[FISV, GPN, FIS, SQ, Stripe, Adyen] On payment processors, distribution, and technology: Part 4 of 4

If you follow the payments space even casually, you are no doubt aware of the sequence of the mega mergers that have taken place between merchant acquirers and core processors this past year. 

Source:

scuttleblurb and public filings

The bolded

companies in the table above are the surviving merged entities, their market

caps and enterprise values current through yesterday. Italicized are the constituent companies of

the surviving entity. Their market caps and

enterprise values are as of calendar year-end 2018, before any of these

mergers were announced. 

Here is a summary of their financials and trading multiples, as of year-end 2018:

As I scan the vast expanse now

occupied by these new behemoths, I must pause to remind myself what it is I’m

looking at. The new Fiserv is, on one

side, a rollup of hundreds of companies (many of those companies roll-ups of

other companies)…a morass of 700 products that span account processing, card

processing, payments, electronic billing, loan processing, and that target

small banks, large banks, credit unions, as well as non-bank billers like

insurance companies, utilities, and telecom providers. The other side is a mosh pit of merchant

acquiring platforms that legacy First Data tried, but failed, to consolidate plus

an issuer processing business plus a debit payment network. I can’t even begin to fathom the degree of

infrastructure heterogeneity underpinning it all. It’s bewildering. 

To simplify,

core processors like Fiserv and Fidelity cater to banks while merchant acquirers

like First Data and Worldpay serve merchants. 

Where their solutions intersect is in the realm of payments, namely 1/ issuer

side card processing and 2/ proprietary payment networks that bridge the

transactions taking place in the store with updates to account balances being

made at the bank. 

I think it makes sense to evaluate the commercial logic behind these mergers along two dimensions: capability and scale. Starting with capability, one compelling reason to combine issuer processing with merchant acquiring is that doing so yields useful information. The data from the 300mn cards that FIS processes can be used to improve a merchant acquirer’s authorization algorithms, resulting in lower incidences of fraud and authorization rates that can be as much as ~200bps higher (mid-80s to high-80s).   

I’m not quite sure what to think about

these claims. First Data and Total

Systems each had significant issuer processing and merchant acquiring

operations under the same roof, and yet I don’t think anyone would point to

those two companies as commanding industry leading rates of transaction authorization

and fraud detection. This makes me

wonder to what degree differences in those metrics are driven by the volume of

data and to what degree they can be tied back to platform architecture (numerous

siloed platforms in the case of legacy acquirers; a single platform in the case

of Adyen). It’s tough to say in part

because no one except Worldpay provides disclosure. Adyen regularly boasts superior authorization

rates, and while it provides no data to bolster this claim, the fact that it

has taken as much share from incumbents as it has and that incumbents neither

dispute its claim nor put forth similar claims about themselves, makes me think

Adyen isn’t just making this up? But I

could be wrong. I just don’t know.

The other capability advantage from merging comes from the debit card networks. Fiserv, First Data, Vantiv, and Fidelity each have their own debit network that shuttles data from the merchant to the card issuer. Every debit card is required to carry at least 2 bugs (Visa and STAR, for instance) and it is up to the merchant to decide which network to route the transaction to. A large national retailer like Walmart or Home Depot will have internal algorithms that route transactions to the lowest cost rail, but small merchants typically rely on merchant acquirers to do this for them. Having another network running alongside Visa and Mastercard gives the acquirer more options to choose from, which should translate into lower routing costs for the merchant. Also, the data captured from the controlling the transaction “end-to-end” – that is, owning the issuer processing, merchant acquiring, and the debit rails – can be used for marketing and demand gen purposes, like cashing in loyalty points at checkout. 

There is nothing new about using

proprietary networks to bypass Visa and Mastercard. First Data launched its proprietary debit

network, First Data Net, in 2001. Visa,

who feared this competing network could siphon away 15% of its volume, sued

First Data. First Data sued back. Amidst the legal wrangles, which eventually

culminated in a settlement in 2006, First Data Net quietly died. Somewhere along the way, First Data acquired

the STAR network with the idea that it could leverage its huge merchant

base and issuer relationships to build STAR into a major rail. But this ambition has fallen well short of

expectations.

