The bus you took to work. The coffee you bought when you arrived. The sandwich at lunch. The dinner. The taxi home. All transacted and paid for, perhaps, with a smartphone via an invisible payments system. Now, imagine billions of people following your routine and you begin to get an idea of the scope of the system and what’s at stake. But perhaps more staggering is the number of people yet to use this system: consumer purchases on a global scale amount to an estimated $41 trillion, and still $17 trillion of that amount still consists of cash and cheques.

“There remains a long runway for secular growth in non-cash digital payments, which are increasing at a rate of 10 per cent a year,” says Brett Miller, an equity analyst with Lazard Asset Management.

And who do you think is leading the uptake when it comes to digital payments? You guessed it: smartphone-wielding young people—both in the West and elsewhere. Specifically, millennials and generation Z—that cohort brought up without knowledge of life before the wonders of the internet.

And this is crucial if we’re to have faith in the growth runway that Miller talks about because millennials are outgrowing us all. According to Pew Research Centre, this year millennials (people reaching adulthood in the 21st century) are expected to overtake baby boomers in population, while, generation X (those born between 1965 and 1981) is projected to pass the boomers in population by 2028.

In this article, we examine the investment case for digital payments pioneers, Visa and Mastercard, and the advent of Chinese powerhouses Alibaba and Tencent, and the uptake in Australia and dominance of buy now, pay later leader Afterpay, whose share price has risen 340 per cent over the past year. And if we’re to invest in these platforms it’s crucial to find out how they make their money before we entrust them with ours. But first a word on the evolution of cashless payments.

In payments we trust

The bedrock of financial transactions has always been trust. But this has evolved to the point where the relationship between the payer and the payee is largely anonymous. The term the boffins like to use is “frictionless payments”: that mild euphoria you get when you swipe for a coffee or jump out of your prepaid Uber without touching your wallet. The persuasive power of fintech hinges on the simple idea of living without carrying cash. Nowadays there’s a digital wallet and it’s as secure as it is convenient—for both customer and merchant.

Photo of credit cards and payment apps

The persuasive power of fintech hinges on the simple idea of living without carrying cash

The names are familiar: Visa, Mastercard, PayPal. But where there are Goliaths there are also digital Davids trying to snare a slice of an expanding pie. And that’s just in the West. In China, online titans Alibaba and Tencent have created “super apps” of their own, which include payment systems used by 1 billion people—three times the population of America. Other markets are about to experience the payment revolution too. India, for instance, where cash still accounts for 86 per cent of all consumer purchase spending, is tipped for its own upheaval. For where there’s a smartphone—and in India one in four people has one—there’s a way to make online payments work.

In Australia alone, awareness of digital payments has reached virtual saturation point. Roy Morgan, a research house, earlier this year found that of the 50,000 people it surveyed, 94 per cent were familiar with digital payments. More than 72 per cent of people reported using at least one digital payment method over the past year.

And the technological revolution, with its smartphones and “wearables” is only accelerating the transformation.

How do online payments processors make money?

In the spirit of knowing what you’re investing in, let’s pause to see how payments work.

Payment models vary but for illustrative purposes, it’s worth looking at the pioneers, Visa and Mastercard, and also the new “buy now pay later” (BNPL) model of companies like Afterpay, which accounts for 87 per cent of the market in Australia.

As Morningstar equity analyst Brett Horn puts it, the payment processing giants of the world, Visa and its nearest rival Mastercard, are essentially “tollbooth” businesses. That is, for the billions of transactions that occur every day they take a minute cut, or what are known as “interchange” or “swipe” fees.

Consider a $100 purchase. In the seconds it takes for a shopper to pay for something, a complex network of data exchange occurs, and every player involved gets to clip the ticket. The retailer or merchant gets about $98 of the $100. The remaining $2, known as the merchant discount and fees, gets divided up. About $1.75 would go to the card issuing bank (the interchange fee); 18c would go to a Visa or Mastercard association (the assessment fee); and the remaining 7c would go to the retailer’s merchant account provider. If a credit card displays a Visa logo, Visa will get the 18c, likewise with Mastercard.

BNPL companies essentially make their money two ways: late payments and merchant fees. In the case of Afterpay, which has 3.1 million customers, it earns about 17 per cent of its revenue from late payments. And it charges merchants 30c per transaction, plus a 4 to 6 per cent commission. Merchants typically use the system because it allows them to shift stock and boost sales.

