Update: Pax Global Technologies
International Growth at a Value Price
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This is an update to my first post on Pax Global, which can be viewed here: Pax Global link. I usually do not find quarterly or semi-annual updates helpful. In fact, short-term updates can hinder long-term investment success by overemphasizing short-term results. A quality analysis should be anchored in long-term fundamentals and, consequently, have a long shelf life. That does not mean operational results won’t fluctuate; fluctuations are natural in a dynamic world. The key is understanding when new information invalidates an assumed fundamental. Events since my initial post, in August 2021, brought into question the most important aspect of my analysis: the security of Pax’s terminals. Consequently, I thought it worthwhile to provide an update on the situation. I’ll update a few other topics as well since I’m here.
March 27, 2022
There are four parts to this update:
FBI raid and subsequent investigation
Financial performance in 2021 and guidance for 2022
Capital allocation and cash management
Valuation
1) FBI raid and subsequent investigation: In late October 2021, the FBI raided one of Pax’s warehouses in Florida. A security news website claimed the raid was in response to questions about the security of Pax’s terminals by a major payment processor. Terminal security, both real and perceived, is critical. If the security of Pax’s terminals is uncertain, banks, payment processors, and merchants will not use the devices. Consequently, the raid and its implications were very serious, and Pax’s share price fell more than 40% the next day.
In the weeks following the raid: Pax denied there were any security issues and held a special conference with shareholders to discuss the matter; the FBI remained silent about the raid, filing no charges against Pax; several major customers stated their support of Pax; and a prominent US-based cybersecurity firm (Unit 42 by Palo Alto Networks, Inc.) independently verified the security of Pax’s terminals, finding no issues. Additionally, according to Pax, several large customers conducted their own security tests – none found a security issue with the terminals. In the five months since the raid, no evidence has surfaced that the allegations from the security news website were legitimate. It seems unlikely the FBI would allow Pax’s terminals to remain in use in the US if there was any question about security, especially given the current geopolitical environment.
Following the initial news, two US customers decided to stop working with Pax. These customers accounted for less than 0.5% of Pax’s revenue in 2020. Management noted that most US customers paused orders for about a month after the raid. However, these customers and new US customers were placing orders again by the beginning of 2022. Pax’s response strategy was to emphasize cooperation and responsibility. It hired lawyers to communicate with US government agencies. It proactively contacted customers to discuss the situation. And it hired a prominent US-based cybersecurity firm to independently verify the security of the terminals. Management commented in late March 2022 that the overall impact to Pax’s business from the incident has been immaterial. Guidance for revenue growth in 2022, which I discuss below, seems to validate this claim.
2) Financial performance in 2021 and guidance for 2022: Pax posted ~27% revenue growth in 2021, with ~25% revenue growth in the second half of the year. Revenue in each geographic region except China grew by more than 20% in the second half of 2021. Historical revenue by region is shown in the image below. Pax saw much stronger revenue growth in the second half of 2020 than in the first half, creating a tougher growth comparison for the second half of 2021 than the first half. Guidance for 2022 revenue growth is 15%. Conservative revenue guidance has been common over the last few years: FY18 guidance was 15-25% growth, FY19 guidance was “flattish” revenue, FY20 guidance was “flattish” revenue, and FY21 guidance was >10% growth. As seen in the image below, revenue growth has consistently exceeded – to put it lightly – the low-end of management’s guidance. Guidance for 2022, which was given on March 23, 2022, provides more evidence that Pax’s business is not seeing a material impact from the FBI raid. Orders have a 3- to 6-month lead time, which means management has good revenue visibility through at least the middle of the year (from late March). Guidance for 2022 incorporates flat revenue in the US, which the CFO said could prove conservative.
Russia is “far less than 5% of total revenue.”
Per management, demand for Pax’s terminals continues to far exceed its production capacity.
There were cost headwinds throughout 2021, related to a strong Renminbi and higher raw material prices. These issues are not specific to Pax – I think you’d be hard pressed to find a company that did not see higher input costs in 2021 – and were reasonably well contained. The operating margin fell by ~100bp and is expected to remain at these levels in 2022.
3) Capital allocation and cash management: this is my sole issue with Pax. There is ~HK$3.5b in cash on the balance sheet and FCFE is usually at least 50% of net income (working capital is a use of cash as the business grows, and it is growing very fast). With net income of ~HK$1.1b in 2021 and presumably at least HK$1.2b in 2022, based on guidance, Pax should be generating at least HK$500-600m in FCFE annually. While it is investing HK$500m in a new production facility to double capacity, this is a one-off project. There do not appear to be other meaningful organic investment opportunities or large acquisition opportunities. Consequently, Pax has little use for the cash it generates, and it has mostly been piling up on the balance sheet. Management has shown some willingness to increase the dividend payout ratio over the last few years, rising from 17% in 2018 to 27% in 2021, but it remains very low. Similarly, Pax repurchased shares in both 2020 and 2021, but only ~33.5m (~3% of total shares in 2019; spending ~HK$165m). For perspective, management issued 82.5m share options in 2019 (only the second time in company history share options were issued). During the critical weeks following the FBI raid, when the share price was 40-50% off the high and investors needed a sign of confidence from management, Pax repurchased a measly ~1.35% of outstanding shares. Capital allocation is discussed on each quarterly conference call and management gives the same generic, uninspiring response. It is unclear if they are ultra-conservative or inept. Operationally, management is excellent, but capital allocation is consistently poor. (This is not to suggest that I think Pax should lever-up or anything aggressive, but there is a middle ground where rational cash management lies.)
4) Valuation: The valuation remains extremely compelling, considering the growth rate, return on capital profile, and free cash flow generation. With the recent increase in dividend payment, Pax now has a dividend yield in excess of 5% (annualizing the HK$0.15 per share dividend recently announced). Moreover, Pax’s growth potential should expand significantly after the industrial park under construction is completed in Q4 2022 or early 2023. This facility will nearly double Pax’s production capacity.
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If you have cash piling up on the balance sheet do you have any evidence the company is actually making the sales generating that cash and that cash is real?