Chit Chat Stocks - Why We Like Adyen Stock (But Aren’t Buying Shares Today)

Episode Date: October 3, 2023

This is our monthly Arch Capital episode. About once a month we will publish an episode that covers a company in the Arch Capital Investors Fund. These episodes will be modeled after our Not So Deep Dive episodes and will also be available on YouTube. Adyen is a prominent fintech company that provides payment processing services for businesses globally, offering a seamless and comprehensive platform to facilitate secure and efficient transactions across various payment methods and regions. Brett and Ryan dive through Adyen and outline the investment thesis for why we like, but aren't buying the company in our Arch Capital limited partnership. ****************************** Chit Chat Money is presented by Interactive Brokers. Switch the best brokerage in investing today: ibkr.com/info ****************************** What is Arch Capital? Arch Capital is a concentrated, long-only equity fund aiming to compound capital at an above-market rate. Arch managers are perpetual learners with a long-term focus that strive to build wealth with our partners through intelligent capital allocation. Learn more here: https://www.archcapitalfund.com/ ****************************** Timestamps Company Background | (3:51) Unit Economics | (16:28) Competition | (28:24) Economies of Scale | (45:17) 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 in. This is the Tuesday Not So Deep Dive episode on Chit Chat Money. And on this episode, we are doing our special monthly investing focused. We call it the Arch Capital episode,

which is the limited partnership that we run. And it revolves around less of a introduction to a business and more of a business that we know well, trying to do deeper analysis and either deciding if we already own the stock, you know, why we own it, giving it a relook, or if it's on the watch list, why it's on our watch list, whether we would buy shares today, kind of going for a deeper discussion and basically presenting or, excuse me, publishing a discussion that Ryan and I would have ourselves. and hopefully people can learn from it and we can learn as well.

So Ryan, welcome to the show. Thanks, thank you. I will add here real quick. Most people might not know this, but we have a fund that we run outside of the podcast. It's a concentrated fund of 10 to 15 stocks and shows like this are, like Brett said, conversations we would have off camera

and kind of pitching slash discussing a potential idea or even an idea that we already have in the fund. And a lot of these are generated from our not so deep dives, which we do each week. So those are kind of the filters where we look at it for the first time. And some of those that we end up liking will ultimately potentially end up in the fund.

Yep, this is a company we've followed for many years now. We actually pitched it. So I pitched it to Ryan as a watch list item back in the spring. and the stock has luckily gone down about 40% to 50%, so it could be a great opportunity to look at it at a cheaper multiple. We didn't plan it, but today, as you can anyone tell from the title, we are talking Adyen, which is not a company, unless you know the stock or the payments industry, you have probably not heard of the company, but it is one of the fastest growing

payments companies in the world. We really like the management team, and we're going to discuss and maybe debate a little bit their competitive advantages, their growth prospects, what price we would potentially pay for it. I will say most people are listening to the audio, but we do have the video either on Spotify or YouTube. And if you'd rather, because we're going to share some graphics here that I think are very important for the payments industry, along with Adyen's specific role in the payments industry. But if you want to look at all these graphics, the easiest way to do that will be to subscribe to the free newsletter that we'll have in the show notes. We'll put a link there. It's much, much easier. And then you can have this along

with each episode on Tuesday. On Tuesday, we send out these to the newsletter. It's very free if you subscribe, or excuse me, it's very easy and free to subscribe to that. But let's get right into it. We do these a little bit differently than the Not So Deep Dive episodes. We basically interview each other back and forth. So one person leads each section, and then we'll get to a wider discussion. So Ryan, you have the first question here. Why don't you ask me? Yeah. So at the end, it seems like one of those that's discussed by lots of investors, but it can be a little confusing to actually understand. And even ourselves, I think we had the sense that we knew generally what they did, but not the true details. And so let's start

Or with that, I know people are going to want us to touch on what's going on now. Why is the stock down? Do we think it'll stay around? We'll get to that. But for starters, what value do they provide to various stakeholders? What are the basics of Add-In's business? Okay. Yes. And if you don't want to listen, if you've already heard what the business does, if you already know what the business does and you've already heard the history, I'd maybe skip about 10 minutes later into the episode because that's about how long these first two sections will be. But I know a lot of people still don't understand this business. It's not like an Apple where you're like, oh yeah, they sell phones, but let's try to get into it. It's going to be a bit

of a mouthful. I'm going to try to start out with a wider view, narrow it down and get a little specific and then kind of come from a back around and say, okay, this is actually the value that Adyen provides to all its customers. So if you go to Adyen's homepage, it says it is quote engineered for ambition. That is a wide thing there, but- Very specific, very telling. Very telling, yes. Yeah, exactly. That doesn't really tell us much, but if you read below that, I think there's a very interesting sentence that gives a great overview of what its products do and its long-term ambitions. Quote, Adyen is end-to-end payments, data, and financial management

in a single solution. Now, one thing I would add on there to help understand Adyen from an investor's perspective is that it hopes to be a global end-to-end payments company. So global end-to-end payments, and then on top of that, adding data and financial management services to their customers. But you might be thinking, okay, what exactly does that mean? I think for context, we should talk about all the stakeholders in a payment transaction. So this would be all the stakeholders in a transaction, which I would maybe call a modern transaction. So we're excluding cash payments because cash is very simple. So there are quite a few, but I would list them off as the consumer, which would be you, the listener, paying with a credit card or some other form of

payment. Two, there is the bank that issued you the credit card. So the consumer's bank, which would be Bank of America, Chase, blah, blah, blah, the list goes on. There is the payments network, which would be Visa, MasterCard, Discover, American Express, et cetera, et cetera. Four, the merchant, which is the seller of the goods and services. Five, the merchant payment processor, which would be the terminal online checkout solution. And then six, and there's others in there sometimes, the merchant's bank. So the, they call this, the terms get confusing. They call, you'll see the term tossed around about the merchant acquire, the acquiring bank. This could be, you know, could be the same bank, could be Bank of America, but this is the bank

