paymenttechology 05 2013 30 sector

Financial Technology Technology

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Disruptive risks to the payment services industry

The payment industry has one thing on its side: inertia. This inertia comes from the large installed base and a global network that caters to millions of merchants, billions of consumers and trillions of dollars of transactions. This network is sticky, easy to use and costly to replace. Consequently, it has allowed the industry to maintain high returns with limited investment. The payment industry has historically been a network of banks or their related parties. The sector was mainly self-regulated through powerful industry-based consortia. These consortia also acted as walls, keeping competition away. We believe that over the past five years there have been various significant structural, regulatory, technological and cultural changes, which have lowered the entry barriers. Although inertia still helps the industry maintain some stability in returns, the structural changes will continue to facilitate the entry of new players, which will eventually lead to price deflation and erosion of returns. The industry is in transition from a quasi-oligopolistic model to a flatter and more competitive landscape where not only the incumbents will see declining returns but even the new entrants will struggle to achieve excess returns.

The first major structural change in the industry, in our view, was the Payment Services Directive (PSD) in the EU and UK; this was implemented in 1999. This directive lowered the barriers to entry in the market, making the sector accessible to new entrants. The second event involved technological developments around big data. Data collection and access to data, analysis, warehousing and processing techniques enabled technology companies to bring greater efficiency and cost savings to the industry. The PSD also allowed these technology companies to take a step-up and directly offer payment services, rather than just being technology suppliers to the incumbents. The third catalyst was the economic crisis, which made retailers and merchants more conscious and vocal about the cost of using the payment infrastructure. This has not only made them more willing to consider using alternative payment systems but has also prompted them to lobby for further regulatory measures which reduce the cost of transactions. Due to these changes, the payment industry is shifting from being a banking-oriented function to more of a technology-oriented industry.

Technology innovation and PSD are a dangerous combination for the payment industry. In our view, all the players in the sector will be affected by these changes, ranging from money transfer companies like Western Union and Money Gram; payment-capturing companies such as Ingenico and Verifone; payment processors including WorldPay, Global Payments and Chase Paymentech; to credit card associations like Visa, Mastercard and American Express. Indeed, quite a few technology-based companies have already achieved significant scale eg Paypal and Wirecard.

Some new technology-based companies seem to be claiming that they could be the next Visa or Mastercard, implying that they can match the returns that the incumbents in the industry make or used to make. We disagree. The trends of disintermediation mean that the profitability pool for the whole industry will decline. Companies such as Google can even disintermediate the pricing model and lead the push for zero pricing or pricing at marginal cost.

Ingenico

Sell (from Hold) Current price

EUR 52.97 Price target

EUR 40.00 29/05/2013 Paris Close

Global Payments (Not covered) Google (Not covered) Mastercard (Not covered) Money Gram (Not covered) Visa (Not covered) Verifone (Not covered) Western Union (Not covered) XOOM (Not covered)

31 May 2013

Ali Farid Khwaja, CFA Analyst +44 20 3207 7852 [email protected]


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Payment industry II

In our first report on the payment industry, we argued that cash is sticky and, contrary to the hype, the move from cash to electronic-based transactions has been slower than expected. We also argued that the mobile payment landscape is extremely fragmented, not only by geography but also by technology architecture and industry participant. This fragmentation, we asserted, would make it difficult for early-stage companies to achieve significant scale to reach the profitability levels implied by their valuations (either private or on the public markets). We also argued that the current payment infrastructure is sticky and that although the sector faces challenges from new entrants, the incumbents will be able to maintain their market shares for a long period. The challengers would prompt price deflation across the industry, however.

In this report, we extend our analysis. We have reviewed some of the regulatory and technological changes that have lowered the barriers to entry in the sector. We think three catalysts, namely 1) regulatory changes; 2) big data and technological developments; and 3) political sentiment are leading to significant structural changes in the payment services industry. We believe that as a result of these changes, the deflationary pressures in the industry will deepen eroding the returns in the sector. We have also examined case studies for three payment services verticals where some of these structural risks are already evident. In the last section, we utilise the framework developed by Adnaan Ahmad in his study Tech Titans or Dinosaurs? dated 29 September 2011 to assess the investment implications of these risks. The framework suggests that while the incumbents in the payment industry might be able to maintain earning stability in the short-to medium term, their share prices may come under pressure due to a de-rating of their multiples.

Background: payment ecosystem

Source: Berenberg

ISO /

Aggregator

POS

Payment

Processor

Merchant

Acquirer

Credit

Card

Network

Issuer

Bank

1

2

3

4

5

76

8

9

1 POS captures card data, does pre-processing and provides connectivity

2 ISO collects the transactions and sends it to processor

3 Payment processor does fraud checks. Requests authorisation from merchant bank

4 Merchant bank submits the authorisation request for credit transaction to credit card network

5 Card network send the request to card issuer

6 Issuer approved or declines the transaction

7 Credit network forwards the card issuers authorisation response to the merchant bank

8 Merchant bank credits the merchant accounts and submits the transaction to credit card network for settlement

9 Transmits information back


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Who is who in the payment value chain?

Source: Berenberg

Catalysts leading to structural changes in the Payment Services industry

Catalyst one: Payment Services Directive opening the floodgates

Prior to the implementation of the Payment Services Directive in the EU and UK, the payment industry was mainly self-regulated. This self-regulation was through industry-wide consortia led by the large incumbents, such as the Payment Card Industry Security Standard Council (PCI) and EMV (Europay, Mastercard and Visa). In our view these consortia also created barriers to entry, since it was difficult (costly and time consuming) for new companies to obtain the necessary certifications from these bodies. We have met many Chinese POS terminal manufacturers which claim to have top-quality products, but lack the capital required to pursue PCI certification. The PCI and EMV have also created the Single Euro Payments Area (SEPA), a framework to achieve a harmonised single payments regime in Europe. The PSD was one of the first major frameworks to be introduced by the regulatory bodies. In our view, this event marked a significant structural change because it introduced a neutral regulatory body into the payment system and in doing so weakened the control of industry incumbents.

