The payments industry has been on a roller-coaster ride since the start of the pandemic. While the overarching story is one of a sudden and dramatic decline followed by a steady and quick recovery, the impact on the companies we cover has been far from even. As results have stabilized, the pandemic has accelerated some existing trends and created some new risks and opportunities. We see four major industry issues arising from the pandemic:

  • A pickup in the ongoing shift from cash
  • An acceleration in the shift toward online payments
  • A falloff in travel spending
  • The potential for a spike in small-business failures

We see PayPal (PYPL) as the best positioned in the very near term, given its focus on e-commerce, but we believe it will ultimately give back a portion of recent growth. We think the market is overly focused on this near-term tailwind and competition for online payments will heat up over time. Visa (V) and Mastercard (MA) face a major problem in the near term, as the falloff in travel has put a major dent in cross-border transactions, which are the most profitable part of their businesses. While this headwind is likely to endure, we expect a full recovery in the long run. Further, we think the networks are best positioned to exploit any global shift away from cash.

Compared with the networks, leading acquirers are relatively focused on the United States, where we see the impact of lower cash use as milder, but we believe this trend could spur international acquisitions. With stimulus efforts winding down, we remain concerned about small-business failures and see Global Payments (GPN) and Square (SQ) as the most exposed if the pandemic persists. We think Square, with its micro merchant focus and concentration in hard-hit industries, is the most at risk.

The impact of cash avoidance on the payments industry

Numerous payments industry participants have said that they have seen the shift away from cash accelerate through the coronavirus pandemic, as handling cash is viewed as a potential way to spread the disease. The shift away from cash was an existing trend, but if this persists it could pull forward this trend and benefit the payments industry as a whole by increasing the volume running through electronic payment systems.

Data from Square suggests there has been a meaningful change in the use of cash, with the company seeing a sharp spike in the number of cashless (meaning over 95 per cent of transactions are noncash) merchants in the immediate wake of the lockdown efforts. Since then, the number of cashless merchants has fallen but remains at a much higher level than it was before the coronavirus, suggesting the aversion to cash has endured. In our view, the length of the pandemic is likely key to how enduring this trend will be, as consumers get used to embracing alternatives to cash. Mastercard has said its research indicates that 60 per cent of consumers intend to use less cash even after the pandemic declines.

Further evidence comes from Visa’s and Mastercard’s results since the start of the pandemic. Debit payments are the most natural replacement for cash, as consumers tend to use debit and cash for smaller, day-to-day purchases. As such, we would expect any shift away from cash to show up primarily in higher debit volume. This appears to have been the case so far, with credit and debit volume showing a sharp divergence since the start of the pandemic.

This evidence is not sufficient, however, because the pandemic has had a sharp economic impact as well. Debit volume tends to hold up better in a recessionary environment, as consumers tend to use credit for discretionary purchases and debit for nondiscretionary ones. However, the gap between credit and debit growth is much wider now than it was in the 2009 recession. This suggests that an acceleration in the shift from cash is playing a role.

However, in considering the potential impact on the payments industry, we think it is important to remember that compared with the rest of the world, the US is relatively advanced in the shift toward electronic payments, which are already the dominant form of consumer payments. This limits the potential benefits of any longer-term aversion to cash domestically. Further, cash use tends to skew significantly to smaller transactions. With the revenue of most payments companies generally directly tied to the size of the transaction, the impact of adding these smaller dollar transactions might be limited.

Looking at the demographics of cash use highlights some other potential dynamics in the shift away from cash. Cash use tends to be concentrated among the very young (under 25 years old) and the old (55 and older). The shift away from cash before the pandemic was driven almost entirely by consumers between 25 and 54 years old, whereas the use of cash by consumers older than 55 years has remained fairly resilient. In our view, this suggests that among older consumers there is a higher level of inertia and resistance to new payment methods. This then likely illustrates the key benefit for the payments industry: The pandemic creates an opportunity to break the inertia that has prevented this age group from shifting toward electronic payments. If the pandemic persists long enough to embed electronic payments as the norm for this age cohort, inertia will then work in favour of electronic payments.

Overall, though, we think any domestic acceleration in the shift away from cash driven by the pandemic will be just a modest positive for the payments industry as a whole, given that the shift will likely be concentrated in older age cohorts, which would diminish in importance more quickly than younger age cohorts over time anyway.

International markets offer better opportunities for growth of electronic payments

The use of electronic payments is not so deeply embedded in other countries, so the magnitude of any one-time shift away from cash could be much higher. We think Visa and Mastercard, with their established global presence, are best positioned to benefit. Between the two, Mastercard looks to be in a better position to benefit from international growth, as its relative market share is higher outside the US

Developing countries tend to be more cash-dominated, but they often lack the infrastructure and access to allow for electronic payments. While the coronavirus could help to speed investment and acceptance of electronic payments, it could also open the window for alternative payments schemes such as M-Pesa, which could cut out traditional players. As such, it’s not clear to us whether the coronavirus would necessarily be an unmitigated positive, in this respect.

