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

I'll just give it again. Dan Perlin, I head up the fintech practice, payments processing and IT services practice here at RBC. And I'm delighted to have Shift4 joining us next. And from the company, we have Taylor Lauber, who's the President and Chief Strategy Officer. So thank you so much for being here today.

Of course. Good afternoon.

Yes. Good afternoon to you. We also have Nancy Disman, who maybe people haven't met. She's the new CFO. And if you don't know Tom McCrohan, he's right there. So you'll get to know him.

Let's just dive right in.

Yes.

Let's talk about the things that caused a little confusion, a little consternation because I think that's what most people are really interested in. And the first thing I want to start with is really kind of the capital that you deployed. It was almost $380 million. Part of that was for acquisition.

Yes.

Part of that was also for this in-sourcing of distribution, which, quite frankly, I think was a bigger piece of the question mark. But why don't you just walk us through the strategic importance of the acquisition, this PSP, why you did that at this time, what that means kind of financially, if you would? And then let's go into the in-sourcing component because that's a bit of a deeper discussion.

Yes. Sure. Absolutely. It's probably prudent to start with maybe 6 months before Q3 and how we were viewing the world. I think we've been one of the more vocal names about sort of caution on macro, what that means for the future. We entered Q3 with the mindset that we're going to focus on 3 really substantial needle movers for our business, kind of each short-, medium- and long-term beneficial. Those 3 were our Gateway Sunset initiatives, so continuing to migrate merchants over from gateway only to end-to-end; better monetizing the gateway merchants that don't move end-to-end; and then how are we going to go to market with our new best-in-class restaurant product into the future; and then lastly, how do we not lose sight on the long term despite sort of hesitation around the medium-term macro picture. And that was where international expansion has been a bit of a strategic imperative for us following our new big global customers all over the world. So we entered Q3 with the idea that we're going to execute on these 3 and just these 3. And if you followed Shift4 for any reasonable period of time, focusing on just 3 things is not something that typically happens. But we thought these are the 3 needle movers that are going to drive the business, again, short, medium, long term. After it well, which is that collectively during the quarter, we deployed about $380 million. There were also a series of different organic initiatives in aspects like the Gateway Sunset project that I talked about.

Yes. We'll get to that now.

The net outcome of that was if you kind of read through the tea leaves and what we talked about on the earnings call is we exited the quarter with $85 million-plus of incremental EBITDA free cash flow that we didn't enter the quarter with. So I think as there was skepticism in the amount of capital deployed, the effective cash-on-cash return on that capital, and quite frankly, the short-, medium- and long-term strategic importance of each of those dollars wasn't necessarily understood either. I think we've seen a bit of a rebound in our stock as investors have started to realize that the capital deployment had both really good, defensive and offensive characteristics. And by the way, we didn't take our eye off the long term. We actually, through that acquisition of PSP, gave ourselves a technical platform that we think further accelerates our kind of move into global commerce.

Yes. Now that PSP, as I understand it, some of the big opportunities that are going to come from that are tethered to Finaro acquisition. Fair or not fair?

It's partially fair. We think the platform already integrated to Finaro. They share customers today. So you get really good synergy benefit when you own both of the assets. That's one. But I think more importantly, the technical integration capabilities it gave accelerate a lot of the merchants we had in our pipeline already. So they're able to route us transactions today. They're already fully integrated. We completed the acquisition about 45 days ago. They're also able to route transactions to Finaro. And there's -- in certain cases, a single merchant is routing European transactions to be settled by Finaro.

Okay. Right. So once the Finaro acquisition closes, which we're hopeful is when, first quarter now or...

Yes.

That's kind of what we're saying?

Yes. I think that's -- so it's governed by a regulatory approval process, which is taking place in Europe right now. So we had hoped it would happen in Q4. I think we're being a little bit more cautious about that now and suggesting it could be Q1. We don't see a lot of reason that would push me on that.

Yes. But the idea is once that closes, then you'll be able to actually go after those international transactions of this client, which we don't talk about anymore by name.