The PSD was passed by the EU on 5 December 2007. In the UK, the directive was enacted through the Payment Services Regulation of 2009 and has been in effect since 1 November 2009. The key aims of the regulation are to create more competition by harmonising the payment industry in EU and creating a single payment market within the EU. Another important change that this directive brought was the introduction of a payment institution. Under the PSD, a payment institution can be involved in services including:

money transfer;

cash deposit collection and withdrawals;

execution of payment transactions;

credit transfers and direct debits;

issuing payment instruments and acquiring payment transactions; and

payments sent through the intermediary of a telecom, IT system or network operator.

Who is who in the payment value chain? Payment cards POS terminal Payment Processors Merchant acquirer Issuer banks Credit Card Network

Debit/Credit card Card reader + POS WorldPay, ATOS Worldline, First Data Chase paymentech HSBC, Barclay Visa, Mastercard, American Express, Discover, China Union Pay

Backed by issuer bank Verifone, Ingenico, Vivotec, Global Payments, Ceilo, Redecard BoA Wirecard Wirecard First data Google?

Produced by: Easycash (Ingenico) Vintev Gemalto, G&D, Oberthur, Morpho, Datacard WorldPay

Wirecard Estimate market size: Estimate market size:

EUR3bn Estimate margins: Estimate margins: Estimate margins: Estimate margins: Estimate margins: 10-15% 14-15% 15-25% 15-25% 25-50%

Innovation trends Innovation trends Innovation trends Innovation trends Innovation trends Innovation trends Mobile phones as card emulators (NFC, camera, barcorde), Contactless cards (RFID), EMV

Mobile phone emulating the POS terminal - Square, mPowa, Pay Eleven, etc.

New entrants especially in online and mobile payments market. Clear2Pay Credorax, Intelligent Payments, Square etc.

Payment processors are applying for license as Payment Institution and trying to enter this market.

Banks are increasingly selling their credit card portfolios to independent third parties

Some countries are trying to develop their own internal settlement systems so as to avoid paying fees to card networks. Regulatory pressures from Durbin Amendment. Retailers trying to encouraging Debit PIN transactions which also avoid the payment fees. Credit card networks encouraging contactless credit based transactions.

Multiple cards, loyalty cards, pre- paid cards Source: Berenberg


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In our view, the PSD had three major implications for the sector. Firstly, it lowered regulatory capital requirements as payment was separated from banking as a distinct activity. Secondly, it encouraged competition by harmonising the legal situation across the EU and by allowing companies to passport their regulatory approval from one member country across the EU. For example, companies registered in Poland can also offer cash collection and money transfer services in the UK or France (and the other EU member states). Thirdly, unlike earlier initiatives that were led by industry-dominated bodies, the PSD is a centralised regulatory-led regime. This lowered the barriers that industry incumbents had created. Consequently, following the PSD, many IT and even telecom companies applied for licences to operate as payment institutions.

Catalyst two: Big data

The creation, capture, storage and analysis of large amounts of consumer data have created another tectonic shift in the payment industry. They allow technology companies to sift through large amounts of data to make more efficient credit-risk assessments of consumers. Companies no longer have to obtain credit-risk assessments from credit information bureaux nor do they need to keep a track of the banking and transaction histories of the individual to assess their complete risk profile. Innovative technology-based companies are now utilising a host of consumer data, ranging from browsing history, IP address, geo-location, telecom billing data, social connections to factors like the typing pattern on the web browser to make a credit assessment. By creating a newer set of credit assessment data, these technology companies have lowered the payment processing cost of the transaction, since they no longer have to pay a third party for access to credit reports. Consequently, transactions have become simpler, cheaper and in some cases, even involve a lower fraud rate. Klarna, a Sweden-based transaction processing company, uses 140 different variables, including the time at which the transaction is made, to assess the risk profile of the customer. Klarna is now processing close to EUR2bn a year in online transactions (20% of all e-commerce in Sweden). The company was founded in 2005 by two 20-year olds. Similarly, Cambridge (UK) based Bango uses analytics such as browsing history, IP address and geo-location to process transactions through operator billing. The very fact that companies like these exist is testament to the erosion of barriers to entry in the industry.

In certain cases, some technology-based payment-processing companies have used the provisions of the PSD to acquire the status of payment institution and are offering services such as merchant acquiring or mobile money. Companies such as Wirecard are even more vertically integrated and have a full banking licence, allowing them to offer credit-issuing services as well payment processing and merchant acquiring. In our view, Wirecard is a classic role model for other technology companies in the sector on how to move up the value chain and improve profitability.

Catalyst three: Politics

In our view, the economic recession that followed the financial meltdown of 2008 has made governments and regulatory bodies around the world more conscious of the high cost retailers have end up paying for enabling card-based transactions. Regulators seem keen to foster more competition in the sector and, besides allowing market forces to bring down the fees, they are also using direct measures to force the incumbents in the sector to lower their fees. Hence the deflation we expect in the sector will be caused not only by the entry of new players but also by direct regulatory measures. Some recent examples of such regulatory steps are as follows.


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1. 5x5 Objective: The World Bank is pushing the 5x5 Objective, which was adopted by the G8 countries in 2009. This aims to reduce money transfer fees from a maximum of 10% to 5% or less over five years. This deflation will have a negative impact on listed companies including Western Union and Money Gram.

2. Durbin Amendment in the US: The US government forced credit card networks to lower their interchange fees on swipe card transactions through the Durbin Amendment to the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010. This amendment was introduced in May 2011 and was the final outcome of a major battle between the lobby groups representing the payment industry versus those representing retailers.

