The digital payments landscape appears to be changing quickly. Most consumers and investors are likely already aware of some of the shifting currents because we can see it and experience it in our every day lives.
More and more of our transactions are now digital / card.
And more and more of our transactions likely involve more tech and maybe less of our personal bank.
For years, it looked like the rising tides would lift all boats within the digital payments universe.
For example…
More digital payments meant happy consumers. Consumers get more rewards for the same spend that would have otherwise been done in cash and more time before having to pay.
More digital payments meant happy banks. Banks get more fees and credit revenues every time a card is swiped and every time a consumer carries a balance.
More digital payments meant happy networks like Visa and MasterCard. The networks get a small but easy cut from each transaction with effectively no extra work.
And more digital payments meant happy merchants and merchant acquirers. Merchants get to please their customers by offering more payment choices, and merchant acquirers get a small cut for their small part in connecting the merchant with the networks.
(If you would enjoy a small refresher on the digital payments value chain, I’ve included a few nifty charts in the appendix at the bottom.)
While this happy state of affairs seem like it should be unbreakable (after all, who would have an incentive to break something that works so well for everyone involved?), it actually does seem like it might be breaking.
Increasingly merchant acquirers appear to be standing on shakier and shakier grounds…and it is not particularly clear to Capital Flywheels whether these risks are well understood or recognized.
Capital Flywheels believes traditional merchant acquirers are increasingly at risk because their business models are becoming irrelevant and face extinction unless they evolve. While merchant acquirers are, indeed, levered to rising digital card payments, their business models are historically NOT digital or high tech in any way and that appears to be a major source of risk.
📜 A Short History of the Traditional Merchant Acquiring Business Model
Years and years ago, the entire digital payments chain actually existed within banks.
Local banks issue credit cards to their best clients. Their best clients get rewards and some working capital benefits since balances do not need to be repaid right away. Obviously, consumers would grow to love this arrangement / product.
However, merchants also need a way to accept the cards issued by the banks. Without specialized equipment, merchants would not be able to do anything with cards presented at the checkout counter. In those days, local banks also acted as the merchant acquirers, distributing points-of-sale (POS) systems that would allow merchants to accept cards. This was a fine arrangement because many merchants likely were already bank clients for either checking / savings accounts or business loans. It was not too hard to try to cross-sell a merchant on a merchant acquiring relationship every time they come in for general banking business.
But over time, the business environment evolved to become more complex, especially in large / dense cities. This meant that any local bank branch alone was increasingly becoming insufficient for distribution and expansion of merchant acquiring. Every time a merchant runs into an issue, it needs to be addressed. And banks have way more pressing issues (on the banking side!) than to try to handle POS issues. When a POS is not working, it’s really a P.o.S. Who wants to deal with that?
As a result, many banks eventually spun out their merchant acquiring businesses and instead focused solely on card issuance and credit. The banks also eventually spun out the networks like Visa and MasterCard, likely assuming that the best economics still remain captured by the banks on the issuing side…which is funny because Visa today has a larger market cap than any standalone bank in the entire world (it eclipsed JP Morgan’s market cap a few months ago). As a reminder, the networks basically run a huge computer database that connects the card presented at the counter with the relevant issuing bank. This allows the merchant to send the bill to the right bank.
The economics are roughly like this in the US: Every time a credit card is swiped, the merchant pays 2-3% to the merchant acquirer. The merchant acquirer keeps roughly 0.3-0.4% and passes on the rest to the network. The network keeps roughly 0.1% and passes on the rest to the issuing bank. Issuing banks keep most of the economics because they are largely responsible for any non-payment by the consumer. The banks bear the credit risk, which can be expensive depending on who the card is issued to. Because of how the economics are structure, it’s clear why banks thought they would be getting the better end of the bargain. Merchant acquirers can focus on doing the stuff the banks don’t really like to do (distribution / sales and issue resolution) while the banks can focus on what they do best – offering credit and charging usurious rates on overdue balances.
