We like to start out all of our discussions by telling investors who we are. We are FINTECH investors, and we define Fintech as “anything utilizing technology to improve an established process.” We realize that half of Fintech is financial, but we don't invest in traditional, credit sensitive banks. Having managed money during the Financial Crisis, we learned firsthand how certain opaque and balance sheet intensive financials could go bankrupt or insolvent.
We prefer transaction-based businesses, generating recurring revenue, with sustainable margins, and significant cash flow. From our perspective, the perfect example of a FINTECH business is the secularly growing payments industry. Names like Visa (V) or Mastercard (MA) that generate revenue and profit per swipe or transaction, without the underlying credit sensitivity or risk associated with that underlying line of credit.
Everybody knows what traditional wallets look like, and they range from old-school leather ones to our favorite Velcro OP wallet from 1980 (see above). A digital wallet is a software application that allows users to securely store and manage their payment information (i.e., credit cards, debit cards, etc.) on their favorite mobile device. Instead of carrying around physical cards or paper cash, a digital wallet allows your smartphone to become your payment device.
Digital wallets are safe and convenient, allowing their users to store, manage and easily make payment transactions. Anybody can store their favorite card and/or multiple cards to use in physical, brick and mortar retailers or for online purchases.
Unlike a traditional wallet, that can be stolen and then utilized by thieves to transact, a digital wallet has advanced encryption technology to protect a users' payment information. Nobody checks the back of a credit card to ensure that the signatures match anymore, right? If somebody steals your wallet, they could shop easily at any merchant, until you call and tell the issuer that your card has been stolen. However, digital wallets have embedded technology to reduce the risk of fraud and identity theft. Fraudsters would need to clone your face or replicate your exact fingerprint to unlock your phone and access your digital wallet. That's obviously much harder to do. In addition, these digital wallet payment transactions can be tokenized. That is the process of replacing sensitive data (i.e., that 16-digit numerical code on your plastic card) with unique and one-time identification numbers and symbols. This retains all the essential transaction information and data, without compromising security.
There are various forms of digital wallets. Software wallets are simply a digital wallet that is accessed from a computer or your mobile device. Hardware wallets are physical devices used to store digital assets offline, like crypto currencies. Within crypto, there can be hosted/custodial wallets, as well as self-custody or hardware wallets. Our loyal readers know that we aren't terribly focused on the use of crypto as a valid payment mechanism, so we'll leave that product discussion and analysis for another day.
For our purposes, we are just going to focus on software digital wallets, as they are much more common and accessible. If you own an iPhone, then you have Apple's Apple Pay (AAPL) pre-loaded digital wallet. If you have a Samsung phone, you have Samsung Pay available for use. Those two, along with Google Pay (GOOG) (GOOGL) and PayPal (PYPL), are the four most popular digital wallets today. According to the Payments Journal, PayPal has been used (over the last 12 months) by 62% of American consumers, followed by Apple Pay at 41% and Google Pay at 32%.
Peer-to-Peer or P2P:
From our perspective, there are three dominant P2P platforms. PayPal owns Venmo (from its Braintree acquisition in 2013), Square owns Cash App and Zelle is the bank-owned consortium run by EWS (Early Warning Services).
Venmo and Cash App are more popular with younger Americans, and more of its users utilize the platform to exchange and transfer smaller sums of money. When it comes to P2P, we view these three as the dominant platforms, but there are major differences in ownership and transaction size.
Zelle:
Traditional banks are desperately trying to connect with their younger consumers, so they partnered up and formed this consortium. EWS created Zelle in 2017 and it is owned by seven banks (Bank of America (BAC), Capital One (COF), JPMorgan Chase (JPM), PNC Bank (PNC), US Bank (USB), and Wells Fargo (WFC)). Zelle has widespread financial institutional acceptance and is currently utilized on over 1,700 different banking apps.
Since its launch, the Zelle network has processed more than 5 billion transactions with 99.9% occurring without incident or fraud. In the 1st quarter of 2023, Zelle processed 639 million transactions, covering a total value of nearly $180 billion. This equates to an average per transaction value of $282. That average is significantly higher than Venmo or Cash App's average and much higher than our weekly Venmo $10 golf wager. Zelle's transactions grew +29% YoY and dollar volume increased +31% YoY.