Developed countries have already largely adopted electronic payments, which hypothetically limits the impact of a pandemic-induced shift away from cash, with a similar dynamic to what we expect in the US But the benefits in developed markets are likely to prove easier to realize in the near term, given that the electronic payments infrastructure is well established.

The ratio of cash and check volume in the US and Europe is much lower than in other regions. Asia-Pacific is somewhere in the middle, but that opportunity is blunted by the existence of China’s UnionPay. Central and Eastern Europe, Middle East and Africa, and Latin America look like the largest opportunity, but a less certain one. All in all, we think Europe represents the best opportunity for the networks in the near term.

Acquirers haven’t fully realised international opportunities

The acquirers we cover remain fairly concentrated on the domestic market. As a result, we would see any major shift away from cash internationally as having a more limited impact. For the acquirers, it might be more important in the way that it influences their capital allocation.

We think any shift away from cash in international markets could spur further foreign investment for our acquirer coverage. With growth in electronic payments shifting internationally as the domestic market matures, we have long believed international expansion should be top of mind for the leading acquirers in order to maintain their scale advantages over time and maintain growth. Given the difficulty involved in launching de novo operations in a scale-driven industry, this expansion is most likely to come through acquisitions.

However, all three of the traditional acquirers we cover—FIS (FIS), Fiserv (FISV), and Global Payments—completed transformative M&A deals in 2019, and we believe large-scale acquisitions are probably off the table until these mergers are fully digested. Any pandemic-induced shift from cash could hasten the timeline for smaller deals, and some international markets are relatively fragmented relative to the US As such, we think smaller deals could prove both possible and attractive to our coverage, and we would have a favourable view of such moves.

E-commerce payments pick up as consumers shop online

Much as the pandemic has accelerated the shift away from cash, it has also accelerated the shift towards e-commerce, as shopping at brick-and-mortar locations now carries the risk of infection. For the payments industry as a whole, this acceleration is likely only a very modest positive, given that it largely reflects a shift between different forms of electronic payments. Still, e-commerce essentially eliminates cash as an option, so there could be some marginal benefit.

However, for companies focused on e-commerce transactions, like PayPal, this has been a material positive. E-commerce has steadily taken share from brick-and-mortar for the past two decades, but growth spiked since the beginning of the pandemic. Ultimately, though, we think pandemic-induced acceleration in e-commerce could prove somewhat fleeting as consumers will grow comfortable with returning to stores at some point. As such, we expect the growth in e-commerce as a percentage of retail sales to partially revert to the long-term trend as the pandemic subsides. All in all, the pandemic-related shift looks like only a mild positive from a long-term perspective, in our view, given that the volume was shifting toward e-commerce anyway.

Further, we think competition for e-commerce transactions will heat up over time. Traditional point-of-sale acquirers such as FIS, Fiserv, and Global Payments were slow to move into online acquiring. However, the online market has become too important for any acquirer to ignore, and merchants increasingly are looking for omnichannel (both point-of-sale and online) solutions from acquirers.

Controlling fraud is a key issue when approaching the online space. While card-not-present transactions are less than 15 per cent of all card payments, they account for over half of all fraud costs. Although overall loss rates have stabilized over the past few years, fraud losses as a percentage of transactions have risen over the last decade.

In our view, one of the reasons PayPal became such a strong online force is that its unique business model gives it access to information on both sides of the transactions, merchant and consumer. We believe that having more complete data on the entire transaction helps control fraud. We think the three large mergers we saw in the acquiring space in 2019 were driven, at least in part, by a desire to more closely replicate PayPal’s approach and become more competitive in serving e-commerce payments. On the consumer side, we have seen large companies such as Apple develop their own wallet solutions.

In our view, scale remains the dominant driver of competitive position for payment processors, and we think fully participating on the online side will be necessary for the leading point-of-sale acquirers to maintain their scale advantages and moats. Despite the fast rise of e-commerce, the bulk of the payment volume in the acquiring industry will remain on the point-of-sale side for a long time to come, which should favour players on this side if they can develop effective online solutions. We foresee a much more competitive environment for PayPal in the coming years, with the company increasingly in competition with companies with considerable resources. Any acceleration in the shift toward e-commerce would likely only strengthen investments and competition in the space.

Reduced travelling means changes for payments industry

The pandemic has led to a massive reduction in travel, and this flows through to the payments industry in terms of travel spending. According to Visa, travel-related cross-border spending dropped about 80 per cent year over year at the start of the pandemic and remained about 70 per cent down in October.

