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Automated Bank Services Ltd is an Israeli company that is in the same business as Visa and Mastercard. Knowing quite well how this sector works, I did not hesitate to study this Israeli company. Its strong competitive advantages (network effect and monopoly) together with a very attractive valuation, especially in comparison with the two American giants, led me to delve deeper into it.
It is a fairly simple thesis, an easy to understand business, a robust balance sheet and strong catalysts that can make it grow without competitors in the next decade. Not without facing a significant risk, which we will see later, but which can become an opportunity for further growth.
I owe this investment idea to my friend Shreekkanth Viswanathan ''Shree```, founder of SVN Capital, who was kind enough to share it with me along with other great companies that may become theses later on. Shree is a manager with an investment philosophy identical to mine. We like excellent businesses, with competitive advantages, well run, with the ability to grow and financially sound, along with the above, we try to have a concentrated portfolio, so that we can monitor it smoothly. Thank you very much for all the experience and wisdom you share with me.
SHVA was born in 1978 by the hand of the big banks in Israel, being owned by them until 2019, when it goes public. The reason for its IPO is a legislation that obliges the owners to hold a maximum of 10% of the company's shares.
Given the impossibility of Visa and Mastercard to enter the country, due to the high regulation and the fact that the payment network is already extended by SHVA, when it goes public they decide to invest in it, leaving the ownership of the company divided between the four big banks in Israel, Visa and Mastercard, all of them with 10% of the company's ownership. This makes them owning 60% of the shares and making the company quite illiquid. This entry of Visa and Mastercard, are a sign of the high quality of the business.
The investment opportunity exists because it is an unknown smallcap, away from the big funds/investment banks, publishing its results in Hebrew and taking weeks to translate them into English, with a huge moat around it and growing. In addition to the above, it offers a very attractive valuation compared to Visa and Mastercard.
It has experienced growth of approximately 10% CAGR since 2013. In 2020 it had revenues of approximately €26 million.
Its operating margins are above 30%, growing each year to above 40%
Both its Net Income and Free Cash Flow are growing since its IPO and it has not suffered the consequences of the pandemic. Data prior to its IPO are not available or I have not found them
Until this year, it had not distributed dividend, but it seems that they have taken the decision to reward the shareholder since 2020 in this way. Buybacks, allowing only owning a maximum of 10% of the shares are not easy.
It has cash of approximately $15 million and liquid assets (80% bonds and 20% shares) of $35 million. No debt.
Its ROIC is above 15%, with the capacity to increase in the coming years.
To understand SHVA's business it is interesting to understand how Visa and Mastercard work, as they are the same type of business, except that SHVA does not perform the money transaction. That function, in Israel, is performed by a company called MASAV, which shares human resources, infrastructure, offices, network, equipment and management with SHVA. This makes them benefit from numerous synergies, but also from a risk that we will discuss later.
Visa and MasterCard act as intermediaries linking card issuers - acquirer - acquiring bank - merchant - merchant bank and facilitating the processing of credit and debit card transactions. They act as an intermediary that allows all parties involved in the relationship to communicate and send the appropriate data in order to execute the transaction. In short, they provide the rails on which the money flows.
In this image, I think it is much easier to get an idea of the business model. The buyer pays $100 in a store for a pair of pants. The store receives $98. The remaining $2.00 is shared by the card issuing bank $1.52, the receiving bank $0.48 and Mastercard or Visa $0.02.
Visa and MasterCard provide the software highway by which transactions are routed between the two parties and ensure that they are authorized and settled. They charge a small fee for doing so. In the case of SHVA it is the same, but in Israel and at different rates.
For the thesis to make sense it is necessary to understand the macroeconomic environment in Israel. In this case, as the investment thesis is concentrated in a specific country, without the possibility of foreign expansion, it is necessary to be sure that the situation is and will be favorable in the coming years.
Israel is one of the most entrepreneurial countries in the world. The legislative system does not stigmatize or marginalize unsuccessful entrepreneurs, but rather helps them to rejoin the system and thus benefit from their experience, favoring the existence of competition and thus the progress of its economy.
There is no brain drain in that country. They may spend a few years abroad training and gaining experience, which will help them to return much better prepared to their country. Another interesting fact is that if a Start up gets a private funding of 2 million, the state will provide another 2 million, always encouraging the creation of new companies.
In the following image, obtained from the World Bank, we can see how Israel is the second country with the second highest percentage of GDP allocated to R & D in 2014 (most recent graph) more than 4%. It is currently number one in the world.
Another positive fact and that brings peace of mind when investing in that country is its unemployment rate, which is around 5%. One of the lowest in the world, which has barely suffered the consequences of Covid and reflects the government's efforts to generate quality employment.
Another positive development is the Israeli government's intention to minimize the use of cash, which will undoubtedly benefit SHVA's business. Some of the measures it is taking are as follows:
Adoption of EMV cards: the Government has, since 2015, obliged card issuers (not SHVA's business) to issue EMV-enabled cards. These smart cards are responsible for protecting the consumer by increasing security levels, preventing fraud and counterfeiting and thus encouraging their use.