JP Morgan also operates a proprietary

closed loop, which I talked about in Part 1:

“In 2013, JPM struck a 10-year deal with Visa, in which Visa charged Chase fixed fee for use of its network and Chase, Visa’s largest issuer, agreed to direct more of its volumes over VisaNet. With a white-labeled card network in place, a closed loop transaction is created when JP Morgan serves as the issuer for cardholder and as the acquiring bank for the merchant that the cardholder transacts at. By “owning” its own card network, JP Morgan can bypass the operating rules set by Visa and Mastercard and negotiate deals directly with merchants, deals that pass through the savings from the Visa deal and/or collect data that merchants can use for marketing”. 

If anyone could pull off a closed loop solution big enough to challenge Visa and Mastercard, you would think it would be JP Morgan, who has more cardholders than any other bank and operates the third largest merchant acquiring business in the US. In 2016, one JP Morgan executive referred to ChaseNet as “one of the most forward-thinking and potentially disruptive business models in the industry”. But the gush of enthusiasm has been abruptly dammed. Management has said very little at all about ChaseNet over the last few years, except that ChasePay, the mobile wallet that runs on top of ChaseNet, is going to be shuttered early next year as adoption was “an awful lot slower than we expected”. 

FIS also

tried to launch a real time P2P and bill payments network, PayNet, on the back

of its NYCE debit rails, with little success (FIS

obtained the NYCE network through its 2009 acquisition of Metavante, who in

turn acquired it from First Data in 2004, who was forced by the US Justice

Department to divest NYCE as a condition to acquiring STAR). In 2013, FIS white labeled NYCE to MCX,

a payment network that major retailers like Wal-Mart, Target, Best Buy, and

CVS, and other with collective volumes of $1tn put together to disintermediate Visa

and Mastercard and avoid interchange fees. 

To get consumers on board, the consortium launched an accompanying

QR-code based mobile wallet, CurrentC, and mandated that participating

retailers block competing wallets like Apple Pay and Android Pay. The initiative failed to gain traction with

consumers because, well, why would it? 

Consumers don’t care about helping big box retailers save money and had

no incentive to replace a good enough habitual behavior (swiping/inserting

credit cards) with an unfamiliar one (downloading an obscure mobile wallet and

using it to scan QR codes). CurrentC was

terminated in 2016, 2 years after it launched.

In short, previous

attempts to support significant closed loop alternatives to Visa and Mastercard

– whether it be issuer processors leveraging bank relationships (Fiserv,

Fidelity), merchant acquirers leveraging merchant relationships (Vantiv), or

both (First Data, JP Morgan) – have floundered. 

There will be some savings from cutting the redundant overhead of two

debit networks (STAR/Accel, NYCE/Jeanie) and some benefits that come from improving

routing efficiencies and enabling private label programs (First Data provides

the technology that powers Synchrony’s private label offering), but I don’t see

these enlarged proprietary networks (and the closed loops they enable) as a

major source of incremental value. 

The more compelling logic underpinning these mergers relates to scale, in the form of cost synergies (the $1.6bn of cost reductions across all three mergers sum to ~13% of total 2018 EBITDA) and enlarged distribution ($1.1bn of revenue synergies that sum to ~3% of total 2018 revenue). The cost synergies will come from the usual stuff like cutting duplicative overhead, consolidating data centers, and squeezing vendors, but also from combining redundant business units – for instance, Worldpay is rolling its issuer processor business into FIS’ and FIS’ is rolling its merchant services business into Worldpay’s.

And then there are the distribution synergies,

which have underpinned acquisitions in this space for decades[2]. In that sense, this year’s mega-mergers may

be transformative in their scope but they are pedestrian in their

motivation.  

Fidelity has relationships with 45 of the 50 largest global financial institutions, who can refer Worldpay’s merchant services, especially in fast-growing emerging markets like Brazil and India. In the US, Fidelity can distribute Worldpay through its regional bank customers, a channel that the latter hasn’t historically had much exposure to. Fidelity also has a loyalty product, a technology that allows consumers to use their reward points at the point-of-sale, that can be cross-sold into WorldPay’s 1mn merchants. Fiserv, with the largest number of core processing relationships in the US, can cross-sell First Data’s credit card processing and merchant services through 20k bank branches. This could be huge for Clover.

