Following up on our interview with Jason Oxman, CEO of the Electronic Transactions Association, a few weeks ago, this week's Industry Focus: Financials covers the investment side of the payments industry.
Join The Motley Fool's Gaby Lapera and John Maxfield as they explain how the space looks now -- how many players there are, how big of a scale they're working on, and what their competitive advantages are. Also, because the space is so ripe for disruption, they discuss the two biggest up-and-comers looking to get in on the market -- Walmart's (WMT +0.58%) CurrentC and Apple's (AAPL 1.45%) Apple Pay.
A full transcript follows the video.
This podcast was recorded on Feb. 29, 2016.
Gaby Lapera: Payment processing, an industry ripe for disruption.
Hello, everyone! Welcome to Industry Focus. This is Gaby Lapera in the studio, and joining me on the phone is John Maxfield. (coughs) (laughs) I'm sorry, you guys are going to have to bear with me today because I'm a little bit sick. I'm going to try and keep the coughing down to a minimum. Today, we're kind of doing a follow-up episode. I don't know if you guys remember, we interviewed Mr. Oxman from the payment processing... foundation? No, that's not the name of it. Anyways, it was a very, very interesting episode where we talked about how payment processors worked and what was upcoming in the field.
And a listener from New Orleans wrote in and said that, while it was very, very interesting, he was kind of upset that we hadn't had a chance to discuss the relative merits of the companies mentioned in the podcast. Which is right, but, I mean... I guess, between me and the listeners and you, Maxfield, it's always kind of hard to talk about whether or not you think a company's going to succeed, when you have a lobbyist in the room, because...
John Maxfield: (laughs) They think they're all going to succeed.
Lapera: Right, and that's their job. So, I think he did a really excellent job of explaining what was coming in the field, but, you know, he's not going to shoot himself in the foot by saying, "Yeah, you know what? I really think that Venmo is going to succeed." (laughs) So, anyways, let's just do kind of a recap. The whole way that payment processing works is, you have four distinct parties involved. You have the issuer, the acquirer, the consumer, and the merchant. Do you want to talk a little bit more about that, Maxfield?
Maxfield: Yeah. You know when you talk about, what are payments, or, what is payments -- I don't even know, to be honest with you, if that's a plural or singular noun (laughs), but let's say it's plural because it sounds better. So, what are payments? Payments are basically just what it sounds like. You have me, like, I go to a store and buy something with my credit card, so I'm a consumer. Then you have the store, which is the merchant, that takes the transaction. Then, I have my bank, and the merchant has their bank. And what the payment system does, companies like Visa (V 3.38%), MasterCard (MA 3.30%), American Express (NYSE: AXP) is they tie all of these things together. They provide the technological infrastructure underlying that. So, when I go and pay, they take the money from my bank, the merchant lets everybody know and they take the money from my bank, and then they put it into the merchant's bank. And that's basically what the payment system is.
Lapera: Right. So, in this case, in the scenario that I constructed before, Visa, MasterCard, and AmEx are issuers, they issue the credit cards. Then, the acquirer, the end acquirer, is going to be the merchant's bank, right?
Maxfield: Right.
Lapera: Yeah. So, let's talk a little bit about AmEx, Visa, and MasterCard. These are the big players in the credit card field right now. There's also Discover, but Discover doesn't really make that much money.
Maxfield: Yeah, and to put it in perspective, this is really an oligopoly, is what this market is, with these three really big players on top. To put some numbers to it, Visa in 2014 -- which, if you look at their 2015 10-K, its most recent competitive landscape data that they give -- in 2014 they processed 98 billion transactions, equal to $4.7 trillion in transactions. Second was MasterCard at 60 billion transactions and $3.3 trillion. Then, AmEx was at 6.7 billion transactions, worth roughly $1 trillion. Then, Discover comes quite a ways down at 2.4 billion transactions, roughly a third of AmEx. So, when you're thinking about the payments landscape, you're really talking about, right now, at least, Visa, MasterCard, and American Express.
Lapera: Right, and this is actually really interesting, right, because Visa and MasterCard are what's called an open loop system, whereas AmEx is on a closed loop system, so the way they make money is actually slightly different.