Activity in the charge card market has increased significantly over the last five years, in light of the continued increase in e-commerce purchases in Israel, and the Reduction of Cash Usage Law. The adoption in the Israeli market of EMV smart charge cards is in advanced stages - Annual Report 2020
Contacless transactions: Technology that allows payment by card or cell phone without having to insert a card. It is a system that is being implemented in public transport and for transactions in stores under 300 NIS (75 € approx). It allows a fast and secure payment.
The Ministry of Transportation and other entities are promoting solutions which will allow charge card payments on public transportation, or connecting payment methods which are currently available on public transportation to charge cards - Annual Report 2020.
Use of payments through mobile devices: The implementation of mobile technology and wallets is experiencing an upward trend. Since Apple Pay was introduced in the country, its growth has increased by 13.5 times.
Finally, I could not end this section without commenting on the war conflict that has been going on in Israel for decades and which does not seem to find a definitive point of peace. As these are political issues, I prefer not to go into detail, but it is obligatory to mention it in view of the possible consequences it may have on our investment.
In spite of being a business very similar to Mastercard and Visa, it is not totally the same. These charge a percentage of the transaction, while SHVA charges a fixed fee depending on the services it provides.
It earns revenue in three ways:
Transaction-related fees: The Company charges a fixed fee to clients for each transaction (NIS 0.6979), for authorization services (NIS 1.173) and clearing (NIS 0.9448), which is divided equally between the clearing entity and the issuer. If the transaction amount is very small, the authorization service is also not charged.
Any payment that is made on an e-commerce platform and requires the use of cards within the country also uses the SHVA system for transactions.
Therefore, depending on the services you provide, you may be charged from NIS 0.6979 (€0.17) to NIS 2.8157 (€0.70) per transaction.
Terminal connection: Each terminal connected in the different businesses offering electronic payments has to pay a fixed monthly fee to SHVA of NIS 15 (€3.94). This provides a recurring and growing income, since as more and more electronic payments are made, these terminals increase. This trend can be seen in the following table.
ATMs: For each withdrawal made at these ATMs, SHVA also charges fees. This revenue stream will decrease as the use of cash decreases.
The following table shows the distribution of the company's revenues.
SHVA has a number of competitive advantages that make it the only player in Israel's payment system. This has been the case for decades and in my humble view will remain so for many years to come. This wide and growing moat has been the main driver for making an investment in SHVA.
High regulation: Although it is not forbidden for a foreign company to enter Israel and set up its own payment system, the high regulatory requirements scare off competition. The non-entry of Mastercard and Visa into the country and their acquisition of 10% (the maximum allowed) of SHVA each, is a sign of both the difficulty of penetration and the quality of the business.
Network effect: When this moat comes to mind, the first thing we think of is V and MA. The same thing happens with SHVA. Numerous terminals connected throughout the country, issuing and receiving banks within this circle make them totally dependent on SHVA for the proper functioning of payments in the country.
In addition to these competitive advantages, SHVA's payment system is highly accepted in Israel. This generates a significant barrier to entry as it requires a very high technological, human, infrastructure and capital cost in order to be able to compete.
Many companies that are in a monopolistic situation could have abusive power pricing with their customers. This is not the ideal situation, or at least the one I look for when investing. Angry customers, suppliers, banks or regulators might favor finding new alternatives to perform the same service the company does and tear down their moat. SHVA has not only not increased its rates in years (although it may do so) but has reduced its rates during the pandemic to favor the functioning of Israel's economy.
The main drivers of growth were explained above, stemming mainly from the cash squeeze. But there are some other catalysts that will help growth.
Card usage: Either physically or via cell phone, the Israeli government's measures to decrease cash will have a positive effect on SHVA, being the main beneficiary of this process.
The Bank of Israel encourages the use of advanced nonpaper-based means of payment, and as such was part of the legislative process for the Reducing the Use of Cash Law, 5778–2018, which came into force in January 2019.
Cash expenditures constituted about 26 percent of total daily expenditures, while credit cards or debit cards accounted for about 38 percent - Bank of Israel
According to Bank of Israel data published in this report and from 2019, card payments constitute about 40% of the total. In Europe these percentages are close to 60% and in the US they exceed 70%. Therefore, compared to these continents and given Israel's strong technological investment, we are facing an assured growth.
E-commerce: The pandemic has accelerated it, but the growth of this sector is unstoppable. Israel is no stranger to this fact and will benefit from all card payments within the country.
E-commerce sector in Israel has grown significantly in recent years. As part of the growth in this sector, the mobile payment sector has also been growing, and capturing a significant share of total online purchases. Furthermore, the use of digital wallets among consumers and businesses (for B2B, B2P, P2B and P2P transactions) has been increasing, which serve both for monetary transfers and to make purchases. These wallets are, in part, based on charge card payments - Annual Report 2020
Operating leverage: As with Visa and Mastercard, the company's revenues will grow at a faster rate than its expenses. The payment network is established, the servers will need upgrades, the staff does not need to grow much, IT equipment and rent would not be a high cost... i.e. low capex. All this would result in higher operating margins and therefore in an increase in profits over the years.