This impressive growth was driven by Zelle's addition of smaller credit unions and community banks to its platform. In addition, EWS management continues to attract usage from small businesses, which has accounted for 150 million new users in 2022. We view this small business focus as a glorified version of our personal, monthly online bill payments. While we use our bank website to pay our mortgage, car payments and credit card bills, more small businesses are using Zelle to handle their monthly bill payments. With its higher average transaction size, Zelle seems like an online banking payment (accounts receivable + accounts payable) solution for small businesses. If we were running Intuit's QuickBooks franchise, we'd view this small business success as a major threat.
Where's the Flaw?
Despite this success, Washington has put Zelle in its cross hairs (read DC testimony / transcript here). US Senators, especially Elizabeth Warren from Massachusetts, have singled out Zelle for “a high rate of scams”. She claimed that frauds on Zelle were occurring “at twice the rate of other banks.”
Back in October 2022, Senator Warren h as issued a report that found rampant fraud on Zelle, with the dollar value of fraud increasing by more than 250% (from 2020 to 2022). This scathing report also found that Zelle was not repaying consumers who were defrauded, leading to millions of lost funds for consumers. Senator Warren's report stated that only 47% of “unauthorized” transactions (classified by EWS as fraud) were returned to consumers in 2021 and the first half of 2022.
Following Zelle's “grilling” in Washington DC, EWS press releases emphasize internal controls and security protocols to stop “bad actors” from executing fraudulent transactions on its network. Management emphasized that it “routinely blocks high-risk enrollments from registering on the network,” and that it can pinpoint fraudsters and remove them from utilizing transactional tokens.
We are attempting to highlight a few key differences between digital wallets and P2P payments. For example, a credit card transaction, handled inside of an Apple Pay wallet, has 100% customer protection against fraud. Transactions also have identifiable information, permitting chargebacks and returns. This isn't the case with P2P transactions.
Taxes:
P2P thrived because it is quite easy to use, and it's a free service. However, as more gig workers began to accept payment by Venmo or Cash App or Zelle, it created a potential tax issue. Historically, to receive tax documents (like a 1099-K), users would need to have spent over $20,000 or have conducted over 200 transactions.
The IRS has taken notice of how popular these P2P app's have become and are trying to force these networks to provide 1099-Ks for income generated over $600 per year. Taxable reporting only involves payments made under the “goods and services” tag, so daily transactions between friends or colleagues isn't IRS applicable.
Can P2P Morph into Digital Wallets or Banking?
While Square (SQ) and PayPal are well regarded for payment processing, both have not yet cracked the digital wallet code. These platforms will ultimately succeed, IF they are able to get consumers to leave a decent balance in their account, like an online bank.
Let's say that the average Gen-Z consumer keeps $1,000 in their Bank of America or Wells Fargo account and uses it to pay for their monthly expenses. These P2P platforms hope to replace B of A and get that $1,000 stashed into their Venmo or Cash App account. Square has been pushing direct deposit for years inside of its payroll product. Its goal is to get employers to deposit bi-monthly payroll directly into their staffs' Cash App accounts. This way, Square essentially becomes the online bank for Gen-Z.
Once consumers are able to shop (both in-store and online) with these P2P balances, their “moat” or ecosystem will be built. We envision a day not too far away, where we will be able to utilize a cash balance, we keep at Venmo or Cash App, at our local retailer. In fact, Venmo just announced that it is now accepted at Starbucks. This instore acceptance would get accelerated, if PayPal and Square were to arrange deals with other merchant acquirers and payment processors (i.e., Global Payments (GPN), First Data (FISV), Worldpay, etc.).
Jamie Dimon, Chairman and CEO of JP Morgan Chase clearly sees the risks these FINTECH companies present. In his annual letter to shareholders, he stated that all incumbent banks should be “scared shitless” of these FINTECH rivals. Not only is his bank being attacked from multiple angles, but Apple just launched a cash management program with Goldman Sachs. It seems as if everybody wants to become a bank and all the banks are trying to change businesses and become something else. Maybe something with easier regulators…
Growth & Adoption:
Maybe the only benefit that emerged from the COVID era was the growth it spurred in electronic forms of payment. During COVID, many people were worried that touching “dirty” paper money potentially increased the chances of catching or spreading the virus. This encouraged contactless payments and increased the use of digital wallets.
Cash usage has been declining for years and COVID just kickstarted its demise. While purchases under $10 are still done with cash roughly half of the time, card usage continues to gain market share from paper currency. This is a secular trend that will continue for months, years and decades, and will materially benefit our payment companies.
