Regulator's concerns about EML Payments appear to be easing

Regulatory uncertainty has been a material overhang for EML Payments’ (ASX:EML) share price since mid-May 2021, when the fintech first informed the market that the Central Bank of Ireland had raised regulatory concerns relating to the recently acquired Prepaid Financial Services business’s anti-money laundering and counter terrorism financing risk and controls.

The initial market reaction to this unexpected news was nothing short of extraordinary. When the shares resumed trading, investors wiped $875 million (around 45 per cent) off EML’s market cap.

EML paid $225 million upfront for Prepaid Financial Services in late March 2020, so the market effectively repriced PFS to zero and devalued the underlying EML business by $650 million.

We thought this was an overreaction and bought more stock. Although we acknowledged the risk of PFS losing its European banking licence and facing a substantial fine, we saw this as unlikely.

Recent updates on EML’s regulatory correspondence with the CBI suggest that regulatory concerns are easing, which we think materially de-risks the investment case.

At the annual general meeting on 17 November, EML provided some colour on the CBI’s concerns, which mainly relate to PFS’s rapid growth.

This is against a backdrop of heightened regulatory scrutiny of the digital payments sector, particularly in Europe. The CBI regards e-money institutions as inherently high risk and expects these institutions to have very strong AML and CTF frameworks.

Importantly, the CBI has not identified any instances of financial crime, AML or CTF events, nor deficiencies with respect to safeguarding, capital adequacy, or solvency measures.

EML’s AGM update also highlighted that PFS has established a positive working relationship with the CBI and made solid progress on a comprehensive remediation plan to meet the bank’s concerns.

This remediation plan is on track to be substantially complete by Christmas 2021 with any residual items to be finalised by March 2022 and EML expects all outstanding issues will be resolved.

The remediation plan is focused on PFS’s control frameworks and will result in increased overheads (people and systems) to meet or exceed best practice and CBI requirements. In time, EML will look to identify efficiencies to mitigate these higher operating costs.

Consensus appears to be factoring in an incremental $5 million of ongoing costs, which makes sense to us. Additionally, in 2020-21 EML took a $11.5 million one-off charge which included provisions for remediation, advisory services related to remediation and a provision for potential fines. So the extent of the cost impact is now understood.

On 25 November, EML announced that the CBI has decided to allow PFS to sign new customers and launch new programs within (undisclosed) material growth restrictions.

Considering new program establishment fees are very high margin and the deep pipeline of new programs, this update somewhat eases a key concern for investors: can PFS continue to grow and take on new business?

EML has 313 deals within the pipeline representing an estimated gross development value of $10.5 billion, potentially worth $40-50 million in revenue in three to four years’ time (assuming a 40 per cent win rate and a historical yield).

To help manage the central bank’s growth concerns, EML has already eliminated some legacy, high volume and low margin programs to create headroom for growth at better margins.

Furthermore, the CBI will not impose broad-based reductions in limit control programs, rather the regulator will continue to engage with PFS with a view to agree appropriate limits under its risk management and controls framework.

This decision suggests the CBI is acknowledging that programs across different verticals and industries warrant different limits, as opposed to taking a blunt instrument approach to the whole program portfolio.

We also learned that the CBI will only impose these growth limitations over PFS’s payment volumes for 12 months or potentially less, subject to third party verification that PFS’s remediation plan has been effectively implemented. We view this as a major positive development because it puts a specific timeline on the growth restrictions which is relatively short.

EML operates within a highly regulated industry that is undergoing rapid change and is therefore attracting heightened scrutiny.

Although the company has been forced to invest in order to satisfy the CBI’s growth concerns, these costs are now built into market expectations and we see scope for the stock to re-rate as the company demonstrates PFS’s strong growth potential. Despite the recent rally, EML’s share price remains 33 per cent below pre-regulatory concern levels.

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