The merger of equals between Global Payments and Total Systems, the last of the mega-deals announced this year, is different from the other two in that neither of the merging entities has a core processing business. Both are “payments” companies, with Global Payments more or less a pureplay merchant acquirer and Total Systems tilting heavily towards issuer side processing. Total Systems, which had leading share in issuer side card processing (#1 in North America; #2 in Western Europe) but a merchant acquiring business less than half the size of #3 Global Payments, found itself subscale relative First Data and WorldPay, who through their respective combinations with Fiserv and Fidelity suddenly gained access to huge distribution channels. 

As a standalone company, Global

Payments was not only partnering with software vendors like its peers, but also

becoming a vertical software vendor itself. 

The horizontal merger with TSYS is a break from this trend but comes

with sensible cross-selling synergies that seem more compelling than the modest

revenue synergies that management has so far put forth (2% of combined revenue

vs. 4% for FIS and FISV). I bet they

realize much more than that. TSYS can

sell issuer processing into international banks with whom Global has merchant

referral partnerships, while Global can establish merchant referral

relationships with TSYS’ issuer processing clients. The combined company has a better shot at

winning JVs with large financial institutions overseas, who bias towards

vendors that can bundle issuer processing and merchant acquiring. There are product synergies too. TSYS has some point of sale devices that can

be cross-sold to Global’s merchants; Global has software and payroll and

analytics that can be sold to TSYS merchants. 

Global Payments has talked vaguely about moving beyond payments and

spinning up an ecosystem that includes connections to third party lenders and

payroll…so, maybe TSYS’ Netspend might be more useful to merchants when bundled

with Global’s payroll processing solution. 

But at just 10% of the new company’s revenue, Netspend could be too

small to matter and maybe it just gets divested. We’ll see.

While these mergers have obviously created companies that are bigger versions of their former selves, are they better versions?

My concern is that while each of these

mergers delivers near-term synergies, they do so by further entrenching these

companies within legacy scale moats when the point of differentiation seems to

be shifting from distribution to technology. 

If these three new companies – Fiserv + First Data, Fidelity + Worldpay,

and Global Payments + Total Systems – were to combine in the merger to end all

mergers, I’m not so sure the resulting fintech Godzilla would have a

fundamentally better offering with which to compete with Adyen and Stripe. At some point, I suppose that by bulking

distribution and product breadth you are optimizing along the wrong

dimension. 

But from an investment perspective, it

seems somewhat counterproductive and beside the point to smugly wonder why Fiserv,

Fidelity, and Global, with their decades of organizational and technical

baggage, aren’t innovating at the same pace as Adyen and Stripe. The legacy players may not be inspiring customer-first

innovators, but they are excellent optimizers, with long histories of integrating

huge acquisitions, exceeding synergy targets, and managing their balance sheets. Lever up, buy distribution/innovation,

realize synergies, de-lever, repeat. 

This tedious cycle can create a lot of value over time when there’s a

key asset at the center (distribution) that can be consistently exploited to

realize synergies. 

Core processing is a durable business ensconced within lots of sticky bank relationships and functions as a key hub for a lot of other technology that banks increasingly need to stay relevant. Merchant acquiring is less moaty and more competitive, but all the major legacy players have made significant in-roads into growthier software channels (which make up anywhere from ~25% of revenue in the case of First Data[1] to ~half in the case of Global Payments). 

This even applies to First Data, who is

reliant on legacy channels and as a standalone company traded at a discount to

peers (11x EBITDA vs. 17x for Global Systems and 13x for Total Systems). Despite its success with Clover and its entry

into integrated payments, First Data never quite shook its reputation as a

stodgy dinosaur, anchored by antiquated technology, too levered to

innovate. But the company’s been on fire

recently, with revenue sourced through its non-bank channels growing ~30%/year,

fueling hsd/ldd growth for its merchant acquiring segment. I estimate that growthy, tech-enable channels

now account for ~25% of the company’s revenue.

And then of course, by merging, all

these legacy guys have substantially broadened and tightened their distribution

arrangements with banks. They may not be

on the bleeding edge of innovation, but they are entrenched in whatever

channels they’re in and I don’t see them being dramatically uprooted anytime in

the foreseeable future.   

