Staying out of Touchcorp

One-off work has made payment processor Touchcorp look cheap, but we are not convinced it’s sustainable.

At first glance, global payment software business Touchcorp is a screaming bargain. To explain why, you need to know only two basic facts.

Assuming you had a spare $240m lying around and purchased Touchcorp outright, you’d receive $16m in annual operating earnings (before depreciation and amortisation). That’s not a bad start. Then there’s the fact that included in that $240m purchase is a $142m investment in fast-expanding retail payments solution Afterpay. Exclude that from the valuation and you’re paying five times operating earnings for Touchcorp’s core business.

Key Points

  • At first glance, company looks cheap

  • However, we have some concerns

  • Not initiating formal coverage

Intriguing right? We thought so too, which is why we took a closer a look. Unfortunately, Touchcorp is not as cheap as it seems but, if a much lower price emerged, we might be tempted. To arm you for that possibility, here’s a summary of the analytical legwork.

The nuts and bolts

Retailers use Touchcorp’s software to facilitate the sale of non-physical products like mobile phone credit, iTunes cards, Medicare payments and even fishing licences. By installing Touchcorp’s software on point of sale systems (EFTPOS) retailers can sell over 600 products, in return for which Touchcorp takes a small slice.

Table 1: Summarised financials
Year to 31 Dec ($m) 2011 2012 2013 2014 2015 2016F
Transactional rev. 16.0 17.8 24.0 26.8
Development rev. 1.1 1.3 0.8 15.5
Total rev. 6.8 17.1 19.1 24.8 42.3 44.0
Gross profit 5.4 13.8 15.8 19.3 35.3  
EBITDA (6.3) 2.6 4.4 5.8 13.2 16.2
EBIT  (6.8) 2.1 3.9 4.9 12.0  
NPAT (7.0) 1.8 4.1 13.5 9.4 12.7
Operating cash flow 0.5 1.7 7.7 3.2 (3.4)  

Now 16 years old, Touchcorp’s network extends to more than 56,000 retail locations, although Optus, 7-Eleven and European convenience retailer Valora still make up half of transactional revenue. Customer concentration is a big risk. But when you consider the long-standing relationships, and the fact that the retailer pays nothing for ongoing use, there’s not much incentive to change. Indeed, Optus recently extended its agreement with Touchcorp to 2021.

In the first half of calendar 2016, the company generated $44m in transactional revenue (on an annualised basis, as illustrated in Table 1). The potential for this figure to grow dramatically is what got us interested. Touchcorp software is compatible with almost any hardware and operating system, which makes it a product with global potential.

In the last two years the company has struck agreements with European convenience retailers Retain and Once, both bigger than 7-Eleven’s Australian operations. Its contract with Valora is also being extended and further agreements with Cornercard and Changeup, two financial services businesses, adds to the growth profile.

Having your cake and eating it too

What of Afterpay, a recent ASX entrant? Last year it contracted Touchcorp to provide the payment backbone for its buy now/pay later business. Afterpay was a start-up at the time and lacked capital. So instead of paying cash, it gave Touchcorp most of its development fee in the form of Afterpay equity ($10m in value in fact). What happened next was incredible good fortune.

Afterpay has become a huge hit with retailers, growing its network from 100 to 600 outlets in less than seven months. Touchcorp benefits from the growing transactional revenue, which it doesn’t have to pay to generate, and the growth in Afterpay’s market capitalisation. Since listing at $1 a share in May 2016, Afterpay’s share price has tripled. Touchcorp’s original $10m stake is now worth about $142m.

Despite ‘14-bagging’ in around a year, it's too early to call this the investment of the century. Touchcorp cannot sell its Afterpay shares until May 2018, so today’s price means very little. With a market cap of $467m but just $1.4m in revenue last financial year, Afterpay has a long way to go before its market value stands up.

Our concerns

Excluding the value of its Afterpay investment, Touchcorp is trading on an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple of 14 times. That could turn out to be very cheap if the new European contracts make a meaningful contribution. What concerns us is the sustainability of core earnings.

In its 2015 prospectus, Touchcorp claimed it derived almost all its revenue from recurring transactions. That’s no longer the case. After the large contracts with Afterpay and Changeup, only half today’s revenues are recurring, as Chart 1 shows. Recent earnings growth, and the higher share price it has provoked, is due to one-off development work.

Table 2: Declining transactional revenue
  1H15 2H15 1H16
Transactional revenue 12.9 13.9 11.1
Development & integration revenue 5.5 10.0 11.1

Operating earnings (before depreciation and amortisation) were $8m in the first half, but they would be significantly lower without the same volume of development work. A future lull in this area would create a large earnings hole, making it hard to justify Touchcorp’s current share price.

These concerns aren’t allayed by the decline in transactional revenue in the first half of 2016 (see Table 2). Touchcorp’s presentations suggest the contrary, but we cannot verify this claim using the reported figures. Something doesn’t add up. Add to that concern a short listed life and a Bermudan incorporation, both of which have the potential to turn up nasty surprises.

Touchcorp does have some very attractive features but we’d need more evidence of the sustainability of earnings growth in its core business before we could consider recommending it. Plus a lower share price. So, close but no cigar. We won't initiate formal coverage at this point but it's one for the watch list perhaps.

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