Payments Industry: Turning Threats into Opportunities
The media has focused a great deal on the payments industry in recent years with headlines featuring high-profile credit card data theft, the introduction of new security standards (chip cards), the launch of mobile-phone digital wallets, and the potential for industry disruption from new entrants.
During all of the hype, we found opportunity in Vantiv, Inc. (VNTV), a 40-year-old payment processing company headquartered in Cincinnati, Ohio. While not as well-known as the credit card networks or the card-issuing banks, Vantiv is a market leader in the large and growing merchant acquiring and financial institution processing space, playing an important role in connecting banks and networks with cardholders and merchants. Management has done an admirable job acquiring key disruptive technologies to enhance its offerings, particularly in the area of “integrated payments” with its 2014 purchase of Mercury Payment Systems. We think Vantiv models how an established financial technology company can conduct M&A to add complementary assets, turn threats into opportunities, and create long-term shareholder value. Though the gap between the current share price and our estimate of intrinsic value has narrowed, we continue to believe Vantiv’s management has the ability to grow intrinsic value over time.
In the commentary below, we provide an overview of the complex payments ecosystem, highlight key areas of innovation and disruptive potential in the industry, and discuss the attractive aspects of Vantiv’s fee-based business model along with the success of its integrated payments business.
The Vast and Complex Payments Industry
According to Boston Consulting Group, in 2014, North American retail payments represented a revenue pool of approximately $238 billion (28% of the worldwide total), with the majority related to credit and debit card transactions (inclusive of various transaction fees, account fees, and interest income). The ecosystem is a complex yet efficient means to authenticate, clear, and settle a tremendous amount of purchase volume between hundreds of millions of consumers at millions of merchants, all of whom connect to thousands of different banks. Credit card networks such as Visa and MasterCard, the card-issuing banks, credit card companies, independent merchant acquirers, and issuer processors come together to form the payment ecosystem. Most money-center banks both issue credit cards and have their own merchant acquiring arms, while some banks outsource or have joint ventures conducting the merchant acquiring and/or issuer processing functions. Vantiv is an independent (non-bank owned) merchant acquirer and issuer processor that was a unit of Fifth Third Bank until 2009 and went public in 2012.
While it is easy to understand that players make money from interest charged on card balances and account-based fees, it is less intuitive to understand the payment industry’s transaction revenue (called merchant discount revenue), a major source of industry profits. Merchant discount revenue is captured by the ecosystem with each card-based merchant transaction. Merchant fees can be a combination of a fixed fee or a percentage of the transaction value. As an illustration, the typical $100 credit card transaction results in $2.50 of merchant discount revenue, with $1.75 going to the issuing bank, $0.25 going to the network, and $0.50 going to the merchant acquirer. The merchant receives $97.50. Small and mid-sized businesses represent most of the industry economics and growth opportunity while large merchants represent most of the volume but less of the economics. Not surprisingly, the lion’s share of industry economics flow to the largest participants, many of which are holdings in various Diamond Hill strategies1.
Innovation and Disruption
The card-based payment industry has seen more innovation, and potential for disruption, in the last five years than the last five decades. The proliferation of smart phones, tablets, and cloud-based software and applications has generated new forms of commerce, challenged existing business models, and changed consumer payment behaviors.
- Silicon Valley startups are attracting increasing amounts of venture capital investment, and private company valuations have soared in the last five years. Companies such as Square, LevelUp, WePay, and Stripe are garnering excitement and, in some cases, achieving multi-billion dollar valuations. However, the startups are finding the industry difficult to disintermediate and are increasingly working with incumbent players in order to achieve scale and tap alternative sources of potential revenue.
- Digital wallet platforms such as Apple Pay, Samsung Pay, and Android Pay contain the user’s preferred payment information for a seamless and secure experience at the point of sale. The transaction is completed without having to present a physical card. Standards around encryption and tokenization, where actual card data is assigned a random alternative value, are designed to make fraud more difficult.
- While browser-based e-commerce has been around for some time now, mobile commerce is growing rapidly and businesses that were traditionally “cash sticky” are being transformed by smartphones that contain a user’s credit card payment credentials. In addition, subscription and content oriented businesses such as Amazon Prime, iTunes, and Netflix would likely not exist without electronic payments.
