Money Movers

by Overheard Wall Street
  • Intro
  • Payments Ecosystem
  • Payment Gateway – Block (Formerly Square)
  • Credit Card Companies – American Express
  • Conclusion/Recommendation

Intro

Not a day goes by that I don’t buy something with my credit card, engage with a Point-of-Sale kiosk for a purchase, or Venmo someone for that late last-minute dollar.

But have you ever stopped to look at how many different players are engaged in the payments industry?

There are a lot – this might enlighten you (or confuse you):

Even this chart doesn’t fully explain the process.

Payments drive so much innovation in our technology-heavy world that it is valuable to stop and think about how it works.

The payments world is deeper than the interaction of swiping your card at a coffee shop, seeing the funds withdrawn from your bank account or credit card, and then going about your day with your quad-shot americano.

The layers and complexity underlying this seemingly simple interaction allow many companies to create value through automation, interaction, verification, and communication among counterparties.

Let’s dig into the ecosystem, learn more about how this process works, and see if we can find some investing opportunities along the way!

Payments Ecosystem

There are two major parts to any transaction: authorization (ensuring you have the funds available for your purchase) and settlement (the merchant receiving your payment).
  1. Authorization

What we see:
  1. I swipe my credit card for a coffee purchase
  2. Point of Sale Kiosk tells me, “please wait… approved!”
  3. I receive my coffee

But a more intricate web of authorization processes is happening behind the scenes. 

Merchants pay a small fee to ensure that the money used to pay for their product is yours and in your bank account.

This authorization process is complicated - moving data from the Point of Sale system through different banks, payment processors, and payment gateways. 

All to confirm that you have the $6.96 needed to pay for the oat milk latte you ordered.

The second part of this transaction is:
  1. Settlement

This is the post-sale, behind-the-scenes work.

At the end of every day, merchants close down their systems, and the payment processor works with the banks to ensure that funds get settled.

You may have noticed that when you use your credit card, it sometimes shows up as a “Pending” transaction for 1-2 days and then hits your statement afterward.

This is when the merchant, banks, payment processors, and gateways are all working together to ensure that the funds are fully transferred from your account to the merchant’s account (after some fees get taken, of course).

This is where the world of payments is still far behind - these transfers can take 2 full business days to leave your account and hit the merchant’s account.

Even in 2022, we have to wait a few days for funds to transfer. Elon Musk is out here flying rockets and getting them to land safely, and banks can’t handle a $6.96 transaction for coffee efficiently.

Technology has made our world more complicated but simultaneously opened the door for more significant innovation and opportunities for companies to make money.

Let’s take a second and define some of these participants:
  • Payment Processors
    • The companies that allow merchants to receive and process information from credit or debit cards.
  • Payment Gateways
    • Software applications allow merchants to accept payments and transmit that payment data back to the processor.
  • Digital Wallets
    • Google and Apple have built-in systems that store credit card information to allow contactless payment.

This chart may help connect some of these participant titles with company names:

Constant innovation is here – more technology is being developed to improve processes, speed, and security daily.

We don’t have the space (and you don’t have the patience) to dig into all these different areas, so let’s pick just two significant areas to look at, and maybe we can revisit other major players in the future.

Payment Gateway – Block (Formerly Square)

The Square logo is iconic; unfortunately, it changed its name to Block last year to focus more on the crypto-craze. (So far, the name has not aged well but that’s a story for another day…)

Let’s focus purely on the Square ecosystem:

Square offers a cohesive commerce ecosystem that helps our sellers start, run, and grow their businesses. We combine software, hardware, and financial services to create products and services that are cohesive, fast, self-serve, and elegant. 

These attributes differentiate Square in a fragmented industry that traditionally forces sellers to stitch together products and services from multiple vendors and, more often than not, rely on inefficient non-digital processes and tools.

Within the Square ecosystem, there are 30 distinct software offerings available to customers that can be accessed through multiple tiers of subscription services.

Access starts with a freemium model – allowing merchants to set up the Square system without paying a dime, which helps new businesses get off their feet.

As the business develops, Square has a tiered system that allows customers to pay for what they need and lean on Square to help them grow when the time is right and not be forced to pay for services they do not need before scaling.

Services range from Point-of-Sale software explicitly built for appointments, restaurants, retail and online services to contract management, marketing, Payment & Commerce API to specific hardware that can be leased for storefront operations.

In 2021, the Square ecosystem processed $152.8 billion in Gross Payment Volume (“GPV”) from over 3 billion card payments.

In Q3 of 2022, Square processed $50 billion in GPV, which brings the 9-month total GPV to $138 billion.

This translates to transaction-based revenue of $1.5 billion in Q3 of 2022 and $4.2 billion in the last nine months of 2022.

