Shift4 Payments, Inc. (FOUR) Earnings Call Transcript & Summary

Great. Can we just take a step back and discuss your competitive mode in these 2 verticals? Why do you have more than 25% share in these large markets? And can you talk a little bit about the technology, the partnerships and your approach?

Yes. It's really interesting. There's only 3 payment platforms, as you know, that can do what we do. And it's Shift4, it's [indiscernible], it's [indiscernible]. And it's product of 2 factors. Like, one, you need the technical capability to drive incremental authorization. So what does that mean? It means you make a reservation for a hotel online. And then that's a card-not-present transaction, you show up at the hotel, you link your physical credit card to it. And then you go to the lobby bar, the restaurant, the salon, spa, and you keep charging back to your room, and we continue to alter the original authorization. So that when you ultimately leave the resort, for example, you have a single [ transaction ] charged in your credit card. Now in a restaurant context, the same thing could be like you're at the bar, you order a bunch of drinks. And then like your football team's winning, so you're like a round of drinks for everyone and you never have to give your card again. And then you go to the table, and you start ordering your meal, and they transfer the check, and you continue to build upon that check. That's a very specific type of technology. Now I'm not trying in anyway to imply that like we're the only ones who can do it. In 2020, almost everyone can. The difference is we were able to do it 25 years ago when a lot of others could not. And doing that, that early, meant we attracted hundreds of software partners that needed that technology. So let's say, you make hotel software. You would never supply hotel software to a payment plus -- 25-plus years hundreds of software companies, and they're not just hotels. They're hotels, they're golf courses, they're salon, spa, they're specialty retailers. And [indiscernible] needed to sell in and around the hospitality environment needed to integrate to the platforms that could drive those transactions. And what ultimately happened over the years is we wind up with 3. Now there were 5, we bought 2 and integrating them [indiscernible] there and narrow the landscape further up and start accumulating the same software integrations. No, it would just be impossible to replicate, would take a lifetime, because you need hundreds of software companies to be able to address a Pebble Beach or Caesars Palace or a Hyatt or a Mandarin Oriental or any of these type of customers that would be examples of our type of customers. So Global Payments saying tomorrow, like, hey, we want to really go head-to-head with Shift4, they go compete and try and take Pebble Beach away from us, they'd be like, great, we can deliver the experience. Just give us 6 years to get all the integrations done. It's not really that compelling or interesting for that type of customer. So that's why it's a very narrow landscape. And because it's a narrow landscape, it affords us the opportunity to really differentiate from the other 2 and drive competitive demand is where we do that is, again, owning more links in the value chain than everyone else. So when our customers need like EMV readers or QR code payments or online ordering or take-out delivery or SkyTab, it's a single vendor solution. And it means a lower effective cost of service, even though really the margins we're able to retain are superior than almost anyone else in merchant acquiring because we're able to eliminate all those other mouths that would need to be fed, other contractors that would need to be brought on to the big conference call during the implementation period. And that's continued to drive our growth, but it's also why we're in such a fortunate position to be in this landscape with you.

Okay. So while you're justified being known for your restaurant and hospitality exposure, you do have around 40% of volumes from other verticals. Would you mind breaking these down for us, what types of clients, vertical exposure is there? Can you have the same kind of mode in more of those verticals that you did in the restaurants and hotels? And I want to recognize that it literally takes years to build the kind of position you have. But I'm just curious about the other verticals there.

Yes, sure. So I think what's important to realize is that the mix shift that's going on in our business is actually like slightly away from restaurants despite our dominance there. So we're still very competitive in that vertical. But the way I like to describe it is 4 years ago, we had one software company delivering us merchants. And that was the software, and we found it for the restaurant vertical. But now if you look at our production over the last year, you'd see dozens of different software companies bringing us merchants in any given month. And they're in all the categories that Jared talked about. And it usually starts with that incumbency we have in the hospitality vertical. So the reason the golf course software provider is talking to us, all the things Jared just mentioned, that goes to parking garages. That goes to rental car software. It goes to [indiscernible] software. And there's just lots of others. I mean a merchant like Caesars Palace, that's 3,000 revenue centers. And you can start to imagine the varied software providers that serve them. Well, when you give them access to a great market, you give them a highly differentiated service model, one throat to choke and then lots of technology enhancement that actually extends the capabilities of their own software, they bring you into mainstream. So the example that Jared cites often, and I think it's creating, is you never know that this is a software that is a rental software company. Obviously makes logical sense for being inside of the major ski resorts in America. But that software exists at local ski shops, whether it's in Main Street in Burlington, Vermont or Summit, New Jersey, and you're renting them for the season. That software provider brings us into all of those locations. And so we get diversification in lots and lots of different industry categories. I would say the largest tends to be retail just because that's the way merchants operate in the United States. It's a major category. But there are dozens of industry codes that make up 2% to 3% or less of our volume.

