A closer look at PayPoint

PayPoint passes a lot of tests which suggest that it has the makings of a good investment.

Above all else, its business is fairly easy to understand. The PayPoint logo is a common sight outside thousands of convenience stores and local shops in the UK and Ireland. It also has a business in Romania.

Inside these shops is a PayPoint terminal which allows customers to do lots of things such as pay utility bills, pay council house rents, buy lottery tickets, top up the credit on a mobile phone and send money to other people. The terminal also helps retailers process debit and credit card transactions. In return, PayPoint gets a small slice of the money spent. When millions of these small slices are added up, PayPoint has been able to build up a very profitable business.

If we have a look at some key financial ratios in SharePad then PayPoint looks as if it is a very good business. I'd go as far to say that PayPoint has many of the desirable characteristics that many investors would love to see from the shares in their portfolios.

The first check I always do when looking at a company is to see what kind of bang it is getting for its buck - its return on capital employed or ROCE. PayPoint passes this test with flying colours.

Like most technology companies, PayPoint doesn't require a huge amount of investment in assets compared to the size of its profits. This means that it is capable of making very high returns on investment. ROCE (the first or green bar) is well over 40% which is excellent. That said, the trend in ROCE has been moving steadily downwards compared with ten years ago but has stabilised in recent years.

Even more important is an ability to generate free cash flow and earn high cash flow returns (for more on the CROCI measure click here). Again PayPoint scores well. Not many companies have a consistent CROCI of over 30%. This is a sign of a very good business indeed.

As well as looking at returns on investment, I also think that it's a good idea to look at profit and cash flow margins (how much turnover gets turned into profits and cash) as well. Companies with high profit margins can withstand a few setbacks in their trading activities a lot better than those with low margins. This makes these types of companies generally safer investments - providing new competition doesn't try to grab a slice of those profits.

Here PayPoint scores well too. Cash flow margins (free cash flow to the firm as a percentage of turnover) are around 14%, whereas profit (EBIT) margins are more than 20%. Both measures have been trending upwards which is an encouraging sign.

Now look at the chart below. PayPoint also converts a very large chunk of its after tax profits (earnings per share) - the first or green bars - into free cash flow (the second or red bars). Investors should generally take comfort when a company's profits turn into free cash flow as it is a sign that the quality of profits is high.

PayPoint's high levels of profitability and free cash flow in recent years have seen it pay out bigger dividends to its shareholders.

That said, the cost of the dividend is taking up a bigger chunk of the company's free cash flow. Free cash flow dividend cover (free cash flow per share divided by the dividend per share) has been trending down in recent years and needs to be watched closely. The current trailing twelve month (TTM) dividend per share of just over 40p doesn't look under threat just now, but perhaps the rate of growth will slow down.

PayPoint's finances are in very good shape. It has no borrowings, virtually no hidden debt and has net cash balances of over £40m.

So PayPoint is making high returns on capital, has lots of free cash flow and what looks like a squeaky-clean balance sheet. So why are its shares falling and underperforming the stock market?

Bills & General

Bills & General (£m)	2010	2011	2012	2013	2014	2015	TTM
No. transactions (m)	339,801	350,970	383,332	432,793	445,597	459,018	461,209
Transaction value (TV)	5,925,249	6,198,171	6,757,902	7,751,965	8,306,601	8,485,736	8,570,272
Revenue	58,564	57,889	64,001	79,783	85,341	89,229	88,951
Net revenue	33,586	33,806	37,390	48,104	54,000	58,954	59,253
Net rev as % of TV	0.57%	0.55%	0.55%	0.62%	0.65%	0.69%	0.69%

The Bills & General segment is the biggest part of PayPoint's business. A large chunk of revenue comes from cash payments for gas and electricity prepayment meters. Energy companies are installing more of these which might be good news for PayPoint.

That said, the move to smart meters by 2020 is opening up different ways for prepayment customers to pay their bills in ways other than cash in their local shop. PayPoint has developed a new service to cater for this which seems to be going down well with energy companies.

PayPoint's net revenue - after commissions and other costs are paid to shop owners - is nudging up very slowly in this segment as growth in Romania hasn't been strong enough to offset a sluggish period in the UK. PayPoint has been successful in getting a bigger slice of net revenue from transactions though - probably by paying less commission to retailers.

Retail Services

Retail Services (money transfer, credit and debit card transactions, SIM Cards and parcels) is faring a little better as there is some growth.

Retail Services (£m)	2010	2011	2012	2013	2014	2015	TTM
No. transactions	38,901	48,425	60,493	73,785	92,308	118,849	130,810
Transaction value (TV)	377,271	394,727	426,527	522,929	667,303	874,449	986,171
Revenue	16,168	19,602	23,659	27,707	35,883	42,294	45,112
Net revenue	8,684	10,827	13,844	16,817	22,105	26,507	28,611
Net rev as % of TV	2.30%	2.74%	3.25%	3.22%	3.31%	3.03%	2.90%

Overall though, PayPoint's net revenue growth across its core business is struggling to grow.

The company has tried to capture the growth in internet and mobile payments over the last few years but has not been able to make this business profitable and has decided to sell it.

It has also formed a joint venture with the parcels company Yodel (called Collect +) to exploit the rapid growth in click and collect services from retailers such as Amazon and John Lewis. PayPoint retailers are a convenient local place to collect parcels and return unwanted ones and has grown strongly.

The business is making a small profit but PayPoint's problem is that Yodel wants to charge more money to shift parcels around the country which will lower the profits of Collect +. It is by no means certain that this business will create a lot of extra value for PayPoint's shareholders.

PayPoint is hoping that its new terminal will help retailers with other parts of their business (such as stock control) which in turn will allow it to get more of them on board as customers. That said, PayPoint remains vulnerable to increased competition in payments from services such as Apple Pay and online services. The risk for shareholders is that a new rival product could see its customers go elsewhere.

Perhaps PayPoint will enter another developing market like Romania where cash still accounts for a lot of personal spending transactions. This might provide the company with a source of future profit and cash flow growth.

To sum up

1. PayPoint has many hallmarks of an excellent business.
2. It has high ROCE and CROCI.
3. Its financial position is very strong.
4. It is struggling to grow its sustainable profits and cash flow.
5. Growth in Romania is not enough to offset a sluggish performance in the UK.
6. The dividend is taking up a larger slice of free cash flow.
7. Dividend growth may slow down after 2016.
8. The company might be vulnerable to increased competition in payments technology.
9. The shares don't look expensive but might not be cheap if profits and cash flow cannot grow.