How Paying Can Make Money

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This podcast was recorded on Aug. 15, 2016.

Kristine Harjes: This episode of Industry Focus is brought to you by Casper. An online retailer of premium mattresses for a fraction of the price. Because everyone deserves a great night sleep. Get $50 off any mattress purchase by visiting and enter promo code FOOL.

Welcome to Industry Focus. The podcast that dives into a different sector of the stock market everyday. It's August 15th and a Monday so we're covering the financial sector today. I'm Kristine Harjes filling for your normal host, Gaby Lapera. Longtime listeners will remember that I actually used to host this show rather than my current Wednesday healthcare show so this is kind of a throwback. I've got financials contributor Jay Jenkins, calling to Fool HQ, in Alexandria, VA. How it going, Jay?

Jay Jenkins: Hey, happy to be here!

Harjes: Welcome to the show. All right, listeners. Think back on your weekend, specifically the financial transactions that you made. I can almost guarantee that you directly interacted with one of the services that we're going to cover today. If you split a bill with friends via Venmo used your card in a farmer's market via Square (NYSE: SQ)or maybe you used near-field technology at the supermarket to pay from you iPhone. You'll be on the frontier of the payment processing landscape which is changing everyday. Today we're going to dig in a little bit to the companies powering the space and some of the ways you can invest in it. Jay, where shall we start?

Jenkins: Well, I think the easiest way to understand the bigger picture and then from that infer the trends and where we're going next is to start with the two gorillas in the industry. The established players Visa(NYSE: V) and MasterCard(NYSE: MA). Compared to all the other space, these two are just absolutely dominant and dwarf virtually the entire industry, they're so dominant. I went and pulled some numbers to get some context to this. Right now the world population is what, 7 maybe 8 billion or 9 billion? Something like that.

Harjes: World population?

Jenkins: Currently there are over 2.5 billion Visa cards in circulation around the world today and there are about 2.3 billion more MasterCard branded cards in circulation around the world today. When you think about that, in the developed world, in the emerging markets, and third world countries all over the world, all these people almost everyone has a Visa or MasterCard. It's staggering, the size and the scale.

Harjes: That is pretty incredible. Is that the number of people that just have the card or how many cards are in circulation? Because you can have more than one card.

Jenkins: Absolutely. That's true and that's a very good point. That's the number of total cards in circulation. Going a step further, they also report their total gross dollars that come across their networks each quarter and those numbers are just as staggering. I may have a MasterCard and a Visa so it may be a little bit of a double count there. In terms of like the global economy these numbers are still just mind blowing. $1.35 trillion in payment volume went across Visa's network in the second quarter alone. That's actually Visa's third quarter, but the quarter into June 30th. On the MasterCard network, $1.23 trillion which is an 11% growth rate year-over-year. It's just massive. It's hard to even conceptualize what that looks like practically.

Harjes: That is pretty incredible. Looking at the companies that make all those transactions happen, how do they make their money?

Jenkins: Sure, that's a great question and it's a little bit of a misconception I think in the general public. Visa and MasterCard are not banks. They don't actually make loans. Their business is much more like ... I think about it like a highway toll collector. Visa and MasterCard went out years ago and built this digital highway and whenever you swipe your card or use "Buyer" online with Visa or MasterCard, that transaction has to go across the highway built by Visa or MasterCard to connect you and the merchant and your bank and the merchant's bank and a lot of intermediary stuff too that's not worth getting into. Fundamentally, that's all they're doing. Their infrastructure that's connecting us, that allows the payments to happen from the card swipe at the grocery store or with Square or buying on Amazononline, they're sort of the action behind your transaction. Then, every time they do that, every time your transaction goes across their highway, their digital infrastructure, they just collect a small fee. When you do $1.35 trillion in payments in a quarter those small fees add up very, very quickly.

Harjes: Yeah, for sure. A bunch of these companies also have partnerships with other companies. I know we heard a ton about the Costcodeal with Visa. That was huge and that actually kind of leads us into a little bit the next company that we want to talk about which was American Express(NYSE: AXP) which lost it's relationship with Costco ... Fairly recently? What was that, maybe a year ago? A little more?

Jenkins: Yeah, they announced it about a year ago and the actual transaction or ... the actual transition I should say was just a few months ago.

Harjes: Indeed. American Express is kind of an interesting one to contrast with Visa and MasterCard because they go beyond just this highway tollbooth collector model.