that the merchant uses. Now, there are a few other in there, but I think that generally helps in understanding what, you know, everyone does in these solutions. Everyone knows about Visa. Everyone knows about your, the consumer, obviously, and the merchant, and that everyone knows about the consumer's bank. But what people don't know is the merchant acquire and the payment processor because a lot of times they're in the background. So where does Adyen come in? Well, they are both a payment processor and the merchant's acquiring bank. They have, say, when you're on a landing page, a checkout page online, they will be the ones setting that up for any sort of company. We'll get into some examples later. And they'll also be that merchant's

acquiring bank on the backend. So to sum it up, online payments may seem easy when you or I do it right, but there are constant moving parts in the backend that a company has to manage for the merchant because the merchant can't really manage this on their own unless they're a gigantic one. So maybe like an Amazon or a Walmart could do some of this themselves. But in reality, they actually go to third parties a lot too. So, they are all there. Adyen is there. They are there to help you tap, swipe, instantly pay for something and do it seamlessly for the merchant. Now, a little context here. Adyen did start in Europe. They are a European-based company and they became, with a banking license, they were able to become the payment processor and

a merchant acquirer. They didn't have to go to third parties, but they only got their license in the United States in 2021, and they're working to get all their banking licenses around the world. So that's something that maybe is a future growth opportunity. It's something that they're working on over the longterm. They'd like to have a bank all throughout there. Ryan, a check in here. Yeah. So you mentioned that they are the merchant acquirer or the merchant payment processor, and they're the merchant acquiring bank. That is not typical. I'm going to talk about that in a little bit, but the companies that Adyen competes with, or that they end up competing with a lot of companies, but

the companies most people probably think of Adyen competing with, the Stripes, the Braintrees of the world, they don't run the same model. So it is- Or not all of them do, yeah. Yeah, most of them do not. So it's a unique model to be both the acquiring bank and the payments processor. Yeah, that's an important thing to note. And if you're a first timer to payments, you might be.

And I think if you, if you are, we have about maybe 10 episodes we've done over the last year or two that cover all sorts of payments companies from American Express, Visa. It runs the gamut, Discover, a lot of them. We've done interviews and not so deep as on all of these. But if you are a first timer, I would think about it like this. Adian is trying to provide every service for a payment transaction, excluding the payments network, which would be a Visa or MasterCard and the customer's bank. So they're not going to try to replace your Bank of America.

That would be a very tall task. They're not going to replace Visa and MasterCard. That seems virtually impossible, but they want to offer their merchant customers, which is who they are selling to, the ability to accept any form of payment they want anywhere in the world, which they are slowly building towards over time. So again, they want to be everywhere in the world and they want to accept any form of payment in whatever fashion you want, in person or online. If you look at their products, there are a ton of them, but the key ones would be Addy and Checkout, which is just with a few lines of code, either through an API or some other sort of solution. You can make a checkout user experience that works on any device across the world. They have accepting online payments, which I think is self-explanatory. They have point of sale systems and software to go along with that.

they have what is called enhancements, which would be add-ons for merchants to improve the customer journey. This includes authentication for customers, connecting shopper profiles across different channels, risk management, revenue optimization. Then they also offer financial services, which would be business bank accounts, capital financing, card issuing, and then global real-time payouts. So those are the add-ons they want to do on top of this. This would be the financial services and the enhancements, that's not really part of the payment transaction, but these are things they can help with their merchant customers, with their large enterprise clients. Anything to add there, Ryan, before I go into a little bit more? Because I want to be

thorough here because it is confusing, but I want any sort of listener to understand it because you can't really understand the investment thesis until you understand where they sit in the supply chain here? No, I would just add that online payments is where they make the bulk of their processed volume. And that's kind of where they got their start. But companies that are customers that subscribe to their omni-channel solutions or their full capabilities, so both the in-person transactions and the online tend to be stickier. And the other thing that's maybe worth mentioning is online payments, from what I understand, tend to have a higher degree of fraud. So having higher authorization rates online is a bigger competitive advantage than having the

higher authorization rates in person, because generally authorization rates are a little closer competitor-wise for in-person transactions. Yep. And authorization rates just means the amount of times when someone tries to pay, they're actually successful in paying. So if you're only at 95%, that means that 5% of your customers are slipping through for the merchant at checkout. You want that to be as high as possible. We'll talk about that as a potential competitive advantage for Adyen. But that leads in right to my next point here is originally, and Ryan will get through this in the history a bit, but originally Adyen's niche was in Europe, serving large enterprises with mostly online payment processing. So kind of three little specific

niches there. But since then, they have expanded to most geographies around the world, or most relevant ones, I would say from a commerce perspective, most forms of payment acceptance, which again, is mainly moving into in-person transactions. And then they are now inching into offering products for smaller merchants, although that is a much smaller part of the business today. They're very, very early on in that. So I think it's a big TBD there. Now, Adyen's value, which Ryan will discuss later in the next section, is providing a modern non-duct tape solution, as we kind of describe it, which can work seamlessly for large merchants around the world.

So this saves Adyen's merchants time and headaches while also improving their own customer experiences. When accepting payments, the most important thing for a merchant is that you don't lose the customer at checkout over either frustration, confusion, other mistakes, or you don't accept a fraudulent one as well. Adyen is best in class at helping merchants make sure payments work at checkout. There will always be kind of leaks, you know, in the checkout process. You're not going to have 100% authorization rate all the time.