The model is straightforward. For example, you spot a $100 pair of shoes you want immediately but you can’t foot the bill. Afterpay steps in and pays the shoe shop $96 ($100 for the shoes minus a $4 fee). It then recoups the money from the customer in four payments of $25 over a period of up to eight weeks. A missed payment incurs a $10 late fee, with a further $7 late fee added seven days after the payment is due if the payment is still unpaid.

And because they don’t charge interest, BNPL companies avoid the National Credit Act, according to ASIC. Afterpay holds a credit licence but does not provide any products regulated under the Act. The company, however, says it does credit checks using its own methodology and “refuses 30 per cent of all purchases and 50 per cent of first-time purchases based on our algorithms and the customer’s history”. It argues that it should not have to apply traditional lending checks because the average outstanding balance of its customers is $208.

We will return to Afterpay as an investment prospect but first let’s consider that of the big names in America and China.

America: land of the payment pioneers Visa and Mastercard

From 1985 to 2006, Visa’s slogan was “It’s everywhere you want to be”. This has since been abridged to “Life takes Visa”. But the message is essentially the same and illustrates why Visa and Mastercard possess a wide moat or sustainable competitive advantage. Keys to their dominance are the sheer scale of their business and the universal recognition and trust in their brand name. “We view Visa’s position within the current global electronic payment infrastructure as essentially unassailable,” says Morningstar’s Horn. The “network effect” is one of the most powerful moat sources a company can have and in the case of Visa it is unmatched.

“The more consumers that are plugged into a payment network, the more attractive that payment network becomes for merchants, which in turn makes the network more convenient for consumers, and so on,” says Horn. “This explains why a handful of networks have come to dominate electronic payments.”

Photo of Visa and Mastercard credit cards

The sheer scale of Visa and Mastercard, universal recognition and trust in their brand name are key to their dominance

Visa, which traces its roots back to the Bank of America in the 1950s, does double the amount of transactions of Mastercard. It has almost 16,000 financial institution partners, 3.3 billion Visa cards in circulation, and 54 million merchants accepting Visa. In fiscal 2018, it processed more than $8 trillion in purchase transactions. And it holds more than 50 per cent market share (by purchase volume) in the US, Europe, Latin America, and the Middle East/Africa, according to the Nilson Report, a global survey of the payments industry.

Horn is bullish about Visa and says the ongoing shift to electronic payments will allow it maintain its strong growth. He projects total and net revenue to grow at an 11 per cent and 10 per cent compound annual growth rate over the next five years, respectively.

Visa stands at No 61 on Interbrand’s list of 100 best global brands. But Mastercard is not far behind at 70. It is the second-largest processor of transactions in the world, with a market share of 26 per cent. It is building on this with an aggressive push into data analytics and increasingly setting security and technology standards for the entire payments industry. Horn expects Mastercard to increase revenue at percentage rates in the low double digits over the next five years, with growth averaging 13 per cent.

Despite their dominance, however, Visa and Mastercard are not immune to risks. They are vulnerable to disruption from new technology, and their oligopolistic status has drawn fire from lawyers and politicians seeking to crack down on their fee levels.

Another trusted name in payments is PayPal, which was a subsidiary of online shopping site eBay until 2015. These days PayPal has more than 200 million consumer accounts and 16 million participating merchants. PayPal built its strong brand name by managing the high risk associated with small merchants in the online and digital sphere by taking a larger share of each transaction for their troubles.

But the increase in the use of mobile devices has let in new rivals such as Apple Pay and Google Pay. The challenge for PayPal is then to become a “force to be reckoned with” at the physical point of sale, says Horn. Much of this hinges on the potential of its mobile payments services Venmo and Braintree. Another risk it faces is the “staggering” bargaining power of big retailers, which is likely to weigh on PayPal’s pricing.

“We expect business-to-consumer sales over the internet (including mobile) will roughly double by 2023,” says Horn. “And PayPal will increase its share of processing as it benefits from its new independence and Braintree builds on its position as a mobile gateway of choice. We think this will lead to a 17 per cent revenue compound annual growth rate through 2023 for PayPal.”

Further down the payments rankings is newcomer Square. Its point-of-sale software and mobile card readers have become a ubiquitous feature of the retail landscape, particularly among small business—its key market. Its business model is built on client onboarding, flat fees and ancillary services such as Instant Deposit and Caviar, an on-demand food delivery service. Square, which was co-founded by Twitter’s Jack Dorsey, has grown dramatically since it listed in 2015, and is reaching the point where it can generate attractive returns, says Horn. But still, the potential is limited.