The merchant acquirers therefore were not particularly attractive businesses initially (which is why the banks didn’t want to do it). It’s a fairly low tech job since the job mostly entails sending sales people to merchant store fronts and convincing them to sign up for a POS / merchant acquiring relationship. It’s a decidedly labor intensive job.
However, once a merchant signs up, the merchant acquirer basically has a recurring cash flow stream. Every time a card is swiped, the merchant acquirer gets a small fee. Unless something isn’t working, the merchant acquirer doesn’t really have to do much after the initial sale. It’s like striking an oil well and then watching it flow and flow for years! Finding the oil is hard but once you find it, once you drill into a willing merchant, the fees start to flow.
That creates an interesting dynamic. Existing merchant relationships are very high margin, but growth in the business is not. Growing the business requires large sales force that need to wander around aimlessly and may or may not be productive.
Wouldn’t it be great if investors could somehow just have the existing relationships AND somehow get growth without spending on sales?
Well, it turns out it’s kind of possible! What investors and merchant acquirers eventually realized was that you can grow faster by acquiring other merchant acquirers than just trying to grow organically! Why spend on sales people with questionable productivity when you can go and acquire another merchant acquirer with known relationship already? There is limited risk since you know exactly what you are getting. In addition, since growth is no longer dependent on the number of sales people, you can fire a bunch of them after acquisition. You get growth and better cost structure all at the same time!
This is actually how traditional merchant acquirers have been operating. While the services they sell (card acceptance) is digital in nature, the business model is hardly digital in anyway.
⚔️ Distribution Disruption
Turns out, merchant acquiring has historically been more of a distribution business than anything. This is curious because distribution business models in almost every industry across the board is seeing massive disruption. This is because the internet is the most efficient distribution channel of the modern world by far.
Many people think retail is dead. This is not the case. Retail distribution is dead. Like malls. Like department stores. Historically, malls and department stores distributed products procured from brands and manufacturers. Unfortunately, the internet can distribute better.
Many people think cable is dead. This is not the case. Cable content distribution is dead. Unfortunately, the internet can distribute content far, far better than cable can. You still need the cable for internet access, but who needs $100 monthly cable content bills?
Instead, traditional merchant acquirers are giving way to new business models that are less focused on labor + M&A value creation and more focused on internet distribution with margins reinvested in better software and technology.
For example, Square, Adyen, PayPal, and Stripe are all merchant acquiring / payment processing businesses that are truly digital-first digital payment companies that leverage the power of the internet for distribution. Without the need to spend significant money on sales / distribution, the money can be reinvested in highly differentiated software and technology.
The difference in required labor are orders of magnitude apart. For example, Square has a little under 4k full time employees. Adyen has a little over 1k employees. In comparison, a traditional merchant acquirer like Worldpay has 8k employees. Fiserv has 24k. And Global Payments has 11k. Traditional players are labor-driven. The new crops of players are not.
Traditional merchant acquirer stocks have been good performers even until recently. Capital Flywheels believes that’s because the financial flywheel of acquisition and consolidation is an attractive one. But unfortunately, it cannot go on forever. Increasingly, merchants are gravitating to the new crop of merchant acquirers because they get more for the same price. Square and Adyen and Stripe offer materially better software at similar prices. While traditional merchant acquirers have to spend on labor (and skimp on important R&D), the new crop of players do not. And merchants are starting to notice.
While the markets historically haven’t made much distinction between the old guards and the new guards, the stock performance of these companies have started to diverge during COVID-19. Investors likely are now correctly recognizing that digital-first merchant acquirers are less impacted (since most of the transactions happen online), but do investors yet realize that digital-first merchant acquirers are likely going to destroy traditional merchant acquirers in the long run both online and offline? Maybe, maybe not!
Capital Flywheels’ Paper Portfolio is fully aligned with the new guards. Stocks like Square and Adyen and PayPal are expensive because they are growing far faster than traditional peers. But even beyond growth, the new guards have business models that are much, much better than the old guards. And that is likely worth something in the long run.
📚 Appendix
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