But Adyen brags about and has, I think, data and kind of see in the numbers and their churn numbers, one of, if not the leakiest or not least leakiest boats for merchants when looking at it on a global basis. Does that make sense? like there's going to be leaks in the boat all the time for these merchants but they want to be the least you know leaky they have in other words they say and there isn't a lot of hard data around this they say they have the highest authorization rates in the industry or at least some of the highest authorization rates yep and okay and before we get to the unit economics because i want to get into

how they actually make money nowadays the company has all these services that they're offering customers. They have marketed kind of a new brand, I would say. It's not too different than it's just combining all the products together into one platform. They call it unified commerce. You'll hear them talk about this a lot. They describe it as, quote, you know, a connected omnichannel solution. It's going to improve upon the siloed solutions for, you know, in-person or online transactions. So they want to have it basically all connected together for a merchant that both sells in-person and online. And I think personally, it's hard to get the true data, but it just makes sense from a common sense perspective that this can be extremely valuable for larger merchants

who want one unified solution for in-person and online transactions. the ability to trade stocks, bonds, options, futures, commodities, and more with high interest rates paid on instantly available cash balances, plus the ability to lend your eligible stock shares to earn passive income all on one single unified platform. That is why we at Chit Chat Money use IBKR and wouldn't use anything else. Restrictions apply. For more information, visit IBKR.com slash info member SIPC. Open an account with IBKR today. get worse before they get better. Apparently, that's how I roll. So bundle up and come along

for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. Now that I think we understand what they do, and for any listener, we're going to have tons of links here because there's a lot of resources in the investment community that explain what Adyen does. So if you want something to read, maybe we'll give a link out to that in the newsletter, which again, there'll be a link for that in the show notes. So how do they make money? It's fairly simple at its core. When merchants process a payment, they give a cut of each dollar spent on, say, a shirt to its payment partners.

For example, in a payment transaction that Adyen processes for the merchant, the cash or the money, I guess I shouldn't say cash, could get split up between them, Visa, and Bank of America. The percent that Adyen keeps can vary depending on the type of transaction, but generally analysts assume around 25 cents is kept, give or take, by the merchant acquirer, such as Addian, on a $100 transaction. I have some graphics here. Maybe I'll share it for anyone listening, but if we do that, yeah, sorry for the little delay there. But for example, if you have a process in the United States, about $2.15 of $100 transaction will go to what they call the

discount fee, or basically this is what gets paid to all the payment stakeholders. So you have maybe $0.22 that would go to Visa, you have $0.25 that would go to the acquiring fee, which would be Adyen or its competitors, and the majority of it is going to go to the bank card issuer which would be the consumer's bank at jp morgan chase bank of america wells fargo etc and again we'll have the graphic of this in the newsletter pretty easy to see but before you understand this it can be can be hard to to comprehend because you kind of think oh you just pay the merchant they keep the money but no there's actually a lot of dollars getting flown around here uh last thing i would say or something to add here it's funny most people just

think uh whether you're like a startup merchant or a customer you pay at checkout and you just think wow mastercard is taking mastercard and visa they're taking more than they deserve they are the smallest chunk of that payments partners take rate now it's pure margin but and they're not taking quite as much risk as the issuing bank, but there's other stakeholders in that process. I think it's just the important part to understand. Yeah. And if you want your credit card fees to go down for merchants, well, all your credit card points are going to go away. So it all goes back to the consumers. Really, the merchants are the ones holding the bag here. Okay. The last thing I want to talk about, and this is something just for context for listeners,

and I guess I did go longer than 10 minutes here. So sorry for anyone that hopped back in, But Adyen looks at its income statement, starting with net revenue, which is the money it keeps after paying out every other stakeholder, which would be Visa, Bank of America, and the merchant. So its revenue is much lower than the actual dollar volume it processes. For example, in the first half of 2023, Adyen processed about 426 billion euros through its network, but only kept 739 million euros in net revenue. This means it had a take rate of just 0.17%, which is estimated because, again, we're not...

Okay, some of them are higher, some of them are lower. And I think there is some revenue they get not from pure payment transactions. So I think 0.17% is a good estimate, but again, not perfect. Okay. Essentially, on a $100 transaction, Addian's total take is roughly 20 cents. Yeah, give or take. Yes. and it depends if you're larger or smaller. Now, I will say I did add about, I think maybe like

five or six graphics that will be in the newsletter. And they are courtesy of some of our friends across the investing world. There is Ryan Reeves from Business Breakdowns, which we'll link to. He has a good write-up that illustrates this pretty clearly. There was Giblet Stocks on Twitter and then Adyen's own website, which has some pretty clear information. But that was a mouthful to start. I think I got through the hardest section there. So Ryan, I'm going to take it over to you. How was Adyen formed? How old is it? What is its ethos that makes it different from other payment providers? Adyen is about 17 years old. So the company was founded in 2006 by Peter Vanderdos and Arnaud Scheif. Sorry, Dutch names are not

my forte. Arnaud was the CTO up until 2020, but he's no longer in the picture. Peter is the CEO still. And the two had, prior to that, they had founded a company called, I think it's Bibbit or Bibbit in 1999. And it was, I think, another payments processing company that was eventually in 2004 sold to the Royal Bank of Scotland. And so in 2004, after they were acquired, There was also Royal Bank of Scotland made a couple of other acquisitions, which eventually formed – they basically took those acquisitions and stitched them together into what's now WorldPay. And so the Royal Bank of Scotland required the team from Bivit, which is now AddIn's team in a way, to stay on with the company for at least two years in order to get the integration process done. But in that time, from what I understand, Peter really discovered that it was this patchwork of products and fragmented efforts from different teams, poor communication going on at some of these larger payments companies, which makes it a lot harder to push products and makes it a lot harder and probably more frustrating when it comes to trying to get what you want done, done. Ultimately, getting to higher authorization rates is a lot tougher when you have to communicate across different teams, don't necessarily respect each other, or you're going back and looking at work that was done by a team that's no longer there.