“We believe Square’s suite of offerings, quick start-up time, and simplified pricing will allow it to attract enough merchants above the $125,000 level to scale and reach an attractive overall return. However, Square’s pricing is significantly higher than that of traditional acquirers, which we believe will be a limiting factor. Square can carve out enough share in its niche to become a sustainable and attractive franchise, but we do not see it as disruptive to the larger acquirers.”

Horn forecasts strong growth overall, with total revenue growing at a 27 per cent compound annual growth rate over the next five years, and 19 per cent over the next 10.

China: the behemoths Alibaba and Tencent

The advent of online payments began in America, but it is China that has embraced it most. The days of cash on delivery began to fade with the widespread adoption of the smartphone from 2012. Nowadays consumers and merchants use a payment app and the camera in their smartphone to scan QR codes to pay for everything from food to utility bills.

Driving the adoption of contactless payments is China’s tech-savvy youth. China’s Gen Z consumers account for 13 per cent of household spending, more than four times that of their US peers, according to Bloomberg. They increasingly spend that cash via China’s two internet behemoths Tencent and Alibaba. The number of people using these sites is staggering. Consider for instance Tencent’s “super app” WeChat, a messaging service that doubles as a payments service (WeChat Pay). As of June 2017, WeChat had 962 million users, compared to China’s population of 1.38 billion. Such a network effect is only expected to grow and boost Tencent’s revenue as more users and more merchants connect to it, says Morningstar analyst Chelsey Tam.

Alipay and WeChat apps

China has embraced online payments via mobile apps such as Alipay and WeChat Pay 

And it’s through the analysis of this mountain of payment data that companies like Tencent and Alibaba are able to boost their revenues even further by helping advertisers to better target their marketing campaigns. “A virtuous cycle has been formed, and it is difficult for a new entrant to recreate the same ecosystem,” says Tam, who sees Tencent as undervalued by about 20 per cent. The company’s adjusted return on invested capital has far exceeded its weighted average cost of capital of 9.7 per cent for the past decade. And in Tam’s view, it will generate excess returns on capital over the next 20 years via various monetisation sources such as online gaming, subscriptions, advertising and payment.

Alibaba is similarly undervalued by more than 20 per cent, according to Morningstar analyst RJ Hottovy. Alibaba’s core retail marketplaces (Taobao and Tmall) generated gross merchandise volume of US$909 billion in 2018—more than Amazon and eBay combined. More than 80 per cent of transactions in Alibaba’s marketplaces are settled through Alibaba affiliate Ant Financial. Whereas the typical credit card transaction in the US generates about 2.5 per cent fees, Lazard’s Miller estimates the comparable cost of an Alipay transaction, which reduces the number of intermediaries, is about 0.5 per cent.

However, such a stranglehold does have its risks, and Alibaba faces continuous scrutiny from regulators over its mobile payment services.

Australia’s conversion to cashless living

According to the Australian Payments Network, the overseer of the payments industry, Australia is among the top ten countries for “digital readiness”. And again, the smartphone emerges as the key facilitator. Nine out of 10 people in Australia have a smartphone. And 7 out of 10 smartphone users use it to make payments. What’s more, they are no longer apprehensive about the security of paying for something using their phone: 56 per cent of Australians are happy to use their thumbprint, voice or retina to grant payment.

The cheque is rapidly being phased and even ATM withdrawals, once considered a revolutionary way to access money, are falling. In February last year, Australia launched the New Payments Platform, which included instant person-to-person payment services PayID and Osko. In its 2018 review, AusPayNet noted that up to 60 financial institutions were on the NPP and about 2 million people had registered for PayID.

Australia now counts about 650 fintechs in operation—a fivefold increase on 2014.

In the past year, Australians have opted to sidestep the banks payment systems and instead used platforms offered by global tech firms such as Apple and Google. The Roy Morgan data shows that in the 12 months to November 2018, almost 7 per cent (1.4 million) people used digital payment systems operated by global tech giants—platforms such as Apple Pay, Samsung Pay and Google Pay. This was higher than banks’ own mobile payments systems, which were used by 5.8 per cent or 1.2 million.

