So today, lets investigate one of those "golden bucket", "green dot", highly attractive industry segments for investment.
In many cases, these kinds of industries have numerous attractive companies within them. Investors can usually do well fishing in these ponds. The same great characteristics often apply to all players.
The first green dot industry we are going to take a look at is Payment Processing. Why is it so great? Let us count the ways...
Payment Processing Is Predictable
Payment processing is an excellent example of a "toll booth" business model.
Think of it - every car, truck, or motorcycle that passes over the Golden Gate Bridge has to pay a fee. And if road-based travelers or transports want to enter San Francisco expeditiously from the north, there is no other option than to use the bridge.
If you think about, that is a pretty great business model. Transports will gladly pay the fee for the convenience, often many times daily. The toll authority can rely on steady and recurring cash flows, and can even raise them occasionally with little worry of losing business. Sure, those transports could use an alternative like driving around to the Bay Bridge, or using a ferry... but what a huge pain for little gain! Realistically, those tolls are not going anywhere.
Payment processing is pretty similar. It provides a way for consumers to pay for goods and services electronically (through a debit or credit card, or even a phone). Electronically is the only way to pay online, and far easier than cash in most instances. On the flip side, processing providers allow businesses to accept payments electronically, handling things such as card validation, payment clearing, fraud protection, and so forth.
For the privilege and convenience, these processors earn revenues from those businesses in a few ways. One, they charge an initial setup fee. Two, they frequently charge a fixed-rate, monthly service charge. And three, they take a small percentage of every sale they process - generally in the 2-3% range. Additional revenues can come in the way of add-on services (like micro-loans, consumer credit, software integration products, etc.).
Like a toll road, payment processors take a small cut from EVERY payment, every day. Think about it - how often do you use your Visa (V), or Mastercard (MA) every day? This sets up one of the business characteristics we love more than any other - recurring revenue. Payment processors have recurring revenue in spades, and as a result are able to accurately predict revenues and cash flows far in advance of spending plans.
Payment Processing Is Stable
This steady, recurring revenue stream is also a stable one.
Think about 3 industries which I would consider "unstable" in an economic downturn: airlines, automobiles, and housing. Airlines have faced 15-20% revenue declines in a recession, as consumers cut out expensive trips and businesses tighten the belt on travel expenses. It is even worse for autos and housing, two "big ticket" expenses that consumers will put off during difficult times, when their jobs could be at jeopardy. To illustrate the point, General Motor's (GM) sales declined 29% in the 2008-09 recession, while homebuilder D.R. Horton (DHI) suffered a 45% sales drop - in one year!
Revenue cliffs like this, combined with the high fixed operating costs of those industries, can lead rapidly to financial distress. In turn, this leads to massive declines in stock prices and big losses for their investors. Not good.
Payment processors, on the other hand, will only experience modest revenue drawbacks. Consumer spending overall will decline. However, the purchases that consumers use electronic payments for most frequently are staples like groceries, toiletries, medications, and other "must haves". Additionally, a lot of payment volume comes from recurring services like utilities (electric, water, etc.), insurance, mortgage and car payments, etc. Given this, even an economic downturn does not affect processing volume all that much.
This can be seen when taking a look at 2008-09 recession numbers. In fact, both Visa and Mastercard registered revenue *increases* during that recession. So too did gateway Global Payments (GPN), and Total System Services (TSS) saw only a 3% decline.
It is hard to overstate what a huge advantage predictable and stable cash flows are to a business model. For investors, they are yet another protection against massive 50%+ stock declines that can wreck a portfolio in short order.
Payment Processing Is Growing
There is a mega-trend occurring right now, known colloquially as "The War on Cash".
This is not only consumer-driven (mainly for convenience physically and a necessity for e-commerce), but also being pushed forward by governments around the world.
Why? Easy - cash is the currency of choice for the "bad guys": global terrorists, money launderers, organized crime, black markets, tax cheats, etc. Cash is nearly impossible to trace and expensive to produce (pennies cost twice as much to make than they are worth).
Already, governments are moving to expedite the process to electronic payments. The European Central Bank is withdrawing the 500 Euro note. South Korea is seriously targeting a coinless society by 2020. Perhaps the most stunning example is in India, where a demonetization of 100 and 500 rupee notes (85% of the total currency) led to widespread disruption.
To move to electronic payments, intermediaries are needed, and this is exactly where payment processing companies come in. Worldwide, electronic payments are increasing at 11-12% annual rates. In developing economies, that figure is over 20%.
Now, line those growth rates up with the current market size and you get nearly 730 BILLION electronic payments per year by 2020! That is simply a massive market, one of the biggest in the world.
Clearly, many companies in the payment processing market enjoy very favorable prospects, with tremendous industry growth, a massive addressable market, and support from governments worldwide.
Payment Processing Has Moats
No "green dot" industry would be complete without some kind of structural economic moat - a set of factors that protects companies from price-eroding competition.
Payment processing is no exception.
The most powerful and effective moat that payment processors can build is the NETWORK EFFECT. This refers to the phenomenon that the more places a payment option is accepted, the more consumers will want to use it - and vice versa. Think about it - what would you rather carry, a Discover card or a Visa? Probably a Visa, right, because you KNOW it will be accepted pretty much wherever you need to make a payment.
The network effect is like a snowball rolling downhill. Once a critical mass is achieved, all new vendors basically HAVE to accept you as a payment method, or they lose customers who demand it. And all customers WANT to use you as a payment method, because they know it will be accepted anywhere.
A network effect is very hard to achieve, but once it is obtained, it is virtually impossible for a competitor to break. Visa and Mastercard have dominated for a long time, despite lots of competition. Paypal (PYPL) has built itself a nice network effect in online payments, with widespread adoption. Apple Pay and its ilk (Samsung Pay, Android Pay, etc.) have been trying to build this network effect but have not yet met critical mass with acceptance.
Perhaps less powerful but still a nice moat attribute are HIGH SWITCHING COSTS for businesses. We've already covered why businesses basically cannot NOT accept Visa or Mastercard, despite those pesky 2-3% fees. Likewise, switching a payment processor - be it Total System Services, or Paypal, or Stripe, or Square (SQ) - is a time consuming and potentially disruptive process. There have to be very clear and meaningful advantages to undertake the project, and usually it is not worth the effort. This means that, once a business has chosen a processor, it likely will stick with it for a very long time. That makes it tough for competitors to come in and steal market share.
With strong NETWORK EFFECTS and HIGH SWITCHING COSTS, payment processing has an excellent "one-two" punch of durable competitive advantages that protect revenues and cash flows from the competition.
Payment processing is the first of 5 "green dot" industries we will be reviewing here at MagicDiligence. The entire cohort of companies in this space are usually good places to start to look for solid, long-term investment holdings. This includes the credit card companies, payment processing firms, and the younger e-commerce based firms that are offering new ways to pay (think Paypal, Square, Apple Pay, etc.). We think all of them are worth a look.
To see the other 4 "green dot" industries as we reveal them, please consider subscribing to our FREE newsletter (along with a complimentary 5 stock report), follow us on Twitter, or even try out our low-cost, high value membership service?