Actually -- so important to note that the closing of the transaction isn't encumbering any of the technical work. As of several weeks ago, we're sharing customers today. So Finaro has a customer that they referred to us that was conducting U.S. volume through a competitor now. Every transaction routes to Finaro. We settled the U.S. volume, and they handle the European volumes. So while we don't get the full revenue benefit and the full margin benefit of supporting the entirety of the relationship, we're not losing any time to make sure that if there's U.S. volume from their customers, we can handle it. And if there's European volume from ours, they'll pick it.

Okay. So -- because we do get this question all the time, if the deal closes in the first quarter and you're able to start to process more European-specific transactions from that region client, what have you, is there an expectation that we would expect to see end volumes start to really accelerate as a result of that or not so much? Like I just want to make sure we're all on the same page.

The acquisition will undoubtedly drive end-to-end volume growth, just in the inorganic nature of the fact that we haven't ever included the acquisition in our guidance. So it will inherently sort of drive volume up in that way, but also that there's volume that both sides are not getting the benefit of that we expect to get the benefit of right away. So yes, we do expect volume growth to benefit both organically and inorganically as a result of that.

Okay. That's great. So let's talk about this in-sourcing proposition. I think you spent a little bit more money on that. Here again, I think it was kind of not well understood what exactly you were doing there or the importance of that for SkyTab POS, of control, all those kinds of things. So maybe this is the forum for you to kind of flesh that out in a little more detail.

Yes. Absolutely. So for those newer to Shift4, we've historically gone to market almost 100% through third-party distribution. That can range from a father and son supporting a dozen restaurants in, I don't know, the hypothetical Poughkeepsie, New York, up to large global software brands, bringing us merchants that they've onboarded into their own software. In the restaurant vertical specifically, we've actually had 4 unique distribution channels. We had our Harbortouch software, our restaurant manager software, our future pad software and our POSitouch software. That's the byproduct of building some good software but also acquiring others when we saw it was opportunistic. Long term, we knew that you would consolidate these groups customers onto a single platform. I think in the midst of the pandemic, it wasn't necessarily appropriate to try to compel your restaurants to switch their software when they were trying to figure out where their next patron was going to come from. But we knew long term that there was going to be huge scale benefit to getting everyone on a single platform, substantial brand benefit and a much more efficient business for ourselves to not maintain for different pieces of software and 4 different distribution networks. In the back of our minds, though, was what happens to 2 different channel partners so we're now competing selling the exact same software in the exact same geography. Channel conflict might present itself in a way that it had never had before. And so that in the back of our mind said, we really need to think about what our distribution model is for this new piece of software. Is there the opportunity to go by your best distribution partners and make sure those are the ones that are going to represent your brand in the core markets where you really want scale and you really want direct distribution? And so we began an exercise to in-source, I don't want to say our best partners, but the partners that had the most scale in geographies we wanted to own direct distribution. We wanted to drive the message unequivocally that this is the software brand that's going to own this market in this geography, and you're going to represent it this way. That began a sort of a 3-tier deployment of capital. There were businesses that we chose to buy outright. We bought the customers, we bought demands, we bought the office, we bought the support desk, et cetera, the bookkeepers. And it gave us a really nice foothold. There are about 6 of these businesses that we went out and acquired wholesale. They had between 50-, 75-plus employees. And they were historically our best distribution partners in those markets. So unlike kind of going out and building a direct sales force, these people have represented our brand for years, and they know us well. They attend our holiday parties, et cetera. There was a tier below that where build owning that many vans and that many offices and that many siblings on the payroll just wasn't practical. So we said what we're going to do is we're going to buy out your traditional residual stream that we've been paying you, the portion of our profits that we share with you, we're going to buy that out and we're going to simultaneously hire your employees. So short-term benefit, we've got this 40% residual share that we've traditionally paid out to our partners that we no longer pay anymore. And then the medium-term benefit is we've got this direct sales force that we've hired. They know our business, they know us, and they're going to represent our brand in a very specific way. And then there were partners that became irrelevant as part of this equation. It just wasn't the dynamic because now we own distribution in a market. It wasn't necessarily practical to have them competing alongside of businesses that we owned. So we paid them all. That saves us cost. And it just -- it negates a duplicity inside of a local market. All told, several dollars deployed, I think you quoted 3 80, that's the totality of capital we deployed for both distribution insourcing and this acquisition. And the near-term benefits are really, really substantial cost of goods sold savings. The medium-term benefits are that we now control so much of our own destiny and sort of driving people towards the product we want in the way we want it done. And kind of the freebie kicker in all of this was through this whole exercise, we got a really, really interesting level of insight into how many of their customers they never brought to Shift4. Everyone kept the message of customers off to the side, whether that was 10% of their book or 20% of the book or 30% of the book. It made for funny interactions and you said, "Wait a minute, you were our best partner and you're keeping 30% of your customers off to the side." Well, now they are highly incented to go cross-sell into that. We call it our low-hanging fruit list. Go after them. They're the customer. You know where they are. You know the objective. And so every one of these presents kind of short-, medium- and long-term benefits. But in terms of how we wanted to let investors digest this, we wanted to make sure, number one, we were doing this at a time where our seasonal production would have been low anyway. This was largely started on July 1. It ended in the middle of August. And the 2 weeks of real, call it, boot camp training, you now got a different way of life. You're now an employee of Shift4. That was going to happen in the last 2 weeks of August, when they wouldn't have been selling much restaurant -- wouldn't sell anyway, at that point in time. And then hopefully, when we released SkyTab on Labor Day that we'd have a really nice track record of production under this new business model that investors could see. And so confusion aside, we're exceptionally proud of the fact that at a time when many of the greatest competitors in our industry were shedding 1,000-plus employees, we were hiring 400. We are doing it in a way that expanded free cash flow dramatically despite that hiring. And we put up 1,000 sort of new sites in between kind of Labor Day and when we talked to investors last week, which I think in the short term, there's always some cobwebs you're kicking out of the process. So to be able to show that level of production is something we're incredibly optimistic about when the machine gets more finite.