Maxfield: Right, that's exactly right. Visa and MasterCard, all they do is provide these services that connect everybody together, and then they just take a little cut from that. But the closed loop system, which is what AmEx does, is, they also provide the banking services. Where you can really see the difference between these business models is if you look at their income statement. So, Visa, MasterCard, all of their income comes in basically services fees. Whereas, at American Express, I think it's roughly 1/5 of their income also comes from net interest income. That is, you have a credit card, you have the credit card loan underlying the credit cards, but as opposed to that loan sitting on a bank at, say, Bank of America, Citigroup, or JP Morgan, or Wells Fargo, American Express actually houses that loan itself, so it gets the interest payments on that.
Lapera: Which is a great business model if you can swing it. But with AmEx, one of the issues is they charge higher fees to have it.
Maxfield: Yeah, exactly. Their interchange fees are much higher. But the thing about American Express right now is that it is in such flux, because it's losing a substantial share of its credit card portfolio to Citigroup because it's losing that Costco relationship. So, even though, when you're looking at the American Express numbers, they're going to be in a lot of flux.
Lapera: Brief pause for listeners who don't know, Costco used to have a branded credit card that they had in partnership with AmEx, and AmEx made a ton of money off that for a long time.
Maxfield: A ton. Yeah, it was a central part of American Express' business. I think the agreement goes back 16 years or something, but then, when it came up for renewal, they just couldn't come to terms on it, and Citigroup stepped in to take over that credit card portfolio.
Lapera: Yeah, it's definitely really interesting. AmEx, Visa, MasterCard, you're probably sitting there thinking, "Yeah, I've already heard of all these companies. These facts you're telling me are very interesting, but what are the opportunities here? Are there any opportunities for disruption? What are the competitive advantages of each relative company?" That probably, I hope, what you're thinking, because that's what we're going to talk about next. (laughs)
Maxfield: Yeah, and just to tee up this conversation, let me put all this in perspective. Visa's operating margin, which is basically their revenue minus all their operating expenses, is 65%. Now, when you think in your head, is 65% good or bad, well, let's compare it to another company that probably has really, really good margins. Let's compare it to Google (GOOGL 2.30%) (GOOG 2.45%). Google's operating margin is 27%. OK? So, again, Visa's operating margin is 65%. Google, which, according to Charlie Munger, probably has the greatest competitive moat of any company of all time, their operating margin is 27%. So, this just goes to show how powerful of a position these three companies, Visa, American Express, and MasterCard, have in that market.
Lapera: Yeah, and it's easy for them. One, they have this huge amount of market share. But it's also easy for them to have such a large operating margin, because it's not like it's a high cost for them to provide the services. Once you have the infrastructure in place, they can make bank, which is what they're doing.
Maxfield: That's right, and a really good lesson here is that, it's almost like a software company. Once you've made the software -- in Visa's case, once you've established that infrastructure -- then it's just a matter of scaling. So, if you can scale up to $1 trillion worth of payments as opposed to $100 billion, or, $4.7 trillion, you're just going to make a lot more money, but your expenses aren't going to racket up very quickly at all.
Lapera: Right, they're not going to rise at the same rate as the amount of money that you're bringing in, which is huge for Visa.
Maxfield: Right.
Lapera: And this is actually one of the competitive advantages that Visa and AmEx and MasterCard do have, is that they do have these established infrastructure networks.
Maxfield: Right. I mean, you know, when you think about competitive advantage, the network effect is the one that really comes to mind with these companies. They already have all of these merchants tied into it, they already have the big banks tied into it. So, they have those relationships and those networks that just make it easy. Because what Visa really does is it provides clearing and settlement services. And that requires people on both sides of the transaction to trust the person that's providing that service. And Visa has established that. So, that network effect is clearly very, very powerful when you consider how wide that margin is, and thus, how seemingly prone to disruption this industry is, but yet, this fact that it's still not been disrupted.
Lapera: Right. So, so far, we've covered two different types of competitive advantages that these companies have, which is the high capital investment required to even start building the infrastructure, and then, once you have the infrastructure, the creation and maintenance of these networks that allow these companies to function. There's a lot of trust going on there, and there's also years and years and years of legal contracts that are binding these people together. This isn't something that's easy for a small, upstart company to break into.
Maxfield: Right, and the other thing you have is, this is a service that is basically provided to banks, fundamentally, is what it is. And when you go back to the beginning of Visa, what was Visa? Well, it was a consortium of banks coming together to provide this service. Well, nowadays, one of the other reasons it'd be so hard to break into this is, it's not like the banks can come together to do something like this again, to maybe break the oligopoly that American Express, Visa, and MasterCard have. And they wouldn't be able to, presumably, because of antitrust concerns.
