The famous hit series Seinfeld has a memorable episode where one of the main character's (George Costanza) wallet becomes filled with cards, receipts, and other junk. In fact, it's so full that he develops a back condition from the strain of sitting with one half of his gluteus maximus so much higher than the other. To counteract the size of his wallet, he is forced to stuff huge wads of napkins under him to even out his sitting posture. What's funny is we all know someone like this…a hoarder of cards, receipts, coupons, and loyalty cards. It's funny in a world that's gone so digital how little development has occurred in the way we pay for things. MasterCard (MA) estimates that 85% of the world's transactions are still conducted with cash. What's clear from technology trade shows is that a battle is being waged over how we as consumers will pay for things in the not so distant future. What's less clear is who the winners and losers in this struggle will be. One thing is for certain: The stakes are high. The industries that could feel serious implications include technology, retailers, and financial institutions.
We will provide our thoughts on the advantages of each model and then ultimately select the path we think the industry is likely to follow.
Visa (V) (PayWave) and MasterCard (PayPass) have stuck their proverbial toe in the water when it comes to the mobile payment evolution. Both have developed a credit card with an embedded chip. The chip turns the average credit card into a "smart" credit card that allows you to "wave" your credit card past a machine attached to a cash register or other payment-receiving device (think subway turnstile).
The alleged appeal is the contactless payment, a method that avoids the need for a subsequent signature (or PIN) for purchases under $50. While this brings modest convenience, there are some pretty inconvenient implications of this approach for consumers and retailers. First, you still need to carry physical cards. Second, merchants need to make hardware upgrades to their equipment to process the signal (NFC for the "geekier" reader) emitted by the card.
The disadvantages (or lack of advantages) seem overwhelming. First, if you have multiple credit cards, such as American Express (AXP), Visa, and MasterCard, you will still need a card for each―meaning there has been no consolidation of the wallet's size. In addition, the stationary nature of the payment-receiving device doesn't enhance functionality. In plainer English, a waiter at a restaurant still needs to return to a central location to process your payment and at retail stores the only distinction is that you wave your card instead of swiping the magnetic strip. This whole model is hardly an upgrade in our eyes.
Many of you have used PayPal and are familiar with its mechanics, but for those of you who aren't familiar with it, here is a quick primer. On PayPal's website, you create a user name and password that you enter each time you visit Paypal.com. Once logged in, you can store a vast array of payment types. For example, you can store your checking account and routing number for wiring money. You can store as many debit and credit cards as you wish. You can even create a PayLater account in which you borrow the money from PayPal at a handsome interest rate.
This is called the cloud model because the information is stored remotely. Users can access their payment options anywhere there is Internet. This has a couple of major advantages. First, as we described, you can access multiple cards and payment options. So, if your wife (or husband) goes on a shopping spree and maxes out one credit card you could designate the purchase to be made on another. This sounds nice, right? You have a bevy of payment options stored by a company (in this case PayPal). You simply log in and select the payment type you prefer and off you go-a walking economic stimulus package. In addition, in some respects, this model also allows you to ditch your wallet, as the information is stored online.
We are somewhat skeptical that this method will gain adoption in the retail space (although Paypal is in at Home Depot (HD)). Notice we didn't say the e-commerce space. Let's be specific. You are shopping online for new shoes from Nordstrom.com (JWN). It's time to check out and instead of tracking down your wallet and entering your 16-digit credit card information for the 3,000th time you are simply required to log in to PayPal. After entering your user name and password, you select to pay with your Alaska Airlines (ALK) Visa because you need those frequent flier miles. Easy as pie. Your transaction will be charged to your Visa as if you walked into your nearest Nordstrom brick-and-mortar store, swiped your Alaska Airlines Visa, and walked out with a new pair of shoes. This works quite well when you're shopping online. But what happens when you are at a physical retail location? Is someone going to whip out a keyboard and ask you to authenticate before each purchase? Is the guy in front of you like me, with 29 different user name and password combinations he can't keep straight, leaving you to wait endlessly as he uses trial and error to recall his login credentials? Is PayPal going to send you some nifty little electronic device that emits your signal to the nearby cash register? Perhaps, but that's another thing to keep track of when the goal is supposed to be convenience. The real question remains, are physical retailers going to invest resources for a payment model that currently only really services the e-commerce community? While the cloud model has some clear advantages over contactless payment, we see too many headwinds preventing this from gaining widespread traction.
Near Field Communication
Near field communication is a fancy way of saying "your phone as your wallet." Likely unbeknownst to most cell phone users, manufacturers have begun to construct smartphones equipped with NFC chips. These chips allow your phone to wirelessly send (from close range) an encrypted message containing your payment information to a nearby register. The concept of storing multiple payment methods on your phone is appealing in our eyes. Phone-based payments also eliminate the need to carry physical credit and debit cards, an obvious convenience. Phone-based wallets will force some type of hardware upgrade for merchants that allows them to accept this form of payment. Clearly, as we mentioned earlier, retailers and merchants must believe that there is critical mass before investing in a new technology. The two biggest players backing phone-based wallets, Google (GOOG) and Apple (AAPL), whose operating systems dominate the smartphone landscape, would seem to satisfy the criteria of "critical mass." Said simply, if Google (Google Wallet confirmed) and Apple (iWallet rumored) both commit to building the capability of digital wallets into their phones, retailers are going to be willing to make an economic investment in the equipment necessary to process these transactions.
