report that came out recently that thought this was maybe malevolent or malicious. And the reason they think that is because-

And we'll link to that in the show notes for anyone that maybe owns the stock. Yeah, the reason that they think that is because the cost of good, a big chunk of the costs for them and the cost of goods sold, it's not the biggest chunk, is the payments out to their distributors

for selling through to the clients. If they buy them, that no longer shows up in the cost of goods sold and you can reposition that into the cashflow statement. There's a line item that says residual commission buyouts under the investing portion of the cashflow statement. So it's no longer looked at as a cost of goods sold expense. Earnings would look a lot worse, gap earnings, if they didn't do that, if they didn't acquire, not to mention it boosts adjusted EBITDA, which boosts their payouts for management.

So it's some red flags there. If you're looking at this as a potential investor here, I would say maybe they can get to kind of 20% free cashflow margins on that gross revenue figure. That's maybe something I would use. And you obviously have to believe in the ability to convert more customers to end-to-end volumes. Here's another thing.

I think this is an example of is companies will give out their own earnings metrics. Companies will give out their own free cashflow definition. It's generally the same operating cashflow minus CapEx. My thought is that the best way to go about it is you decide when you read the cashflow statement, what your definition of free cashflow would be for this business. And I think with shift four,

you got to be a little bit unique given those what's that either the financing or investing, whatever that one is below operating cashflow, that little, that segment, there's a lot of stuff in there that is, you know, it's significant cost for them. Yeah. It's, it's, I don't know. Cause my gut reaction is to say like they're massaging earnings. They're fine. They're doing some financial engineering to get a better payout, to make it look better, to prop up the stock. That might not be the truth. They may have really good rationale for acquiring their distributors. They may have good rationale for all the acquisitions they've made. Maybe they think that free cash flow can get closer and

closer to being similar to adjusted EBITDA, but for the time being- If it's similar, just use free cash flow then. That's always my thought. Then why are we ever even using it just to deep it up. Yeah. So I don't know. I guess the earnings were a little frustrating to go through, but it is a business who has been growing fast on the top line. That's worth noting. For sure. Yeah. Yeah. All right. Balance sheet. Let's go through this. They have $744 million in cash and cash equivalents, 56 million in long-term investments in securities. I believe a big chunk of that is SpaceX. I don't know how to think about this because They got SpaceX as a customer, and I think at a similar time, they bought their stock.

So if you've got to buy stock in every company to make them your customer, that might be concerning. What payments is consumer payments? Starlink. Oh, Starlink. Yeah, I forgot about that. I think it might be broken out independently. And I remember seeing that they bought some shares. I'm not sure if it's – there may be some other equities in there in the long-term investments. but it's small. It's not huge. And I mean, Starlink, you know, first of all, I'm pretty

sure the valuation on those shares has gone up and the Starlink is probably not a bad customer to have. So call it $800 million in cash and investments. Liability side of thing, on the liability side of the balance sheet, they do have $1.74 billion in true debt. That was all issued when rates were incredibly low. So props to them. They have a 2025 convertible note, a 2027 convertible note, and a 2026 senior note. That's a fixed rate. The convertibles, both the closest one, the 2025, which I think comes due in just about two years, converts at $80.48. Today, it's, what'd you say it is? $64, somewhere around there. Yep. So it needs some stock improvement to get there.

If not, it's no interest, basically. I think they have an effective interest rate on here of like 0.5%, but really, it's really low interest. And the 2027 is a $123 conversion price with less than 1% interest. The senior notes are basically 5% interest. All in all, they're not paying a lot of interest on this. But if their adjusted EBITDA figure is overstated here, it's a pretty hefty leverage ratio because their net debt is around, I think, $800 million, call it $800, $900 million. And their quoted adjusted EBITDA is $290 million. So it would be a net debt to adjusted EBITDA figure of three times.