Lapera: Yeah, which kind of casts Visa and MasterCard, the way they are now, in a very interesting light. (laughs)
Maxfield: It does! It's kind of the other side of that. There's antitrust questions on both sides of the coin here.
Lapera: And, I don't know if you remember this, but, I believe AmEx actually recently just finished a lawsuit where they were being subjected to antitrust claims.
Maxfield: I don't remember that, but any time you have such powerful players, I think antitrust is always operating on the periphery.
Lapera: Yeah. But anyways, I like I said, it's very hard for small companies to break into this space, which is why, it's interesting that the people that you are seeing who might be disrupting the space are Apple and Walmart of all people.
Maxfield: Yeah. So, you have Apple Pay, which is a payment system that operates over the iPhone, then you have Walmart's -- when we were looking at it, it looked like it's also in a very early stage, like its beta phase. But CurrentC, these are two very different things. So, here's the interesting things about Apple Pay. So, when you think about Apple Pay, you think, this clearly must be really disruptive, right? But, what Apple Pay is, fundamentally, and this is kind of how Visa explains it, is, it's just an on ramp onto the existing infrastructure. So, typically, when you go to the store, you just use your credit card, you swipe it or put it in one of those horrible chip readers that they're still trying to figure out how to make them take less than 2 minutes to process the information...
Lapera: (laughs)
Maxfield: ... and that's how you would access their network. Now, with Apple Pay, the way it works, you just put your Visa or your MasterCard or your American Express or your Discover or whatever it is onto Apple Pay, and it just uses near field communications to do the same thing if you would be doing if you swiped your card. So, it's just another way to access the existing infrastructure.
Lapera: Yeah, which is really interesting, because, how disruptive is Apple Pay ultimately? Maybe we get rid of our physical credit cards, and that's it. Right?
Maxfield: Right. And the other thing to keep in mind is -- one way to get a sense of how disruptive Apple Pay in particular is, is to look at what Visa, MasterCard, and these companies think about it. And when you look at Visa and MasterCard and AmEx, they're all on board with Apple Pay.
Lapera: Oh yeah, they love it, because it just means more payments for them, which is ultimately what they want.
Maxfield: Yeah, that's exactly right. So, to them, they're seeing it as a benefit. But here's the thing, and we were talking about this before the show, the question is, in the short term, it seems like a great way for Visa, MasterCard, and American Express to boost up their payments volume, to make payments easier, to reduce the percentages of payments that are still being done over cash and shift that over to their networks. So, it seems like a great way to do that in the short run.
But here's the question -- over the long run, let's say that Apple Pay really takes off, and let's say everybody adopts this with iPhones, and more people buy iPhones because they want to have access to it, and all these different things. At that point, if you have a large share of all purchases going over Apple's network, that puts Apple in a really strong competitive position vis-a-vis MasterCard, Visa, and American Express. And you just have to wonder, if Apple is able to position itself like that, if it would eventually start to charge more for using that on ramp, if you will, to the existing payments network...
Lapera: Yeah, it's definitely really interesting. Whereas, CurrentC, which is the product created by Walmart that is still in beta test, I don't think you can get it unless you live in Columbus, Ohio -- I guess you can download it, but it's not going to do anything for you -- it's trying to cut out the payment processors entirely. Walmart and its little consortium decided that they were spending too much money paying the credit card processors, and they were going to just cut out the middleman entirely and hook up customers' bank accounts directly to Walmart or whoever it is. That way, they could get paid directly without having to pay any service fees.
Maxfield: Yeah, and if you think about it, you think, why would Walmart want to get involved with this? But if you look at its income statement, and you look at its revenue, it earns more than $400 billion worth of revenue. And it's a discount retailer. The name of Walmart's game is to sell things as inexpensively as possible. If you look at interchange fees, they're anywhere from 1-3%, 3% being American Express, and Visa and MasterCard on the lower end of the spectrum, well, that 1-3%, if Walmart could somehow take that out of the equation, so just take Visa, MasterCard, American Express totally out of the equation, it could drive down the cost to its consumers even more.
So, this is not a tangential thing for Walmart. This is a fundamental piece of its business. Now, the question is, whether it can get its own payments system up and going. But if it can, that's unquestionably bad news for Visa, MasterCard, and American Express.
Lapera: Right. But of course, there are other concerns with the Walmart system. I don't know if you remember QR codes from a few years ago?
Maxfield: I don't. (laughs) I don't.