3. Merchant fees price-fixing case: In October 2012, Visa and Mastercard agreed to pay $7.25bn for an out-of-court settlement with around 7m retailers in response to a legal case for price-fixing. This has been one of the largest out-of-court settlement in the US. The case is still lingering as some retailers are not satisfied with the payment offered by Visa and Mastercard.

4. Mastercard versus the EU: In May 2012, Mastercard lost a landmark case in which the EU ruled that the company was overcharging for cross-border card transactions (http://www.ft.com/intl/cms/s/0/e34d1f56-a580-11e1-a77b-00144feabdc0.html#axzz2UgDGoUfO).

5. Visa Europe lowers interchange fees: On May 2013, Visa Europe yielded to EU anti-trust complaints and proposed to substantially lower its interchange fees on cross border credit card transactions (http://www.ft.com/cms/s/0/7d56931e-bcac-11e2-9519-

00144feab7de.html#axzz2UgDGoUfO).

In our view, this change in sentiment at the regulatory bodies represents a significant transformation for the payment industry. Another result of this change is that regulators seem more encouraging of new entrants in the industry, especially from the technology sector. This is probably why the regulatory regime seems to be more tolerant of mobile payment systems that might not be as secure as the standard methods.

Impact of these structural changes

In our view, these structural changes in the payment industry will lead to the following developments over the short, medium and long term. The impact in the short term should be as follows:

1. a substantially lower cost of entry for new companies interested in offering payment services;

2. entry of a host of new companies to the sector. These companies will either offer innovative solutions that are more convenient or lower costs;

3. the incumbents have been forced to acquire some of these earlier-stage businesses at a high premium in order to expand their own product portfolios;

4. new competition is forcing incumbents to move into other market verticals, either horizontally or vertically. These changes are creating additional competitive tension;

5. price deflation in some areas of the payment value chain. However, incumbents will try to compensate for this price deflation by developing


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additional business lines, expansion into new geographies and new market verticals; and

6. both the gross margins and operating margins of incumbents will come under pressure as they will have to increase R&D and sales and marketing costs in order to develop new revenue streams and defend market share.

The impact in the medium term should be as follows:

7. the start-ups will start moving up the curve, both in terms of technology

and in terms of customers, thereby intensifying competition; and

8. new entrants will need to compete on pricing in order to lure customers

away from the incumbents.

The impact in the long term should be as follows:

9. the industry will transition from a consolidated oligopolistic structure to a fragmented and competitive one. Generally in such transitions, returns on investments decline to marginal levels and excess profits are eroded down to zero. The media and printing industries are examples where competition from digital players has led to diminishing returns; and

10. large technology companies such as Google could disrupt the pricing model by lowering pricing to low or below-marginal cost levels.

We explore some examples of such disruptive risks in different payment services sub-segments. Case study one: Disruptive risks in the money transfer industry International money transfer industry is dominated by US-based companies Western Union and Money Gram. Western Union, the largest incumbent in the industry, has a 150-year history and was once the dominant player in the telegraph industry. The company was spun off from First Data (largest payment processor) and re-listed in 2006. Western Union has a network of 500,000 agent locations in 200 countries and last year the company moved around $80bn in cross-border payments (231m consumer-to-consumer and 432m business payments). A vast global network, high brand recognition and long history are the key differentiating factors, allowing Western Union to achieve around 20% operating margins and revenues of $5.7bn in 2012. However, some of the trends we highlighted earlier are creating structural risks for the company.

Firstly, there is regulator-driven pressure on fees. Initiatives such as 5x5 aim to reduce the fees charged by the likes of Western Union by half over the period 2009-14. Secondly, due to the PSD, any money transfer business based in Europe can provide such services across the entire EU. This has made it easier for banks and telecoms companies from emerging markets to open up their payment institution subsidiaries in countries such as the UK to provide money transfer services to the diasporas from their respective countries. For example, it is common to see money transfer businesses owned by banks from India, Bangladesh and Pakistan in areas of diaspora population in London. Thirdly, technological developments such as adoption of the internet and smartphones have allowed the development of digital-only money transfer channels. Companies such as XOOM, Paypal and Skrill allow the transfer of money from web-based platforms. This has eroded the benefit of a vast bricks-and-mortar agent network. The move to mobile-to-mobile money transfer further reduces the importance of a bricks-and-mortar network as it allows more convenient money transfers with lower overhead costs. Besides these developments, there has been the entry of more innovative companies offering potentially disruptive pricing based on new business models.


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For example, UK-based TransferWise (which is backed by Paypals Peter Thiel) allows peer-to-peer money transfer at a fraction of the cost charged by traditional agencies like Western Union. TransferWise charges only a EUR1 fee for transactions up to EUR200, ie less than 0.05% versus the average fee of more than 7% in the money transfer industry. TransferWise lowers the cost of transactions by using a clever scheme of enabling direct peer-to-peer exchange of money in different currencies rather than actual exchange and transfer of money. The World Bank maintains a database of remittance prices to track the progress on the 5x5 objective (http://remittanceprices.worldbank.org/).

Global average total cost for sending US$200

Source: World Bank, An Analysis of trends in the average total cost of migrant remittance services, March 2013

In our view, the cost of setting up a money-transfer business serving the UK-India corridor is as low as $200,000. A business that previously would have taken years to achieve scale and a global footprint can now be set up in month. The prices offered by the likes of TransferWise and TransferGo are already near the marginal cost.

