4. Why Adyen's valuation is too demanding

Adyen, my favorite little payments company out of Netherlands, reported its H2 2020 results today. Those results blew way past sell-side consensus expectations, and Adyen’s stock price is at all-time highs. I’ve spent a bunch of time following this company and also looked through a few new sell-side reports on it today, so I thought I’d share some valuation thoughts here while those thoughts are still fresh in my head. Before you continue reading, please check out the replay of Adyen’s earnings webcast. If you haven’t already seen it, it’s well worth it. Instead of standard webcast slides, Adyen made a delightfully whimsical little animation comic, with some pleasant bebop music in the background.

Adyen Payments @Adyen

Today we released our H2 2020 financial results which reflected business resilience and continued profitable growth in the second half of 2020. Listen to the call and see the results here: adyen.com/ir

With that out of the way, I’ll just come right out and say that I think we’re entering ‘capitulation’ territory. I’ve seen or heard many variations of the following sentiment crop up recently: “Damn, Adyen has always looked expensive to me but it just keeps going up! With stocks like this, at some point you just gotta close your eyes and just buy it! Aargh. What to do… Let’s just buy”.

That’s kinda problematic. I honestly think there’s nothing wrong with owning optically expensive shares - but you still need to have some explicit assumptions about what this business will look like 5 or 10 years out into the future and what the “end state” is where market shares are stable. For a reasonably slow-changing market with well-defined / well-understood business models and a plethora of quantitative data (volumes, profit margins, etc) doing anything else is probably speculating, not investing. As a reminder, here are Adyen’s current financial metrics:

• approx. fully diluted enterprise value: €66 billion

• 2020 total volumes: €304 billion

• 2020 net revenues: €684 million

• 2020 EBITDA: €402 million (i.e. 59% margin but management guides for 65%+ in the medium-term and buyside is probably already at 70% if not higher).

• Trailing TEV multiples are thus 96x net revenue, and 164x EBITDA.

Who are the incremental buyers of Adyen shares at this price? What are they shooting for? In a nutshell, I think the buyers think Adyen will easily grow into its multiple. But I think that belief should be examined further, and it fails to properly take into account some important limiting factors to Adyen’s long-term size.

The “micro” limiting factors

Adyen is not a tech platform business in the classic ‘FANG’ sense of the word, even though I think it often gets confused for one. Adyen’s approach to its market (merchant acquiring & payments processing) does not have the characteristics that support the emergence of a platform business. A “winner-take-all” platform business emerges when the market has at least a few of the following characteristics: customer network effects, high barriers to entry, high customer switching costs and high barriers to customers ‘multi-homing’ (i.e. diversifying across multiple vendors). In payments processing, almost none of this is true. Let’s take these elements apart, one by one:

There are no network effects. For example, Subway (an Adyen client) derives no benefit from the fact that Joe & The Juice is also an Adyen client.

The barriers to entry are not high. This is proven by the ongoing growth of newer market entrants. Take Checkout.com (I wrote about it in my previous post) - as recently as 3 years ago this company was largely unknown in the broader market but now it is rising as a credible competitor to Adyen when Adyen bids for sizeable ecommerce accounts.

On switching costs, they are not as terrible as they are made out to be. Even though it is painful for a merchant to switch over to a different payments provider, it is doable and merchants still do it.

Finally, and perhaps most importantly - merchants prefer to have multiple processors. It is simply good business practice. As a merchant, by having multiple payments processors you add some redundancy and reduce business continuity risk. The merchant also gets to measure the processors’ performance and authorization rates more directly, which helps the merchant play the processors off each other to get the best pricing at contract renewal time. No materially-sized competent merchant will let Adyen run 100% of the merchant’s Visa & Mastercard business.

Adyen bulls also do not fully appreciate the extent to which Adyen might struggle to really penetrate the small end of the merchant base (i.e. SMEs). Long-term, winning significant market share in that segment requires either having a combination of a probably inferior product but a very strong distribution / partner-integrator ecosystem (i.e. this is basically First Data), or doing what Stripe and Square are doing, i.e. be extremely good at marketing and bundle a compelling range of other products and services on top of the core processing capability. Can Adyen really do better at being Stripe than Stripe? Does Adyen have a consumer-facing product that it can potentially leverage in the direction of a closed-loop system (like Square)? The answer to both of these questions is clearly “No”. For all the talk of Adyen “killing” all its competition and winning new contracts left and right, the SME end of the market will always be less hospitable to Adyen.

