This article originally appeared in Motley Fool Rule Breakers.
Banking, borrowing, and buying: From bartering sticks to digital transactions, the flow of money has come a long way, and today's improvements in technology are turning the most established of conventions upside down.
Here, we'll take a closer look at innovations in the financial services industry -- online banking, payment processing, and crowdfunding -- and talk about the companies tapping into them.
The Economist recently compared finance to an economic time machine -- helping savers transport today's surplus income into the future and giving borrowers access to future earnings now. If finance is the time machine, banks have long been the fuel -- matching savers with borrowers and collecting interest spreads in the interim.
Banks have traditionally benefited from enormous switching costs. Switching banks is a pain, and a recent Accenture study found that 40% of U.S. customers have been with their current bank for more than a decade. Relationships were important, and banks built out thousands of branches and a buffet of financial products to attract and maintain their customers.
But perhaps the buck stops here. The same study found that the younger generation isn't quite as interested in those physical branches:
- 40% of 18-to-34-year-olds said they would gladly switch to a bank that was "online only" and had no physical branches.
- 94% of 18-to-30-year-olds are already active users of online banking.
- 71% of all respondents (any age) consider the relationship with their bank as "transactional" rather than "relationship-driven"
It seems the massive network of branches built by the largest of banks has shifted from being an asset to an enormous liability. Online-only banks don't have to pay the costs of running bricks-and-mortar locations, which is a savings they can pass along to customers in the form of more attractive interest rates. They're also able to avoid many of the hassles that have aggravated traditional banking customers for years: ATM fees, account statement fees, and the like.
Rule Breakers discovered Bank of Internet (NASDAQ: BOFI ) as a well-run, online-only bank that was hitting all of these metrics. In 2013, BofI enjoyed an efficiency ratio of only 41%, compared with traditional retail banks in the 50% to 60% range (note that lower is better here). The bank saw loans and deposits grow more than 30% last year, and the net interest margin was a healthy 3.8%.
We recommended BofI in November 2012 and again in May 2013. Even though our original recommendation has nearly tripled in less than two years (up 182%, beating the S&P by an incredible 140%), we still think there is plenty of upside from here. BofI is sitting on roughly $3 billion of deposits, which is roughly 1/380 of the $1.1 trillion that Bank of America holds, according to Capital IQ.
There are several other online-only banks emerging -- some publicly traded -- that offer various terms for their services. When considering any of these as investments (or as a banking partner), think not only about the metrics described above but also management's track record and the quality of the loan portfolio. Online banking is an exciting field that's growing quickly, and the past five years have been a phenomenal time to make loans. But fundamentals such as risk management and conservative underwriting are still incredibly important, so management tenure should also be considered.
Human beings made $15 trillion of retail transactions last year. That's a lot of money trading hands, and behind the scenes is a massive and profitable industry of payment processing.
Every time a credit or debit card gets swiped, retailers pay a 1% to 3% fee for payment processing. This fee gets split up a few ways -- an interchange fee goes to the bank that issued the card, and a bit goes to the retailer's bank for clearing the transaction. But there are also virtual toll-booth collectors, such as Visa (NYSE: V ) and Mastercard (NYSE: MA ) , that take a cut of every transaction just for managing the information highway that the transaction was processed on.
Visa and Mastercard are juggernauts. They both have enormous market caps, enjoy greater than 40% net profit margins, and have provided phenomenal returns for investors. Strong network effects further solidify their oligarchic position; consumers want to use credit cards that are accepted everywhere, and retailers want to accept credits cards used by the most consumers. Combined, Visa and Mastercard accounted for 87% of all global card transactions in 2013.
But even with such a strong competition position, the credit card companies show signs of being vulnerable. Security issues plagued Target (NYSE: TGT ) over the 2013 holiday season, when it reported that it lost personal data on 40 million shoppers because of a security breach in its credit card machines. What's more, technology is accelerating a broader shift in consumer preferences -- from paying with credit cards to paying with mobile devices. Mobile opens the industry's doors to disruption. Research firm Gartner estimates that mobile payments have increased from $49 billion in 2010 to $235 billion in 2013, and they're expected to reach $720 billion in 2017. Any industry that grows 15-fold, to nearly $1 trillion in less than a decade, is worth some Rule Breaking attention!