Jenkins: Absolutely, and the Citigroup(NYSE: C) Visa and Amex comparison is absolutely fantastic to illustrate the differences in these two companies. American Express believes one of their fundamental competitive advantages is that they call it a closed loop ecosystem. Meaning, you swipe your American Express card, that transaction happens on an American Express built digital highway. They're completely in control there. Then, the actual credit card is American Express debt so they're actually kind of like the bank. They actually own the debt. They're funding the transaction if you use the credit card. That compares to Visa. Again, Visa doesn't make loans. Visa's not in that business. When Costco-Amex decided to part ways, Costco couldn't just go to Visa. They also had to go find a bank and that bank ended up being Citigroup. They essentially replaced one vendor, American Express -- which did both functions -- and now they're replacing it with two vendors because Visa doesn't have that lending function that American Express is. That distinction is important because first of all it changes the way they make money. They make money on the transaction fees, which is their primary driver of income at American Express, but they also make money on loans. They collect interest, they have interest expenses just like a traditional bank or community bank would do if they were in the consumer debt or credit card market.

Harjes: Even though they might be smaller on the actual network side when you compare American Express to your MasterCard or your Visa, they also have this bank business.

Jenkins: That's exactly correct. American Express has a 108 million cards in circulation which, again, you compare that to the 2.5 billion Visa cards. That's a drop in the bucket, but they're still able to generate a lot of revenue from those transactions fees. In the second quarter they generated $6.8 billion in non interest income. Then, additionally they generated $1.8 billion in net interest income. They have the transaction business that's much smaller it's not quite the blanket like Visa or MasterCard is, but it's supplemented with this lending business which ... $1.8 billion in net interest income, that's substantial. That's a lot of money.

Harjes: Is American Express the only company out there playing both sides of this?

Jenkins: No. As we kind of get deeper into the industry you'll find that outside of Visa and MasterCard everyone sort of has their hand in different pots. Discover Financial(NYSE: DFS) is the closest natural comparison with American Express. Fundamentally they do the same thing. They have a payment network. There's the Discover network, Diner's Club, they have a couple other brands around the world in different geographies and they collect payment money on each transaction that goes through just like we've already described. They also have a banking subsidiary that makes loans. Discover actually made mortgage loans up until last year. This is the first year that they haven't. They sold off their mortgage book so that kind of an interesting ploy too. They weren't just payments, they were full on into the whole consumer debt side of things as well.

Harjes: That is interesting. I didn't see that. One thing I did see recently when I was reading about Discover is that gas prices are actually lowering card spending and I'm sure this is a trend that is happening for all of these companies that we've talked about. Discover noted that they had 4% credit sales growth in the first quarter and it would've been closer to 5% if gas sales and the leap year were thrown out.

Jenkins: That's so interesting. You get these huge companies with such scale it's amazing what one extra day in a quarter can do to their year-over-year numbers. It's going to be a little bit misleading. Then, you throw in something macro like gas prices. Analyzing these companies, it's simplistic in that they're all sort of similar and you can kind of get the business model, but then the more you dive in these little nuance factors can really throw you off if you're not paying close attention.

Harjes: Yeah, those little things will make or break your analysis of the company. We want to move on from some of these more traditional established players and talk about some of the ways that the space is being disruptive.

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Okay, Jay. Back to your regularly scheduled programming. What's next in this industry? What are some of the movers and shakers changing things?

Jenkins: Sure. This is where it starts to get a little bit confusing for folks that don't follow this on a pretty regular basis because it's kind of gotten a little bit murky. There's a lot of new players. People are doing different things. The Internet and smartphones have really changed the way consumers interact with merchants. Whether you're buying from an e-commerce site or like you mentioned a farmer's market with your debit or credit card. These are things that 20 years ago didn't exist and in some cases eve 5 years ago didn't really exist. It's changing pretty rapidly.

Harjes: Especially on the broad scale that they exist on now. I mean, I use app Venmo to pay my rent.

Jenkins: Absolutely. Venmo's a perfect transition too because I think PayPal (NASDAQ: PYPL)is the company that really started this massive shift in the payments business. To me PayPal was the one company that made doing business on the Internet easy. That's where they started, eventually they were bought by eBayand then last year were spun back separately into their own distinct company, but over the last 15-ish years PayPal was the company that allowed entrepreneurs or small businesses or even established companies. They made it really easy to sell their products online and as we know today everyone shops online.