But if some of that's overstated, you could be looking at maybe five times net leverage ratio. Not to mention, if the cash flow isn't growing or some of the cash flow isn't kind of real here, they're going to be paying a lot of that debt down over these next couple of years, especially if it doesn't convert. Or worse, they might be rolling that debt and having to acquire new senior notes or something at an even higher interest rate, which I think would be a bad scenario for this business. Yeah. All right. Good detail there. I think that was very thorough. Hopefully, I think the listeners got some good detail there. A lot of numbers. We throw too many numbers out. So if you get confused, we're going to get to that now. We're going to get to the discussion here shortly. Let me just say, okay, I'll say it this way. Growing fast, profitability is

we don't know necessarily what it really looks like on a steady state basis. And the balance sheet is not the best. Yeah. Good summary. Yeah. Let me get to valuation very quick. Market cap, about 5.4 billion. Add on that net debt. We had an EV of about 6.3 billion by my count. EV to net revenue, or actually, excuse me, I'm going to use two earnings multiples here, or one's not an earnings multiple, but one I think is a multiple that can give you some context on this business. First one is going to be EV to net revenue, which I'm saying net revenue is that gross revenue, less network fees, like we talked about before. Right now, based on the 2022 numbers, they're trading at 8.7 times revenue. And then if you look at operating income, which again,

we did talk about the confusing earnings, but I just used standard operating income. That is fairly low. You could probably guess they're going to get some leverage there. But again, they're not right now. And they're currently trading at 66 times that number. So So maybe that would be closer to 30 to 40 if they weren't investing for growth and they weren't doing all these things and they were showing their true unit economics and kind of increasing their margins to what they could be over the long term. But that's still an expensive multiple given that they are trading at about 8.7 times their true revenue figure.

On the other hand, they are growing at about 30 to 40% a year. So this could come down rather quickly, but this is definitely not one of those stocks at least in the payment space or the software space that we've seen over the last few years. And yeah, I guess when it was closer to $30, it might've been cheaper, but it's not one of these where we've seen it just totally bombed out and having these valuations compressed to sales ratios down below five. Let's go to anecdotal evidence, Ryan. What do you think about this business? I know we all interact with these types of products constantly. And my thought is a lot of these are commodities and they look the exact same. I can never tell

difference between any of these things except for when they have the name on the side but i'm curious what you think well um i guess on the product side i maybe have interfaced with it without knowing but i don't i think the proof is in the pudding with them being able to upsell to the um to their merchant acquiring services they obviously have some really notable customers some big customers. And it sounds like it would be very difficult to replace, especially since customers of that size, that's probably not their first priority. But I don't really like companies where it feels kind of like a patchwork of different businesses. And the other thing I don't, I'm not a huge fan of serial acquirers, especially ones that like

care a lot about adjusted EBITDA because they have a lot of acquisition and integration expenses that they continue to back out. So if that's on an ongoing basis, it just feels like you're constantly playing with fake cashflow. And you're going to incentivize to grow the fake numbers that actually are creating shareholder value. If they were incentivized in the proxy statement on free cashflow per share, maybe I'm okay with it, but they're not. yeah so i don't know i sometimes get turned off by businesses that are constantly buying or constantly buying new ones new companies especially if it doesn't if it feels unrelated like it feels like you're just moving into a new market it it's hard to keep up with 100 and i

think as an example here we've looked at adyen for a long time we have it on our watch list we did an interview with Mostly Borrowed Ideas last year. Maybe that was two years ago. Hard to remember at this point, but either way, still relevant for that business. Scuttleblur's covered them a lot. They're covered all the time. And again, like I said, we looked at them. And to me, looking at Adyen, who has no acquisitions, the acquisition strategy in payments, I think it's a flawed long-term approach because you, like they say, have to duct tape things together and Adyen can get better performance than a lot of these companies. so i think at its core when you have something like and again it's just my anecdotal opinion