The technology to use digital wallets has existed for over a decade, but its usage wasn't terribly widespread. With COVID and the global pandemic, more merchants decided to turn on the NFC (near field communication) capabilities in their POS (point of sale) terminals. By enabling tap-to-pay, merchants increased speed at the cash register and decreased the need for their employees to handle paper currency.
Electronic payments have migrated into the restaurant industry too. A few years ago, a waiter or waitress would present a patron with an invoice and take card or cash payment back to their terminals for processing. Now, more and more restaurants are bringing the terminal to the customer and payment can be made at the table.
New Entrants:
Others are trying to enter the digital wallet market, but we believe “the ship has already sailed.” Banks are trying to make a “last ditch effort” to be their consumers super app, instead of getting relegated and considered simple utilities. That same bank consortium (EWS) is trying to develop its own digital wallet.
In addition to these big banks, Synchrony is mulling creating its own digital wallet for its 70 million private label cards. We hate to say that something has no shot, but this isn't a product we expect to succeed. This just seems like a legacy provider of plastic cards trying to be relevant in an increasingly digital world. In our opinion, the best these issuers can hope for is getting the top spot in an existing digital wallet. By getting that “preferred card” spot, an issuer can garner the most usage on a smartphone.
In its annual report, Synchrony stated that “in the future, we expect our products may face increased competitive pressure to the extent that our products are not, or do not continue to be, accepted in, or compatible with digital wallet technologies such as Apple Pay, Samsung Pay, Android Pay and other similar technologies.” As of today, Synchrony works with Apple, Samsung, and Google. However, it seems like Synchrony is formulating a plan for its own digital wallet because it worries that it may not be able to work through other existing platforms in the future.
We have several questions on these new digital wallet offerings. How will they differentiate themselves versus existing players? Banks can offer credit and debit cards, but how will they incorporate closed-loop or stored value payments? Will these new digital wallets be able to handle identification cards, loyalty cards, and airline/concert/sports tickets? How can new entrants become the preferable choice to replace the digital wallets already getting used by Americans?
Maybe merchants can offer discounts for usage, but we're not sure that will drive long-term usage. We think merchants are better at selling products and services aligned with their expertise. Maybe issuers and banks can incentivize usage by offering more miles, points, loyalty, rewards, etc.? We think that issuers are better at lending, than they are at marketing We don't believe that banks are the best technology innovators, but they certainly can try (and spend money). From our perspective, it is challenging to steal market share and disrupt an industry that isn't really broken.
Social & Other Benefits:
Another “benefit” of digital wallets is their social feature. We personally view this as a negative, not a positive, but younger people love to post on social media (Facebook, Instagram, Twitter, etc.) what their payments are for. Some people post this transaction (and a photo) to let their all of their followers know.
When we pay $5 for a drink at Starbucks, we don't care to inform the world that we've been grossly overcharged for plain black coffee. Creating a virtual and public paper trail of your expenditures might help “tell your story”, but it isn't our favorite version of transparency. As my mother always said, “to each their own.”
Digital wallets have tons of advantages, that we are embracing. When we attend Tampa Bay Lightning games, we love having our season tickets easily accessible on our phones (via the Apple Pay wallet), as well as our timed parking pass. When we travel, loading the airline ticket into our Apple Pay wallet is much more convenient than printing out a paper boarding pass. Others are using digital wallets to track their expenses, budget properly, and even help them easily pay their bills. Digital wallets are still in their infancy and have decades of future growth; we believe the smartphone is simply the best interface and platform for digital wallets.
Conclusion:
We are loyal Apple users (iPhones, iPads, iMac) and find their Apple Pay to be a useful, convenient, and safe digital wallet to use. Samsung and Google users also seem pleased with their preferred digital wallets. In our opinion, these new entrants are “a bit too late to the party” to make a meaningful dent versus established players.
As of today, both Apple Pay and Google Pay have a distinct advantage in the digital wallet arena. Both firms have spent billions of dollars ensuring that their apps are easy to use. Also, and maybe more importantly, the consumer experience is embedded and native to the operating system. This ties their digital wallet to the device, which cannot be replicated.
While it is possible that these banks can create a complementary product (through EWS), their late start will make this a “hard road to climb.” Nobody likes to admit the fact that they don't have a strong, forward-looking opportunity to leverage their existing customer relationships. Unfortunately for these late entrants, the market has pretty much already spoken.
Warren Fisher, CFA
Founder and CEO
Manole Capital Management
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