Harjes: Yep. It's huge and PayPal still is the heavyweight here. They have 184 million active users and 14.5 million merchants. They generate 9.2 billion in revenue in 2015. As you alluded to they actually own Venmo. They acquired Venmo via the acquisition of Braintree for $800 million back in 2013. Venmo is very quickly up and coming player in this market. Just in this past January of 2016 they had their first $1 billion transaction month. They were the third most downloaded app last year and this could certainly change the game going forward.

Jenkins: Absolutely. If you're 35, give or take, years old or younger you almost certainly have Venmo. I mean, it's ubiquitous at this point for that millennial generation. It's an interesting conundrum for PayPal. They have this app that is absolutely on fire, but as of right now they're losing money on it every single day. Venmo, all it functionally does is it allows you to transfer money from one person to another directly. It's really fast, it connects to your bank account. The transfer is basically instantaneous and then you just have to go through the normal day or two that it takes banks to process the deposit after the fact. At this point that's completely free to consumer.

Anytime if you transfer with a credit card or a debit card, Visa or MasterCard in most cases, are going to charge a small fee that PayPal is right now footing. A couple percentage points. Not a lot, but with a product that's growing this rapidly and this many users it adds up to millions and millions of dollars a quarter. The big question is can PayPal somehow monetize Venmo to capture this millennial mobile movement that's happening without doing so in a way that turns off users and stifles the growth rate.

Harjes: There are a couple of points that I want to make on that. They do make some money by allowing merchants to accept Venmo as a payment option. This just started on July 27th with 11 merchants. The merchants are charged a small fee here, but really the heart of their business is peer-to-peer. It's you and I go out to dinner and we want to split the bill, but neither of us carry cash because who carries cash nowadays so I'm going to send you my half via Venmo. That's really the heart of it. The thing about that is it's a competitive space. There are other players out there trying to do the same thing. Venmo all of a sudden wanted to charge a fee or you had to pay to download the app or there was a membership I think they would lose a lot of their customers.

Jenkins: Exactly. It's kind of a land grab right now. Like you saw 10 years ago and even still to this day to a degree with Amazon. Just cutting prices, operating without any profit intentionally. Just land grabbing. We have to be the number one seller on the Internet. We have to be ubiquitous. We have to go from being tissue paper to being "Kleenex". Once you get to that point you can have options and you can try different things. To your point, the first thing they're trying is opening up on the business side where they can charge businesses to accept Venmo, much in the same way that Square -- which I'm sure we'll talk about probably next -- does, in the same way that to a degree MasterCard and Visa do, as well. It's kind of a transaction revenue model. I think that makes sense and I think PayPal's already really good at transaction revenue. Something like 88% or 90% of their total revenue comes form transactions. It just happens that those transactions today are e-commerce as opposed to peer-to-peer or smartphone based ... Not necessarily as formalized as you know, an e-store essentially.

Harjes: Right. You mentioned Square. Tell me a little bit more about that.

Jenkins: Square, I think, is one of the more interesting of the current payment processing companies. Square's very young, they're not profitable yet, but they're growing very, very quickly. Square came to fame overnight it seems. I like to think about Square, what PayPal did for e-commerce Square has kind of done for physical, but mobile business. Farmer's markets, food trucks, small businesses that once they go out into the community to find their customers, they can get on Square, order the small dongle that connects to a smartphone and just like that in a day they can accept credit card payments on the go. We take it for granted today, but just a few years ago that was big problem. That was going to the ATM and paying $2 or $4 for an ATM fee to get cash to then go back to buy lunch. Today, we don't have that problem. Today, everyone can accept cards and Square's the driving force behind that change.

Harjes: It interesting to me that that charge that you used to pay on an ATM to get out cash is now actually being passed on to the seller because Square will charge the seller 2.75% of the transaction in order to facilitate it.

Jenkins: That's right, and it's the same thing. That's fundamentally the same business that Visa and MasterCard do as well. Square's just sort of another layer on that information highway. Square doesn't have necessarily the infrastructure certainly not that Visa and MasterCard do so they're just another entry point to get onto that Visa, MasterCard, or American Express, or Discover highway. That 2.7%, some of that goes to maybe Visa, maybe MasterCard. Square keeps some amount of it. Banks, other intermediaries get a little cut of it. My point of saying all this is that from the merchants perspective it might be slightly more expensive, but it might not also. It's really not a huge change on the merchant's side either form what they were doing accepting credit cards they way they have since the '80s.