For those who like to build a mental picture of what the next generation of the payment landscape is likely to look like, we've provided a quick example below. Let's imagine you walk into Nordstrom carrying your Android (Google operating system) or iPhone (Apple operating system). At the store, you become mesmerized by a stylish pair of sunglasses you want to buy for the handful of sunny days we have in Seattle. You approach the register and instead of reaching for your wallet you pull out your phone. You select an "app" (software application for smartphones), which securely stores all your credit and debit card information. The retailer's software (via NFC signal) sends your phone a message asking which card you wish to use for the purchase and the total purchase amount of the sunglasses, then offers to email you a receipt. You then enter a PIN or some verification (think voice authorization, finger signature, someday maybe a fingerprint) confirming that you're the authorized individual making the purchase. The purchase is complete.
Let's look at the advantages of this approach over the traditional payment paradigm. You never used your physical wallet. You didn't have to sign that rushed scribble that never looks the same and has never been declined by a retailer (so much for authorization). Your receipts don't go into a file that you can never find and instead are easily stored electronically. In this way, even though many modern improvements start as either more convenient but not as secure (airplanes) or more secure but not as convenient (alarm systems), "it's more convenient and it's more secure" is the type of efficiency that drives innovative technology.
Compare phone-based wallets to the other next-generation payment scenarios of contactless payment or cloud-based payment. The contactless structure has the obvious drawback of forcing consumers to continue to lug around physical cards to process transactions. In our view, this is a critical drawback likely to prevent widespread adoption of the payment type. The cloud-based model has potentially more advantages as it allows for the virtual storage of multiple payment options on a database accessed via any Internet connection. However, we see two strong headwinds that we believe will stand in the way of this model going mainstream. First, it's unclear how consumers will access this cloud-based wallet. Will you log in at every retailer? Will you show each retailer a new type of credit card that can access your cloud-based wallet? It just seems farfetched that consumers will replace one physical system for another. The second headwind is merchant adoption. The company most likely to back a cloud-based wallet is PayPal. In fact, as we've described, this technology is already in existence and has failed to gain much traction. Simply put, we find it hard to believe that brick-and-mortar merchants are willing to adopt a payment system that seems designed to service "e-tailers." Further, how much faith do retailers have in PayPal's ability to influence consumer behavior? Apple has been extremely successful in popularizing items that were already in existence. The iPod wasn't the world's first digital music player. The iPhone wasn't the world's first smartphone. The iPad wasn't the world's first tablet. Yet, with staggering success, Apple has driven mainstream consumer adoption. The near consensus rumor is that the iPhone 5 (slated for release late this fall) will have features that allow it to serve as an e-wallet.
Additional Investment Considerations
Here is a quick overview of how we see the industry in question impacted as the mobile payment landscape unfolds.
Credit card companies seem safe to us. Their function is to provide money to purchasers who don't want to use cash or debit cards. It's illogical to think that because you pay with your phone you will eliminate the use of credit cards. The true test of those who believed that credit cards' largest advantage was their function as a cash alternative saw that argument go up in smoke when the introduction of debit cards didn't put Visa or MasterCard out of business.
In some ways, we see credit card companies as the biggest beneficiaries. We believe that anything that simplifies consumers' ability to pay makes them more likely to purchase using that method. Plainly, if it's more convenient to use a phone than the current physical credit card, one would conclude that consumers will gravitate toward more phone-based purchases.
Chipmakers who supply the NFC hardware are also likely to benefit. More and more phones will need to be outfitted with the new-generation chips equipped to send secure encrypted packets to merchants. Some companies we follow are strongly positioned as a result of their expertise and pre-existing relationships with smartphone makers.
Merchants are likely to face up-front costs associated with accepting payments from a phone-based wallet. This presents a really difficult evaluation because two persuasive arguments can be made. On one hand, one could argue that if retailers replace bulky registers that require proprietary software to process payments and instead manage inventory with iPhones or iPads, their costs could go down. Said simply, if anyone who owns an iPhone could download an "app" that allows the phone to become a register, we see a downward pressure on costs. If merchants have to supplement their existing registers with technology to accept phone-based payments, their costs are likely to increase. One thing all merchants are likely to enjoy is the ability to profile client purchases and offer awards programs without the hassle of requiring consumers to carry yet more physical cards. We view established merchants (think Nordstrom) as largely unaffected. On the other hand, we think that iPhones that can become registers lower the barriers to entry in the retail space. This is good for small businesses and likely to keep prices down for consumers.
We think the situation is a slight positive for phone makers. Some consumers who don't have smartphones could theoretically upgrade for the added convenience of a phone-based wallet. In less developed markets, this is likely to help accelerate the adoption of smartphones, but in our minds it isn't a game changer. Where we see the real advantage and area for growth is in smartphones replacing physical merchant terminals as payment-accepting devices. Nordstrom and Apple have already started to equip sales representatives with phones instead of using the traditional stationary register checkout process. Allowing mobile salespeople to process checkout transactions from various locations in a store provides obvious efficiencies for retailers.
We think there is moderate risk to those who make registers and software and perform checkout-related activities. It's likely that those who make software will evolve to write software (also provide the hardware) and remain in place. Those companies that simply provide hardware (terminals) to merchants are in a very scary position. These POS providers face additional increasing threats from companies such as Square, which allow for select smartphones and tablets to act as a register, accepting credit card payments. The vendor simply pays a small percentage on each transaction. This eliminates the hefty startup and continuing maintenance costs for vendors that come along with classic POS providers.
The recent launch of the Microsoft (MSFT) tablet includes a wallet application. And while Microsoft has hardly been an innovator of late (i.e. Zune) it marks a significant milestone. Apple is likely to be close behind whether it comes with the next iPhone, iPad, or iWhatever. In the investment world predicting certainties is a loser's game but we are willing to make an exception in this case. Five years from now consumers will have more payment options. The devices we call phones/tablets will do more, store more, and have greater value. If it's not Apple or Microsoft it will be someone else. The days of lining your chiropractor's pockets with money because your oversized wallet gave you back issues is over.