Yes. One of the follow-ups to that is the, call it, 400-or-so employees that you captured. Some -- again, you went out outright and acquired Dan, the whole thing, others you bought -- or hired the employees rather. How is the for those employees, right? Because these are important people to you. They know the product. They're in local market, as you said. And now you're kind of unleashing them with even a bigger, broader mandate under Shift4. How do you retain them?

So there's -- maybe set aside this initiative, there's a core tenet inside of Shift4 that every employee at Shift4 is an owner of Shift4. At the lowest level, that means our entry little hires were given $50,000 in stock the day they joined with a multiyear investing period. That was the same in these circumstances. So at any level, when employees come into Shift4, we want them long term aligned to the economics of the business. Something sort of lesser known is that our founder actually funds happen out with his own stock. So it doesn't actually impact the financials of the company. He just believes that owning a stake makes you think better about working at the business. So employees own 42% of Shift4 in aggregate, and this -- that ratio didn't change as over bringing up these people. In terms of the short term, now they've got a near-term priority of going out and cross-selling SkyTab. Because there's a bunch of ways they can do that, not the least of which is the book they had in their back pocket the whole time anyway. And then I think it's confidence in the product. That was really important. If you represented a particular product of ours for 20-plus years, you thought that was the best one, even though we had 3 others. And they all thought that theirs was the best. And so part of this whole exercise was bringing the 400-odd people that have joined the company, plus 200 people that had been involved in the development of the product, out to Las Vegas for a multi-day Here's what this product is, here's what it means, here's why this is so important, here's why we did this. There were whispers for 6 weeks and no one quite knew what was going on. You're on the team, you're in the room and motivating the heck out of them. And I think the near-term sales success is going to help propel kind of the motivation that this was the right firm to join at the right time.

Yes. Now in addition to the in-sourcing strategy to help drive and gain control over SkyTab, you've always talked about -- and that's not just for that, but you've also talked about having close to 100,000-or-so restaurants that are kind of out there yet to be converted into this new product. Where does that stand? And how do you think that ultimately plays out?