Also, think about when Peter, who ended up leaving in 2006, think about when he left. If there's a problem with the code or the infrastructure that was built by Bibbit or anyone from that founding team, it's a little difficult for the remaining employees to know what's going on. And so that's kind of what he's talking about when he talks about this patchwork of fragmented solutions being built into these legacy payments providers. So anyways, Brett, anything to add there? No, I don't think so. It's just very hard. Anyone that makes software, if you try to combine two code bases together, it's going to be quite difficult. And a lot of this stuff is very old. So it was built, you know, pre-internet, very, very much older than a lot of our modern, before some of these modern solutions have been invented.

And the people that manage it might be gone. I mean, it's just a lot of, say, technical debt that they saw across these companies. And there is extreme number of acquisitions or basically these sort of assets within the industry get tossed around a ton. So it's actually more extreme than maybe a normal industry would be. Right. And I didn't mention this, but WorldPay, which was stitched together acquisitions, was spun out, I think IPO'd, then acquired by private equity, then sold to FIS for $43 billion. So it's like Brett said, it's been passed around from ownership team to ownership team

and probably had new touches put on each step along the way. And it just makes it a lot harder to manage than one seamless solution, which is what Peter wanted to build. So when he left, Peter, along with Arnaud and I think seven others from the original Bivit team, ended up starting their own. They wanted to build their own payments processing company, and they gave it the name Adyen, which translates to start again in Sranan Tongo. It's a language I'm certainly not familiar with, but the name wasn't taken. They wanted to start over.

they wanted it to be a clean start, and they wanted to have a clear understanding within the organization of how everything was working. I found this quote from an analyst named Michael Willard. He says, let's just take a step back and think about this for a second. Peter helped create an incumbent processor in WorldPay and spent two years inside of it. He then created a business built to eat WorldPay's lunch. So this is unique and I think important part of Addy's story. So Peter is what's called a round two founder. Who knows better than any anyone on the planet, how to attack the vulnerabilities of these incumbents. That's exactly what they've done since spinning out and building Addian. I know it's a little

cliche to talk about a company's culture because everyone brags about their culture, but Addian, it really does shape the way they run their business. Today, most people familiar with the business describe the company as basically just a bunch of payments nerds who enjoy the complexity involved in the entire payments process. They are very protective over their culture and meticulous, not only about protecting that culture, but how they choose to grow. So a board member interviews every single person that's hired at Addion, whether that's a front desk assistant or a lead engineer, there has to be a board member that interviews every single one. And you're not going to find that at most at the typical company.

So the other part, this is a no acquisition company. As you might imagine, we just talked about the struggles that happen when you acquire. And they try to cut out middlemen wherever possible, which enables them to ship products and software updates faster. Here's an example of that from the blog Scuttleblurb, which had a great write-up on Add-In. Highly recommend reading it. And when he's talking about how Add-In differs from other payment service providers, he says, a merchant who wanted to accept card payments could open an account with Stripe who would rent the bank identification number, BIN, of acquiring banks, rent-a-bin, an arrangement that gave Stripe the right to onboard merchants according to the acquiring bank's underwriting

rules. Stripe pays a fee to the acquiring bank who still assumes risk of loss, but otherwise retains most of the merchant-acquired economics. So they are basically setting up an account. Stripe is sort of a middleman in this case where they're setting up an account at a bank, but they don't have a banking license themselves. When it comes to Add-In, he says, instead of renting BINs or integrating with an aggregator, they own banking licenses outright wherever they can and directly integrate with local

payment methods. Like I said, this helps Add-In be a little more agile, but it also gives them more share of the economics in a typical transaction and allows them to have higher authorization rates ultimately. And I do have the next question for you, but just to give you a breath there, I will say that the history is very important, not only the company's history, but management's history, their prior workforce is very important for us in our answering two of our key questions is one, does the company have a competitive advantage?

And two, do we trust the management team? Those are very important for both of those, which we'll hit on later. And again, our third question, which again, these are the three questions we ask on every company, competitive advantage, management team, do we trust them? And third, is the stock basically cheap? So Ryan, you have the next one here. And I will try to share the screen for everyone because there's a great graphic that Ryan is going to try to analyze, although there is a lot of numbers there.

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Go right ahead. Yeah, Adyen has tons of competitors. Here, hold on. Yeah, sorry, did I get out of your notes? Yeah. The ones that probably come to mind for most people are Stripe and maybe not Braintree because it's not quite as popular, but they've become pretty relevant as of late. But the enterprise payment processing space is enormous.

It's at the end processed over the last 12 months, $848 billion in payments. That puts at the end at about 2% of all enterprise processing, maybe a little higher. There's this chart that Brett's sharing right now, but it just goes through the market share among all the providers. And so among the modern acquirers, which is more the disruptors, if you want to call them that, Stripe is reported at the highest, but we don't always get updated numbers there. Stripe and Add-In process a very similar amount of volume. So I think it's pretty equal at around two, maybe a little higher than 2%.

Checkout.com is in there. Braintree is growing quickly as well. That's a part of PayPal. And then the three largest payments processors in the US are JP Morgan Payment Tech, FIS, which owns WorldPay, Pfizer, which owns FirstData, and Global Payments, I think is another one that's included there as well, but that's about fourth largest. So there are a lot of legacy payments processors that still command a lot of market share. They are deeply ingrained within the payments process for a lot of these companies that just probably haven't ever bothered to switch for a while. And Adyen has kind of been eating away at that market share over time. You look at a company like Pfizer,

which owns First Data, their market share is flat relative to 2016. It's really kind of down over the last two, three years. Same with WorldPay. Chase has actually done a pretty good job of growing, but those are kind of some of the big ones to think of. Barclays is big abroad or in Europe. Do you think I'm missing any there? I don't think so. I think the most important thing is that essentially in 2016, modern acquirers had 0.5% market share. And then the scaled ones had 99.5% market share. And these modern ones have grown a ton. But the 2022 estimates is that the scaled incumbent players have 93.2% market share. So look, you can't just say, oh, Adyen's growing and scaled incumbent players have 93% market share. They're going to

