Adyen

The Dutch payments mensch

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HOW PAYMENTS WORK

Adyen is an acquirer. Before getting any further, let’s make sure we have a lay-of-the-land because it’s complicated. If you haven’t already read our post on Visa, it would help to do so.

Basically there are six parties involved in an off-line credit card transaction (we only included five in the Visa post to not make it as confusing):

1. Account holders (that’s you, buying stuff)

2. Issuing bank (that’s your bank)

3. Card network (that’s Visa, Mastercard, etc.)

4. Merchant (the place you buy stuff)

5. Acquiring bank (the Merchant’s bank)

6. Payment processor (transfers funds)

You may be thinking, “wait, I didn’t see acquirer in there?!” So observant you are. An acquirer is a blanket term when the merchant bank (acquiring bank) is also a payment processor. JP Morgan’s Chase Paymentech is one such example.

Here is a graphic of how everything works together. I won’t get into the specific details again from the Visa post but the card networks sit in between your bank and the merchant’s bank, shifting funds around. Your bank gets paid the most (~2-3%) in the transaction because they are on the hook if you don’t pay your balance off (and if you’re late on payments, the credit card fees are so high because there’s no collateral on your end).

But one thing that wasn’t shown was the processors. These are companies like First Data (now under Fiserv) and Worldpay (now under Fidelity National), that contract with merchant banks to provide point-of-sale terminals and the actual processing of payments. As mentioned, some banks have processing capabilities themselves but they usually outsource this function as it is really a scale game.

This is where Adyen comes in.

Rather than split up the merchant bank and processing functions, Adyen does both. This allows the company to process payments faster because it doesn’t have to rely on banking partners to settle the funds.

Here’s how that fits into the system:

MORE CAVEATS

I wish this were less confusing but there are several more caveats. Adyen, before May 2021, was just a third-party processor in the U.S. under both Wells Fargo and Deutsche Bank but acted as an acquirer in Europe. The company has a pan-European credit license, allowing it to take control of funds, rather than just processing them and it received a US charter in May of 2021.

I first heard of Adyen after eBay stopped using PayPal a few years after it was spun out of eBay. That was peculiar to me because PayPal had been owned by eBay for so long. Surely, they had a good relationship after 20 years! But eBay stopped its decades-long exclusive relationship with PayPal, moving to Adyen’s payment platform. Now, PayPal is just one of the payment options for eBay, while Adyen gets a majority of the volume as the default processor.

The reason this is important — that Adyen can act as both a processor and a merchant bank — is because of how cobbled together its competitors’ products are. Adyen’s streamlined, full-stack approach provides for better authorization rates versus acquisition-hungry behemoths like Fiserv and Fidelity National. Imagine this scenario. You run an e-commerce website and a transaction from a buyer in Poland gets denied because, well, you’ve never had a buyer from Poland. After frustration, the buyer leaves your site, never to return again. That’s the pain of low authorization rates. Broadly, since Adyen doesn’t have to deal with integrating hundreds of acquisitions and merging data lakes, etc. it has an edge in authorization.

Another distinguishing factor about Adyen is that it services very large clients. Among some of the most prominent are Uber, Booking.com, and Spotify. In fact, Spotify’s payment product owner said that Adyen helped decreased chargebacks by 70%. This is really the value add. Since other payment processors aren’t vertically integrated and their systems can be so disparate because of the long history of acquisitions, Adyen can ensure that more payments are approved. That potentially translates into millions of dollars saved. As evidence of this superior technology, Adyen’s volume-based churn has averaged less than 1% since its IPO in 2018.

THE NUMBERS

The company reports revenue on a gross basis as well as a net basis. The majority of gross revenue is from settlement and processing fees. Since Europe accounts for more than 50% of the company’s overall sales, the company can also recognize more revenue since it acts as the merchant’s bank as well as the processor. Net revenue is after the costs to the card networks and the issuing banks are disbursed. You can actually think of net revenue as similar to gross margins since those costs are directly associated with the revenue-producing activity.

To give some more context, Adyen’s TTM net revenue was a bit over $1.4 billion. But on a gross basis, it was $9.6 billion. That comes out to around an 15% “gross margin.” However, this is different than Costco’s gross margin of 12%. Theoretically, they are similar, but in practice, it’s different. For Costco to sell another item, it has to buy it from a supplier, keep the inventory, move it around the stores, display it, and finally sell it. That takes a lot of extra capital. For Adyen, it’s just money (really, it’s bits) moving through a system. At scale, it doesn’t require a lot of incremental capital.

Putting some numbers to it, Adyen’s gross PPE as a fraction of its net revenue is just 5%. This is compared to Costco’s at over 21%. It’s clear that while Adyen looks like a low margin business, it really isn’t.

On its net revenue numbers, EBITDA margins are around 60%. Even if we used gross revenue, free cash flow margins would be a respectable 7%. But on the net revenue numbers, these margins jump up to around 50%, signaling a very high free cash flow conversion. Yet another piece of evidence that Adyen is a capital-efficient business.

Management’s medium-term guidance is for revenue to grow in the high-20/low-30%’s while increasing EBITDA margins to over 65%. While using management’s estimates, it’s not unreasonable that the company could grow EBITDA around 25-35% for the foreseeable future.

Rather than expand into all sorts of things like its start-up focused competitor, Stripe, Adyen has been laser-focused on creating a great experience for enterprise customers. The top 10 customers account for around 33% of revenue and SMB merchants make up less than 5% of sales currently.

To be clear, Stripe and Adyen operate somewhat differently. Stripe is sometimes called a payment processor as well but it has joint ventures with Wells Fargo and BBVA, who actually do the processing. Stripe, along with Square and sort of PayPal as well, would be considered payment facilitators. These are web gateways, that act as portals from a website to the processor. In exchange for demand generation to the processors and the merchant banks, these “payfacs” take hefty fees (~3%). This is compared to Adyen’s take-rate of gross revenue, equaling 1.2%. Payfacs can typically charge much higher prices because smaller merchants a) don’t want to deal with lengthy merchant acquiring paperwork and b) don’t have the same leverage that big merchants have since they don’t do as much volume.

Payfacs essentially aggregate a bunch of smaller merchants, taking the burden of dealing with all things processing and merchant bank. Rather than going into a bank office branch, wrangling down a manager, filling out hundreds of pages of an agreement, buying a bulky POS system, and then paying fees upon fees…putting your email into Square’s website and being sent a chip processor in a few days is a heavenly experience. It’s sort of the same thing with Adyen just for much bigger merchants and therefore, lower fees.

The fact that Ayden’s value prop has been so clear, lowering payment fees for big customers, has enabled the company to grow its total processed volume by 57% annually over the past 7 years.

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The company is very focused on the merchant side of the business whereas a company like PayPal has historically focused on both merchant services as well as consumer wallets.

I think the ultimate takeaway from Adyen is the power of focus and a clear vision. From the beginning, the company’s founder knew that a fully organic tech stack, meaning no acquisitions, would vastly differentiate the company from competitors. Further, the company doesn’t focus on the consumer side of the business and therefore it’s not nearly as popular as Stripe or PayPal if you were to poll a random sample of people off the street. However, if you talk to heads of finance or operations at large retailers, they almost certainly know about Adyen and its value prop.

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