because i don't work in payments and stuff like that the the end product that people pay with is a commodity and now you can add on switching costs you can add on um all these things on top of it to be a merchant acquire but if you do it through acquisitions it's much more likely i think that you're not going to have the success rate. Remember they talked about that network that was off or whatever you mentioned earlier. You're not going to have the authorization rates. You're not going to have all the key performance indicators

that these merchants care about. Be as good as someone like Adigan or you're going to have a much harder hill to climb because you're trying to combine all these products together and make them work seamlessly. And that's just very difficult compared to doing it slower and from scratch. all right future growth opportunities ryan these ones are tough i i really have a tough time here

because they acquire stuff and then basically grow your payments following grow international but what do you think here what's what is how does shift for payments grow what's the biggest opportunity in your mind yeah it was kind of tough to pick an avenue here uh they recently acquired a company called venue next which is apparently a white label solution that stadiums can adopt where people can pay from anywhere they can have stuff delivered to their seat they can have uh i think they can pay with the app at the point of sales system um sounds like that's potentially an easy upsell for them they're very they are a very good sales organization and they've been acquiring a lot of uh big stadiums since then since that acquisition so it seems like it's

working out for them. That's one. The other one is, this is kind of the most obvious one. It's what everyone's tracking, is upselling to the merchant acquiring services for their existing customers and new customers. But Scuttleblurb, he raises this interesting point, which is it's going to take time. So he says, there are several challenges to converting gateway-only sellers to end-to-end processing. First, large merchants are busy managing the complexities of their core business and consolidating gateway functions with merchant acquiring is understandably the last thing on their minds. Second, merchants will often take shift four's consolidation proposal to their existing acquirers who will respond by cutting processing fees to keep the

business. Third, the large enterprises that shift four caters to will often have banking relationships bundled with their merchant acquiring. So it's not as easy to upsell as it might sound just because they have a foot in the door with the gateway processing. They might not be the most important software vendor to these huge complex organizations. So it'll take some time. They've done a good job so far, but maybe some of the low-hanging fruit might be picked off already.

Yep. And mine's going to be going after these large entertainment venues. Again, they talk about stadiums. They talk about big entertainment complexes. They talk about entertainment festivals. For example, I guess big ones like music festivals, stuff like that. And they also talk about the chance to move internationally for reference. Like I mentioned earlier, they're only in North America, Europe, and Japan. There are a lot of other markets to go after. They talked about Latin America. I wouldn't be surprised if they made an acquisition down there for a payments processor. When I'm down there, they have basically the same stuff as over here, except it's just a different company. something like a square, a clover, a toast, whatever. It's essentially the same, but they could easily acquire their way into that market. Given that this is the case,

given they've had a lot of success as a sales organization and they can still upsell here, I would not be surprised if they keep growing net revenue at a double-digit rate for the next five years. What do you think, Ryan? Does that seem like a reasonable bet to make? Yeah. And they've done a good job expanding into different verticals and growing within those verticals. So I think the proof's in the pudding there when it comes to just the overall revenue growth rate, that that's really my highlight here is that the business is growing fast.

So that can, we've talked about some of the problems maybe with the organization or with shift four, growth can alleviate some of that, especially if your end clients are growing themselves. I guess that's something we haven't even talked about. If these big enterprise businesses are growing the volumes and you're just a take rate, that's fantastic. The lowlights though, maybe the name, that's one, they should fix the name. Oh, the name of the company. I thought you meant the name of the CEO. No, just the name of the company is a little funny. But, okay, I'll try to consolidate all this down to one because it's all pretty much governance related. But Jared Isaacman, very bright guy.

