Is this undervalued stock primed for a rebound?

After a variable 1H22 report earlier this week, investors were quick to focus on the downside, but there is plenty of room to grow from here, says Lakehouse Capital's Erwin Tan. 

Payment solutions company EML Payments (ASX:EML) got a kick in its share price, falling 8.7% to $2.67 on Wednesday on the back of a 4% drop in earnings to $26.9 million. 

The company also reported higher establishment fees and overhead costs - up 24% to 48.5 million, its largest increase in over half a year - in conjunction with regulatory troubles in Ireland, with provision for legal costs estimated to be $10.5 million. 

But even with the cool market reception, Tan believes EML's long-term growth story makes it a buy:

"EML was still able to grow the business with revenue up 20%, which was mostly organic. And then you also have more customers lined up to be onboarded. 
"I think it looks like a recipe for long term revenue growth."

In this wire, Tan provides a rundown of the best and worst points in the half-year report, and why EML's expansion and customer revenue opportunities still rate it as a long-term buy. 

EML Payments key results 1H22

• Gross debit volume (GDV) up 206% to $31.6 billion
• Revenue up 20% to $114 million
• Underlying EBITDA down 4% to $26.9 million
• Net Profit After Tax (NPAT) up 6% to $13.1 million
• Underlying operating cash inflows down 58% to $14.7 million
• No dividend

Edited transcript

What are your main takeaways from the result? 

Erwin Tan: The key takeaway there was this was a tough half for the business. You have negative rates weighing down on interest revenue, the CBI (Central Bank of Ireland) issue, the increasing compliance cost for the business. They're also slowing down client onboarding. So it also affected upfront establishment fees, plus it slightly affected the gift card business during the holiday season. So it was tough, lots of things happened, but despite what seems to be a negative result, there are reasons to be upbeat about the company, mostly because these things are not permanent. 

To give a few examples: interest rates are already starting to go up. The Bank of England already increased the rates by 40 basis points and other central banks are likely to follow suit. The CBI remediation is expected to be fully done by June, and then the cap on the material growth restriction lifted by December (or possibly earlier). 

Establishment fees will come back once the company starts winning new clients and onboarding them in Europe. It's the same story for malls. In fact, the volumes for the first half are already 6% higher than pre-COVID levels. So, there's some room to move for the business. 

I think the only thing that sticks here would be the increase in compliance costs. So, if you look at it in the short term, you would see that this might be a hit to profitability. Fair enough. But with the long-term view, I think the overhead cost would not go up at the same level and revenue would keep going up. And so margins would eventually follow. 

The main positive here is that with all that happening, EML was still able to grow the business with revenue up 20%, which was mostly organic. So despite all this happening, there is reason to be enthusiastic about EML's future. And I think patient investors would be rewarded here over the long run. 

What about the market reaction? Was it an overreaction, underreaction or appropriate?

I have to put a caveat that I'm not the best person to comment on short term reactions, that's why I'm a long term investor. But given that, I think it's the right initial reaction to the stock given half year numbers, the loss of interest revenues, establishment fees and the higher compliance costs. You have a step change of lower revenues for the management fees in the interest rate, but also a step change higher on the compliance costs, with management already guided to full year numbers. 

I think what people did not expect was how it varies from half to half and the downgrade was not equal across throughout the year, and it's more pronounced during the first half.

The stock was down almost 10%, but as the market digested the update the stock recovered during the course of the day. I think it was fairly digested by the market, but this is more of a 'show me' kind of story. Over time as the business reports their progress, I believe the share price will follow. 

Were there any surprises in the result investors should be aware of?

Yes, the variability between the first half and second half. It's the impact on the guidance that they gave for full year and how that kind of actually plays out. While that's on the negative side, Cregan also mentioned on the conference call that they were expecting a few ASX worthy deals to be announced in the next four to eight weeks. If they're ASX worthy, they would at least be seven figures in terms of revenue contribution for the business. So I'm personally excited to see what that would be, what new verticals you get. We'll see how it goes.

What are your expectations and outlook for EML and the wider payments industry?

I think when people look at EML, people usually associate it with the verticals they operate in. So malls, gaming, government. Their main space or theme that they operate in is embedded finance. 

It's not a new concept or anything, but it is one that plays out over years. I'll explain this way: I played with a lot of Lego when I was young, the blocks for kids. So think about a bank's service offering; each service is akin to pieces of lego that are ultimately connected to form the bank's overall service proposition. In EML's case, one block represents payments. Another block would represent loans, and so on. You're taking one block at a time by taking a specific financial service and embedding it to your own service, offering to enhance it. 

A lot of other non-financial companies are offering financial services. If you think about Uber, they're offering wallets to keep their drivers sticky. So it's long story short. Every company I think will become engaged in FinTech. When you think about the space, I think we're still super early. EML plays in the card space and that is just one Lego block in a huge market. 

Is EML a buy, hold or sell?

For us, we've invested in the business for a long time now, and it's obviously a buy. It's one of our core holdings in the Lakehouse Small Companies Fund, and despite what you may see on the headlines, I think this is a pretty sticky business with a loyal customer base. The CFO talked about this again yesterday: he said customer churn is less than 1%, or maybe a fraction of 1% over the three years cycle, and this half you saw that the CBI kind of capped the number of companies that EML could onboard. So the growth in the business is mostly with existing customers who spend more or generate more revenue over time.

And then you also have more customers lined up to be onboarded. So I think it looks like a recipe for long-term revenue growth. It's also an interest rate beneficiary and with exposure to malls and economies fully reopening. We see hiccups like the recent CBI issue, but a few years ago people were worried about specific contracts, like with Caesars or LuLaRoe or the death of malls because of Amazon. 

If you zoom out on what started out as a gift card business with one client in a single country you'll find a global business with multiple product lines, with no single customer with more than 5% of revenue. The price of admission for long-term outperformance is you are subject to bouts of market volatililty. However, in my view, the growth in this business is likely to reflect in the share price over time. 

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