These margins currently hover around 40% and have always remained at this level, except in 2017 (for which I have no data). Visa's are over 60% and Mastercard's are over 50%. With the ability to grow and the point we will see below, these margins could increase to similar levels.
New services and price increase : SHVA is working on a currency conversion service to execute payments abroad with Israeli cards. In addition to this, with the incursion of EMV smart card technology, fraud and card misuse will be prevented.
This could bring the total service charge above the current 2.8157, resulting in higher profitability. These prices could also increase without having to increase services, but this is not the company's policy.
In this case we are dealing with a company with a management without Skin in the game. In a business that, as Buffett would say, could be run by a ham sandwich.
Despite being a simple business to run, given its strong competitive advantage, the management has been in the position for years, knows the industry well, makes the right growth decisions, manages it conservatively and has salaries commensurate with the position they hold.
They have not made any acquisitions in recent years, and their growth has been entirely organic. Share buybacks have not been made so far. What they have started is a dividend distribution policy, in order to benefit the shareholder.
On November 11, 2018, the Company’s Board of Directors adopted an earnings distribution policy, subject to the Company becoming a public company, according to which the Company may distribute to its shareholders annual dividends of up to 50% of the annual net profit during the preceding year- Annual Report 2020
In the following table we can see the salaries (none exceeds €300,000 per year), bonuses (for short and long term objectives) and shares held (none). It is true that I would like to see some alignment of interests
Although there are several exposures, such as that in the future a competitor may enter (very unlikely) or that payment technology evolves to the point where SHVA is no longer necessary (the board does not value this as they are not able to predict it) there is a risk that is important to mention and take into account.
This company, owned by the major Israeli banks, is in charge of executing the payments transmitted by SHVA. The two companies share staff, offices, servers, managers and other common resources due to the synergies between them.
Israel's competition regulator has ordered the two companies to separate as they are against Israel's Antitrust Law. This executive order has been appealed several times by SHVA, arguing that in the event of the separation, the costs of both companies would increase to such an extent that they would have to pass it on in higher prices, which would not benefit either the payment system or Israel's economy. To date, these appeals have been rejected, but there is no final ruling.
The different scenarios are hypothetical, but some are already being considered:
Acquisition of Masav: The acquisition of Masav could be valued at 300 M NIS. With NIS 100 M cash and common owners, it would not be difficult to raise the necessary funds to acquire it. This would incur higher revenues, margins and dominate the payment system completely.
Separation: This scenario is likely, although I find it hard to think it would be executed. Everyone would be hurt, SHVA, Masav, businesses, banks, consumers, payment systems and the economy by increased costs. The above and the fact that in the last decade SHVA has had four legal proceedings, two of which have come to nothing, one of which the board does not even give importance to and another which is still in process, make me optimistic.
The concern is that discontinuing the synergy between the companies and the high costs of separation will lead to higher prices that will eventually be passed on to consumers in one form or another. According to an opinion attached to the motion, the estimated operational cost increases (excluding separation costs) following breaking synergies is NIS 15.3 million per year for the Company, or 30.7% - Annual Report 2020.
Acceptance of appeal: In this scenario everything would continue as it has been up to now.
One of the interesting points of the thesis is the valuation offered by the company. It is currently trading at 21xPER and 14xEV/EBITDA, very attractive multiples when compared to Visa and Mastercard or numerous companies that have seen their valuations soar without producing a profit.
Visa currently trades at 33xPER and 25xEV/EBITDA. Mastercard trades at 37xPER and 28xEV/EBITDA. It is true that these are global businesses, with higher operating margins, a more established brand and more mature. But it gives us a view that SHVA is trading at a more than fair price.
To estimate a price I consider that SHVA can grow at a low double-digit average over the next decade. Given its recent 1H-2021 results, with 30% growth over 1H-2020, the first few years of this decade its growth will be higher, although I prefer to remain conservative on its growth.
Its operating margins I estimate could be close to 50% as it continues to grow, putting it at the level of its peers, Mastercard and Visa, but not quite catching up.
Despite its growth, monopoly and margin expansion I am also conservative on its multiples. Being unknown, growth limited to a single country and regulatory threats make me cautious.
With this in mind, we get quite an interesting return, in a highly protected business with no competition in sight. On top of this, we have to add the dividend that has started to be paid out. Sorry if the image quality is not optimal.
This is a very interesting investment opportunity for the coming years. A monopoly with the widest and fastest growing moat there is, the network effect, at a very fair valuation, a very solid balance sheet and capacity for growth, both for the tailwinds of the sector and for the new services it can provide. Being a small cap, unknown and publishing its results in Hebrew makes it even more attractive.
DISCLAIMER: This analysis is neither a buy nor a sell recommendation. It is my particular view of the business. Each person should do their own research.