Yes. Just one thing to layer on, I think it's worth pointing out. 21 years in payments, had an opportunity to talk to hundreds of different software companies. None of them like doing payment integrations, period. Like they don't want to do that. They want to make their software better and then sell their software. So you take like a Microsoft, for example, who completed an integration with Shift4 so they can sell their software into the form shops at [ Caesars Palace ]. When they had an opportunity at UPS stores, they just brought us in with them. And now Shift4 has the processing for like 5,500 UPS store locations. We displaced JPMorgan, who's the incumbent provider. We also really like 4 or 5 other vendors that were very costly that were in the process too. The point is like Microsoft wanted to sell an 8-figure software package or I'm just guessing on that, I don't know for sure. But what they didn't want to do is have to write another software integration. It takes like 6 months. It's so much different. Like in the world of Strike Online, you can maybe do a PAN integration in days or weeks. But when you go to do like encryption and device integration and contactless, like that is a very lengthy process. So every one of our software partners may have integrated to us because of something to do with our resort or hospitality business and then is going and selling into other markets like Microsoft does on a ski rental software company or any of the golf courses or salons or spas. They're more inclined to take us into those environments because they already did the heavy lift of completing the integration. So they know it works, which de-risks the entire roll after the new customer. There is an economic alignment there, too. So no reason to go back and try and complete that process from a whole new vendor. And that's why we kind of have that fortunate seat at the table even as we move outside of hospitality into all these other adjacent verticals.

Great. I wanted to touch on the 3dcart acquisition. Perhaps you could say a few things about who they are and what they do. I guess the main question is how these capabilities will be integrated with the rest of Shift4 and what that integrated new end-to-end offering will look like to your customers?

Yes, this is an awesome one. We're so excited with it because, first, I mean, there is obviously some diversification element that comes into this. It's one heck of a capability enhancement, and it has all these interesting growth verticals for us. Mostly, it's also cool that we're like the underdog right through the start. So you think about it, you've got this technology platform. It's very mature. It's been around for a long time. It has a capability set totally comparable to like a Shopify, who's this $100 billion-plus giant. Shopify has got like 1 million customers, 3dcart's got 14,000 customers, right? So it kind of goes -- reminds us of 2017 when we bought all those really small software companies that are $1 million EBITDA businesses. And we were able to radically transform their revenue model and how they go to market. And if you try to unscramble those eggs today, every one of those businesses we acquired in '17 would be 10x the size. And now we've got another crack in a really exciting vertical like e-commerce. So what are the different things we can do with this, knowing that we've got all these great volumes right from the start. I mean, we're not starting from scratch at all. One, we have 200,000 customers already, and I can tell you, every one of them's got a website. Most of them are probably selling something online. So the idea we could take this capability and make it available to all of them, and we don't have to really even charge for it. We can just capture payments volume that we're not already getting today and that's worthwhile to us. On the same note, you look inside the 3dcart base of customers, there's 14,000 customers there. They're doing a couple billion a year in volume right now. They support like 100 different payment platforms. I can guarantee you that's going to be one, and it's very easy when we make that one to cut that volume over because unlike in the card-present world that we specialize in, you don't have any of the physical devices or encryption fees. So the idea that you can transition a lot of volume over right from the start very quickly, which is a heck of a revenue synergy, is very achievable for us. Now both of us have a go-to-market strategy independent of just the existing base. We have 7,000 software partners at Shift4 that are out interacting in commerce all the time, whether they're talking to restaurants or retailers or hospitality customers. They all likely need some sort of a web presence. And today, that business is going to a Shopify or a BigCommerce or a Wix or a Square or something. If we can go out and pursue those customers with our massive third-party distribution network and win that business on to Shift4's 3dcart platform. And we can do it without charging any SaaS fees and be entirely disruptive to the Shopify model because we're going to capture payments. But that's not dissimilar to what we've done in software by giving away software in order to capture payments. It's not dissimilar to how we've given away QR codes or contactless payments or SkyTab as a product in order to capture payments. And then you go back to 3dcart's go-to-market plan and say they're competing on the Internet. They're probably always like a top 5 in terms of web stores if you were to size it up and just do some Google searches, right? So it was a very responsibly run business. I mean, it was EBITDA positive, like $4 million. We paid very reasonable EBITDA multiple for it. So that means there's a ton of capital on our side that we can put into this to enhance their profile and maybe to run it at one of the top 2, top 3 players as an underdog, not have to charge any of the type of SaaS fees that would be resident within the Shopify or a BigCommerce model in order to drive payments. So there's so many good directions we can take this product. It's why we are so excited to get this deal done.