The merchant of Buy Now, Pay Later

Younger people, in particular, are also changing their habits, opting for BNPL services such as Afterpay Touch Group (ASX: APT), or its rivals Zip Co (ASX: Z1P) (which has two products: Zip Money and Zip Pay). The use of BNPL has risen from 400,000 users to 2 million between 2015–16 and 2017–18, 60 per cent of whom are between 18 and 34, according to the Australian Securities and Investments Commission. And transaction numbers have risen from 50,000 in 2016 to 1.9 million in June 2018.

With a few technological tweaks, the delayed gratification of the old-fashioned layby system has been usurped by the instant gratification of the BNPL system. The system is not without its critics. BNPL companies have thrived against a backdrop of recession-free living. A Labor-led Senate probe into the BNPL system earlier this year heard that typical users are young (about 40 per cent of Afterpay’s customer base), earn less than $40,000 and mostly are students or in part-time work. According to ASIC, one in six of BNPL users are overdrawn, have delayed payments or borrowed more to service their debts. There have been claims by some users that their credit rating has suffered and that they risk being refused loans from traditional banks.

Despite its soaring share price, Afterpay, founded in 2015, posted worse-than-expected half-year results. Profit was non-existent and it made a loss of $22 million over the six months. Much of its costs relate to employment and its expansion in the US and the UK Revenue, however, rose by 85 per cent to over $112.3 million as the number of customers over the half more than doubled and the number of transactions tripled. Late fees accounted for about 17 per cent of its revenues.

It has benefited from the shift away from credit cards to debit cards and has been growing most aggressively in store rather than online. Australia and New Zealand account for about 80 per cent of its revenue. The company, which paid no dividend, has 3.1 million customers, and millennials account for 70 per cent of its transactions.

It has about 23,000 merchants in Australia and began its expansion into the US a year ago—a move that has been growing faster than expected, generating up to $10 million. It is also set to open in the UK this year.

India and beyond: a digital downpayment

When you consider that 2.5 billion in the world don’t have access to banks, there is a lot of room for growth. The next frontier for the revolution in digital payments is India, the world’s fifth largest economy. As in China, the ingredients are in place: a population of 1.33 billion, with increasing access to the internet, and a quarter of whom have access to a smartphone. And unlike China, the government is keen for online payments to take off as it sees it as a way to formalise the economy and boost tax compliance, says Miller.

In 2016, the Modi government abolished 500 rupee and 1000 rupee banknotes and made it easier for third-party mobile wallets to connect with bank accounts and transfer money between third parties—a system known as United Payments Interface, or UPI, wallets.

“By pairing smartphone adoption with the government’s initiatives, we believe the stage is set for significant secular growth in digital payments in India,” says Miller.

A bank official counts discontinued notes in a bank in Gauhati, India

In 2016, the Modi government abolished 500 rupee and 1000 rupee banknotes

Visa and Mastercard already account for about 80 per cent of card-based payments in India, but there is much jostling in the market. As well as a local debit network called RuPay, there is also an Alibaba-backed digital wallet called Paytm. And Google and Facebook are also experimenting with UPI wallets. “We believe the US-based processors will compete vigorously, lest they miss out on this next large market opportunity as they missed out on China,” says Miller. “The Chinese companies will be an important factor as they look to expand their presence across Asia. Nevertheless, we could see a scenario where the government ends up favouring local initiatives.”

And China and India aren’t the only growth stories. In the southeast Asian nation of Indonesia, there is a battle for supremacy among two homegrown “super platforms” called Grab and Go-Jek. In a country of 264 million Grab and its rival Go-Jek, which began as ride-hailing services, are looking to emulate Alipay and Tencent’s WeChat. They too have created digital wallets that can be used to buy anything from groceries to mortgages, notes Fortune magazine’s Clay Chandler.

“GrabPay operates in six Southeast Asian nations—and could go wider with help from a new prepaid-card partnership with Mastercard,” Chandler says. “Through Grab Financial Services, Grab offers loans to local consumers and entrepreneurs who otherwise have no bank accounts, using their digital-payment histories to help establish creditworthiness.

“Go-Jek’s Go-Pay system currently operates mostly in Indonesia; the company says it’s on pace to process well over $6 billion worth of transactions this year.”

Perhaps the last word should go to Thomas Olsen, a partner at Bain and Company, a consultancy. “We talk about the trade war but you could think about the ‘payments war’,” he says. “It’s different participants but investment is very large, and it varies a lot by country and by jurisdiction.”

Somewhat ironic, you might say, especially when you consider that the root word “pay” in “payment” derives from the Latin “pacare”, to pacify, because the digital payments world has been anything but peaceful.

This article was originally published in Your Money Weekly