High Conviction Idea: Bountiful Benefits At A Pleasing Price

Disclaimer: Nothing in this article is financial advice. It is speculative and might be wrong. It is published here as an educational resource derived entirely from public documents. I own shares in the companies mentioned and may buy more. The article was first published on 10/30/2024 at mostlycharts.substack.com

The Setup

In January 2024, the share price of Edenred, a European benefits intermediary, began to slide.  This followed seven years of consistent share price gains, from below €17 in 2016 to over €60 by mid-2023. Before the slide started, the valuation peaked near a rich 30x EPS (NTM).

In subsequent quarters, the company confirmed (or even slightly increased) its 2024 earnings target. The original target was for EBITDA to grow >12% in 2024. More specific guidance given later in the year put expected EBITDA growth at >13%.

Still, the shares slid. As of late October 2024, the valuation has slipped to about 13x EPS (NTM). The multiple has been cut in half in less than a year.

Meanwhile in February 2024, Edenred’s closest competitor and second in the market in terms of revenue share—Pluxee—was spun off from parent company Sodexo, a European food services and catering brand. Pluxee’s EPS multiple at the time was about 20x (NTM).

In subsequent quarters, Pluxee raised its 2024 outlook. Yet by May, its share price also started to slide and continued its downward trajectory until its EPS multiple reached about 10x (NTM) as of late October 2024.

Both businesses have attractive characteristics: low capital intensity, good returns on capital, a long runway of potential growth at 2x GDP or better, leading industry positions with sticky customers, good branding, and a chance to further consolidate the industry.

I would expect a business with those characteristics to trade at a fair value of about 20x EPS. Indeed, Edenred traded at-or-above this level even when its growth was more subdued (pre-2016). Edenred’s improved growth and ~50% multiple expansion post-2016 was driven by diversification beyond meal benefits, a focus on better market penetration, and digitization of its voucher program. Pluxee is pursuing similar growth drivers, so multiples in the 10-13x range seem unjustified for either company given a robust growth outlook.

Why are the stocks selling off if financials are so strong?

The major concern is a fear of regulation—specifically, price controls.

A minor additional concern is falling interest rates, since both companies generate significant income from investing “float.”

My thesis is that both concerns are overblown.

Quick Business Overview

Employers contract with Edenred and Pluxee to issue benefits cards to employees. The biggest part of the market is meal benefits, but these cards are also used for other types of benefits such as a transportation and wellness.

With these types of benefits, the employers load money onto a card adminstered by Edenred/Pluxee. Edenred/Pluxee keep the cash on their books until employees spend it. Employees then spend the money at pre-approved merchants.

The market exists because of tax incentives for employer benefits and because of cultural expectations about employee perks in Europe and South Amercia - the largest markets for both Edenred and Pluxee. The tax system in the U.S. does not incentivize meal benefits, so the U.S. market is small for both companies.

The companies generate revenue from four sources. In order of largest to smallest (my estimation), they are:

1. Transaction fees from merchants when employees redeem benefits. This seems to be the source of most of the controversy among investors.

2. Commission fees from employers to maintain the benefit program.

3. Interest revenue on float.

4. Miscellaneous fees for various types of benefit programs (i.e., some types of benefits have a monthly service fee).

Price Controls

The crux of my thesis is that for Edenred and especially Pluxee, most of the business is already operating near the level at which regulators are considering price caps, so the current threat is isolated.

Here is some background on the situation.

The French Competition Authority (FCA) initiated an investigation in 2019 into anticompetitive practices among the four meal voucher companies that control most of the market in France. As of late 2023, total fines of €415 million have been implemented and upheld by appeals courts. This one-time fine is completely manageable for both Edenred and Pluxee.

More concerning is that the FCA also scrutinized an increase in merchant fees between 2018 and 2022 for the four companies. However, by late 2023, the FCA decided price caps were not the best policy response.

This was not the end of the saga. Edenred recently disclosed that the Italian government has introduced legislation to cap merchant fees at 5% for benefits with private employers (the benefits for public employers are already at this level). This legislation is only proposed; it has not yet passed.

If fully implemented, Edenred disclosed the new Italian law would negatively impact its EBITDA by up to €120 million per year (roughly 10% of current EBITDA).

Based on this disclosure, I am estimating the uncapped rates for private employers in Italy are perhaps in the 8-10% range. Note: I could be missing something and have not confirmed this with the company.

If we assume that the entire business is subject to a 30-50% price cut over time (8-10% fees going to 5%), that would indeed be a reason not to not own the stock. However, some basic math suggests most of the business is already operating at or under the 5% level.

The details of that calculation are as follows: Edenred processed €41 billion of benefits volume in 2023, which resulted in operating revenue of €2,311 million, for a total take rate of about 5.6%. This includes a fee charged to the employer, which my preliminary research suggests is usually in the range of 1%. Thus, average merchant fees are probably below 5%. Pluxee is also in this same range, with 2023 business volume of €23 billion and operating revenue of €953 million, for a total take rate of about 4.1%.

Again, I haven’t yet confirmed this with the company. I might be missing something in this calculation. However, this Edenred price list for merchants suggests 3-5% is the correct range for some merchants.

It’s worth noting that Edenred expects EBITDA growth in 2025 of at least 10% even if a half-year of Italy price-caps are implemented. This suggests underlying growth in the business is still very strong. On its public calls, the company is trying to assuage concerns about Italy but is perhaps missing that investors are mostly concerned about whether more widespread price controls are likely.

