Tyro Payments (ASX: TYR) provides merchants with the required infrastructure to accept electronic payments, as well as business banking products.

It is the fifth-largest merchant acquirer in Australia by terminals behind the major four banks. Tyro mainly caters to small to medium-size enterprises in the hospitality, retail and health sectors. It is also expanding into adjacent verticals like trade, accommodation and services.

Tyro’s value proposition is to address merchant friction points, rather than being a generic merchant acquirer. Its solutions are easily integrated, accept a broad range of payment types, and come with a multitude of ancillary features.

These features can be industry-specific (for example bill-splitting for restaurants) or available to all (for example online gateways for e-commerce payments). Tyro’s strategy is to embed its solutions into a merchant’s ecosystem to limit switching, while cross-selling other products like business loans.

Market wasn't sure what to think of earnings

Tyro’s fiscal 2024 results slightly exceeded expectations, with underlying earnings before interest, taxes, depreciation and amortisation (“EBITDA”)—its preferred profitability measure—growing by 32% from the prior year, beating Ler’s forecast by 4%.

The company’s shares surged after the results and ended the day down close to 6%, Morningstar's Shaun Ler thinks the initial surge reflects growing appreciation for Tyro’s improved operating leverage thanks to reduction initiatives, more diversified revenue streams and product innovations.

Ler says these factors should enable maintainable profit growth at Tyro. But he wasn’t quite as enthused by the results as the market. Perhaps other investors agreed given the subsequent pullback. 

He thinks the company’s higher earnings during the quarter appear to be of a lower quality, as they were driven more by higher-than-expected merchant fees, interest income, and corporate segment income than by facilitating more transactions.

These developments led Ler to raise his revenue margin assumptions for Tyro but reign back his previous forecast of high signle-sdigit transaction growth. This more than offset the effect of higher margins, and Ler lowered his Fair Value estimate for Tyro from $1.70 per share to $1.60.

Shares remain undervalued

Despite Ler's modest reduction to his Fair Value estimate, Tyro shares continue to look undervalued. The company’s earnings before interest, taxes, depreciation and amortisation ("EBITDA") margin expansion and free cash flow growth will likely continue into fiscal 2025, with management guiding for further improvements in gross profit and EBITDA margins.

Ler was also encouraged to see Tyro executing on multiple growth strategies, including merchant diversification and product enhancements.

Assuming Tyro reduces its merchant fees over time, he expects these initiatives to support more stable transaction volume growth over the next five years, mitigating downside risks from near-term soft consumer spending and reducing the risk of large merchant losses.

Most notable was Tyro’s ongoing push into less economically sensitive merchant verticals like health and services, along with two newly announced markets, further reducing merchant concentration.

Ler’s valuation includes a forecast that Tyro’s transaction volume will grow to approximately $62 billion by fiscal 2034, representing a compound annual growth rate (“CAGR”) of 4% from the $43 billion of transactions processed in fiscal 2024.

This assumes incremental market share losses but with growth still supported by future alliances with other financial institutions, extension of merchant verticals, and further rollouts (and adoption) of ancillary features.

Big banks set to compete with more focus

Notwithstanding Tyro’s technological capabilities and extensive ancillary offerings meant to add value for merchants, we think Tyro’s offering could be replicated by larger, better-resourced institutions with existing but bigger payment networks.

Tyro is the fifth-largest merchant acquirer in Australia, with 109,248 terminals as of June. 30, 2022 (over a total of approximately 946,000). This is behind those of the major four banks, who we view as Tyro’s primary competitors given their extensive footprints.

With the banks having divested their noncore operations in recent years, Ler expects them to protect and grow their merchant networks more proactively from here on, as on-selling business banking products is a key revenue source for them.

Tyro’s rough method in the past has been:

  1. Selling to a niche merchant cohort like small to medium-size enterprises in health, hospitality and retail)

  2. Resolving merchant-specific friction points, like introducing Pay@Table for restaurants where they can retrieve bills remotely or split bills

  3. Building merchant stickiness through ancillary offerings like bank accounts, e-commerce payments or integration with apps

Ler sees no reason why the major banks can’t replicate these services at lower customer acquisition costs, a reality that underpins his No Moat rating for the company.

Square and Adyen likely to compete too

Tyro looks better positioned to hold its ground against the likes of Square, which is owned by Block (ASX: SQ2), and Adyen (AMS: ADYEN).

The relatively capital-light nature of routing payments will encourage competitors like this to keep investing – and they are likely to forego short-term profitability in an attempt to close the gap with Tyro. That being said, these companies lack Tyro’s ability to settle funds on the same day, and do not offer the same variety of integrations and payment methods.

Merchant overlap between Tyro and these players is also limited for now, with Square mainly catering to micro merchants and Adyen focused on enterprise/online merchants. However, Ler sees Square’s use of its Afterpay offering to acquire new customers and move upstream from micro merchants suggests that this could change.

Evolving payments sector increases uncertainty

Ler says it is relatively difficult to forecast Tyro’s earnings growth because of the fast-evolving nature of the payments market. And given its early growth stage, any changes in his assumptions for Tyro’s market share - particularly on expansions into new markets – could have an outsized impact on his earnings forecasts and Fair Value estimate.

Similarly, there is potential for stronger competition from better-resourced competitors who, like Tyro, are building up their offerings and a scalable user base. Notably, a deliberate strategic shift to replicate Tyro’s value proposition to merchants in specific industries could diminish Tyro’s relevance.

There is also a risk of innovation in payments that could diminish the role of intermediaries, such as merchant acquirers like Tyro. For example, if adoption of low-cost real-time payments grow rapidly, this could put pressure on merchant services fees or force Tyro to spend up to demonstrate its value-add beyond payment processing.

As a result, Ler has attached an Uncertainty rating of Very High to his valuation of Tyro. A prolonged economic downturn would be especially detrimental to Tyro, as the bulk of its merchant customers consist of small to medium-size businesses and in cyclical sectors like retail and hospitality.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.