Visa: A Tollway On Global Payments

Summary

• Visa has built a cozy eco-system which appears impregnable.
• Examining each part of the eco-system helps us to consider the potential for its longevity.
• To date, the payment giant has skillfully managed to balance the oftentimes competing interests of consumers, banks, merchants and other digital payment networks extremely well.

The Basics

First, let’s cover some of the basics on Visa’s (NYSE:V) business model. Payment networks like Visa and Mastercard (MA) act as a middleman between merchants and issuing banks. They collect a fee from the merchant which is largely paid out to the issuer of the card. These fees help the issuer pay for cardholder benefits such as rewards and a fee is paid per transaction to the card network according to contracted terms. A small fee is also paid to the acquiring bank.

ACH Payments Pose Limited Threat

Disruption is the age-old question posed around Visa’s moat. Many believe the ACH payment network could replace the card network, enabling payments to be directed from bank accounts directly. There are, however, problems with ACH. It is an incredibly clunky network, less secure and slow to use since it requires real-time checking account verification. On the other hand, VisaNet is more efficient, faster and links all banks in the world. Moreover, consumers do not wish to carry multiple cards or have multiple payment options when they can use the one they trust and are familiar with.

Is Alipay the Exception?

In China, it has proven possible to build an alternative network. Alipay, with its 1bn users, competes directly with the Chinese card operators, such as UnionPay. However, building an alternative that connects to enough banks to offer widespread acceptance is a massive undertaking and Visa’s dominance in the United States allows it to retain global relevance. Nonetheless, there have been attempts in the west to build competing networks. Dwolla was founded in 2008 to facilitate inter-bank transfers between consumers or businesses. However, to date, the venture has garnered de minimis adoption and the model appears unsustainable. Dwolla has struggled to attract banks to take up its own real-time clearing service.

The Digital Payment Players

The most successful innovations in the payments space all use the existing card infrastructure. PayPal (PYPL), Square (SQ) and Apple Pay (AAPL) all run on the existing rails established by Visa/Mastercard. When Apple Pay was being crafted, many observers questioned whether Apple would seek to cut out V/MA and build a closed-loop payment network. However, this is no trivial undertaking. Aside from the infrastructure and know-how of setting up an inter-bank payment network clearing house and processing on behalf of customers, merchants, issuers and acquiring banks, Apple would have to take on all the counterparty risks that V/MA assume. Moreover, the banks would have to agree to face Apple as a counterparty. This undertaking would require regulatory clearance.

The other main barrier is merchant adoption – gaining the same global reach as the incumbent networks is not trivial and requires an army of sales and business development specialists. Without universal acceptance, it is extremely challenging to compete with V/MA. To achieve universal acceptance a new network would need to hire a huge sales force to infiltrate brick-and-mortar retailers, restaurants and other physical channels. The beauty of Visa’s model is the role of the merchant acquirers, who push acceptance for VisaNet by signing up new merchants.

Although it has the scale and financial resources, establishing a payment network does not really play to Apple’s strengths. Apple excels at hardware design and branding/marketing. Rolling out large-scale connectivity or data processing-based solutions is not a core strength – witness the debacle with MobileMe and Maps. Whenever Apple has created some kind of successful service, such as music distribution through iTunes, the company has shown little interest in overturning the incumbents (e.g. record labels). Instead, Apple adopts a more collaborative approach and seeks a cut from the incumbents.

By partnering with the card companies, Apple overcomes three large hurdles: 1) accelerated near field communication (NFC) roll-out/POS merchant activation; 2) trust/acceptance by banks, and consumers; and 3) clearance by regulators. There is great potential innovation around payments - Apple could build out a one-stop digital loyalty program partnership with retailers and use payment history data to leverage behavioural insights and provide targeted promotions (the advertising possibilities are also a key attraction for Google Pay but adopting NFC within Android’s open-source software poses far greater challenges and has been slower).

The Perspective of the Banks

Getting the banks on board is pivotal in disrupting the card companies but highly challenging. Any new form of payment network (let's call it NewNet) needs to tap customers’ bank accounts to enable payments. This requires NewNet to integrate with banks in the back end to enable live payment settlement; i.e. needs to know that the customer actually has the funds to pay the merchant. If the transaction is not done live there is credit risk. In this case, NewNet would pay the merchant with their own money and then hope to get that money back from the customer when they settle. If the customer did not have the money then they would have to absorb that cost as a write-off or bad debt. If there is credit risk involved, then the model is not as easy to scale and compete with V/MA.

There are a lot of banks in the world and yet there are only a small number of payment networks. There would be significant switching costs (investment, re-plumping, re-skilling, etc.) for the issuing and acquiring banks to change their back-end infrastructure to become compatible with a new payment network. Banks are slow with IT initiatives, especially when it comes to core banking platforms (live customer account information and payment authorization). More importantly, banks receive the bulk of the merchant fees, so cutting out the card companies would hit bank revenues heavily. The card companies give the lion’s share of payment economics back to the banks, which means all banks globally are eager to be part of the network. There is very little incentive for the banks to give NewNet access to their payment gateway without seeing a greater share of the economics. Such a move would risk aggravating the existing relationship with V/MA and of course there is no guarantee NewNet would go on to take off and gain acceptance.

Finally, there is the issue of safety. Visa and Mastercard employ an army to fight fraud and drop unauthorised transactions. Oftentimes, there is a time lag between payment and delivery of goods. In that timeframe a merchant could defraud a customer by not delivering the product or by delivering the wrong product. If a customer used a credit card there will be a full refund to the customer and the cost of merchant fraud is absorbed by the merchant acquirer. Hence, the fees paid by Visa to the merchant acquirer are critical as they cover fraud detection and costs. There appears to be very little incentive for the acquirer to add a new payment network with an unproven security track record.

The Customer Experience

Visa plays an important role for consumers, enabling faster, easier and more convenient payment for goods both online and physically. The impact of the COVID-19 virus will only go to accelerate the shift from cash to card payments as the world becomes more focused on hygiene and physical handling of cash and coins becomes less appealing.

The card companies also have extensive reward schemes, enabling consumers to collect reward points which have proven extremely popular.

Are Merchants Happy?

Of course, the merchants are the ones who pay for the privilege of accepting a card payment. All else equal, they would prefer a customer to pay with cash. However, merchants also accept that payment networks bring them new customers and facilitate a frictionless payment experience, which is particularly important for online sales. Most large merchants negotiate and receive better rates on the existing networks, hence the incentive for them to use a new network is not that strong. If the standard fee to a merchant is 2-3%, the likes of Walmart (WMT) and Costco (COST) are paying significantly less. It should be noted that under the Durbin Act in the United States fees on debit card transactions are lower.

Summary and Valuation

Through whichever lense you take, Visa and Mastercard have created an incredibly cozy and inclusive eco-system, which takes care of the issuing banks, merchant acquirers and digital payment players. With a forward P/E ratio of around 30x and the prospect of high single-digit / low double-digit growth, the shares offer reasonable value.

Thank you for all the support. My last article on Royal Dutch Shell was one of the most popular to date. To receive alerts on each new article, feel free to click the orange "Follow" button.

Analyst’s Disclosure: I am/we are long V. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.