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Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) founder and CEO and Warren Buffett's aversion to tech stocks is well known. The Oracle of Omaha has said repeatedly that he does not like to invest in tech stocks because he cannot effectively predict their future cash flows, and he believes that often the nascent industries represented by tech companies generally include more losers than winners.
Buffett broke that rule a few years ago with his investment in IBM, and Berkshire's recent move to invest in Apple made headlines (though that move was initiated by one of Buffett's deputies without his input). But broadly speaking, throughout his career, his commitment to investing in what he knows and following a few basic ground rules has made a fortune for him and his investors.
Buffett's favorite sector is arguably insurance. Not only is Berkshire a major investor in several financial and insurance companies including Visa, Mastercard, and American Express, but it also fully owns GEICO, Gen Re, and a handful of other insurance providers.
He's long championed the insurance business because of the float it gives the greater Berkshire empire. As he put it, "Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums -- [of] money we call 'float' -- that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit."
Today, however, tech companies are disrupting industries from transportation to manufacturing and many others. Below are three tech companies that have made innovative inroads into the payments sector, applying Warren Buffett's favorite business model in the process.
1. Paypal Holdings
The former EBay subsidiary has done more than any other company to pioneer online payments, and at a market cap of $45 billion, it's now more valuable than its former auction-house parent. Today, Paypal (PYPL 0.94%) has over $13 billion in deposits, more than many financial institutions, including American Express and SunTrust Banks. The company has grown to be the preeminent online payments provider with acquisitions of companies including Braintree, Venmo, and Xoom.
Like traditional credit card companies, Paypal makes money through merchant fees in the 2% to 3% range, and it also earns interest income on money kept in Paypal accounts. When one of the 179 million Paypal customers receives a payment through the service, the money stays in their Paypal account until its withdrawn, allowing Paypal the benefit of the float that Buffett loves so much. The company does not break out earnings from interest, but at the end of 2015, it had $4.4 billion on its balance sheet in short and long-term investments. Even at a modest interest rate, it could be earning $50 million to $100 million, if not more, annually on those deposits.
2. Square
While Square (SQ +2.01%) is too small for Berkshire to make a meaningful investment in, and is experiencing many of the familiar growing pains of a start-up, such as a lack of profits, the young payments specialist has several attractive features.
Founded in 2009, the company best known for providing merchants a small square accessory that allows them to accept credit card payments on a smartphone or tablet continues to grow rapidly, with adjusted revenue jumping 64% in its most recent quarter. Like Paypal, the vast majority of its revenue -- 94% -- comes from processing fees. Though the company is building out other revenue streams such as Square Capital, which lends money to merchants, and should help it become a more well-rounded financial services company. Square has also spent heavily on investments in the business, including research and development, and sales and marketing. Still, with a gross margin of about 38%, the underlying profitability of the model is apparent.
Finally, the market may be underestimating Square; it trades at just 2.2 on a price-to-sales, half of the valuation of Paypal, and much less than the traditional credit card companies.
3. Starbucks
While not actually a tech company, Starbucks'(SBUX +3.42%) mobile strategy has been a key driver of its growth in recent years, and has put it miles ahead of any other retailer or restaurant in mobile payments.
The coffee giant now has 20 million global loyalty card members, and process a majority of its transactions in North America through its loyalty card or mobile app. Developing that program over the last several years has given Starbucks $1.2 billion in customer deposits and a nice little revenue stream to go with its coffee business. In each of the last two years, Starbucks has made about $40 million on breakage income -- i.e., money loaded onto gift cards that get lost or unused -- and the company had over $1 billion in investments on its balance sheet as of its latest report.
The company has also taken the next step in leveraging the popularity of its loyalty card, partnering with Visa to make a prepaid Starbucks card that's accepted anywhere Visa is. The new card is expected to come out toward the end of year; such an arrangement could greatly expand Starbucks' financial revenue stream.
With a competitive moat from the loyalty program and interest-paying float to boot, Uncle Warren would likely be happy with the outlook of the coffee king.