take all that over time. But given the other context that I think we'll hit on this episode, there is a big runway for growth. You can't base an entire investment thesis off of the total addressable market, but Adyen has nothing to worry about here. Yeah. And as I mentioned, Adyen has about 2% of the entire processing market. In online only payments processing, it's closer to, I think it's low teens, mid teens. that that kind of area um got rid of the okay no sorry one second um i think the company that's probably caused the most trouble lately sounds like it's been braintree uh it kind of sounds like the stock decline came from braintree so for anyone that hasn't kept up at the end for a long

time was kind of felt like this bulletproof stock people love the business they didn't hire very many employees. They had incredible margins. And somehow with those incredible margins, they were still able to grow at rapid rates. They report half years instead of quarters. So this half year, they announced big declines in margins because they were hiring a lot of people. They've said this publicly. And I don't think that came as too much of a surprise for analysts. But what came as a surprise is they said they were seeing pricing pressure in North America And on the conference call, they basically called this out. They didn't say it specifically by name, but basically Braintree is undercutting them on cost.

And given some of the pressure for merchants today, they said it was kind of due to higher interest rates. Merchants are willing to take a risk on their payments processor and go for the lowest cost provider or the lowest price competitor, which in this case seemed to be Braintree. So management seems to think this isn't going to stick around. They think over time, merchants will recognize that at the end, because of their higher authorization rates, is the best return on spend because you're getting more revenue back on your transactions relative to using Braintree, even though it might not cost as much. But it kind of remains to be seen because basically, they're betting that this market share loss isn't going to last over time, and it's kind of temporary, and people are just looking for ways to cut costs where they can. The other competitor that I think is maybe the scariest, in air quotes, or the biggest threat would probably be Stripe. That's the one most people probably think of. We talked with Mostly Borrowed Ideas last year about Adyen, and he kind of laid out this risk as well. There's a big pay gap between what Stripe pays its employees and engineers and what Addion pays its employees.

I believe Stripe average salary for the same role is about 50% higher. Now, some of that might come from having a workforce in the Netherlands that's a little more frugal, maybe doesn't expect as much compensation as someone living in Silicon Valley. But it's also in some ways a risk because companies can have global workforces now. The not willing to compromise on how much you pay employees could be a win for the people that are willing to and willing to sacrifice margins in the short term. He kind of lays out this question where he's like, payments moves fast, right? And you think about what Add-In offers versus a lot of the competitors, and it's marginal.

It can be a big difference if you're processing a ton of volume, but the authorization rates are probably fairly close, at least in North America. And so what's going to be the biggest differentiator if we look out 10 years? It's probably going to be whichever company has the best talent that can ship the best products and do so the quickest. And if Add-In is known for not paying super well, or at least not as relative to Stripe, there's some risk that Stripe's going to be able to out-innovate. That hasn't happened, but I think that's worth the risk. And in terms of online processors, they've grown pretty much just as quickly as Hattian over the years. So I think that's probably the most formidable competitor. I have a question though. Do you think, and this

is probably the most important question to answer right now, do you think Braintree's share that it's taken in North America can last? I think short answer, yes, but I don't know if it's a long-term concern for Adyen or its shareholders. Well, obviously, if you were paying 100 times earnings, it might be, but Braintree is taking a little bit of share here in North America specifically because it's discounting heavily. I heard rumors, and again, it's a lot of black box stuff where it's kind of tough to get precise data because a lot of these deals are behind closed doors and stuff like that. But I hear they're giving a 50% discount in some cases to Adyen. And as I'll go through in my competitive advantage section, they're not seeing globally

the gross churn reduction that, or excuse me, not reduction, increase that you might expect with that with such a big price discrepancy. So I think even though they could potentially Brainsheet could do this for a while. I actually think it helps solidify that Adyen does have a competitive advantage, but it is definitely a risk though, right? Where, okay, you could look at a customer like Spotify or Uber, who's going to use Adyen because of the global capabilities, the, well, maybe both of those aren't too omni-channel, but essentially the global capabilities, high authorization rates. And since they're so global, North America, yeah, it can matter but you gotta have everything so i still think yeah we'll see it's a big tbd i mean

i'm curious your thoughts here because it seems like braintree has the firepower to do this for a long time but even though they're discounting so much it actually hasn't hurt eddie's business too much as of late yeah it's i think the interesting part to look at is the situation that PayPal's in generally, Braintree is the bright spot in PayPal's portfolio right now because the branded checkout for them is declining a bit. They say they're maintaining market share, but other companies seem to be growing a lot faster. So it seems like they've got a lot more competitors and margins are starting to erode. And so having this one bright spot in your portfolio to call out, it seems like

they can consistently tell investors like hey we're growing we're growing volumes at braintree really quickly and they don't have to necessarily break out the pricing that they're getting they can just talk about the volumes 100 and you see it in the margins like the margins are deteriorating at paypal because braintree is growing so much quicker and it has lower margins than a branded checkout, but I don't think the merchants are stupid. I think merchants know, and maybe it's an experiment. Maybe they're just testing it and saying, you know what? Braintree is coming in with these really low ball offers in terms of price.

Let's see if they can compete on authorization rates. But merchants, they're not just going to look at it, especially some of the bigger enterprise merchants. They're not just going to look at it and say- Yeah. They're saving 10 basis points max. Like who cares? Yeah. Think of your subway, right? You either save 10 basis points in every transaction. So if someone's spending, what would it be? Say a subway, let's say it's a big one, a hundred bucks, right? They save 10 cents on that a hundred dollar transaction, or you go with one provider, Adyen, who has worked really well for you, has reasonable prices. I don't know if that's really the juice is really worth the squeeze there. But here's my concern is in the conference call, Peter, the CEO calls out that our cost of ownership is still the lowest because we generate higher returns.

