Why investors are taking another look at Cuscal

A cut-price acquisition and a growing stream of digital payments have put Cuscal firmly on investors' radar. Here's what's driving the story.

Although Cuscal has a 60-year operating history, it has been listed on the ASX for only a short time and, in that time, has largely been ignored.

At least, that is, until we put it on the Buy List in March, after which the company made an acquisition at an astonishingly cheap price.

Cuscal operates a toll for electronic payments, collecting a fixed fee for transactions made across multiple payment rails.

If you pay by tapping your phone, credit card, or through EFTPOS or the Osko payment platform, there's a decent chance that Cuscal processed some of those payments.

Why every tap and subscription counts

There are three reasons for buying the stock, current price notwithstanding.

One is that the volume of transactions across the New Payments Platform, which provides instant, direct-to-account settlements, is growing explosively.

Consumers now pay for small purchases like coffee and train rides with a tap rather than with cash. This generates additional fee income for Cuscal.

For another reason, thank Netflix.

Streaming services such as Spotify and Amazon have been credited with changing consumer behaviour, from paying large annual sums to smaller, more frequent monthly subscriptions.

Everything from TV, music, insurance, toilet paper and telecoms is now largely paid by monthly subscriptions.

Splitting payments into 12 neat amounts is manna for Cuscal, as it generates 12 times the fees for the same annual payment.

The RBA reports that between 2013 and 2023, the number of payments per person rose from 330 to 730. That figure is no doubt higher today.

The third reason for buying the stock is the most compelling because it also confounds.

The acquisition that could transform earnings

Last year, Cuscal acquired Indue, a smaller competitor that has been in its crosshairs for years.

Indue offers a service like Cuscal's, only it leases payment rails and connections.

Cuscal can now migrate all of Indue's revenues that ran through leased infrastructure to its own. Doing so will make a dollar of revenue at Indue even more valuable.

The acquisition should significantly lift earnings, but not immediately.

First, Cuscal needs to integrate transactions into its own payment system by certifying payment paths, migrating bank cards and meeting reporting and security requirements. This is expected to take two to three years and cost $25-$30 million upfront.

Cuscal also needs to wait for lease terms to expire before Indue's transactions are moved over.

These are for a maximum of three years.

For the first year or two after the acquisition, the benefits of the purchase won't show and the cost of completing it may hide transaction growth.

After year three, though, earnings should explode.

A near-monopoly at a bargain price

Following the purchase of Indue, Cuscal recently agreed to buy Paymark, New Zealand's original EFTPOS network, from French processing business Worldline for $27 million.

The deal is expected to complete by June 30.

Paymark was New Zealand's first EFTPOS provider.

As with Cuscal, it operates the switch that routes payment authorisations between merchants, acquiring banks and card issuers.

Every time a Kiwi taps to pay at a supermarket or petrol station, there's a good chance it's going through Paymark's infrastructure.

The business processes more than 1.5 billion transactions a year and serves all four major NZ banks alongside merchants in every industry.

Around 75% of NZ merchants are connected to the Paymark network. This is not a niche business, it's a core part of the national payments infrastructure.

How Cuscal struck its best deal yet

Paymark was sold by the banks to French group Ingenico for NZ$190 million in 2018. Worldline then absorbed Ingenico in 2020.

So, how did a sought-after quality business end up as a distressed asset? Because Worldline itself is in financial strife.

Paymark was in the firing line because it was due to absorb $21 million in capital expenditure that Cuscal will now take on. This is what happens when a distressed seller meets a patient buyer.

Paymark is expected to generate A$5.4 million net profit next year, implying that Cuscal is paying just five times earnings for a near-monopoly asset with guaranteed transaction growth ahead.

For comparison, the Indue acquisition was struck at 25 times earnings.

Paymark won't provide the same opportunities for scale, but the capital project will end by 2030.

After that, the business will generate a reliable, growing stream of earnings. The return on capital on the purchase price will likely be more than 20%.

To fund the deal, Cuscal is raising A$33 million in new equity, the bulk of which is a fully underwritten institutional placement priced at A$4 per share.

This results in about 7.5 million new shares, equivalent to about 3.9% of existing shares on issue. The dilution is modest.

There are no heroic assumptions needed here.

These kinds of assets, at this sort of price, are rare. It is the best deal we've seen for a while.

That said, Cuscal is a better-than-average business but is not exceptional.

It must carry a huge capital buffer that stifles returns, and the big banks remain formidable competitors.

But a second sensible acquisition suggests that, in upgrading the stock in March, we may have undercooked growth potential and underestimated management.

So far, this has been a masterclass in capital allocation. With the share price up 21% since, we're downgrading to HOLD.

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