Case study two: Disruptive risks in POS terminal industry The second industry we examine is point-of-sale (POS) terminal business. This industry has gone through various stages of consolidation and is now dominated by US-based Verifone and France-based Ingenico. On our estimates, Verifone has a 55% share of the industrys revenues and Ingenico 30% of this $5bn industry. These incumbents benefit from high barriers to entry on the back of factors such as a global footprint, recognised brand, longstanding relationships with banks and payment processors and industry certification requirements under the PCI and EMV. These factors have allowed Ingenico to achieve c45% gross margins and 15% operating margins on the payment terminal business. Technology does not seem to be a major differentiating factor as there are numerous local players in countries such as China, Russia and India. However, it is costly and difficult for these businesses to expand globally due to high costs of certification and difficulties in building relationships with payment processors. Meanwhile, the adoption of devices such as smartphones and tablets and the development of mobile phone based POS terminals (MPOS) are creating structural risks for this sector.

Dongle-like MPOS such as those developed by Square in the US are significantly cheaper than standard POS terminals, since they can use the processing and connectivity tools of a smartphone. Consequently, companies such as Square and Intuit are offering customers these hardware solutions for free. In comparison, a POS terminal typically costs $150-350 per device. Secondly, due to some of the regulatory changes we mentioned earlier, MPOS companies can offer their own

2008Q1

2009Q3

2009Q1

2010Q3

2010Q1

2011Q3

2011Q1

2012Q3

2012Q1

2013

Global Average 9.81% 9.67% 9.40% 8.72% 8.89% 9.09% 9.30% 9.12% 8.96% 9.05%

Intnl MTO Index 10.54% 10.36% 10.29% 10.60% 10.73% 10.12% 10.16% 9.80% 9.51% 9.24%

8%

9%

10%

11%


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payment-processing and even merchant-acquiring services. While in the past new entrants were kept out of the business by the relationship of incumbents with payment processors, now the newcomers can offer payment-processing services directly. Companies such as Square are offering MPOS for free, making money by charging payment-processing fees. The entry of Square and the media attention it received seem to have opened the floodgates in this industry. According to Ingenico, there are more than 40 clones of Square offering MPOS solutions in Europe. The website www.mpos-world.com has an interesting global map: it shows various MPOS companies operating in different parts of the world.

Some of the companies offering MPOS in Europe

Square ROAM Data - Ingenico

Intuit Verifone

iZettle LifePay

mPowa Cube

Payleven Qube

Wincor Nixdorf Swish

Wirecard CodaMation

Monitise Ezetap

SumUp Payworks

Miura Sage

Famoco Groupon Source: www.mpos-world.com

In the past, incumbents such as Verifone argued that mobile-based solutions lack the requisite complexity, technological requirements and security features. According to the incumbents, these MPOS products do not target their existing customers but only address a new untapped market segment the tier-4 or micro merchants that previously only accepted cash transactions. However, the evidence from the past 12 months does not fully support this view. Some dongle-based systems are now EMV compliant, can support smartcards and are integrated with retail systems. POS terminal versus Dongle POS Terminal Six months ago

Dongle-based systems Now Dongle-based system

PCI-PTS 3.0 approval Acceptance of PIN Debit/Smartcards

Not capable Capable

EMV 1 and 2 approval Readiness for smartcards

Not capable Capable

Visa, MC, Amex, Discover, NFC, Readiness for any contactless wallet

Not capable Not capable

Integration with coexisting retail system Not capable Capable

PCI-SRED approved end-to-end encryption Not capable Not capable

Source: Verifone, Berenberg

In our view, it is only a matter of time before these early-stage MPOS solutions move up the technology curve and start to put more pricing pressure on not only the POS terminal industry but also on payment processing. Square in the US has already developed some sleek products which offer much broader transaction-related services. Also, many MPOS businesses in Europe are already EMV compliant.

Case study three: risks to credit card networks


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In our view, the credit card networks have the highest barriers to entry in the payment services ecosystem. Hence companies such as Visa and Mastercard make 50-52% operating margins. The industry is dominated by Visa, Mastercard, American Express and Visa Europe. There have been a few new players in the industry eg Discover, Japan Credit Bureau (JCB) and China Union Pay (CUP) but generally competition has been muted. Growth in e-commerce and online payments has facilitated new competition and alternative payment networks. These include Paypal wallet-to-wallet transfers or debit-based schemes like GiroPay in Germany, iDEAL in Netherlands and Interac in Canada. In markets like the UK, start-ups such as GoCardless are pushing ACH-based debit solutions that bypass the payment networks and consequently have a lower cost per transaction. The Merchant Customer Exchange (MCX), a consortium of leading retailers in the US, also aims to bypass the payment network in our view by offering a direct ACH-based system. The pace of development of alternative systems has substantially increased over the past few years. Besides more competition, the sector faces regulatory pricing pressure as mentioned earlier.

Investing in times of disruptive risks: findings from Tech Titans or Dinosaurs?

Regardless of the inertia and stickiness derived from large market share, long-term relationships and brand recognition, many incumbents involved in payment services industry face disruptive risks. In order to analyse the investment implications, we draw on the findings from the research report, Tech titans or dinosaurs?: a history lesson published by Adnaan Ahmad on 30 September 2011. Adnaans study looked at the following case studies: IBM: 1987 to 1990;

Xerox: 1972 to 1985;

Digital Equipment Corporation, DEC: 1987 to 1994;

Sun Microsystems: 1993 to 2002;

Kodak: 1999 to 2007;

Polaroid: 1990 to 2000;

Yahoo!: 2004 to 2009; and

Lotus Software: 1988 to 1992.

The six key findings of the report were as follows.

1. Generally, the P/E rating on these stocks de-rated substantially in the first year or two after the discontinuity, and subsequently oscillated around trough levels. For example, IBMs P/E peaked at 17x in 1987 and troughed at 9x in 1990, oscillating between 11x and 13x in the intervening period a time when investors thought the stock was cheap.

2. Earnings at most of these companies did not fall off a cliff a quarter or two after the entry of a new technology/competitor. For example, DECs operating margins were 18% in 1987, 15% in 1988 and 11% in 1989, before dropping precipitously to -14% in 1994.