We get higher authorization rates, so you get better revenue. So in the long run, we're the best choice. Don't you think merchants are like aware enough to be like, yeah, okay, that makes sense. As opposed to, yeah, but Braintree just offers it cheaper for the integration. I would think that they're not that dumb. Maybe they're more willing to experiment right now because of the difficult environment. But I would be, and maybe this is why investors are so concerned, I would be a little more concerned that Braintree's market share growth could keep going.

Yeah, I agree with you. But I think if we get to the next section, I will have some data here. Hopefully, yeah, I have it in the next section. that I think maybe shows that Adyen is not in as much trouble as they talk about, as people talk about. Okay. Let me ask the question as we do a little interview here. Why do you believe Adyen has a competitive advantage? Because this is really important here. I think this is pretty much what's driving the stock right now is whether or not its competitive advantages can last. do we think well this basically says yes we think it has a competitive advantage but do we think

they can last and what are the competitive advantages yeah well i might revise it because i did write the question down because i think this is important is it specifically do we think the moat can widen and expand over the next five years so when i wrote up adian as a watchlist pitch internally early this year i just copied over what i had here and changed a few things and I still believe that I'm talking about the competitive advantages. I still believe a lot of this applies today. So first, before looking at any qualitative reasons, any of our opinions here for Addy and his differentiation, I believe there is really something to be said here about just looking at its rapid market share gains since 2015. So if you look at 2015, it had 32.2

billion euros processed. In 2022, it had 767.5 billion euros processed. That is a 57% compound annual growth rate. So why have they gained so much market share? I think a key reason, authorization rates. We've talked about this, but Addian's purchase authorization rate is known to be superior to the competition on average. Higher authorization rates mean a better customer experience at its merchant customers and more revenue generation for its merchant customers, since more payments are getting approved with less fraud. It is a win, I'd say, for all parties. and something merchant acquires are continually trying to improve.

And why is it better? It comes back to the history here because it is not a bunch of acquired solutions from different geographies, from different eras, from different regions, blah, blah, blah, being built by a legacy institution. It is a 21st century software stack with zero acquisitions. They say they're never going to make an acquisition,

which is great because most acquisitions destroy capital. But in this case, it's double great because we've seen the historical examples of these jumbled together solutions. It makes the connectivity much cleaner. Again, unified commerce across the omni-channel solutions here for the large enterprises. And it makes it much easier for Adyen to win and retain clients, even though it might be facing that pricing competition from the likes of Braintree. Now, you might say, okay, that's a good narrative.

And Ryan talked about that. You know, why are they losing a little bit here? But I think the proof is in the revenue growth that is still occurring from existing customers, which is where the majority of their revenue growth does come from. A lot of large merchants will use multiple acquirers here so they could have a contract with both Stripe, Adyen, and Braintree, for example, or others, could be others. and even with that with the multiple you know customers or excuse me providers out there as merchant acquiring solutions if you look at their customers like uber spotify wise crocs they continue to send more volume to them each year on average now not every customer is going to do that now braintree has really discounted themselves in north america to take a little bit of share but

again. On average, it has worked. And there's also evidence here in their superior, I'll call it gross volume churn. Actually, that's what they call it, which means the payments volume from the prior year that gets churned away to a competitor in the existing year. So that number is less than 1% and shows that Addian's products are sticky and superior to legacy products since virtually none of its existing customers switched their payment volumes over to the other merchant acquires. Now, they also had a quote from the recent conference call that they said, again, to reiterate, they saw more than 80% of their growth come from existing customers, as well as less than 1% of volume churn. So even with the pressure from Braintree, they're still getting

80% of their growth from existing customers and this really low churn. I think that shows that they do have competitive advantages. So to sum it up, we're going to kind of qualify what their competitive advantages are. I think they have multiple ones. First is the process and technology. I mean, I think that's pretty clear. Management principles, positioning versus the bundled solutions. Second, and this one might be a little confusing. I'm curious your take on this one. I think they have a bit of an economies of scale here because they can offer a better value prop if they want it through volume discounts, the bigger they get. Also, they have all these different products across all these different geographies.

That is really, really tough for an upstart to compete with. What are your thoughts maybe to pause there on the economies of scale? It makes sense, but we don't really see that. They were asked on the conference call, would you discount because your incremental margins are really high? would you discount for bigger customers to try to you know compete against brain tree and they kind of said like i don't know they kind of shrugged it off and so it doesn't seem like they're inclined to do it what's interesting though is they i think they have that competitive

advantage but they have these other competitive advantages through process right that they actually don't need to pull that lever so actually i think that's kind of a positive right where they have economies of scale but they their margins are so fat that they actually don't they don't to use them and the last one and have a switching cost you know even though they have multiple processor you know here multiple excuse me merchant acquirers here adding another merchant acquire to your system is you know not something you can just turn on overnight you're not going to have 12 of them and you can't switching the volume like it's a big risk one and switching it across everything or you know point of sale solutions if you're adding on more than just the

online checkout button and you're adding all of these things that add-in offers which people are are doing more and more over time, and they're adding on more products over time in more geographies. I think there are some switching costs here. And with the economies of scale advantage, which again, they're not really implementing, but I think is there. I think that can only improve over the next five years as they expand. And the switching costs should only expand as competitive advantage. I think the process one will probably be the same, but it's quite strong, probably the most important one here. But I think the economies of scale and switching costs really will help as they grow at the point of sale stuff, card issuing,

you know more checkout landing pages but tightening its relationship with the large merchants that again already have one percent volume churn i think i have a lot of other stuff here but it's kind of just going over the same thing anything else ryan before we move on to the management team i think the most telling like the most telling thing about the competitive advantages here is the volume growth like 32 billion to 800 billion dollars in seven years that doesn't happen on accident that doesn't just happen because you have a good sales force that happens because you have a better product and i mean that's the biggest proof for me i mean a 60 percent cagger over seven years is pretty insane and they've

I'm glad you brought up that stat because I had some skepticism over them just saying that we have higher authorization rates, but just looking back, I think the proof's in the pudding. Yeah. I think there's a lot of good stats out there that show, hey, people like this product and they're not leaving. And all the other competitors, except for the modern ones that we talked about, have way worse solutions that are probably impossible to fix.

