Lately, iPayment has been purchasing small-merchant portfolios from Motley Fool Inside Value recommendation First Data Corporation
That's a good question. Perhaps the market doesn't like the idea of growing through customer acquisition. But that is the nature of the game in the small-merchant segment. It is highly fragmented and doesn't generate the volume that a huge national account can generate. But then again, there are many small merchants out there who need the service in today's pay-by-plastic culture. The company seems a bit undervalued with a P/E of 17 based on 2005 earnings, especially since it has been generating a return on equity of just more than 15%.
When you start looking at the cash flow statement, things get even more interesting. The company requires minimal capital expenditures. Free cash flow (cash flow from operations minus capital expenditures) is higher than earnings, implying good earnings quality, and has been growing very fast (>50%) since 2003. I think this is why the chairman wants to take the company private.
From the first quarter of 2005, iPayment generated $14 million in free cash flow. Assuming it generates that much each quarter, it would generate $56 million for 2005, a 49% increase. So to see what the chairman expects to return from these cash flows, let's do a quick DCF calculation.
Assuming free cash flow grows at 25% per year for the next five years and then at 3% to infinity thereafter, Daily might expect to earn an 18.8% return on his investment. In a world of uncertain returns, it seems as though Daily recognizes the company to be undervalued and is willing to make a big bet while the odds are in his favor. Who said markets always get the price right?