3. These companies did not respond quickly enough to the discontinuity (culture, politics, lack of foresight) and stayed in a state of denial for too long. For example, Ken Olsen, DECs CEO, said there is no reason for any individual to have a computer in his home as he continued to focus on high-end computing rather than pushing into the PC market.

4. Restructuring was piecemeal, and the first cut was never the deepest. For example, Polaroid cut its headcount by 5-15% on four separate occasions.


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5. Management changes led to further re-organisation, restructuring and a new strategy resulting in additional time to market and employee morale challenges.

6. Boards also thought that companies could do it alone again, refusing take-out offers which, in hindsight, was a mistake. Yahoo!s board decision to forgo Microsofts bid at double its current share price is an example of this.

The application of these findings to our analysis suggests that the incumbents in the payment industry might be able to display stability in their returns for a longer period than generally expected. However, there may be a de-rating in the share price before an eventual decline in earnings. There is already evidence of such de-rating in the share price of US-based payment companies including Western Union, Global Payments, Verifone and even Mastercard. Global Payments: Peak P/E multiple 30x versus 11.5x now

Source: Bloomberg

Verifone: Peak P/E multiple 29x versus 10.6x now

Source: Bloomberg

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Mastercard: Peak P/E multiple 30x versus 20x now

Source: Bloomberg

Western Union: Peak P/E multiple 22x versus 11x now

Source: Bloomberg

Downgrading Ingenico to Sell: 30% downside to current share price On the back of these views, we are downgrading Ingenico to Sell from Hold. Given the opportunity for Ingenico to gain share in the US as well as robust growth in emerging markets, the company might be able to post healthy earnings growth over the next couple of quarters. However, with the stock trading on around 20x next year P/E, we believe this growth momentum is already priced in.

Over the past 12 months, Ingenico has been benefiting from market share gain at Verifones expense. We think that Verifone will be able to stabilise its position by October/November (the end of its fiscal year) and that ultimately this will stall Ingenicos earnings momentum. Incremental competition from MPOS companies might be only in the tier-4 market segment right now, but over the next 12 months some of these companies will move up the technology curve and start competing directly with Ingenico. This competition is likely to lead to price deflation and pressure on Ingenicos gross margins. Payment terminals account for around 70% of Ingenicos group revenues. Transaction services, the remaining 30% of the business, has already seen a sharp deceleration in growth, which the management attributes to macroeconomic woes in Europe.

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We are modelling 10% earnings growth over the next three years and maintain our price target of EUR40, based on what we see as a generous target multiple of 13.6x Ingenicos next year expected earnings of EUR2.93. The current share price is 30% higher than our price target. The share might be supported in the next couple of quarters by strong earnings momentum on the back of continued market share gain from Verifone and early market share gain in the US from Equinox. But we think that, by the end of the year, earnings growth will have stabilised while some of the structural challenges to the business will be becoming more visible. See the Ingenico section below for more details.

Ingenico SA Small/Mid-Cap: Technology Hardware

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Downgrade to Sell on structural risks

Ingenicos share price is up 24% since the start of the year and 56% over the past 12 months. We think most of the positives have been fully priced in. The market seems to have appreciated Ingenicos strong earnings momentum. While the payment terminal industry tends to have underlying growth of 5-7%, Ingenico has been able to significantly outgrow the market with c15% yoy organic growth over the past year. This outperformance has mainly been due to market share gains from Verifone and Equinox in the US. We think that by the end of the year, Verifone will have been able to resolve its internal issues and defend its share, thereby dampening Ingenicos earnings momentum. Also, we think that at the current valuation the market is ignoring some of structural issues the company faces in the medium-to-long term, eg the increase in competition from mobile-point-of-terminal companies. We keep our price target but downgrade Ingenico to Sell as the current share price is 30% higher than our PT.

Verifone faces a combination of internal execution and acquisition-related issues. Over 2011-12, the company made two large acquisitions: Hypercom in the terminal business and Point in the services business, distracting management and leading to significant dis-synergies. Management also tried to switch focus from pure terminal sales to a more services-driven strategy, which alienated a few customers and delayed necessary product development. The payment terminal industry could be considered a duopoly between Ingenico and Verifone; consequently, Verifones loss has largely been Ingenicos gain. Verifone has had a management overhaul and is aiming to resolve these issues by October. Verifones stability and eventual recovery may well end Ingenicos dream run.

Furthermore, the success of Square seems to have opened the floodgates to new entrants offering smartphone-based terminal solutions. We think these companies will lead to price deflation in the sector over the next 18-24 months and put pressure on Ingenicos gross margins.

Our price target of EUR40 is based on c13.5x 2014 P/E (1.3x PEG ratio).

Sell Rating system

Current price

EUR 52.97

Absolute

Price target

EUR 40.00 29/05/2013 Paris Close Market cap EUR 2,312 m Reuters INGC.PA Bloomberg ING FP

Changes made in this note Rating Sell (Hold) Price target EUR 40.00 (no change) Chg 2013e 2014e 2015e old % old % old % Sales 1333 - 1499 - 1671 -

EBIT 193 - 217 - 231 -

EPS 2.58 - 2.93 - 3.10 - Source: Berenberg estimates

Share data Shares outstanding (m) 52 Enterprise value (EUR m) 2,623 Daily trading volume 150,085

Performance data

High 52 weeks (EUR) 54.70 Low 52 weeks (EUR) 33.60 Relative performance to SXXP CAC MS 1 month 1.3 % 1.4 % 3 months 8.4 % 15.8 % 12 months 26.0 % 44.2 %

Key data

Price/book value 5.7 Net gearing 18.6 % CAGR sales 2012-2015 11.5 % CAGR EPS 2012-2015 10.9 %

Business activities: Development and sales of POS terminals. Offers transaction services to handle card transactions.

