Please refer to our disclaimers, which can be found in the footnote of this page and here.
11 October 2024
We’ve followed the global payments ecosystem for a long time. We are attracted to the secular tailwinds driving digital payments including the continued share-gain of cards over cash/check and the growing share of online commerce, where there is greater economic capture. We first began our work with an industry study where we sought to understand the duration of the secular tailwinds and how the power in the value chain was evolving. We may share this study in a future letter.
Our work led to two investments, Visa and Block. We think the card networks (Visa and Mastercard) will continue to maintain their dominance. While there has been some increasing power in other parts of the value-chain, and a modularisation of some of their services[1], these networks remain irreplaceable assets. We follow both Visa and Mastercard but prefer Visa on valuation grounds.
We observed increasing integration between point-of-sale (“POS”) services, gateways, payment facilitators, and merchant acquirers to provide superior software and data-driven value-added services such as fraud detection, lending, inventory management, payroll etc. Within this segment we have preferred those focused on small-to-medium sized businesses (“SMEs”) like Block. SMEs are more likely to seek a one-stop-shop payment solution leading to higher yields for the provider, with price less likely to be most important variable. In contrast, enterprise customers prioritise pricing, with large customers often appointing multiple providers to avoid lock-in and enable real-time payments routing to optimise cost. We looked closely at Adyen[2] but did not get there on business quality for this reason (it’s unclear to us whether the business will commoditise). We landed with Block because it had a dual ecosystem of merchants in its integrated POS / payment facilitator business (Square) and consumers in its banking business (Cash App). We saw merit in the potential synergies between these two ecosystems and without this, Block would not have met our quality criteria. We discuss Visa in this letter and will save Block for a future discussion.
We first invested in Visa in November 2021 (see chart below). As the market declined, we used Visa as a source of capital to invest in stocks with higher forward returns. We reinvested in Visa in November 2023, due in part to worsening forward returns in other names.
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Crash Course in Payments for those Unfamiliar
Payment networks are built on a four-party model that includes the consumer, the consumer’s bank that issued the card (issuing bank), the merchant, and the merchant’s bank (merchant acquirer). When a card purchase is made, the card network routes the payment request to the issuing bank. Once the issuing bank authorises the transaction, the transaction is posted to the consumer’s account and the issuing bank pays the merchant acquirer less an interchange fee (the issuing bank’s charge). The merchant acquirer then pays the merchant less an amount called the merchant discount (i.e. the fees to all the facilitating participants including the interchange fee). Typical merchant discounts rates are around 2% for credit (closer to 3% online, or if involving payment-related software services on top, and cheaper for debit). The issuing bank takes the lion’s share given it assumes the credit risk in most transactions (unless the merchant isn’t using certain security measures). The other participants each take a small share. The card networks also coordinate the clearing and settlement information for the banks and offer various value-added services in the process, including real-time fraud analysis to assist issuing banks in the authorisation decision. The card networks also set the rules regarding payment disputes and will manage the dispute process as an added service if required. When payments are made online, card details are collected by a gateway (akin to the physical card terminal), which can be an independent company or integrated with either the merchant acquirer / payment facilitator or the card network.
Source: Goldman Sachs
Source: Goldman Sachs
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Visa is a global payments network that facilitates the switching (authorisation, clearing and settlement) of card-based payment transactions between consumers, merchants, and their associated financial institutions (card issuer banks / merchant banks), while also providing associated value-added services. The network spans more than 200 countries/territories and involves more than 4.5b card credentials, 15k financial institutions, and 100m merchant locations. Its large scale means that Visa, in effect, earns a toll on global consumption.
All network participants adhere to Visa’s payment protocols, including payment dispute processes. The network's value to each participant grows as it expands, demonstrating strong network effects. Although Visa also operates a physical infrastructure network, the primary strength lies in its protocol network. Replicating the physical infrastructure would not easily persuade participants to switch to a different framework. This has resulted in a concentrated market structure, with Visa and Mastercard together accounting for approximately 75% of global card volume outside China, with Visa holding just under 50%. They are the only truly global payment networks.
Historically, competition between Visa and Mastercard has been directed towards issuing banks because merchants were incentivized to accept both forms of payment due to their scale. However, regulatory changes have required debit cards to allow routing over competing networks at merchants’ discretion, meaning a merchant may accept a Visa debit card but then choose not to route the payment through Visa’s network. Consequently, competition now also orientates towards larger merchant acquirers and merchants, as the networks encourage merchants to select their routing network (it is no longer a shared monopoly in acceptance).
Visa’s Strategy, Source: Annual Report
Visa takes a small piece of every Visa-related transaction. This includes volume-based revenue (~12 basis points of card volume / $15b revenue), transaction-based revenue for switching services (~5.3 cents per transaction / $11b), transaction-based revenue for the provision of value-added services such issuer processing, gateways, and risk-based solutions (~2.2 cents / $5b), cross-border processing revenue and currency conversion (1%-1.5% / $12b)[3]. They also earn non-transaction-based value-added services and other revenue from things like consulting ($4b). These revenues are offset by a contra-revenue item called Client Incentives (~10 basis points / $12b), which are contractual discounts to various parties to win their business[4]. Issuers historically received most of the incentive payments but since the introduction of debit routing choice regulation, these incentives also flow to the large merchants and merchant acquirers (in fact, in debit, they now receive a greater share than the issuing banks[5]). Management doesn’t think about incentives as something distinct and manages the business for growth on a net basis. Visa’s share of the economics in the value-chain is a minority (7%-15% depending on offline/online, debit/credit, and what value-added services are used, representing 12-40bps of the payment volume). Despite taking a minority share, the limited capital required to operate the network, relative to its scale, means Visa earns very high returns on invested capital.
Source: Company Data
Source: Company Data, Kalakau Avenue estimates
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What infrastructure underpins a payments network?
A card network is physical communications network, for example, VisaNet is made up of state-of-the-art data centres connected through 1,600 secure network endpoints linked by 1.2 million miles of fibre-optic lines. Hence the use of the phrase "card rails" when referring to how payment communications occur. Like any communications network, card networks require speed and capacity to function with real-time services. The network connects all the parties involved in a transaction but also connects other networks to facilitate non-network and non-card-based payments.
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