Another frequently misunderstood point - strictly speaking, it’s probably true that Adyen’s technology is better than that of big banks’ processing arms such as JPMorgan’s Chase Paymentech. But the processing volumes of the banks will not go to zero, because Chase Paymentech still will deliver superior authorization rates for Chase Manhattan cards. Similarly, BofA’s payments business will deliver higher authorization rates for BofA-issued cards than the authorization rates that Adyen can get on those cards. Reasonably sophisticated merchants realize this. In a decent proportion of cases a big merchant should keep a bank-owned processor to run the BofA cards through BofA payment infrastructure, etc. This is important because card issuance tends to be relatively concentrated. In the US, almost 1/5th of all cards issued are issued by JPMorgan / Chase; Citi and BofA also each have something like a 10% share of the market, too. Therefore, just like the hostility of the SME market, the “bank advantage” on certain card issuers serves as an invisible ceiling to Adyen’s potential share of the total addressable market. This point neatly leads me to the next topic - just how big is the addressable market?

The “macro” limiting factors

For Adyen, there are just two “macro” 2020 figures here that are most important: Visa & Mastercard combined credit & debit $ volumes of $14 trillion, and global personal consumer expenditure ex-China of c.$35 trillion (down by % MSD - % HSD vs 2019, but normally it grows by % LSD). Card volumes were flat in 2020, which is impressive given that consumption was down somewhere between 5-10%. Card volumes are expected to grow 14% in 2021 and then resume a pace of growth that is closer to what it was in 2019 i.e. HSD% and then gradually decaying to MSD% growth, resulting in $1 trillion of incremental new annual credit & debit volumes. The Visa & Mastercard volumes basically are the best proxy of Adyen’s TAM.

Adyen’s 2020 volumes of €304 billion are equivalent to 2.5% of total Visa & Mastercard credit & debit volumes in that year. Recall that payments processing is not a winner-take-all-market - it’s a merchant’s priority to diversify across multiple payments processors. Recall also the discussion we just had about the challenges Adyen will face in penetrating the SME merchant base (as well as the challenges in trying to overcome the “bank advantage” for certain card issuers). Realistically, there is no way that Adyen will get even a 25% share of the total market, in my view. Some of that is due to Adyen’s own (stubborn?) refusal to buy anyone.

But let’s imagine for a second that Adyen' did have 25% market share - imagine that Adyen’s market share will magically jump to 25% in 2021, i.e. imagine Adyen will process €3.5 trillion in 2021. Keeping % take rate constant and assuming the EBITDA margin jumps to 70%, this results in a theoretical Adyen ‘max. market share’ EBITDA of €5.4 billion. From this EBITDA level, the only real growth Adyen could achieve would come from the growth of the broader market (i.e. the MSD % - HSD % growth of global credit & debit volumes). Adyen currently trades at 12.5x this theoretical EBITDA. Given the significant leap we’ve just made where we assumed complete success in growing market share, 12.5x EV/ EBITDA doesn’t seem like a particularly attractive valuation level. Take a moment to think again about the gravity of the assumptions needed to get to that number. We just assumed that 25¢ of every dollar spent using a Visa or Mastercard by a consumer globally is set to be processed by Adyen. We also jumped forward in time. Even if Adyen was to succeed in getting a 25% market share globally, that would take many years. By jumping forward in time, we completely ignored the ‘time value of money’, implicitly discounting the time period by 0%.

Some closing thoughts

Hands down, this is an amazing company. I just don’t think the current share price provides room for a particularly attractive long-term % IRR for an investor. But I will continue monitoring and look for periods of meaningful share price weakness where I can reassess. And longer-term, it is possible that Adyen’s management could surprise and introduce new products / services that monetize in different ways and expand Adyen’s addressable market beyond the current core business.

I can also always be wrong, and I want to learn. Looking forward to getting some feedback and points of disagreement.

DISCLAIMER: Nothing written here is investment advice. I and/or parties associated with me may have positions in securities mentioned in this post or elsewhere in my Substack. You are recommended to do your own work or engage the services of an authorized financial advisor.