Non-institutional shareholders: Morpho 12%

31 May 2013

Ali Farid Khwaja, CFA Analyst +44 20 3207 7852 [email protected]

Jean Beaubois Specialist Sales +44 20 3207 7835 [email protected]

Y/E 31.12., EUR m 2011 2012 2013E 2014E 2015E

Sales 1,001 1,206 1,333 1,499 1,671

EBITDA 184 223 251 274 288

EBIT 111 164 193 217 231

Net profit 56 97 115 134 143

Y/E net debt (net cash) 110 75 311 198 75

EPS (reported) 1.10 1.80 1.96 2.28 2.44

EPS (recurring) 1.10 2.28 2.58 2.93 3.10

CPS 3.54 0.83 0.35 2.18 2.37

DPS 0.10 0.27 0.27 0.27 0.27

Gross margin 41.6% 42.5% 42.8% 42.0% 40.8%

EBITDA margin 18.4% 18.5% 18.8% 18.3% 17.2%

EBIT margin 11.1% 13.6% 14.5% 14.5% 13.8%

Dividend yield 0.2% 0.6% 0.6% 0.6% 0.6%

ROCE 5.1% 8.7% 10.7% 11.4% 11.5%

EV/sales 2.4 2.0 1.8 1.6 1.4

EV/EBITDA 13.0 10.7 9.5 8.7 8.3

EV/EBIT 21.5 14.5 12.3 11.0 10.3

P/E 40.7 19.6 17.3 15.2 14.4

Cash flow RoEV 7.6% 1.8% 0.8% 4.7% 5.1%

Source: Company data, Berenberg


14

Three reasons to Sell

In January, when we downgraded Ingenico to Hold from Buy, we argued that the risks from a Verifone recovery and new competition were balanced by the returns from the opportunity of market share gain, especially in the US. Ingenicos Q1 2013 results subsequently provided convincing evidence of the earnings momentum, which was driven by strong growth not only in the US but also in Asia Pacific on the back of market share gain from Verifone. The market has rewarded Ingenico for this and the stock is now trading at a record P/E multiple of c17x 2013 PE. We think that, at current valuation levels, the balance has shifted and the market is ignoring some of the structural risks.

On the positive side, we still believe that Ingenico has a golden opportunity ahead of it in terms of gaining share in the US. We are forecasting Ingenico to double its market share in the US over the next three years, which should help the company achieve above-trend growth of c11% CAGR in the period. This is higher than the 5-7% underlying growth rate of the payment terminal industry. However, current valuation suggests that this is fully priced in.

Over the medium-to-long term, there are significant structural risks to the POS terminal industry. We have discussed some of these above. Also, we expect Verifone to solve its internal execution issues over the next 3-6 months. A stronger recovery by Verifone combined with aggressive pricing could create risks to our estimates for Ingenico. Similarly, if Equinox became more aggressive in defending its US share or if Chinese competitors such as PAX become more widely adopted in the US, this would create further downside risks for Ingenico.

In our view, the key reasons to sell Ingenico are as follows.

Reason one: Ingenicos revenue growth rates of the past five quarters are not sustainable

It is imperative to understand the fundamental dynamics of the POS terminal industry. This industry will essentially be a replacement business when the market reaches maturity. For example, in developed markets, which account for 50% of Ingenicos terminal business, a merchant only buys a new POS terminal to replace an existing one. The typical replacement cycle is 4-5 years. Consequently, these regions collectively tend to grow by c3% pa. In the past few years, European replacement demand has accelerated due to new regulatory measures such as EMV (chip and pin) and demand for greater functionality (NFC, RFID etc). The replacement cycle in our view is now over, with demand from these regions ebbing.

Emerging markets are still growing by 7-10% pa due to the rollout of new terminals. We think these markets, especially countries with large populations such as China, India and Indonesia, can sustain high levels of demand growth over the next five years. Once they reach maturity, the growth in demand from these regions will also decline to the levels of more mature regions. This means that eventually, once the emerging markets have reached maturity, the POS industry will typically grow at 2-3%.

Over the past five quarters, Ingenicos terminal business has grown by around 15%. This extraordinary growth rate has mainly come from market share gain from Verifone. The POS industry has gone through several cycles of consolidation and can now be considered a de facto duopoly between Verifone and Ingenico.


15

Verifone has c55% market share by revenues and Ingenico 30%. There are smaller local players in different markets but no other global players. A key reason for the duos large consolidated market share is that most large customers of POS terminals tend to have a dual sourcing policy. When Verifone in 2011 acquired Hypercom, then the third-largest company in the sector, it created dis-synergies, especially in geographies where Verifone and Hypercom were the two main suppliers. These markets opened up to Ingenico as a second source supplier, leading to an acceleration in Ingenicos revenues. Besides this, Verifone faced internal execution issues since managements focus was distracted by the acquisitions and because it was trying to move away from the terminal business to a more services-based business model. Hence Ingenico has had a special situation gain courtesy of the issues facing Verifone.

We think Verifone will be in a better position to defend its market position by the end of the year. The company has had a change in management and is now more conscious of the challenges it faces. It has publicly stated its ambition to be back on track by the end of its fiscal year, ie October. A recovery by Verifone would imply that Ingenicos dream run will eventually come to an end with growth then starting to taper off.

We still expect Ingenico to continue to outperform the market over the next three years due to market share gain in the US from Equinox (the former US business of Hypercom). However, the growth we expect is not sufficient to justify the current valuation.

Also, there are downside risks if Verifone becomes more aggressive in trying to regain lost market share. Further, PAX a Chinese company that is the number-two player in that country has recently won a large US customer, Heartland. There is a risk that PAX emerges as a competitor to Ingenico in the US too. The third scenario which could entail downside risks to our estimates is if Equinox were acquired by a larger company that could provide it with more capital to defend its market share. In any/all of these scenarios, Ingenicos revenue growth rate would decline to single digits.