While it remains to be seen whether the payment startups will gain the material industry volume and market share needed to justify their valuations, it is clear that they have spurred the industry into action and changed industry behavior. Incumbent payment players are now innovating, investing, and/or partnering with or acquiring companies to solidify their position in the payment ecosystem. So far, economics and market share for the incumbent players have largely remained intact. Consumers tend to be creatures of habit and adoption of new technology, particularly with regard to finances, can be slow. One major benefit thus far has been the increase in small and medium-sized businesses entering the payment ecosystem, growing the industry’s transaction revenue pie. The risk going forward will continue to be the disruptive potential of new entrants inserting themselves into branded financial services and the potential erosion of industry pricing.
Vantiv: Fee-Based Business with Secular Growth
Vantiv will continue to benefit from the secular growth within the industry. The Nilson Report forecasts credit and debit card purchase volume to grow at approximately 8% compound annual growth rate (CAGR) through 2019 while paper-based payments will decline at approximately 6% CAGR. Vantiv CEO Charles Drucker recently stated, “We’re the behind-the-scenes player where transactions actually move… it doesn’t happen without us sitting in the middle.” Vantiv operates two segments, Merchant Services and Financial Institution Services, collecting a fee every time a credit card or debit card is swiped at one of its merchants or financial institutions, essentially charging a small sum to a high-volume base on a regular basis.
Vantiv’s merchant base (80% of net revenue) includes approximately 800,000 merchant locations across the United States. In 2015, Vantiv processed approximately 19 billion merchant transactions. The merchant client base has low client concentration and is heavily weighted in non-discretionary everyday spend categories such as grocery, pharmacy, and quick-service restaurants. Vantiv has strong presence with large national retailers including ten of the top 25, with merchant customers typically signing three- to five-year contracts. Fees are either a percentage of the merchant discount rate or a fixed fee per transaction.
Vantiv’s financial client base (20% of net revenue) is also well diversified and includes approximately 1,400 regional banks, community banks, credit unions, and regional PIN debit networks. In 2015, Vantiv processed approximately four billion transactions for these financial institutions while focusing on small to mid-sized institutions with less than $15 billion in assets. These financial institution customers typically sign five- to six-year contracts and fees are based on a fixed fee per transaction or volume driven for value added services.
Vantiv provides a full suite of payment processing services on its single proprietary processing platform. The nature of the business evokes a quote by Warren Buffett about the attractiveness of investing in a toll bridge: “A toll bridge would be a great thing to own if it was unregulated…because you have laid out the capital costs. You build the bridge in old dollars, and you don’t have to keep replacing it.” Vantiv is able to generate recurring, stable transaction revenue while benefiting from strong scale efficiencies that generate high levels of profitability and cash flow2.
Continued Growth from Integrated Payments
In recent years, Vantiv’s acquisitions have added capabilities and new distribution channels that have been accretive to growth. After acquiring Litle & Co (e-commerce) in 2012 and Element Payment Services (integrated payments) in 2013, Vantiv made its largest acquisition in 2014, acquiring Mercury Payment Systems (now called Vantiv Integrated Payments). Mercury is a pioneer in the integrated payment space where payment solutions are “integrated” into business management software applications and sold through independent software developers and dealers. At the time of the acquisition, Mercury had relationships with more than 600 developers and 2,400 dealers, indicating increased market penetration ahead. This distribution channel reaches small and mid-sized businesses in industry verticals such as salons, spas, coffee shops, bakeries, and other small restaurants. These businesses tend to be the hardest to reach and more economically attractive to Vantiv than large merchants, largely representing “greenfield” growth opportunities to gain market share. Revenue from the integrated payments channel should grow at a mid- to upper-teens rate in 2016 as compared to the firm’s overall 7-9% revenue growth guidance. In a business where scale matters, we like the old industry adage, “quantity has a quality all its own.” Through continued investment that enhances their competitive advantage, we believe Vantiv will remain a full-service leader with significant scale.
1 As of March 31, 2016, Diamond Hill owned shares of JPM, C, WFC, COF, DFS, AXP, and VNTV.
2 2015 Financial Highlights: $1,682 billion net revenue (2011-2015 CAGR 18%); 22,991 billion transactions (2011-2015 CAGR 16%); $804 million adjusted EBITDA (2011-2015 CAGR 16%); 48% adjusted EDITBA margin; $449 million adjusted net income (2011-2015 CAGR 25%); $431 million levered free cash flow (2011-2015 CAGR 34%). Source: Vantiv Investor Presentation, February 2016.
Originally published on April 18, 2016
The views expressed are those of the research analyst as of April 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.