In my last two columns, we talked about the quality of recent IPOs and discussed risks. Meanwhile, behind the scenes, I've been looking closely at recent public offerings. Well, kids, I've found one that merits attention: iPayment (NASDAQ:IPMT).

Making payments possible
Today's focus company provides credit- and debit-card payment processing to nearly 60,000 merchants. It makes money by taking a cut of each transaction. iPayment's typical customer processes charges of $250,000 or less per year, with an average transaction value of $75 -- meaning they're the typical small retailers in any town.

Now, credit card processing is a lucrative, large, and crowded field. iPayment competes with the likes of the much larger Concord EFS (NYSE:CE), First Data Merchant Services (NYSE:FDC), National Processing (NYSE:NAP) and Global Payments (NYSE:GPN). However, iPayment is thriving because it specifically serves an overlooked niche: the smaller merchants.

It might help you conceptualize iPayment's strategy if we draw comparison with a firm that has been around the block.

Payroll outsourcer Paychex (NASDAQ:PAYX) also targets small to medium-sized companies. Its largest competitor, Automatic Data Processing (NYSE:ADP), caters to giants. Working in its shadow, Paychex has flourished because it provides personalized customer service to the little guys who are accustomed to being overlooked.

Paychex has also been an outstanding long-term investment, compounding more than 20% annually over 10 years. I'm not connecting dots with crossed eyes and suggesting that iPayment can compound at that rate, too, but the similarities in focus and strategy are notable.

Both Paychex and iPayment target millions of smaller businesses, and both have active acquisition strategies to help get the job done. Both continually acquire smaller players, improve their results with economies of scale, and sell additional services to their newly acquired clients. In 2002, iPayment made four acquisitions, all additive to results. iPayment is expected to make more purchases with the proceeds of its recent IPO.

How iPayment sells cheaply
How can this young company afford to market itself to millions of small merchants?

Well, it can't. So, it doesn't try. Instead, iPayment's product is sold primarily through 500 independent sales organizations (ISOs), meaning a sales force of 2,000 pitches iPayment products for commissions rather than salary. This allows iPayment to make "minimal direct investment in sales infrastructure and management," while still carpeting the country with marketers.

Keeping a lid on sales costs only adds to a business model that is not capital intensive. In fact, the company's 10-Q reads, "We currently have no significant capital spending or purchase commitments." I'll say. In fiscal 2002 and 2003, total capital expenditures were only $0.2 million and $0.1 million, respectively -- mainly purchases of computer equipment.

With a cost-light, transaction-based business model, iPayment could become a strong free cash flow generator even while continually expanding operations. From the 10-Q: "By outsourcing... we maintain an efficient operating structure, which allows us to easily expand our operations without significantly increasing our fixed costs."

A "take-a-cut" business model
As an eBay (NASDAQ:EBAY) investor, iPayment's business model reminds me in small ways of eBay's revenue structure (and PayPal's): iPayment takes a cut of every transaction. It's clean. It's high-margin. It's repeat business.

Again, from the 10-Q: "We derive a majority of our revenues from fee income related to transaction processing, which is primarily comprised of a percentage of the dollar amount of each transaction we process, as well as a flat fee per transaction."

Businesses that don't need to reinvent themselves every year, or put out new generations of capital-intensive products, or fend off becoming obsolete, are often attractive investments. That's why I cotton to transaction-based and service-based business models, like eBay and Paychex, and why iPayment interests me.

Recent results
In the most-recent quarterly results, merchant transaction volume rose from $356 million to $1.33 billion, and the company's revenue jumped from $16 million to $46 million -- with 80% of that gain coming from acquisitions. Let's take a look at some numbers and see what might be unfolding:

    iPayment Quarterly Results ($000)
Quarter ended 3/31/02 3/31/03 Transactions 356,000 1,338,000 Revenues 16,479 46,675Interchange fee 6,706 24,010Other serv. costs 7,961 16,277SG&A 1,169 1,829Tot. Oper. Exp. 15,836 42,116Pre-tax income (563) 1,269 OCF (654) 1,304 Cap ex. (50) (242)FCF (704) 1,062

You can see that in the March quarter, iPayment was profitable -- reversing last year's losses -- and achieved a free cash flow (FCF) margin of 2.2%. Look at operating expenses. By far, the largest expense is "Interchange fee," a usage charge paid to card-issuing banks upon any transaction. The downside to an immediate charge is that it lowers free cash flow, but there's nice upside to this being the largest expense.

The company's traditional operating expenses are a small portion of sales and are not growing nearly as quickly. While revenue rose 183% year-over-year, service costs (outside of Interchange fees) rose only 104%, and Selling, General and Administrative (SG&A) expenses rose just 57%. SG&A should decrease handsomely (as a percentage of sales) as revenue increases.

Good expectations
The company expects revenue to grow about 20% this year to top $200 million (excluding any acquisitions), while operating margins should be 11.5% to 12.5% -- a measurable jump from single digits last year. Additionally, free cash flow should start to gain traction.

The three analysts covering the stock expect $0.84 in earnings per share this year, or $15.1 million based on 18 million shares outstanding. At $26 per share, the company has a $460 million market value and trades at 30.9 times the forward earnings estimate. Currently, earnings are expected to grow about 20% annually. The company's long-term annual sales growth goal is 20%, with 5% to 10% coming from acquisitions.

Without doubt, iPayment's 30 forward multiple makes the stock expensive, but it'd be a disservice if I didn't suggest that this price could ultimately prove reasonable. Paychex rarely traded below a 30 multiple during its first decade (I know -- different time, different company; it's just an example). And just like Paychex, iPayment could exceed expectations through smart acquisitions, new services and new service fees.

Of the $75 million raised in the IPO, $55 million was used to repay outstanding debt accumulated through acquisitions, but there's a bit more debt to be paid. So, I wouldn't be surprised to see a secondary stock offering. Were that to happen, it could dilute shareholders another 5%, 10% or more, only adding to today's share-price risk.

The stock was recently $26. I'd want to see it back around $18 (for about a 20 forward multiple) before I'd seriously consider purchasing it. The risk of buying here is price: If iPayment only meets expectations, the stock will likely underperform. The risk of not buying here: If iPayment exceeds its goals, the stock could be a very strong performer in a decent market.

Still, I'd rather risk missing a gain than risk capital on an expensive newcomer. This is a business with great long-term potential, though, and I'll be watching it.

Jeff owns shares of eBay and Paychex and the Fool owns a disclosure policy.

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