Lapera: They're these blocks that were speckled black and white, and you could take a picture of it with your phone and it would redirect you to a website or, I don't know, give you something. Do you remember? They would have it and it would be like, "Take a picture with your smartphone and it'll give you all this interesting information."
Maxfield: I now know exactly what you're talking about.
Lapera: OK. The Walmart CurrentC app uses QR codes to make these payments.
Maxfield: Oh, it's like the 90s. But not the 90s...
Lapera: Right, (laughs) it's like early 2000s, exactly.
Maxfield: (laughs) Blast from the past.
Lapera: Exactly, and it's just kind of bulky. Apple Pay, Google Wallet, Android Pay, all of those things operate using near field technology. You just hold up your phone to the pay pad and it beams the information that it needs, then they talk to each other, and that's it. Whereas, with the Walmart thing, you actually have to pull up your QR code and take a picture, or maybe the app takes a picture, it's not 100% clear to me exactly how the QR codes work for the CurrentC.
Maxfield: It seems clumsy.
Lapera: Exactly, it's just an extra step you don't need to take when you're swiping a card or holding up your phone to pay, just tapping it.
Maxfield: And here's another interesting thing. Talking about, evidently, the clumsiness, the way you have to access CurrentC, these new chip readers...
Lapera: (laughs)
Maxfield: If you think about Apple Pay coming at the same time -- I mean, I'm still blown away by the fact that they introduced this technology. And, these are extremely smart people trying to figure this stuff out. But clearly, there's something in there with these chip readers that makes it difficult to process these quickly, because you put your card in, it could take 20-30 seconds. Right?
Lapera: Right.
Maxfield: And if you have a long line, that could take a while. So then, you think, Apple Pay is coming at almost the exact same time that you're adding all this additional time to this new credit card technology. And Apple Pay -- I haven't tried it -- evidently is almost instantaneous. So, if anything, you would think that these new card readers are going to drive adoption of Apple Pay.
Lapera: Yeah, maybe. Part of the reason it takes so long with the chip reader is because it's generating a new code for the transaction that can only be used for that particular transaction, which is why it takes 20-30 seconds at a time to process, as opposed to just swiping, where you're just transferring information off a magnetic strip. But, with the Apple Pay, you're right, it is a lot faster. But another consideration to take into account with the Apple Pay is, most of the merchants in the MCX, which is the consortium that Walmart runs, have disabled the near field technology on their payment pads, so you can't use Apple Pay or Google Wallet or Android Pay at any of their stores. You have to use CurrentC. And CurrentC hasn't been rolled out to those stores yet. (laughs) I mean...
Maxfield: So, you basically have to just use either the swipe or the chip, it sounds like.
Lapera: Yeah. In the majority of Walmart stores across the country. If you're in Columbus, Ohio, and you have the beta test of the CurrentC, then you can use that at their stores. But you can't pay with Apple Pay at any Walmart stores in the rest of the country. They obviously don't want that, because that would be competing with their network.
Maxfield: That's so interesting, because you can also see how, a company like Walmart, which makes its money on volume, would want to be pushing transactions through as quickly as possible. Yeah, that's so interesting, because you would think that if Apple Pay is significantly faster, for a volume retailer... but then, you have the competing CurrentC platform that they're trying to get up and going. And I guess, in their analysis, getting that up and going is more important than moving those lines.
Lapera: Yeah. Do you want to hear, I just pulled up a list of merchants who are part of the Merchant Customer Exchange. Do you want to hear what some of them are?
Maxfield: Yeah, let's hear this.
Lapera: We've got Wendy's, Wawa, 7-Eleven, Chili's, Baskin-Robbins, Bed Bath & Beyond, Dunkin' Donuts, Exxon, CVS, obviously Walmart, Gap. The list just goes on and on. Hy-Vee, which was my favorite grocery store in Nebraska, (laughs) I don't think they exist in Virginia.
Maxfield: Wait, let me get this straight. All of these have disabled near field communications on their readers?
Lapera: I'm not sure if all of those have. I know Walmart definitely has. But, there's the potential for all of those merchants to disable the near field communications on theirs as well. If you're a listener and have used near field communication, Apple Pay or whatever, at any of the merchants I just listed, definitely write in, because I'm really interested in hearing about this.
Maxfield: This is, to just get back -- this is such an unbelievable opportunity for disruption. Again. So, you'd think something -- whether it's CurrentC or whatever it is, you'd think something is going to happen in this space at some point. And I think that's why so many fintech companies are focused on it. So, it'll be interesting to see if anybody can actually tap into it.