For the networks, the decline in cross-border spending hits particularly hard. While there can be some differences among domestic payment types, the biggest gulf is between domestic and cross-border transactions. Disclosure is limited to obscure the pricing spread, but we estimate the fees Visa receives on a cross-border payment are about 6 times as high as a domestic payment (8 times if the transaction is settled in a currency other than the US dollar). Mastercard likely has a very similar spread. As a result of higher fees, cross-border transactions have an outsize impact on the networks’ revenue and profitability, accounting for a little over one fourth of their transaction-related revenue.

The dramatic falloff in travel spending has been somewhat offset by a rise in cross-border e-commerce. As a result, cross-border volume fell about 50 per cent-60 per cent at the outset of the pandemic. However, unlike other areas which have seen a strong recovery, there has been little sign of improvement. There has been solid improvement in intra-Europe transactions, but these are priced similarly to domestic transactions. Cross-border volume (excluding intra-Europe) remained down about 40 per cent year over year for Visa and Mastercard in October. It is difficult to imagine a scenario where cross-border travel and spending recover quickly, given government restrictions on international travel, and this is likely to be a material and extended headwind for the networks.

The good news for the networks is that history suggests travel will ultimately fully recover. Historically, this has happened over a three- to four-year time frame, and in this case a snapback will likely hinge on the development and distribution of an effective vaccine, the timing of which is uncertain. Further, the initial recovery in travel is likely to be based on intranational travel, which will not drive cross-border transactions for the networks.

While the duration is uncertain, it seems likely that the networks will endure an extended period of decline in the most profitable area of their business but then also a period of outsize growth when travel spending normalizes.

Small-business failures remain a risk for some electronic payments providers

Going into the pandemic, businesses across a number of industries faced a potentially difficult period, due to the general macroeconomic impact of the pandemic and a prohibition of certain activities. Small businesses, especially, appeared to be at risk, given their limited resources. For the acquirers, this presents a risk of resetting their client base at a lower level. For acquirers more focused on large merchants, such as FIS and Fiserv, this risk looks balanced by increasing share for larger survivors. But for Global Payments, which focuses on small and midsize businesses, and Square, which has its roots in serving micro merchants, we think the risk remains.

Government stimulus seems to have meaningfully delayed this issue, and to date Global Payments and Square have performed roughly in line with peers, suggesting no dramatic impact yet. With Global Payments only modestly underperforming peers more focused on large merchants, its focus on smaller merchants does appear to be an additional drag, but not a major problem.

Bankruptcy filings also suggest the situation remains fairly contained. Bankruptcies have risen in 2020, but only modestly, and the level year to date seems quite mild given the situation, suggesting stimulus has been largely effective in this respect.

But stimulus efforts have wound down, and recent election results make divided governmental control the most likely outcome. In this scenario, it is difficult to gauge the possibility, form, or magnitude of further stimulus. As such, it certainly seems as if small businesses could be more and more at risk as the pandemic drags on.

For Square, its micro merchant focus could be magnified by its industry mix; its five largest industry exposures are food and drink, retail, professional services, beauty and personal care, and health and fitness. Of these, four are among the hardest hit, according to Yelp data. Collectively, these four industries accounted for 67 per cent of Square’s gross payment volume in 2019. If the pressure on small businesses drags on or intensifies, the company could be hard-pressed to make up for the loss in volume through its moves upmarket.

Square’s reliance on smaller merchants is somewhat magnified by its Square Capital business, through which its offers loans to its merchant customers. Clients pay back the loans with a daily percentage of their sales volume through Square. Given the current macroeconomic uncertainty, the company might find it difficult to find investors willing to take these loans, and if loan performance sours, this could be a longer-term obstacle.

Overall, the risk of small-business failure would seem to continue to grow larger the longer consumer behaviour is constrained by the pandemic, and the falloff in stimulus could be a catalyst to escalate this issue. We see the small-merchant focus of Square and, to a lesser extent, Global Payments as an ongoing risk.

Pandemic doesn’t dramatically change favourable long-term picture for payments industry

While the pandemic will likely have a material impact on the payments industry in a number of ways, we don’t think it dramatically alters the favourable long-term picture. In our view, payment processors are characterized by healthy margins, limited reinvestment needs, and strong long-term growth prospects driven by the ongoing global secular trend toward electronic payments. The pandemic may alter the course of individual companies, but in most cases, it is likely to magnify existing trends or create temporary roadblocks that will dissipate over time.

While they are likely to take the biggest hit in the near term due to the falloff in cross-border transactions, we continue to believe Visa and Mastercard hold the strongest competitive positions over the long term. Despite the ongoing evolution in the payments industry, we think a wide moat surrounds the networks and their position in the global electronic payment infrastructure is essentially unassailable.

The other players generally hold significant advantages consistent with a narrow moat, primarily driven by scale within their niches. We think it would be very difficult, but not impossible, for these companies to be displaced by the ongoing evolution in the payments industry. We believe narrow-moat companies operating in an industry with favourable long-term trends should also enjoy investor interest.

a table showing Morningstar ratings for payments providers

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