That's clear. He's a rocket scientist. He started a payments organization when he was 16 years old. I mean, clearly kind of a wunderkind type of person. He feels a little pumpy to me. A little musky, I got to say. A little musky. Yes. In December of last year, when the stock price was down a lot from its highs,

first of all, there was speculation that he was going to get a margin call. He's taken out a margin loan with his shares as collateral, but he also said, that's speculation. So he also said publicly, he was incredibly frustrated with the company's public market valuation and suggested that he might take the company private. For me, first of all, if you're interested in driving long-term value don't you kind of want a discount you can like constantly buy back your shares you can and you can do so creatively and you're issuing the rsus you already own a lot of this you're going to increase your ownership stake my concern is that it feels like he's thinking well if the public shareholders aren't going to give us a premium valuation

and foot the bill for us what why would i be public it doesn't he's not thinking about us as partners because it's like, oh, we're going to go private if you're not going to give us a premium valuation. Then what's the benefit of being public? It's like, we're partners, not just people to foot the bill for you. You don't want a risk of a take under if you bought at 60 and they take you under at 40, even though the stock price was lower at that point. I think that's definitely a big risk for me there. Yeah. The related party transactions as well. There was also a material weakness in internal controls. I got to say that one looked okay.

But again, you never want to see that. Yeah. The CFO left last year. So there was some management turnover. People also said that maybe he was fired in relation to the internal weakness and stuff. But it also kind of came at a time when they were acquiring a lot of their distributors, which felt like potential earnings massaging going on there. Last one. He goes up in rockets.

so and he's obviously very crucial to this business people looked at that or told me to look at that i gotta say i didn't have time or didn't really care for it uh how much how many times has he done this do you know i think he only did one mission it was a spacex one um he talks about it a lot i mean he's very into rocket science i heard a number of interviews where he's kind of on these like space related podcasts and it seems like a big point of focus for him he has another company as well that does like pilot training i don't know it just sounds like a distraction some people can run multiple organizations doesn't it doesn't feel like he's he's deserves the liberty to run a public company while running

a bunch of other stuff, just, I think you have to get to a certain level before you can do that. And maybe sometimes even I'm giving Musk the benefit of the doubt because of the size of Tesla or whatever, but I would say I don't like it in general. It feels kind of undeserving for shareholders. Like if I'm a shareholder, I want somebody who's really wholly committed to that business, especially if they own 80% plus the voting power. Agreed. All right. Let's keep moving up forward. My highlights, I'd say same as yours on the going after the large venues, they're going to have higher switching costs.

So hopefully extremely low churn and they should hopefully be able to grow over time. Plus like with PayPal and like we'll talk about, I think with almost every payments business that we're going to look at this month, which what are the other two bill.com and visa? I think they would also be within this category shift for is inflation proof as they are take rate business on payments volume. So I like that. Maybe if you're worried about deflation coming, which would be quite funny if that happened generally in 2023, 2024, if inflation kind of went away because that's all we talked about the last two years, that would not be great for this business. But they are inflation-proof, which is good.

And they seem to have fine-yield economics. These businesses do have good gross margins. Not great. Remember, you got to take out that. Network fees do not. Just look at revenue. But yeah, low lights, governance red flags, we discussed that. The cash flow generation is not what it seems. Ryan went into it. But if you basically take out all the actual cash costs from the, you know, not just CapEx, they have three other or four other categories there. they burned $240 million last year versus the $267 million in positive free cash flow they

would define under the operating cash flow minus CapEx definition. And again, that's not X-ing out SBC. So I don't know if they're actually creating value for shareholders right now. They are burning cash. Second, or third one, acquisition strategy, don't like that. And then fourth, the unit economics on some of these payment processes and gateways are a lot, are not as strong as I think some people may think, even though I mentioned that they're fine, I think they're not as good as maybe the true costs over time are. So you have one, the high network fees that you have to pay out. Everyone knows about those. But second, you also have to have a lot of customer support still there. You have to have the hardware costs that usually get subsidized or sold at cost to these

merchants. And fourth, you have to have a sales staff kind of permanently in there. You have to have a lot of actual employees working with these companies, integrating implementation costs. You have to sell them on it. You have to have support because a lot of these times there's downtime on these. And a lot of times you really do not want anything to go wrong because if you can't process payments, a lot of stuff gets screwed up, especially if you're working, think about it at a stadium, concert, wherever. You got to give your founders RSUs. Yes, exactly. So I think given the long-term sticky nature of these relationships, you'd say that they're probably going to have a positive ROIC, a positive return on invested capital. But I don't think it's as good as some people may make it out to be as maybe some bowls for these payment processors. The similar ones, Toast, Square, Clover, Shift4, maybe even toss Olo in there, although Olo is slightly different, but there's a lot of them out there. And I don't like the business as much as I did maybe three, four years ago. Let's wrap things up here, Ryan. Let's go through your bull and bear case.