Growth rates for the merged entities will reflect a blend of the low/mid-single digit growth in core processing, fueled by continued demand for digital technology, and high-single digit growth in payments and merchant acquiring, driven by consumer spending plus a secular shift from cash to electronic payments. I think the new Fiserv and Fidelity are each growing around 6%. Global Payments, which has a heavier mix of growthier revenue streams and directly owns vertical SaaS companies, is maybe growing 8%-9%. Using 2018 as my base, if I grow revenue accordingly; layer on announced (but too conservative) cost and revenue synergies[3]; assume a 2.5x target net leverage ratio; and devote free cash flow to share repurchases[4], I can pencil out a scenario where, at the current price, all three companies trade at ~12x out year earnings. If they can sustain mid/high-single digit organic growth rates that far out, maybe Fiserv and Fidelity go for 20x and Global Payments trades at more like 25x, implying their shares compound at a ~10% rate. These are highly simplistic assumptions, but they don’t seem all that unreasonable to me.   

In the meantime, I think Adyen will continue kicking ass. Unlike Square and Stripe, who are expanding into other value-added services like lending and reporting tools and debit cards and whatnot, Adyen has achieved quiet success among large enterprises by applying scalpel sharp focus to the pain point of merchant payments (Adyen’s singular focus on payments, its contentment operating in the background, with no larger ambition of running its own wallet or whatever, was one of the key reasons eBay hired Adyen as its primary payment processor last year)[5].

Relative to legacy acquirers, who are hobbled by the need to divert resources maintaining multiple platforms, Adyen’s single platform gives it a structural and durable cost advantage while its nimble organization, engineering heavy staff, and customer-first culture gives rise to faster rates of innovation. Adyen’s 57% EBITDA margins and 50% revenue growth rates are well above the mid-30s margins and high-single digit organic growth realized by legacy peers. Due to fundamental differences in platform architecture and culture, I see little reason to expect the gap on either of those metrics to close anytime over the foreseeable future. If you assume, let’s say, 20% revenue growth (a function of 25% volume growth + a little take rate compression) and 80% contribution margins, you can walk your way up to 70% EBITDA margins 5 years out. That feels a little preposterous to write, but it’s not like you need to assume a radically different state of the world for this scenario to materialize. 

Still, Adyen trades at 45x revenue and 80x EBITDA lol. There is a wide range of growth rates and take rate compressions that I would consider reasonable for Adyen, but its current valuation implies meager returns for most parts of that range. To earn a low-teens return on this stock, you basically need to assume 30% annual volume growth over the next 5 years, to $800bn (compared to today’s payment volumes of $2.5tn+ for First Data, $1.5tn for Worldpay, and $1.2tn for Chase Paymentech), and slap a 40x multiple on year 5 EBITDA. It is somehow easier for me to imagine Fiserv, Fidelity, and Global Payments plodding along at high-single digit organic growth rates and exceeding their synergy targets. This yields a less attractive ~10%+ rate of return, though maybe the predictability of that outcome is worth the return trade-off. But then again, in this game, sometimes it pays to be a dreamer 😉

[Thanks for reading. What did I get wrong? Let me know by posting on the Message Board]

Footnotes

[1] Per the events timeline in the

FIS/WP merger proxy: “In September 2018, Worldpay engaged Credit Suisse as

financial advisor to assist Worldpay in exploring strategic alternatives for

its issuer solutions business, which was a low single-digit revenue growth

business, and contacted several parties to solicit their interest in a

potential acquisition of the issuer solutions business. In that regard, on

September 27, 2018, Mr. Drucker [CEO of Worldpay] called Mr. Norcross [CEO of

FIS] to explore FIS’ interest in a possible acquisition of the issuer solutions

business”.

[2] Banks like these distribution

agreements because they attract merchant deposits and generate referral fees.

[3] Assumes 50% contribution margins

on revenue synergies. Also assumes

$500mn of Fiserv’s $900 projected cost synergies are recycled into other

initiatives, per management guidance.

[4] I assume shares are repurchased at

a price that bakes in 8% appreciation over 5 years.

[5] SaaStr podcast episode #285

interview with Adyen COO Rolant Prins 

Disclaimer:

At the time this report was posted, Forage Capital did not hold shares of

Adyen, FIS, FISV, GPN, or SQ. This may

have changed at any time since.