Great. That's really helpful. I just wanted to touch on conversions. One of the business model differentiators for Shift4 is the opportunity to convert from gateway-only to end-to-end payments volume. You've already reported a couple of conversion-fueled quarters. How long can this continue? Could you explain the pitch and what caused the pitch, ignored the pitch? What's the most common reason given?

Yes, sure. I think it's important to maybe just set a stage for newer investors that don't quite know the history. The reason that 90-odd percent of our volume is gateway volumes is because we acquired these 2 platforms in Shift4 emergently. So we don't go to market with a gateway product. We just happen to have a lot of gateway customers and lots of gateway volume. Gateway-only volume was $185 billion in 2019 for example. So this idea that we have a gateway product and an end-to-end product really isn't how we go to market. We go to market with an end-to-end solution. And the most logical consumers for that solution are the customers who've used gateways in the past or have to use gateways because they use multiple pieces of software to run their business. The way we go to market in terms of offering that end-to-end solution is through the software partners that Jared described, so every one of those software partners that has an integration knows that they can bring in customers into a fragmented historic gateway-only model, which is like your separate phone, your separate MP3 player, your separate camcorder, et cetera, or they can work with Shift4, and they have an end-to-end solution where the devices drop with the merchant location the next day. And it all works incredibly seamlessly, and they get lots of technology benefits for having done that. So our software partners are really the ones that take that offering and deliver it in the merchants. And so what we do to compel that gateway migration because it's so beneficial not only for the merchant and their economics, they save money, but we also make 3 to 5x in gross profit for having done it. What we do to compel that is we obsess over feature set enhancement and what are the pain points of the day that are going to compel a merchant to want to make that decision. QR codes is a great example, but I would say every 3 to 4 months, there's a different pain point of the day that's being addressed. And hotels might have a different pain point than restaurants, for example, or retailers. But to use that QR code example, we pushed out a highly needed feature in the middle of a pandemic for contactless payments. And we made it available to every one of those software partners. And what was so nice about it is it was totally noninvasive for the merchant environment. It just shows up on the bottom of the receipt. No incremental hardware, just enable it, and it's there. But if you want to take advantage of it as a software provider to give to your existing merchants and help you sell new software or as a merchant yourself, you have to adopt to our end-to-end platform. So it really takes what is a nice to have, which is some cost savings and vendor consolidation and makes it a must-have because we're carrying it with features that what otherwise would be very, very hard for that merchant or software provider to go it alone.

Yes. And really, what Taylor's explaining why customers would naturally want to get in that platform, we're not selling a vacuum they don't need already. They're already paying on 4 or 5 different vendors to get an experience that we could deliver as a single vendor solution. The only reason they're doing it is at the time they signed up for the gateway, our iPhone of a service just simply didn't exist. So then it goes to the question, well, when are we running [indiscernible]? Well, we bought our first gateway 3 years ago. It's still representing probably 50% of our multi-production, then we topped it off with another $100 billion in volume less than a year ago. So you still got this $185 billion volume pool that you can continue to draw up on. And it's not like they're going anywhere else. There's only 2 other platforms that can do this. And you're talking major brain surgery to go in and rip out all the wiring, this utility of a service that's being provided, like a complex resort environment just to move it to somewhere else because we so desperately still want to have a separate phone, a separate camera, separate MP3 player versus an iPhone. So what's happening is the incentives and the capabilities were available, respond to different customers at different times every single month. And 50% of our production in any given month is coming over from those existing gateway customers. That's going to continue to happen for a very, very long time. I mean, we haven't even scratched the surface yet in the enterprise customers that just have a longer sales cycle. So there's a lot of life left with that. We think the entire $185 billion is addressable. It's just going to happen over some period of time. The other thing I'd say, too, and I mentioned this in my investor letter this past quarter is like as much as everybody loves talking about the gateway convergence, and I understand why because it's so easy to get your arms around, it's very quantifiable, it's like just captive base of volume that's eventually, inevitably going to line up over contributing to your end-to-end volume. Just keep in mind, we've been in business 21 years. We've grown revenue every year for 21 consecutive years, and gateway was only part of the story 3 years ago. And prior to that, we had 4 different software families contributing payment volume to us. But a year prior to that, when you go into 2016, really one software brand is contributing payments on to us. So I think the Shift4 story is about always making sure where the puck is going. And I think that in the road ahead, at least in terms of the vision we unveiled in our Q3 earnings, like we're going after global commerce. We're going after an enormous [ case ] and delivering our integrated payment capabilities, which is very unique to the U.S. market across multiple hemispheres. And of course, the gateway to the vendor platform will play a role in that but so much more. So in terms of expectations, the same as we delivered a gateway capability and a great story around it 3 years ago, expect us to do the same, similar to 3dcart in a number of different avenues beyond just the world we live in today.