The extreme bear argument is that merchant fees could fall to levels commensurate with major credit cards, which would be in the 1.5-3.5% range. I would make several counter arguments to this bearish thesis.

1. The four major credit cards are processing well over $10 trillion in payments per year, so the 1.5-3.5% fee level common to these processors is commensurate with truly global scale. Also, fees equilibrated at that level mostly by free-market mechanism. Benefits intermediaries like Edenred and Pluxee process less than $100 billion in volume, which is on the order of magnitude of 1% the size of the credit card market. To have a level of fees that is 2x credit card fees at only 1% of the scale is completely reasonable, in my opinion.

2. At absolute maximum penetration, the benefits market would be perhaps $1 trillion in volume. Even if fees moderated by half (closer to credit card fees) as market penetration grows, the addressable revenue opportunity would still increase 5x.

3. The Italian government’s 5% proposal probably represents the limit of government price caps in the near term, so a 5% cap should be used as the bear case. Also, the Frech government has seemingly taken price caps off the table.

Interest Rates

One reason this business model is attractive is because Edenred and Pluxee generate interest revenue on cash held until the employee uses the benefit.

Taking Pluxee as an example, in FY23 (ending August), Pluxee generated €99 million of revenue (likely very high margin) on average “float” of about €2.4 billion, for an interest rate of about 4.1%. This compares to €38 million of float revenue in FY22 on average float of €2.2 billion, for an interest rate of about 1.7%.

Clearly, rising interest rates were a nice benefit for these companies and declining rates will be a headwind. But at such depressed valuations as we see currently, a return to sub-2% interest rates is not going to significantly impact the thesis.

For example, if interest rates return to 2% levels, I estimate the cumulative earnings growth headwind would be about 10%, whereas EPS should be able to grow 15%+ per year just from normal business operations.

Also, the risk and opportunity are more balanced on this point. Interest rates could also return to 5%+, which would be a tailwind to EPS growth.

As a side note: free cash flow for the business appears at first glance to be almost impossibly good—far exceeding net income. However, this is because the accumulation of float is treated in the change to working capital. When adjusting for this, free cash flow still looks strong, but it’s a normal proportionaly to net income. In short, using EPS rather than free cash flow is probably the best valuation metric for the company.

Opportunity

If I am right about this thesis, both businesses should grow earnings above GDP over the next two years, even if interest rates decline and some price controls are put in place. And if that level of earnings growth materializes, I expect both to return to a 20x+ multiple on EPS.

Of the two, I am partial to Pluxee. Although it is the smaller competitor with less of a track record in the public markets, it seems like the better opportunity for several reasons:

1. Pluxee is slightly less expensive on a forward multiple basis.

2. Pluxee’s overall take rate is lower, suggesting there may be less of a difference between current rates and potentially capped rates.

3. Pluxee may have more potential for operating leverage over time. It has already guided to 250 basis points of margin expansion through FY26. Additionally, its FY23 EBITDA margin of 34.5% compared to Edenred’s FY23 EBITDA margin of 43.5% suggests Pluxee has plenty of room to drive profitability.

4. Pluxee’s smaller size may make it more nimble and able to capture a higher growth rate.

Therefore, I am going to focus my opportunity analysis on Pluxee.

Pluxee is targeting low double-digit organic revenue growth through the August 2026 fiscal year, as well as “recurring EBITDA margin” of 37%, up from 34.5% in FY23.

If we assume 10% revenue growth but then subtract a proportionate impact from Italy and then also assume interest rates return to 2%, EPS for FY26 would be about €1.50-1.60. This is below consensus, but thoroughly factors in several bearish scenarios. If we assume the controversies have cleared at that point and the forward growth outlook for EPS is double digits, a 20x forward multiple is reasonable.

That math suggests the stock could be worth €30-32 per share by the end of FY25 (August). The closing price on October 29, 2024 is €16.17. That’s nearly a double within a year. And things could certainly go better than that.

Risks

The biggest risk is that I am wrong about the current average level of fees and the potential level of regulatory pressure.

The next biggest risk is a major recession. This is an economically sensitive industry. High unemployment is bad for benefits spending.

The third biggest risk is capital allocation. Both companies have been acquisitive, and while the opportunity does exist to create efficiencies via consolidation of capital-light businesses, acquisitions increase the risk of something going wrong—destroying valuable corporate culture, mishandling systems integration, drawing the ire of regulators, or simply overpaying.

The final risk is that European and South American markets come to resemble the US. Pluxee and Edenred don’t have major operations in the US because the US does not incentivize meal benefits via the tax code (the US does have certain similar items in the healthcare area and occasionally in transportation). In some sense, the businesses only exist because of inefficiencies created by the tax code: the profit captured by intermediaries such as Edenred and Pluxee represents a classic economic deadweight loss. Stated differently, it would be more efficient for companies to just pay higher wages to employees, who could simply spend the money however they wished.

However, this system of benefits is deeply embedded in certain European and South American cultures and tax code, and I don’t anticipate it will change. In fact, I expect the US will become more like Europe over time as government spending (and thus tax burdens) increase, causing more systematic inefficiencies.

Conclusion

This article is a first-impression analysis. More detailed work needs to be done, including conversations with the company, detailed modeling, and a dive into the nuances of the operations. However, I wanted to state my thesis now because Pluxee reports earnings tomorrow (October 31), and I expect things will be fine. It’s harder to say, however, when sentiment will begin to shift. But as low as expectations seem to be, it probably won’t take much for the valution to improve.