Reason two: new competition from MPOS companies will create price deflation and margin pressure

As we argued above, the POS industry faces structural risks from smartphone- and tablet-based terminal solutions. The hype around Square has highlighted the opportunity to entrepreneurs globally and there are 40-50 or more clones of Square trying to enter this industry by offering cheaper MPOS solutions. While these companies are currently only targeting the low end of the market and might not be technologically and commercially mature, it is highly likely that ultimately they will gain maturity and pose a greater challenge. The pace of innovation such companies have demonstrated in the past 12 months is impressive. A year ago, Ingenico and Verifone were dismissing these companies pointing out that these new entrants do not support EMV, a key regulatory requirement. However, within a short period, many EMV-compliant solutions accepted by Visa and Mastercard have emerged. Some of these challengers are being backed by sizable payment companies such as Wirecard, ATOS, Wincor Nixdorf and Sage. The plethora of solutions available free of cost is bound to create pricing pressure for Ingenico. We are modelling a 200bp reduction in Ingenicos gross margins over 2013-15. Depending on how the competition evolves, there could be greater risk to our estimates.


16

Reason three: stock may de-rate when investors become concerned about the disruptive risks

A key finding of our Tech Titans study was that, while companies facing disruptive risks might be able to maintain stability in their earnings in the short term, they typically experience a de-rating in their valuation multiples. While the payment terminal industry faces multiple disruptive risks, investors are currently ignoring them as short-term earnings upgrades are keeping them satisfied. A payment terminal typically costs $150-350 while the competing solution is free! At the moment, the alternative solution may not be technologically comparable with a standard terminal but it allows new entrants into the industry. Over the next 12-18 months, these solutions should improve technologically and offer innovative services around transaction management. Square in the US has already launched innovative tablet-based inventory management solutions. These MPOS solutions seem to fit the classic definition of disruptive risk as defined by Clayton M. Christensen in his seminal book Innovators Dilemma.

We think EUR40 is a fairly generous valuation that assumes Ingenico will gain market share in the US and does not factor in more challenging competitive scenarios. It values Ingenico at around 13.5x next year P/E, which is more than 1x the PEG ratio. The current share price is 30% above this level. While the next quarter may still be strong, we think that by the end of this year revenue growth will have slowed. Over the next 12-18 months, pricing pressure will become more pronounced with gross margins starting to decline. Over the next 24-36 months, the disruptive risks will probably become more visible. Hence we have a Sell recommendation on the stock.