Lapera: Yeah. And the other thing that's really interesting about CurrentC and Apple Pay is, are they going to be able to get people to adopt it? Taking a piece of plastic out of your wallet and swiping it is pretty fast, and people are really used to it. So, how are they going to convince people to change over?
Maxfield: Yeah. And, if they change over, what does that do for Apple's business model? Right? Think about what a powerful position it would be in, not only vis-a-vis the financial industry, but also vis-a-vis Android phones. If more and more people and more and more retailers are adopting Apple Pay, and Android doesn't come up with a product that I'm sure they're working on...
Lapera: Well, Android does have Android Pay, I believe it's called.
Maxfield: Right.
Lapera: But, I don't think it has quite as big of a market share as Apple Pay does.
Maxfield: Yeah. And if you think about Android, those phones, the companies that make those phones are more focused on the hardware, whereas Apple's got experience with both hardware and software. So, this is a software side to it. You would just think, this is a huge opportunity for a company like Apple to further tie people, its customer and new customers, into its existing ecosystem.
Lapera: It's really interesting that you say that, because my impression of Android is that they are a lot freer with what they allow to be done to their software. Like, they allow end product consumers to take their software and modify it and create apps, and their app store, I think, is a little bit more friendly to letting apps into it. So, I know a lot of my really big techie friends are really into Android because they can do all these things to it that you can't do with Apple. Apple really does a pretty good job of hiding its operating system and how apps work. It doesn't want you getting in there, (laughs) you know what I mean?
Maxfield: Yeah. But, if you think about the average consumer...
Lapera: That's true.
Maxfield: ... the average person, they want a seamless experience that is really easy, where you have a really close integration between your software and your hardware. And it's that kind of closed system that differentiates Apple. So, if they can marry yet another software element like iTunes, if it can marry another software element to its products, it just seems like it would provide another brick, if you will, in its network or network effects or switching costs, with respect to its consumers.
Lapera: Yeah. This is going to be a very interesting field to watch. There's one other thing I wanted to talk about with CurrentC before we moved on -- or, I guess, ended the show, because we're definitely running up against time -- which is the safety issue from CurrentC, because they are hooking up directly to your bank account. I don't know if there's any fraud protection associated with CurrentC like you have associated with Visa and MasterCard. Even companies like Venmo, they have ... well, I guess Venmo belongs to, I want to say, PayPal, now? But they do have some fraud protection built in. If you report fraud happening, they'll cover most of the costs except for $50, I think, depending on how much gets stolen. But I have heard of horror stories with that, too.
So, the question is, for an app that's hooking directly up to your bank account, because that's how it works, they're not using the payment processing network, what kind of protections has Walmart built in to make sure nothing happens?
Maxfield: Yeah, and I obviously don't know the answer to that question, but I would venture to say that Walmart is all over it. (laughs) You know what I mean? Or, to the extent that Walmart could be, because, having the safety of your payments is a really important thing. That's one of the reasons that people like Apple Pay so much. Again, I don't understand the technology, but the conversation out there is that Apple Pay is even more secure than these new chip card readers. So, it's just another area where they can differentiate themselves. So, if CurrentC and Walmart isn't able to differentiate themselves on the safety element, certainly, they would come down a notch in the view of consumers relative to Apple Pay and the credit card companies.
Lapera: Yeah. I think Apple Pay and CurrentC definitely both have a long way to go in marketing themselves to consumers, either way, because it took me a long time to find info on both of them. And it shouldn't be that hard to find information on a product you're trying to sell to people. (laughs)
Maxfield: Yeah. And maybe we're just dinosaurs. (laughs)
Lapera: I know. I'm going to turn 27 in three weeks, man. I basically have one foot in the grave. (laughs)
Maxfield: (laughs) Yeah, you're approaching 30, that's when it all ends. I remember when I was 14. There was a guy who lived down the street who was 30, and I was like, "That guy's so old." But certainly, the more people adopt it, it's just, I think that builds on itself in somewhat of a snowball effect.
Lapera: Yeah. Well, this is something we're definitely going to have to keep an eye on. Thank you very, very much for joining us this week, John. As usual, people on the program may have interest in the stocks that we talk about. Don't buy or sell based solely on what you hear. Thank you guys so much for joining us! Definitely email us to let us know how you're paying for your groceries this week. You can reach us at [email protected]. Thank you very much and have a great week!