We're running short on time here, but I did want to touch on margins. You saw some good EBITDA margin expansion in the third quarter. Can you talk about the drivers of that? And do you anticipate similar expansion in the fourth quarter? And then just in a normalized -- more normalized environment, where would you expect margins to be? And what levels would you be comfortable with in the medium to longer term?

Yes sure. Kevin, this is Brad Herring. I'll be glad to take that. So you did see margins in Q3 recover off of Q1 and Q2, which were depressed from COVID. So we reported 32%. Big drivers there are the kind of natural scalability of this business, right? You're talking really high pass-through rates. As that volume comes in and converts to payment revenue, it passes through very nicely all the way through the bottom line. So we did expand in the low 30s. We do see continued expansion in that over time. This business will continue to scale. At the same time, we're going to continue to make investments in the business to drive that top line growth. So you will see a low 30s number expand over time into mid- to upper 30s. I do want to highlight a little bit of seasonality. So you asked your question about Q4. You will see the margin expansions really more heavily in Q2 and Q3 just because of the natural seasonality of the business. When you get into Q4 and Q1, those tend to be a little bit slower on the margin side. But you begin to see that expansion come back in Q2 and Q3 of 2021 just due to a natural seasonality effect in the business.

Great. And I'll try to squeeze one more in here. Just on M&A and capital allocation, how would you rate your different capital allocation priorities?

Yes. I think I'll speak to that. I think we're actually incredibly fortunate that we're able to make investments in a number of areas that have proven very fruitful in terms of value creation for the business over the years. We're very lucky in kind of a successful IPO and to rapidly deleverage the business in order to make investments across a number of different avenues. I mean, just to give you a sense, 5 -- the last 5 years prior to the IPO, we were levered at 6x. We have a very supportive equity partner who is very efficient with our capital stack. And that meant we were operating in a relatively constrained environment. Now over probably 3 years, last 3 years, we've tripled EBITDA. And we did it, having to be very selective with very high-return thresholds to cross. So if we wanted to make investments in research and development so we'd have the next QR code or QR Pay product, well, that may came at the expense of an inorganic opportunity where we probably felt we could create a lot of value. And if we wanted to do an inorganic-type transaction because we have had a lot of success with M&A, well, that might come at the expense of dollars we could allocate to customer acquisition costs because our unit economics are phenomenal. We have like 8-month payback periods when you look at LTV to CAC. So we've always had to be very selective and prioritize where we allocate capital. Now we're sitting in a place where, on a net leverage basis, we're like less than 1x, where we can invest more in customer acquisition cost because we should totally do that when you have 8-month payback period and a value prop as strong as we do. So we are doing that. And we're also investing more in research and development so that we have that next, whatever, QR Pay is going to be or whatever that similar type of product is for the problem 2 years from now because solving pain points is one of the ways that we capture business and to differentiate the market. And without question, you can guarantee you that Shift4 is looking at the M&A climate today no different than 2017, where we're looking at ways we can dramatically transform the business just as we did in 2017. So we're very lucky that we have the financial firepower, the low leverage position to be able to go out and make investments across the spectrum. And I'd expect us to continue to do so. And I'd say they're all equal parts of importance.

I think we're officially out of time. I want to apologize for some of the technological glitches we had at the beginning, but this was really helpful. And I really appreciate your time this morning. Thank you.

Thanks very much.

Absolutely.