17

Financials

Profit and loss account

Year-end December (EUR m) 2011 2012 2013e 2014e 2015e

Sales 1,001 1,206 1,333 1,499 1,671

Cost of sales -584 -694 -763 -869 -990

Gross profit 417 513 570 630 681

Sales and marketing -97 -122 -135 -152 -169

General and administration -114 -133 -158 -178 -199

Research and development -77 -93 -73 -74 -82

Other operating income 1 10 0 0 0

Other operating expenses -19 -9 -10 -9 0

EBITDA 184 223 251 274 288

EBIT 111 164 193 217 231

Interest income 58 - - - -

Interest expenses -85 - - - -

Other financial result 0 - - - -

Financial result -27 -14 -17 -13 -13

Income on ordinary activities before taxes 84 151 176 204 218

Extraordinary income/loss -3 0 0 0 0

EBT 81 150 176 204 218

Taxes -23 -50 -58 -67 -72

Net income from continuing operations 58 100 118 137 146

Income from discontinued operations (net of tax) - - - - -

Net income 58 100 118 137 146

Minority interest 2 3 3 3 3

Net income (net of minority interest) 56 97 115 134 143

Source: Company data, Berenberg estimates


18

Balance sheet

Year-end December (EUR m) 2011 2012 2013e 2014e 2015e

Intangible assets 681 700 662 625 588

Property, plant and equipment 34 38 30 28 0

Financial assets 67 61 61 61 61

Fixed assets 782 798 753 714 649

Inventories 95 105 136 157 179

Accounts receivable 335 332 365 415 462

Other current assets 18 22 22 22 22

Liquid assets 348 384 388 501 624

Deferred taxes 9 4 4 4 4

Current assets 805 847 915 1,098 1,291

TOTAL 1,587 1,645 1,668 1,812 1,940

Shareholders' equity 623 689 408 503 575

Minority interest 7 -1 -1 -1 -1

Long-term debt 428 381 621 621 621

Pensions provisions 13 12 12 12 12

Other provisions 34 38 37 37 37

Non-current liabilities 474 431 671 670 670

Short-term debt 30 78 78 78 78

Accounts payable 297 281 345 395 450

Other liabilities 95 107 107 107 107

Deferred taxes 60 60 60 60 60

Current liabilities 482 526 590 640 695

TOTAL 1,587 1,645 1,668 1,812 1,940



19

Cash flow statement

EUR m 2011 2012 2013e 2014e 2015e

Net profit/loss 58 100 118 137 146

Amortization and depreciation 51 54 53 35 35

Other 15 5 20 20 20

Cash flow from operations before changes in w/c 124 159 191 192 201

Change in inventory 16 -12 -31 -21 -22

Change in accounts receivable -72 -2 -33 -50 -48

Change in accounts payable 26 16 64 50 55

Change in other working capital positions -30 3 1 -21 -14

Change in working capital -60 6 1 -41 -29

Cash flow from operating activities 94 162 192 171 187

Cash flow from investing activities -107 -53 -400 -45 -50

Cash flow before financing -13 109 -208 127 137

Increase/decrease in debt position 204 -4 240 0 0

Purchase of own shares -6 4 0 0 0

Dividends paid -5 -14 -14 -14 -14

Others 0 -51 0 0 0

Effects of exchange rate changes on cash 4 -1 0 0 0

Cash flow from financing activities 196 -66 226 -14 -14

Increase/decrease in liquid assets 182 43 18 113 123

Liquid assets at end of period 328 370 388 501 624


Growth rates yoy

(%) 2011 2012 2013e 2014e 2015e

Sales 10.4 % 20.5 % 10.5 % 12.4 % 11.5 %

Organic - - - - -

External - - - - -

EBITDA 10.9 % 21.2 % 12.7 % 9.2 % 5.0 %

EBIT - - - - -

Net income 46.5 % 72.9 % 17.9 % 15.9 % 6.7 %

EPS reported 37.1 % 64.2 % 9.1 % 16.4 % 6.8 %

EPS recurring 35.4 % 107.6 % 13.2 % 13.6 % 6.0 %



20

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21

Please note that the use of this research report is subject to the conditions and restrictions set forth in the General investment-related disclosures and the Legal disclaimer at the end of this document.

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Disclosures in respect of section 34b of the German Securities Trading Act (Wertpapierhandelsgesetz WpHG)

Company Disclosures Ingenico SA no disclosures (1) Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as the Bank) and/or its affiliate(s) was Lead

Manager or Co-Lead Manager over the previous 12 months of a public offering of this company. (2) The Bank acts as Designated Sponsor for this company. (3) Over the previous 12 months, the Bank and/or its affiliate(s) has effected an agreement with this company

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(4) The Bank and/or its affiliate(s) holds 5% or more of the share capital of this company. (5) The Bank holds a trading position in shares of this company. (6) The Bank and/or its affiliate(s) holds a net short position of 1% or more of the share capital of this

company, calculated by methods required by German law as of the last trading day of the past month. Historical price target and rating changes for Ingenico SA in the last 12 months (full coverage)

Date Price target - EUR Rating Initiation of coverage

12 July 12 46.00 Buy 09 November 10

18 January 13 46.00 Hold

18 March 13 40.00 Hold

31 May 13 40.00 Sell

Berenberg distribution of ratings and in proportion to investment banking services

Buy 41.49 % 53.13 % Sell 19.37 % 9.38 % Hold 39.14 % 37.50 %

Valuation basis/rating key

The recommendations for companies analysed by the Banks equity research department are either made on an absolute basis (absolute rating system) or relative to the sector (relative rating system), which is clearly stated in the financial analysis. For both absolute and relative rating system, the three-step rating key Buy, Hold and Sell is applied. For a detailed explanation of our rating system, please refer to our website at

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22

General investment-related disclosures Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as the Bank) has made every effort to carefully research all information contained in this financial analysis. The information on which the financial analysis is based has been obtained from sources which we believe to be reliable such as, for example, Thomson Reuters, Bloomberg and the relevant specialised press as well as the company which is the subject of this financial analysis. Only that part of the research note is made available to the issuer (who is the subject of this analysis) which is necessary to properly reconcile with the facts. Should this result in considerable changes a reference is made in the research note.

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Legal disclaimer This document has been prepared by Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as the Bank). This document does not claim completeness regarding all the information on the stocks, stock markets or developments referred to in it. On no account should the document be regarded as a substitute for the recipient procuring information for himself/herself or exercising his/her own judgements. The document has been produced for information purposes for institutional clients or market professionals. Private customers, into whose possession this document comes, should discuss possible investment decisions with their customer service officer as differing views and opinions may exist with regard to the stocks referred to in this document.

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Analyst certification I, Ali Farid Khwaja, CFA, hereby certify that all of the views expressed in this report accurately reflect my personal views about any and all of the subject securities or issuers discussed herein.

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23

United States of America This document has been prepared exclusively by the Bank. Although Berenberg Capital Markets LLC, an affiliate of the Bank and registered US broker-dealer, distributes this document to certain customers, Berenberg Capital Markets LLC does not provide input into its contents, nor does this document constitute research of Berenberg Capital Markets LLC. In addition, this document is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers.

This document is classified as objective for the purposes of FINRA rules. Please contact Berenberg Capital Markets LLC (+1 617.292.8200), if you require additional information.

Third-party research disclosures

Company Disclosures Ingenico SA no disclosures (1) Berenberg Capital Markets LLC owned 1% or more of the outstanding shares of any class of the subject

company by the end of the prior month.* (2) Over the previous 12 months, Berenberg Capital Markets LLC has managed or co-managed any public

offering for the subject company.* (3) Berenberg Capital Markets LLC is making a market in the subject securities at the time of the report. (4) Berenberg Capital Markets LLC received compensation for investment banking services in the past 12

months, or expects to receive such compensation in the next 3 months.* (5) There is another potential conflict of interest of the analyst or Berenberg Capital Markets LLC, of which

the analyst knows or has reason to know at the time of publication of this research report.

* For disclosures regarding affiliates of Berenberg Capital Markets LLC please refer to the Disclosures in respect of section 34b of the German Securities Trading Act (Wertpapierhandelsgesetz WpHG) section above.

Copyright The Bank reserves all the rights in this document. No part of the document or its content may be rewritten, copied, photocopied or duplicated in any form by any means or redistributed without the Banks prior written consent.

May 2013 Joh. Berenberg, Gossler & Co. KG

Payment industry IICatalysts leading to structural changes in the Payment Services industryCatalyst one: Payment Services Directive opening the floodgatesCatalyst two: Big dataCatalyst three: PoliticsImpact of these structural changes

Three reasons to SellReason one: Ingenicos revenue growth rates of the past five quarters are not sustainableReason two: new competition from MPOS companies will create price deflation and margin pressureReason three: stock may de-rate when investors become concerned about the disruptive risks

FinancialsContacts: Investment BankingDisclosures in respect of section 34b of the German Securities Trading Act (Wertpapierhandelsgesetz WpHG)

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