It's just a core tenet on how we think about growth. And by the way, in the best of times, we're skeptical of anyone's ability to go find the next new customer. And so where we deploy capital is typically to find pockets of customers that are in some way captive or beholden to a particular technology and educate those customers over time about why migrating their payments, upgrading their software makes good sense. And so what that means today is we've got a software brand that we built and nurtured for 20-plus years. That's great. We get payments. We get SaaS revenue from those restaurant brands that we acquired, where largely we just said, "Go get the payments and don't disrupt the way those merchants have traditionally used the software." But knowing in the back of our heads that Windows-based software has a longevity to it or has a certain half-life to it. I'd probably they'll use the obi. And so now we're sort of telling that sales force, "You can do any one of several things. You can go find an existing customer that's already been giving us payments, but they're on software. They're frustrated with the software. They don't want to pay for a new workstation or something like that, go give them SkyTab." We'll get a really nice as benefit from that existing customer. You'll get a 40-odd percent revenue lift from that customer by migrating them over to SaaS or find the customer that you've had for years. They're in that back pocket. They're not giving us any payments revenue, not giving us SaaS, and get them on to SkyTab. They're going to have a phenomenal product experience. They're going to net save money, and we get a substantially higher lift because they effectively feel like a new customer. Even though they're loyal to our software, they consider themselves a long-time customer of Shift4. That idea, and it's a core tenet to how we think about growth, we never want our salespeople to go have to find a new customer. And by having this Rolodex of 1,000 -- 100,000-plus restaurants where less than 15% are paying a SaaS, you can see that they can cross-sell into that base. for a really long period of time without ever finding a new customer. And if your product is any good, you're going to find new customers too. I think we've tried to demonstrate that with all the best intentions, salespeople like to go out and hunt to bring you new customers. But that -- as we think about macro and we're cautious about macro, knowing we've got a Rolodex of 100,000-plus restaurants that are beholden to us in some way, shape or form, makes us feel really good about not worrying about when the next p is going to show up.

Yes. No, I think it's a great strategy. All right. So that's friction point number one. Check. Number two is spread.

Yes.

And the question there is that you've been really good about breaking out spread, in particular, for your high-growth core. It's been very stable. There's just no disputing that. The concern is, obviously, as you , which we'll talk about in a little bit, they probably have lower spreads. But this whole mix shift that the dynamic plays out every quarter, I think, has also created some concern with investors, maybe confusion, maybe concern, maybe both. How do you kind of make people feel better about this go-forward metric, so to speak?

So a few different things. I would say, a core tenet to how we've found success in our growth overall has been a continued march upmarket. Our average customer joining in 2017 was the Barn Grill in Boise, Idaho. Our average customer joining in 2019 was a small to medium-sized hotel. Our average customer joining us to now is a big hotel, a stadium, a global broadband service provider. So we've been very adamant that this step-up market is going to compress spread. We've tried to be deliberate about showing our spread inside of verticals so people know it's not giving pricing away. Quite frankly, all the best payment providers in the industry charge premium prices. I actually want to go -- get on my soapbox for a moment and say I think that the big legacy payment providers have done a huge disservice to somehow convince the investment community that's saving a Nikola transaction is how you compel merchants to join you, if it's not. All the fast-growing platforms charge premium price. So need to give away pricing, but we have found lots of markets we can grow into, and quite frankly, big merchants that we can win from incumbents at like or premium rates. And you're right, it has caused a lot of confusion from investors because investors see outsized volume growth from us. And they say, "Wow, that should look just like the customers they had before." No, we're actually getting bigger and bigger customers every single day. And the laws of physics or that those customers should pay a little bit less for the volume. So what we've tried to sort of guide people to is this concept that we will price at or above what we consider best-in-class peer. Best-in-class peer, we consider -- at every different level, we've got different sort of competitors, but we will price at the same level. And if it's a $1 billion-plus merchant, you should not expect them to come in at the same spread as the bar and grill in Boise, Idaho. The one thing getting a little bit introspective and kind of reflecting on what I think was a misstep in how we communicated was we do owe investors a glide path. One thing that's been challenging for us is we've had a lot of success in our high-growth core. We've grown merchants quite fast. We've grown the quality and size of those merchants in a pretty demonstrable way and spread compress modestly as that happens. But now we're demonstrating success in 6 new verticals that I don't think anyone believed we were going to have success in a year ago when we set up and talked about those verticals for the first time. And as we have success, that will change the dynamics of how volume and the corresponding revenue grow. So one of the commitments we're trying to make coming out of this is we owe a new bridge to what we think volume growth will translate to in terms of revenue growth. None of this, by the way, should be implied as a deviation from the medium-term guidance we put out. It's just the reality that as you can now measure success in new verticals and can measure the contribution of merchants in new verticals, we should give a clear glide path that when volume exceeds by X, you should expect revenue to exceed by Y.