Okay. Now, we talked about management, but I want to reiterate here because we do have to answer this question every time. So why do we like the management team, Ryan, and do we trust them? This will be a short section, but I just want to close things out with management. Well, Peter, the CEO, owns a lot of equity. I think it's about 3% of the shares outstanding, which today, I don't know what the market cap of the enterprise value is, but probably close to half a billion dollars or something

like that. So he's wealthy and it's because of his add-in ownership. And the organization has consistently been self-funded. They could have taken way more capital in if they wanted to early on, but they chose to build on their own. They were generating 60% revenue or volume keggers without this employee to revenue one for one increase. They were doing it because, like I said, they had a superior product.

And I just really love their cost conscious efforts. I mean, they mentioned that they don't pay anyone in the company more than a million euros, which like I said, that's a bit of a risk, but the fact that they've been able to grow and do so profitably all this time without raising capital and just bolstering your employee base, I think that it really shows or it's a good testament to the management team. I mean, you just kind of have to listen. like i don't know what to say for the like do we trust them yeah i guess it's like he seems like an

honest guy yeah like a lot of times when the not so deep guys will get to a conclusion of hey i don't know if i trust this management team and yeah we're not going to be perfect on that but in this case i think i do trust them and i think there's evidence that we should so not for me i trust them because they have again like ryan mentioned long-term focus they're zigging while others zag with the employee acquisitions, right? So they are currently, and we'll talk about this in the valuation section, they really increased their employee, I guess, hiring over the last few quarters. And that's because there's been a big downturn in the software market.

So there's been a lot of smart employees they want to go after. It's opening up. There's a bit more attractive on a salary front. And now they're going after that. And they're going to do that for the time being and really overhire for the next couple of years. But then they said, okay, we're going to really slow down. I also like, or go ahead, Ryan.

Like the question is tough. Like do you trust management? Sure. That doesn't mean it's going to work out. Like any management team can fail, but at least in this case, we know they're not going to be picking our pocket while they do it. Like they're not just going to be ripping RSUs. Yeah.

Like just tons of options and getting paid $15 million a year to burn money. Like it's a management team that cares if they fail, they fail. But at least we know they're in it with us. Yeah. And they're a founding team. They have a track record that is highly impressive. Again, I would mention that 57% payment volume CAGR. They have the lean organization.

And yeah, it's hard to describe with a bunch of numbers, but this is probably in my top five of management teams for kind of new companies, right? For maybe it's founder-led or maybe it's just modern companies. Some of them might not be founder-led anymore. And I would think along with them in my top five would be an Airbnb and a coupon. long curious if you're putting them in that same category ryan current management teams yeah probably up there yeah i haven't owned them for long enough to really i probably have like a better appreciation for companies that we've owned for a while that management teams we like but

it seems like they do a very good job of running their organization for the long term and that's kind of what you get with founder management teams yep and i will say that is a good disclaimer we don't own shares of adiant today uh but if you're catching our i guess tone here or you know what we're alluding to our conclusion is going to be that we do like the business so we could easily own it next month next week a year from now so just full disclaimer there we are biased all right ryan i think we like the business yeah that's pretty clear let's do the valuation work, run through the numbers. Is the stock cheap? Maybe give some estimates on what you think they could earn. Yeah. So again, all numbers here are going to be in euros.

Makes it a little complicated for them, but we do not do complicated models. Generally, we're just looking at getting confident on the competitive advantage in the management team, which we are as we've concluded throughout this episode, and then trying to buy at what we think is a conservative price. These projections have a 99% plus likelihood of being wrong, but I'm going to go through them. For context here, in 2022, Adyen generated 1.33 billion euros in net revenue at a 55% EBITDA margin. We're comfortable here using EBITDA margin because Adyen with minimal capital expenditures, high net cash position, and the ability to earn interest income, I think generally free cashflow should not be too different over the long-term from EBITDA.

In the first half, though, of 2023, Adyen's EBITDA margin sunk to 47.4%. And then over the long term, management believes it can hit 65% EBITDA margins after it gets through this period of intense employee onboarding. So that's kind of the main context we think of here. Now, for our forward estimates, we only went out to 2025 when we made two assumptions. 20% average net revenue growth, and a range of EBITDA margins from 40% on the downside to 65%, which is management's long-term target. And what we came out to was that, well, this is not an estimate, but then we'll have four kind of earnings multiples here.

The first three are estimates or basically look through ones at what we think they could earn. The first one is what they actually earned. So if we look at first half trailing 12-month EV to EBITDA, it is 28.8. Now, if we assume they could earn a 65% margin, that comes down to 21. And then if we go out to 2025 off of our estimates, they would have a EV to EBITDA margin at, or excuse me, I should be clear, an EV to EBITDA multiple at a 40% margin of 19. Then under the most optimistic scenario, at a 2025 EV to EBITDA at a 65% margin, it would be down to 11.7. I'll share the chart here, but Ryan, just for a little context for everyone, and again, it'll all be in the newsletter. But Ryan, any thoughts there generally before we kind of go to the final decision?

Well, they say something they talked a lot about is that they have a lot of control over their margins. It's all salaries, pretty much. They're just paying their workforce. Now, I think it gets harder to control the more employees you add, which is a risk they're kind of taking. But if they think they can get to 65% and they've done it in the past, I think they can do it again. So, I think a 65% long-term normalized margin is a fair estimate. And yeah, it seems cheap, assuming that they can continue to have solid growth rates. It doesn't need to be 60% from here.

If it's 60% from here, then just buy the stock. Yeah. Not advice, but just saying. Yeah. Don't expect that growth rate from here. Yeah. All right. What price would we buy it at or would you buy it at?