Full case, they continue to grow end to end volume. They continue to grow new customers and those theoretical kind of margins we talked about are come to fruition. That would be... I mean, if they're doing that and the growth rate is north of 15%, which seems doable, this could probably work out to a solid return. I'll leave it at that. And what, you want me to go through mine first? So at 8.6 times net revenue, I really think you

need to expect that double-digit growth probably at 15% plus on a compound annual growth rate for your net revenue and better margins than people think. So you need margin expansion plus this 15% CAGR on the net revenue. And I think you need smart capital allocation. Yeah, the convertible notes were at a good time. Yeah, they bought back stock at a good time. I think you really need to expect this finance department and the founder, whoever's making the decisions here on the capital allocation front to be very intelligent here because they got to use this highly valued stock correctly. I think the expectations on this business are generally high. And if you want to own shares, well, your expectations need to be even higher than the market. So yeah.

I think the big question I have here though, and a lot of questions for these digital payment companies in general one well this is specifically for shift four what happens once they finish the end-to-end conversion with their existing customers how fast are they going to be growing then and second in general for a lot of these companies what happens when you know the quote unquote war on cash tailwind eventually ends is it become a hyper competitive business that's my big concern yeah i don't know if i'm worried too much about tam because there's a lot of enterprise customers that are available but i do have some other worries i guess the bear case for me is that the cash flow is really inflated they it's all going to go towards paying down debt over

the next couple years they might have to roll that debt at much higher interest rates i mean the balance sheet is not great if those profits aren't what the company says they are so i don't know There was some validity to some of the points in Blue Orca's short report that gave me some pause. I'm not smart enough to invest in companies where there's a lot of red flags. Some people can do it because they know the industry so well, they know the product, they know what's going on with all those dynamics and they can look past the red flags. Not for me. Especially in a space like this i need someone a capital allocator who i really trust and i know is going to take care of me as a minority shareholder yeah and i think that's gonna i don't need to go through my pair

case it's basically the same when we look at red flag businesses or something that might you know someone might describe as a whatever you want to describe it we're looking at stuff that we want we want to buy something that might be a deep value investment at three times earnings with a bunch of red flags not at nine times revenue i think that sums it up all right more less interested ryan i think i know the answer to this final thoughts before we go yeah i'm less interested i would not be surprised if this continued to grow quickly but i'm gonna miss the boat here because uh the red flags were a lot for me yeah if they're doing a trillion dollars in end-to-end payment volume by the end of this decade each year you know congratulations to

anyone that owns that i think it's possible i think the stock would work but again yeah i'm less interested it's not for me i think this business is in a highly competitive industry they They have yellow flags with their governance issues, and they traded a steep multiple. So why should I have confidence this is a good risk-reward opportunity at these prices? Yeah, maybe at two, three times revenue. If you think the margins are going to be good, this would be a great opportunity if you add in those risks because of the red flags, because of the governance issues, because you're riding with a guy that owns this entire thing and goes into the Rockets.

But right now, I just don't see the opportunity. on the other end though if they keep growing it'll be fine all right ryan anything else before we go no that's it okay give us a review on apple or spotify if you like the show we are not financial advisors anything we say on the show is not formal advice or recommendation we are general partners at arch capital and clients may hold securities discussed in this podcast thank you everyone for tuning in next week we have bill.com the week after we have visa and And the week after, we're doing Airbnb. So it should be three really fun ones in a row.

We'll see you next time.