Harjes: Yeah, that's very true. One other detail too, the square story that I want to bring up. The way it actually works with the little thing that connects to your phone is that it plugs into the headphone jack. There are these rumors going on that Appleis planning on getting rid of their headphone jack in the next iPhone which that could potentially be problematic for Square, but Square is already trying to react to this. They used to give out that little piece of hardware for free, but now they have a new near-field communication technology contact list device that can also do the chip card reading now that all the credit cards are starting to have those little chips and that's actually going to be $49 for a seller to actually buy one of these new devices.

Jenkins: Right. That sounds like a lot versus free, but compared to what they would pay for a traditional card machine in the past that's really not too bad of an expense. It's going to be interesting to see how they respond to that. Has the behavior changed such that the expectation is that it should be free. Can they actually convince people to go that route.

Harjes: It's just an interesting point on the Square business model where they're not looking to make money on that hardware. Really, they're looking at how to be as accessible as possible so that people are in their ecosystem and they're making money on the actual transactions.

Jenkins: Yeah, that's exactly right. You're totally right. They're thinking outside the box in a lot of ways too. Square is a technology company first that just happens, I think, to be in the financial technology space. It was started by the founder of Twitterso they come from a background that's not sort of burdened by the conventions of the financial establishment so to speak. To me what that means is it allows them to think a little bit differently about what services they could provide or necessarily should provide. One big item they talk about a lot is data mining through all of their transaction data and really working in using and advanced computer algorithmic ways to find how people are spending, how merchants are using the service.

Can we offer them working capital loans that can increase the efficiency of their balance sheet and income statement? Maybe drive sales higher. Can we offer consulting services to come in and say, "Hey, we think based on your data you might be a good fit for this or that. That could help your business in different ways." They're kind of looking at the whole space as a blank canvas and they're using what they're learning everyday as they operate and as they grow to think of new, unique, and potentially game changing ways of doing business and payments. They're really on the cutting edge.

Harjes: That is super interesting. As an investor looking at this space -- we've mentioned a bunch of companies today -- Can we directly compare them? How does one go about valuing them and determining what could be the best buy?

Jenkins: Well, it's really hard because you have established companies that are growing pretty rapidly, but they're not growing like a start-up would coming out of Silicon Valley. Then, on the completely other end of the spectrum we have a start up coming out of Silicon Valley that's growing at these astronomical rates. The way investors approach these are going to have to be pretty different. On the one end you have Visa/MasterCard, both companies great returns on equity, growing solidly, huge major competitive advantage, and they're valued at somewhere around $30 P/E right now. I think it's about 28 and maybe 32 as we are recording this. Then, on the other side you have Square which is not profitable, growing really, really quickly. How do you value that? I'm not a venture capitalist. That's not really my forte. I would have a very hard time valuing Square and understanding where it could be in a year or in five years or in ten years. Then, somewhere in the middle you have Amex and Discover which are kind of like Visa and MasterCard, but they're also kind of like traditional banks.

They have major regulatory hurdles, they have capital requirements, they have to go through the Federal Reserves CCAR stress test. All this extra burden that comes with being a lender, being a consumer lender. Amex and Discover trade a little bit, maybe 10, 11, 12 times P/E versus the high flying valuations you get for Visa or MasterCard so it's kind of a trade-off. What do you understand? If you don't invest in banks in general, that could a pretty big turn off for Discover or American Express, but if you like the stability of having a loan book that's going to generate net interest income quarter after quarter could be seen as a value only paying 10 times earnings.

Harjes: Right, or if you want exposure to the banking industry without buying a bank.

Jenkins: Sure, absolutely. You get the benefits of the loans. Some would argue that having some regulatory oversight is beneficial because it kind of opens up the books in a way for investors that you wouldn't otherwise see and you have this amazing non-interest income coming in that's just considerably higher than a regional banks is going to be able to produce or certainly a community bank who generally won't mess with the credit card side of things.

Harjes: Right, great. Thank you so much for your thoughts today, Jay. It's been fun reliving my days as the host of Industry Focus: Financials. As always, people on the program may have interest in the stocks that they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Jay Jenkins, I'm Kristine Harjes. Thanks for listening and Fool on!

Jay Jenkins has no position in any stocks mentioned. Kristine Harjes owns shares of Apple and Costco Wholesale. The Motley Fool owns shares of and recommends, Apple, Costco Wholesale, eBay, MasterCard, PayPal Holdings, Twitter, and Visa. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.