Okay. So on the one hand, the stock looks cheap. If you think you could easily get back to 65% margins, I think they can do that due to the fact that after getting to net revenue, like Ryan mentioned, the only costs are R&D marketing, maintaining the systems and corporate overhead, which is all employee costs. And they're very good at being disciplined on that. There's also a ton of operating leverage here. Basically, they've been able to grow with the same employee base and then you're growing

your net revenue at 30%. I mean, margins are going to expand. So I think they can get back to 65%. I like their chances of growing at a double digit rate every year this decade. I think they can probably grow at 20% for the next few years. And I think given their long-term advantages versus the legacy ones, they can probably grow at a double digit rate, especially because inflation helps them out. However, I do want a bit of a margin of safety because things can go wrong on the margin side, I think, from a competitive front. I think we're pretty close to where we want to buy, where we're looking for, again, like when we want a high quality growth business who we would like to buy maybe at 20 times-ish earnings, give or take, and we're pretty close

there but again if margins are compressed okay the ebitda multiple is 29 right now so yeah curious your thoughts it i tend to like the idea of not paying more than 20 times my estimate of current year earnings because i've done it before we've done it before and i was wrong on the growth rate. And then suddenly multiple compression kicks in and it's a much worse investment than you might think. Right now it's at 22 times trailing EBITDA. EBITDA is honestly not that bad of a proxy for earnings for this business, just given that they don't really put a lot of money into stock-based compensation and it's really cash heavy, like the balance sheet. I don't think they have any debt. EBITDA might underrate it, honestly, because of the

Free cash flow has been higher than EBITDA over the years, but I think it feels like if I'm waiting for 20 times earnings, and it's at 22 times, and it's a business that's grown volumes of 57% off of a $32 billion base, which is not small, so gone from 32 billion to 800 billion in seven years, and I'm like, I won't pay 22 times, but I would pay 20. i'm haggling over pennies and it feels like i should just be an owner yeah and i would say it's theoretical earnings right the actual trailing ones are 28.8 29 but yes i agree with you there so i'm oh i'm using evie uh yeah but you're using a 65 margin i'm just using the

trailing EBITDA? If you had a trailing EBITDA, I'm pretty sure it was at 22 times. Unless Koyfin was wrong. Koyfin was wrong. Okay. Yeah, I did that earlier. What's that? So what's their...

28.8. No, what's their last 12-month EBITDA? Oh, 692 million euro. Okay. yeah well that might change my answer yeah third so basically 30 times if you do sure yeah so yeah it might change my position sizing how about that

yeah uh that's i that's why i kind of think a little lower that's why i'm in camp of a little lower before you add anything yeah okay i mean i still think it works from here but i trust the management team a lot but yeah this kind of gets into the next question which we're going to talk about what scares us as for an investment natty and which is we've studied a lot of payments businesses now and it gives me the sense that i i think i it's in my circle of confidence but i also worry that i know just enough about payments to really be dangerous and hurt my returns because maybe i don't understand the differences in authorization rates between jp morgan payment tech in the u.s and add-in like what if the authorization rates are not that different

yeah i mean there's times when jp morgan's speaking from issuing bank to the merchant banks and like they're just talking to themselves they've got to have a high authorization rates on that yeah but i would also add that that hasn't been different than 2015 so even if that is true they have had a history of gaining market share yeah it is a concern though there's a ton of uncertainty in general even if you understand the space right a lot of disruptors now adyen with their no acquisition model you know we do think they have a competitive advantage and the management team uh is very strong i think but yeah my biggest concern concern is the threat on pricing which leads to the threat on ebitda margins because i don't think like braintree is having too much of

an effect on them right now because like okay but look if we can see from their ebitda margin they could still you know remain profitable both of these companies if pricing comes down a lot so So in general, we think the fatter the margin, the wider the competitive advantage needs to be. If we're going to buy a business such as Adyen and think it back to 65% EBITDA margins, I think we need to be confident that it has an extremely strong competitive advantage. I'd be much more comfortable maybe betting that it has 40% to 50% margins. And I do think Adyen has a strong competitive advantage today, but not nearly as strong as someone like Visa. But then on the other hand, I know I'm flip-flopping a lot. I think if things go right for Adyen, they could have as strong of a mode as Visa does

today, but in 10 years, maybe not as strong as Visa's would be then, but given the scale they could get to, I think that they could have a very impressive and competitive advantage, especially given the competitive set out there. Yeah, I agree. And I'm afraid we might be kicking ourselves down the road for like, after they've demonstrated that they can have 65% EBITDA margins. We were like, we don't know if they can really get to that margin. That's true.

Yeah, I know. Because it is cheap if you think it's at 65% margins. So I think this is a big question for any listener. And they didn't do a very good job answering that on the call. There wasn't a lot of color. And I think that's part of them as a management team is they don't care about what EBITDA margins are going to be next year. And there was a lot of questions that were like, is it going to get worse?

basically analysts concerned and they're like yeah maybe yeah yeah we don't know the timeline yeah there's a little bit of uncertainty there but i think that's a good way to wrap things up ryan anything to close out before i do the disclosure no i think that's it wait what was our conclusion i i don't i don't want to buy these prices but it's high on our watch list it's very close let's see what the price is right now so as we're recording the european price is 705 and 7 cents honestly two days ago was that like 650 which would probably be at the buy price but i think around there is where i'm more comfortable i know it's a bit nick picky but that's on it's like the top of our when it's close to the top of the range of kind of where

you would buy i think you can't just like get too lenient on that because we're already getting a little bit lenient here even if we assume they hit 65 yeah agreed all right well that's going to do it for this episode. Thank you everyone for listening. Again, as a disclosure, we are not financial advisors. And if 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. If you want the show notes, charts, graphics, all that good stuff, subscribe to the newsletter in the show notes. Thank you everyone again for tuning in. Hope you learned a lot from this episode and we'll see you next time.

Thank you.