Any long-term, quality-focused investor would most likely agree that Visa (V -0.23%) and Mastercard (MA 0.07%) are two of the best businesses in the world. They benefit from powerful network effects. Their revenues and earnings have increased at impressive rates over the past decade, which has resulted in strong stock-price performances.
But that doesn't mean investors have nothing to worry about. Continue reading to learn about one potentially major risk that could undermine the dominance of these two card payment giants.
The possibility of direct payment methods
Both Visa and Mastercard make money by charging fees anytime one of their billions of cards in circulation is used at checkout. It has proven to be a very lucrative business model. However, merchants bemoan these so-called interchange fees that they must pay. To be clear, most of the interchange goes to the banks that issue the cards to consumers, not to Visa and Mastercard. Nonetheless, if retailers, who are typically already operating on razor-thin margins, could find ways to reduce payments-related expenses, they probably would.
One such retailer that highlights a possible threat to these leading card networks is Target (TGT 0.18%). The business has a RedCard debit card that allows shoppers to save 5% on any purchase in-store or online every day. This offering is unique because it pulls money directly from a customer's checking account, there's no need to use Visa's or Mastercard's rails anytime the card is used.
In fiscal 2022 (ended Jan. 28), 20% of Target's $108 billion of overall revenue came from the RedCard program, which includes credit card products as well. The company doesn't report how much is from just the debit card, but that's not an insignificant sum. If 2% of these RedCard sales avoid going to interchange fees, Target could've saved $432 million in 2022, a figure that should mainly flow to the bottom line.
What if other companies, particularly those that lean on repeat purchase behavior, follow a similar approach as Target and set up direct payment mechanisms? I'm thinking of streaming services from the likes of Netflix or Walt Disney. Or even other huge retailers like Costco or Home Depot. Popular restaurant chains like Chipotle Mexican Grill or Starbucks can also follow suit.
Of course, consumers would need to be incentivized to not use their general-purpose credit cards and instead switch their payment preferences. To do this, companies would likely have to offer one-time or ongoing discounts. And if not enough people sign up, it could end up being a losing proposition.
But this is exactly the type of thing that could disrupt Visa and Mastercard.
Shareholders can remain optimistic
It's a good idea for shareholders to be mindful of the risks that their companies face. While direct payment systems are a good idea, I don't believe they pose a huge threat just yet.
Those credit cards that run on Visa's and Mastercard's networks are extremely popular. In fact, in the three-month period that ended June 30, both businesses together handled a ridiculous $5.4 trillion of payment volume. Combined, they command 86% of the card market in the U.S.
Cards aren't just popular because of their convenience and security but also due to the attractive perks and rewards they offer. It would be a major shift in consumer behavior if shoppers set up different accounts, just for payment purposes, with a multitude of different merchants. Instead, they could just stick to their go-to credit card and not have to deal with the hassle of managing numerous login credentials.
Visa and Mastercard are, without a doubt, two of the most dominant businesses in the world. And the growth they've achieved, as well as their outsized profitability, indicate that their competitive positions are virtually impossible to disrupt. Investors can relax for now, but it's smart to pay attention to potential risks.