Yes. Is it your expectation that you'll give that to us in 4Q going into next year?

I don't want to set that tone only because our new CFO is.

You're welcome to say. You're not in.

No. I think we've traditionally used the Q4 call, which is in Q1 to talk about how we think the next year is playing out. I think we're going to be 1/3 of the way towards our medium-term guidance. We owe a double-click on how we think that's going to play out. But let us set the date first.

Yes. That's fine. And then the third is really like gateway conversion and understanding the dynamics there.

Yes.

You called out 3 different types, quite frankly, of conversions. I'll let you explain them, but the starting one was kind of connections that you said just don't make economic sense so they can move on. But then there's like the incremental ones that you want to price to keep. And then there's larger enterprise ones that I think, over time, are a little more bespoke. So maybe you could talk to those points.

Yes. So we'll start with the idea that we've got this massive portion of payment volume flowing through our platform that is dramatically undermonetized. We're earning $0.05 per transaction, and those led by our competitors who are earning 40, 50 basis points, 60 basis points on the volume. And they're doing nothing special, right? They're just receiving transactions, but we're outputting, we're doing all the technical work. The better thing for the customer is to work with a common platform for all of that, and they can actually save money in aggregate. So that's the core tenet. And by the way, that will fuel a ton of our growth because we can, again, take an existing basket of customers, better monetize them, give them better service while simultaneously saving the money. Every one of those customers converts gross profit contribution for us, but they also save money themselves. So it's like a win-win for everyone but the transaction. We've had this strategy in place since we acquired our last payment gateway in the end of 2019. And at the time we acquired it, here is each step we're going to take to convert merchants from being just a 30-point plan, very nicely articulated convincing our Board that this is a good transaction to do at the time. Worked reasonably well in the first couple of months that we acquired that gateway, and then the pandemic hit. And the plan goes -- I don't want to say in the dumpster, but it certainly goes in the file cabinet for a while, which is these are largely hospitality merchants. They're under extreme duress in their core business. You want to do nothing but help. You want to provide nothing but carrots. And if you can win some merchants, great, but you really just want these merchants survive what is a pretty existential moment for their business. I am exceptionally proud to say that during -- from the start of the pandemic to the 2-year anniversary, we added 10% of the hotels in the country to our end-to-end platform. So the value proposition worked and resonated even at a time where merchants kind of had anything else to think about. But as the pandemic kind of eased, as operating environments got easier, as hotels got busier, as the restaurants got more expensive, we started to revisit some of the more deliberate, I used to say aggressive, now I'll say deliberate, tactics inside of our conversion plan. And those included things like there are connections that are entirely noneconomic. There's not -- it's not a function of the merchants paying us more money. It is simply we will not maintain this. It's not -- it doesn't make any sense to maintain it. And we're going to send that platform. You can join our end-to-end, and that's pretty low friction or you can leave and that's your own decision. But there's not an economic way out of this. It's just too expensive for us to maintain. Coupled with the challenges of hiring into the euphoria that was 2021, we said we need these resources. We can't support a business model that's not economic. And then separately, there is a basket of customers that -- we want to compel the conversation. They just don't think about this every single day. And what's a good way to compel the conversation? Well, a good way to compel the conversation is to increase price. We know what the value of the service we're providing is, and we think we should increase price. And then lastly, there are these enterprise customers that you just have to approach one by one. And it's governed more by the timing of the agreement they signed 3, 4 -- what we choose to do that morning, we make up. I would say, of the sort of 3 tactics we took on this, shutting off the one connection we did proved to be quite sensible, meaning it compelled a really nice portion of those merchants, virtually all of them, to move over to end-to-end. There were a handful that just never picked up the phone, and we simply turned off the connection, and that's the end of the day. And I don't think it was done in a reputationally damning way. We just gave months and months of notice that this was going to happen. Of the -- and then the enterprise, I think we've done a really thoughtful job of negotiating a fair agreement. In many cases, they were getting the service for a song because one of these gateways was owned by the big bank on the other side. And so we simply said, we're doing this amount of work, and we're getting this portion of the economics. Help us change this. And they've been very receptive to that, by the way. And they know that if you want to move to end-to-end, you'll get that whole discount back or that increase in price, we'll rebate it all back. So those conversations are going incredibly well. It's just all these agreements. The one in the middle is like this little existential moment for us because we put through this price increase, and no one called. And I remember like sitting with our management team in July and saying, "We're not sure whether this is a good thing or a bad thing." We implemented a price increase. It was modest, but apparently too modest because everyone just paid are. And that created a little bit of a moment for us, which is care, whether they're on a gateway and paying you well or on end-to-end. Now we've got a long way to go before they're paying the equivalent. But I think we sort of said if a merchant is quite content with the operating environment and they're paying us fairly, we probably should be a little bit less religious about end-to-end. Again, this is going to feed kind of growth in the business for many, many quarters to come because it's a pretty -- it leaves it up to the merchant to decide what they want to do but on our economic terms, which I think is reasonable.