So which companies should you consider? Several businesses and technologies are fighting for a piece of the mobile payments pie, but we should keep in mind that change isn't as easy as it seems. Retailers must first accept the terms (and fees) of the new mobile payment processor. Smartphones must have the appropriate middleware installed, to access and transact with their customers' bank accounts. Telecom operators must have wireless networks that can securely handle the payments. And then there's the deal of privacy: How much of our purchasing and personal information are we comfortable being captured and shared for marketers to analyze?
Even considering these hurdles, three companies are really catching our eye. The first is PayPal -- which is a fully owned subsidiary of eBay (NASDAQ: EBAY ) (at least for now). PayPal accounts for nearly half of eBay's total revenue, and its mobile payment transactions rose from $750 million in 2010 to $27 billion in 2013. PayPal allows for credit transactions and also for them to be bypassed by directly linking bank accounts (which makes it easy to transfer money between friends). It is quickly becoming a top dog in mobile payments, being accepted at more and more merchants and building strong network effects of its own.
A second company on our watchlist (and when is it not?) is Google (NASDAQ: GOOGL ) . The company is embedding a technology called host card emulation, or HCE, into its newest Android operating system (dubbed KitKat). HCE gives merchants access to consumers' mobile devices without having to first obtain permission from the mobile network operators (which was one reason that the company's first attempt at mobile, Google Wallet, fell short). KitKat is now installed in 8.5% of all Android devices, up from 2.5% just five months ago. With more than 1 billion Android phones now in peoples' pockets worldwide, Google has a captive user base who would love to use a convenient app to make payments. Expect a lot more Googling goin' on.
Lastly, we should keep our eyes on the social networks. Facebook (NASDAQ: FB ) allows transactions and potentially money transfers between friends. With a user base that is larger than the population of India, Facebook hosts the largest social platform in the world. This will probably attract social transactions -- such as Fantasy Football league dues or birthday presents. Even so, the golden goose for Facebook isn't the transactional fees. The company is much more interested in the metadata -- which is the information about the purchases its users are making. This is of prime interest to advertisers, and that's where Facebook makes most of its money.
Small businesses are the lifeblood of our economy. Although there are nearly 18,000 U.S. companies with more than 500 employees, 28.2 million have fewer than that.
Though smaller businesses constitute 99.7% of all U.S. companies, the odds are certainly stacked against them. The Small Business Administration reports that half of new businesses fail within the first five years, and two-thirds close their doors within a decade. The most common reasons that companies give for failing? Lack of capital and lack of expertise.
Fortunately, there's a new way for the up-and-comers to raise early capital funding and gain access to a wide base of expertise. It's called crowdfunding.
Crowdfunding was initially conceived as a way to build brand recognition: Start-ups would offer a T-shirt or access to not-yet-released products in exchange for money from early supporters. Sites such as Kickstarter attracted artists and musicians who had a creative vision, as well as business success stories, such as Oculus Rift (now a part of Facebook) or Pebble.
But the rules are changing, and crowdfunding is about to become much more mainstream.
In October 2013, the SEC allowed companies to raise up to $1 million by selling equity directly to accredited investors (determined by annual income or net worth). The SEC is expanding the scope even further today, working on letting anyone -- you, me, our grandmas -- directly invest in small, private start-ups. Transactions could take place either through existing brokers (Scottrade, Fidelity) or on newly formed online portals.
In the grand scheme of things, crowdfunding will make it easier for small companies to fill up their piggy bank. These companies, previously unable to raise enough money to launch a product or campaign, can now compete against their bigger rivals. This could easily have bigger implications -- such as accelerating the pace of innovation and lowering the barriers of entry -- which could weaken the competitive position of existing market leaders across all industries.
With crowdfunding being such a new trend, we don't yet have any public companies on our radar. We would expect the newly formed portal operators, such as SeedInvest or Indiegogo, to scale in size -- pushing down commission costs and profiting from an increase in volume. There are also other peer-to-peer lending platforms, such as Lending Club, which allow borrowers to obtain unsecured personal loans (as opposed to equity) to start up their business. Most players are still privately traded, but this is definitely a space worth keeping an eye on.
The Foolish Bottom Line
The financial-services business is massive, but there's a clear trend that transactions are increasingly being done over the Internet rather than in person. We believe that online banking, mobile transaction processing, and crowdfunding are three areas to watch as technology continues to innovate the flow of money.
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