Roughly equal to 3% of payment volume.

Bulls
  • Expanding its operations beyond business-to-business and business-to-customer interactions with CashApp gives Block more opportunity in the person-to-person market, which has room to grow.
    • Block only receives revenue when CashApp users use their CashApp debit cards for purchases. This means that the potential to monetize person-to-person transactions is ahead and could be accretive to Block.
  • Block has taken meaningful actions in 2022 to reduce costs, cutting operating expenses from an estimated $72M in Q3 to $42M, which boosted their adjusted EBITDA to $327M.
    • This is unique in a market where many software companies are implementing layoffs to lower costs; Block slowed down its hiring plans earlier this year to avoid being caught in a similar scenario.
  • Block has also seen significant growth internationally, with the most recent revenue growth at 55% in international markets. Expanding its business overseas will be necessary to achieve profit targets.

Bears
  • Block has been investing in itself to prolong and expand its growth opportunities but has failed to achieve profitability, even with highly positive revenue growth recently.
    • Converting this continued growth to profitability is a key factor that many analysts are watching, and until Block can prove itself, uncertainty is high.

Key Metrics as of 11/16/22
  • Current Price: $69.29
  • Cash: $5.6 billion
  • LT Debt: $4.4 billion
  • Q3 Net Income: ($18M)
  • Q3 Free Cash Flow: ($20M)
  • NTM:
    • Revenue: $20 billion
    • Net Income: $1 billion
    • P/E: 39.8x
    • P/FCF: 24.1x

Credit Card Companies – American Express

American Express fits the role of a few of our key players in this market.

AMEX operates as a card issuer, a merchant acquirer, and network services, along with other services related to cardholders.

The primary source of revenue for AMEX comes from what they call “Discount Revenue,” which is all the revenue received from transactions made by cardholders and agreements made between merchants and AMEX allowing merchants to accept AMEX cards as a form of payment.

In 2021, this revenue totaled $25 billion.

American Express processed $394 billion of transaction volume in Q3 2022 alone – with $339 billion coming from billed business and $55 billion from processed volumes.

Q3 revenue totaled $13.5 billion, with $7.8 billion coming from “Discount Revenue” sources.

That volume is near 8x the volume of the Square ecosystem.

Bulls
  • American Express operates a closed-loop system – they issue credit cards to the consumer, use the underlying payment network and have direct relationships with merchants. 
    • This is a significant tailwind to profitability as AXP can capture multiple points of revenue within its system.

Bears
  • Discretionary spending is a larger portion of AXP’s revenue than other card distributors. With high inflation and rising recession potential, discretionary spending is usually the first place consumers will cut back.
  • AXP also faces the headwind of negative consumer perception, given a history of its cards not being as widely accepted as Visa or Mastercard.

Key Metrics 11/16/22
  • Current Price: $153.20
  • Cash: $31 billion
  • LT Debt: $42 billion
  • Q3 Net Income: $1.865 billion
  • Q3 Free Cash Flow: $4.06 billion
  • NTM:
    • Revenue: $58 billion
    • Net Income: $7.8 billion
    • P/E: 14.4x

Conclusion/Recommendation

Many companies are operating in the payments space, so the list of options is expansive.

But after reviewing both of these companies, there may be some solid opportunity for investment here.

Block has been hammered this year, dropping over 55% YTD, which has put them in a discounted pricing position for many investors to jump on board.

Its growth and all-encompassing ecosystem provide ample opportunity for them in the future. And even amidst that, they are generating a large amount of revenue from Bitcoin (while we have seen Bitcoin drop more than 50% this year as well).

American Express is a behemoth in this space, generating business for over 150 years in the financial area. And they are cash-flowing giants, as well.

AXP has weathered the market conditions this year incredibly well, only being down 5% YTD, which is light years ahead of many others in this area. It may not be a company that significantly outperforms the broader index, but it is not one you will see going away anytime soon.

Both of these options would be solid choices for investment.

Block provides more significant upside potential, with the risk that other areas of technology may bring macro-related risks, given Dorsey’s connection to Twitter and the different regions of cryptocurrency.

As a technology-focused firm, Block may rebound faster after this recent technology sell-off, or it may flounder for a while still. The losses this year are not promising, but on the bright side, Block still has more cash on hand than LT debt, which is a good sign in our book.

And AXP is printing cash left and right. As more consumers have returned to their old spending habits, AXP has been there to get its cut of the action and benefited greatly this year.

Recessionary fears are looming for many investors, but within the payments space, we see the opportunity to jump on board with companies like AXP, which should weather the financial storm ahead, or Block, which has more growth potential ahead, given the recent selloff.

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