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Very Bad Times Ahead for VeriFone

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

VeriFone Systems (NYSE: PAY), a leading manufacturer of credit card and electronic payment terminals, was once a solid growth stock, clawing back from the recession to post record profits as credit card penetration increased around the world. It was a solid business model that seemed destined for success. Unfortunately for shareholders, the company decided to reinvent itself over the past two years. It made expensive acquisitions, attempted to shift its business model from hardware to services, and lost major contracts. Top that off with macro weakness worldwide, and you’ve got one lethal combination -- which caused the company to lose nearly half of its market cap in a single week.

Fumble in the first quarter

First, let’s take a look at VeriFone’s disastrous earnings preview and compare them to analyst expectations.

<table> <tbody> <tr> <td><strong>(Non-GAAP adjusted)</strong></td> <td><strong>Company Forecast</strong></td> <td><strong>Analyst Forecast</strong></td> </tr> <tr> <td>1Q EPS</td> <td>$0.47 to $0.50</td> <td>$0.73</td> </tr> <tr> <td>1Q Revenue</td> <td>$425-$430 million</td> <td>$492.5 million</td> </tr> <tr> <td>2Q EPS</td> <td>$0.45 to $0.50</td> <td>$0.80</td> </tr> <tr> <td>2Q Revenue</td> <td>$435-$450 million</td> <td>$514 million</td> </tr> </tbody> </table>

Source: Wall Street Journal

It’s clear that the stock’s 40% plunge was justified. But have those bleak earnings crushed its longer term fundamentals? Let’s compare VeriFone to its French rival Ingenico and domestic competitor NCR (NYSE: NCR) and see how it stacks up.

<table> <tbody> <tr> <td> </td> <td><strong>Price to <br />Earnings (ttm)</strong></td> <td><strong>Price to Sales</strong><br /><strong>(ttm)</strong></td> <td><strong>Return on <br />Equity (ttm)</strong></td> <td><strong>Debt to Equity</strong></td> <td><strong>Profit Margin</strong></td> </tr> <tr> <td><strong>VeriFone</strong></td> <td>31.03</td> <td>1.85</td> <td>5.20%</td> <td>99.99</td> <td>3.55%</td> </tr> <tr> <td><strong>Ingenico</strong></td> <td>31.97</td> <td>2.52</td> <td>9.66%</td> <td>73.34</td> <td>5.79%</td> </tr> <tr> <td><strong>NCR</strong></td> <td>32.16</td> <td>0.78</td> <td>13.78%</td> <td>157.42</td> <td>2.44%</td> </tr> <tr> <td><em>Advantage</em></td> <td>VeriFone</td> <td>NCR</td> <td>NCR</td> <td>Ingenico</td> <td>Ingenico</td> </tr> </tbody> </table>

Source: Google Finance

VeriFone doesn’t shine in any category, but Ingenico has an edge with lower debt and higher margins. That means Ingenico's recent gains in Europe, at VeriFone’s expense, could be a major threat.

The business

For most of VeriFone's 22-year history, it has followed a simple business model -- selling credit card payment processing hardware to retailers. These systems eventually needed to be upgraded or replaced, and VeriFone would then sell the next generation of products. These products included merchant-operated and self-service payment systems across a wide range of industries.

<img src="http://media.ycharts.com/charts/d42287c0ec036860ff195990ef97777b.png" />

PAY Revenue TTM data by YCharts

VeriFone’s top and bottom line growth over the past five years has been strong, but the company has noted that its business model is unpredictable. Considering that credit card terminals do not need to be upgraded often, the company’s revenue stream can be unstable if retailers refuse to buy new hardware.

VeriFone decided to focus more on services -- which generate predictable monthly fees -- and less on new hardware sales. To accomplish this, VeriFone began subsidizing and giving away more machines, taking losses in order to generate continuous future revenue through newly introduced monthly fees. However, this new focus on services revenue -- which accounts for 12%-15% of its top line -- led to a loss of market share at its core hardware business.

VeriFone intends to shift to an even split between hardware and services revenue by 2015. However, this change is expected to cause more pain for shareholders, with the company anticipating a revenue decline in 2013 and a return to mid to high single-digit growth by the beginning of 2014.

The great shopping spree of 2012

VeriFone’s acquisitions of Swedish payment services provider Point and Lift Retail Marketing Technology, both completed last year, have also been criticized by analysts.

Point is a major point-of-sale transactions service in Europe, which handles over 10 million transactions daily for 450,000 merchants across 11 countries. The takeover cost VeriFone $820 million -- with a final price tag of $1.05 billion including Point’s outstanding debt. That’s a steep price tag for a company completely based in crisis-stricken Europe.

Meanwhile, Lift -- which was acquired for an undisclosed amount -- produces digital displays that are set up next to cash registers at convenience stores and gas stations. On checkout, the system analyzes the products in a customer’s shopping basket, then cues the cashier to suggest additional purchases based on current preferences. VeriFone claims that the technology can boost a location’s sales by 2% to 5%, however that figure remains unproven.

Wedbush Securities analyst Gil Luria noted that Point and Lift didn’t boost VeriFone’s growth as much as originally anticipated, and its remains unclear when these acquisitions will become earnings accretive.

Macro and micro pains

VeriFone also faces some major problems worldwide. The company’s increased exposure to Europe, lower than expected revenue from Brazil, and economic uncertainty in Venezuela have all weighed on earnings. Major customers have also delayed or canceled projects due to lingering economic uncertainty, especially in key emerging markets.

VeriFone also lost an exclusive $35 million contract to install electronic payment machines in approximately 7,000 taxis in Washington, D.C. due to the contract being “improperly handled.” 

The future is now

Looking forward, VeriFone must adapt to rapidly shifting trends in the industry to stay ahead.

The electronic payments industry has evolved a lot over the past six years. Smartphones equipped with NFC (near field communications) technology are considered the future of electronic payments, in which a smartphone can be programmed to synchronize with payment terminals for instant payments.

Visa (NYSE: V) and MasterCard (NYSE: MA), the two largest credit card companies in the world, have already launched their own NFC services -- PayWave and PayPass, respectively -- which were initially added as a chip for traditional plastic cards, but then later added on as a hardware feature in new smartphones.

eBay’s (NASDAQ: EBAY) PayPal has notably taken a different route, extending its email-based payment services to retail stores with cards that can be used in lieu of credit cards.

VeriFone has prepared well for these shifts. It already offers NFC-equipped terminals and recently inked a deal with PayPal, allowing PayPal users to log in at VeriFone’s terminals to pay, eliminating the need for a physical card altogether. VeriFone also launched SAIL, a payment platform for individuals and small businesses that uses a dongle that can transform any smartphone into a credit card-swiping device.

The Foolish bottom line

Despite VeriFone's positive advances in new payments technology, you'd be a fool -- and not the Motley kind -- to invest in VeriFone. Asking investors to wait for two years before its costly shift from hardware to services pays off is simply naive. The company's shopping spree in 2012 revealed that it is unable to quickly and effectively integrate new businesses, and a loss of major contracts around the world shows that its execution is lacking. While VeriFone's industry of mobile payments is exciting, investors are better off picking a more solid bet -- such as Visa or eBay -- to profit from this revolution.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends eBay and Visa. The Motley Fool owns shares of eBay and MasterCard. You can follow Leo Sun on Twitter at https://twitter.com/leokornsun for more investing ideas. 

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