By David Randall
NEW YORK (Reuters) - A data breach at Target Corp that exposed the credit card information of tens of millions of holiday shoppers was a major black eye for the retailer. In its wake, investors and analysts are circling companies that could benefit from a major upgrade in credit card technology.
One of their favorites: Verifone Systems Inc, a $3.2 billion market cap company that is one of two major global manufacturers of point-of-sale terminals and mobile payments systems and could profit from any major upgrades of payment technology. Analysts at JPMorgan Chase and Jefferies & Co upgraded their outlook for the company in the last 10 days, helping send its shares price up about 25 percent since the Target breach was first reported on December 18.
Yet for its shares to continue to rally, Verifone must prove to analysts and portfolio managers it has taken steps to right its own ship after several years of choppy performance.
That question mark is a product of several years of poor acquisitions and a history of missing earnings estimates that left the company's shares down more than 20 percent for the year just before the Target breach become public - in a bullish year for stocks. It hangs over the company as a new wave of credit card technology looks poised to finally make inroads in the U.S. after being the standard in Europe for years.
"Verifone has a tremendous and recently unappreciated position in the industry, yet it's kind of a messy place. The new management team looks great, but this is like waiting for Godot," said Jeffrey Bronchick, whose $56.3 million Cove Street Small Cap Value fund has one of the best performances in its category over the last three years, according to Morningstar data. In the Samuel Beckett play, two characters wait endlessly for Godot, who never shows up.
Verifone declined to make executives available for this article.
Bronchick said that he sold his position in the company during its recent rally in large part because, at approximately $29 a share, its stock price looks expensive. The stock trades at a forward price-to-earnings ratio of 19.5, which is well above the approximately 16 times multiple of the broad market.
"The stock is reflecting a seamless next two years and I think there's little likelihood of it," he said.
The bullish case for Verifone rests largely on expectations that the slow-to-change credit card industry is set to adopt new technology that could cut fraud in the United States. The country accounts for nearly half of global credit card fraud despite handling only 27 percent of all card volume, said Darrin Peller, an analyst at Barclays who covers the industry.
Merchants, retailers and credit card issuers have long resisted upgrading to a card system, now ubiquitous in Europe, that stores information on chips embedded in the cards themselves. Rather than relying on the easily copied magnetic stripe on the back of cards, these cards, called EMV for Europay, Mastercard, Visa, create a new code for every transaction, making it difficult for hackers to duplicate.
As an incentive to push card issuers to upgrade, Visa has warned that merchants' banks may start bearing the costs of fraud starting in October 2015 if the merchants don't upgrade.
Some Verifone terminals were in use at Target locations, according to Peller, the Barclays analyst. That investigation continues and Peller said it was unclear whether they were involved in the data breach, but he did not expect Verifone to face liabilities in connection with the loss.
Target said on January 10 it could not yet estimate the costs it would face in relation to the breach. The company did not respond to a request for comment or say what terminals it used. Verifone declined to comment for this article.
The data breach at Target has created "a growing sense of urgency" among merchants to upgrade their point-of-sale terminals in order to read EMV cards, noted Andrew Jeffrey, an analyst at SunTrust Robinson Humphrey. "For the first time, we get the feeling that the cost of conversion is being outweighed by the open-ended liability associated with making consumers whole when their accounts are compromised, and the potential damage to retailer's brands," Jeffrey noted.
An implementation of the EMV system in the U.S. would push merchants into buying 15 million to 20 million credit card terminals, said Peller, the Barclays analyst.
Those purchases - which Peller says large companies would split between Verifone and French company Ingenico, its main competitor - would likely help turn around Verifone's solutions services division. Revenues in that part of the business fell 20 percent, to slightly below $1.07 billion, in its fiscal year that ended in October.
"Verifone could see around $100 million or more in incremental annual revenue for a few years from its existing U.S. installed base, with longer-term upside from market-share gains and services revenue over time," Peller noted in a report published in 2012. He said the estimate is still reasonable.
That upgrade process would likely help Verifone investors more than Ingenico shareholders largely because several years of poor management have depressed Verifone's stock price, said David Rudow, an analyst who works on the $968 million Thrivent Mid Cap fund.
He sees new CEO Paul Galant, who came on board September 23 after heading up Citigroup's enterprise payments business, as more capable of steering the business than its previous management team, which Rudow said ignored product cycles and focused too much on next-generation mobile payment systems at the expense of the more profitable terminal business.
"If you look at stock charts, Ingenico is a beautiful chart - straight up - and Verifone is the opposite," he said. Ingenico's shares rose 44 percent in 12 months to new all-time highs and are up 450 percent over the last five years. Despite their relative stock performance, Verifone and Ingenico have remarkably similar product lines and are the two largest providers in nearly all markets they compete in, he said.
The idea that "execution issues experienced by Verifone are eminently 'fixable'" prompted Bradley Safalow, founder of Atlanta-based research firm PAA Advisors, to recommend a short position on Ingenico in November. He expects the company's share price, currently trading at nearly 66 euros, to fall to 35 euros as Verifone continues its turnaround.
Jason Kupferberg, an analyst at Jefferies, said Galant will likely take steps to standardize products across Verifone's global regions, allowing the company to cut by half the number of distinct products it offers and cut costs as well. Verifone said in December that it expects to earn up to $1.40 in net income per share in its 2014 fiscal year, a figure 10 percent below Thomson Reuters I/B/E/S estimates of $1.56 per share.
"This management team looks like it's trying to under-promise and over-deliver and is being very conservative in their guidance," said Joshua Schachter, whose $90.1 million Snow Capital Small Cap Value fund has been adding to its position in Verifone.
The Verifone rally following the Target breach has led some analysts to question if the company is becoming overvalued.
"Before recommending the stock after the run it's already had, I would argue that you probably want to see a couple of more quarters of evidence that it can regain market share back and grow from here," said Peller, the Barclays analyst.
The stock is currently trading at $28.98, slightly above the median target price of $28.50 among the 15 analysts tracked by Thomson Reuters. That high price is leading some investors to wait for a pullback before buying back in.
Among them: Bronchick, the Cove Street portfolio manager who recently sold his shares.
"If this company was trading at $21 a share, I'd be pounding the table for it," he said.
(Reporting by David Randall, editing by Linda Stern and Gunna Dickson)