remiss if I didn't ask you about recent trends that you might be willing to share with us. Your core business as opposed to new verticals here, we're talking about kind of hospitality, restaurants, hotels, those kinds of things. What are you seeing? And how far out are you willing to share those things?

So last time we talked about recent trends, I think our stock out murdered because I just had $140 granola breakfast at the Palace Hotel at your last conference. And I thought that, that wasn't going to be able to continue. So I got it wrong. The breakfast is still $140. So the consumer is still quite healthy. I say that with a bit of trepidation because we see the payment volume coming through our customers, it looks immensely healthy. It's just the underlying fundamentals that we see, the $60 stake, the $140 breakfast that don't feel sustainable. So we're quite cautious on what the same-store growth profile looks like among our merchant base. Hotels, I would say, that conference in June was probably the first time that we saw a packed hotel, right? And that trend did continue through the summer and the fall. Like people went back to school and people went back to work, and it fell a little bit normal. You saw a little bit of a trail off in hotels. We're still seeing room rates are quite high. So there's durability in their pricing power. I still see a resurgence in business travel, which is nice. There's some more travel left there. But we're abundantly cautious. I think the idea that hotel rates can stay where they are, that stake prices can stay where they are as things that -- again, we've called it wrong for too many months, but I think it's something that just -- it's prudent to not be planning for your customers to grow for you. As we think about how we're going to grow in 2023, it's got a lot more to do with adding new customers than restaurants selling more $90 steaks. The interesting kind of dynamic we have going on right now in our business -- or one of the interesting dynamics is stadiums, which is that we've had a lot of success adding stadiums. But the installation cadence has been something that we've learned a ton. We installed a boatload of and NFL stadiums. And so we're seeing the benefit of a fall sports season. We'll see what things like the World Cup do to the gaming merchants that we have. We think that there's some really nice kind of new contributors that are going to level out some traditional seasonality. But it's -- in many ways, it's more of the same. It's very, very strong spend in categories. But you can't read The Wall Street Journal or Bloomberg and not a question why people are cutting back on their energy bills with somehow by state process.

I understand. Well, unfortunately, we're out of time. I mean I had a whole section on new verticals we could spend another 0.5 hour on. But thank you so much.

No. Thank you.

And thanks for fleshing all the stuff out for us. I think the stock reflects clarity.

Awesome. Happy to do it.

All right.

Thank you.