Why our confidence in EML has increased

News of a potentially highly effective COVID-19 vaccine has provided a welcomed boost for so called ‘out and about’ stocks which are viewed as key beneficiaries of an economic re-opening scenario. Over the past few months, the Montgomery Small Companies Fund has been busy seeking ‘vaccine insurance’ to position the portfolio further towards the re-opening trade.

Here, we have been focused on identifying well-run businesses with a clear and sustainable competitive advantage which ultimately should deliver strong market share gains along the journey back.

EML Payments (ASX:EML) screens particularly well from this standpoint so we have lifted our exposure within the Fund. The global Fintech was a market darling heading into the pandemic, demonstrating rapid growth and operating leverage across its capital-light, technology-rich digital payments processing platform which enables Fintech clients to disrupt their respective markets. However, the onset of the health crisis saw the stock aggressively sold off as the majority of EML’s earnings stem from the shopping mall gift card business (Gift and Incentive segment which includes malls represented 63 per cent of FY20 gross profit), predominantly within Europe and the US which were disproportionately infected.

FY20 results

At the FY20 results in August, the company confirmed that its malls business had suffered from closures, social distancing and unmanned kiosks over March through June, bottoming out in April which was down 87 per cent relative to February. Despite this, the company remained cashflow positive during the lockdown period which was a much better outcome than the market had feared. Recent trading has shown continued improvement. Encouragingly, EML’s higher-growth reloadable segment proved resilient throughout the pandemic, continuing to deliver double-digit organic growth, launching new programs and signing up new clients.

1Q21 trading update

EML provided a solid 1Q21 trading update in October, highlighting ongoing strong reloadable growth, significantly improved trading in the Gift and Incentive segment and good cash generation. Notwithstanding a seasonally soft trading period, first quarter Gift and Incentive volumes recovered 41 per cent on 4Q20 and came in just 11 per cent below the prior corresponding period, well ahead of market expectations. 1Q21 EBITDA was $10 million, a strong result against a tough backdrop.

The Christmas effect

The December quarter (2Q) is the crucial trading period for EML’s Gift and Incentive division with around 45 per cent of segment volumes generated in November and December (Christmas sales). The near-term outlook remains highly uncertain considering rapidly rising COVID-19 infections and lockdowns across Europe which could be extended into December.

To help analysts setting their forecasts, EML disclosed that the 2Q seasonal uplift in gift card volumes in FY20 (pre-COVID) was worth around $0.4 billion generating c.$24 million revenue (6 per cent revenue margin) and $19 million gross profit (80 per cent margin). Consequently, annualising 1Q21 EBITDA of $10 million equates to a $40 million baseline and then analysts can make their own assumptions around the COVID-19 impact on the seasonal uplift occurring in 2Q21. With consensus FY21 EBITDA sitting at $53 million, we estimate an implied 30 per cent adverse impact to the second quarter seasonal spike. This looks reasonable although certainly not without risk.

Perhaps more importantly, the recent encouraging vaccine news materially increases confidence in a solid earnings recovery in FY22. Market estimates are for EBITDA to rebound 40 per cent in FY22 to $74 million, still well below pre-COVID expectations of $95-100 million.

Looking back, one positive arising from the pandemic was EML’s ability to reprice and restructure the Prepaid Financial Services (PFS) deal in late March, allowing the company to retain a strong balance sheet ($118 million net cash as at the end of June) which offers optionality for further acquisitions. Valuation remains attractive for the growth potential of the business, in our view, with the stock trading on 12x recovered EBITDA (FY23 EBITDA $93 million).

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