Visa's Quality Business Model Faces A Looming Threat
Last month I made an initial addition to The Prime Portfolio by taking a stake in Visa (V). The fundamental business quality of Visa is well understood by the market, and the stock is priced accordingly. Obvious business highlights include operating margins that reached above 60% prior to the Visa Europe acquisition, net margins near 40%, highly scalable business model, dominant competitive position, and decades-long growth catalysts.
But while those qualities have led to outlandish historical returns, I’m more concerned with the Visa business model and whether it can sustain similar performance in the future. Consistent with that mindset, I’m laser-focused on strategic developments that could threaten or improve the competitive position of the company.
As background, I’ve committed to building a new portfolio from the ground up, in public view, and with the aid of the Seeking Alpha community. The objective is to build a collection of my highest conviction holdings in a concentrated portfolio of approximately 8 to 12 stocks: The Prime Portfolio. The objective is to target long holding periods with portfolio turnover of 10% to 20%.
My primary goals for this research are to monitor my current holding of Visa stock, to determine if circumstances merit increasing the weight of Visa in my concentrated portfolio, to decide whether a future investment in Visa's rival MasterCard (MA) might be warranted, to disseminate information to fellow investors about potential risks, and to contemplate whether I should gradually diminish exposure to the payments networks if industry conditions become unfavorable.
As the first addition to the portfolio, I’ve discussed the positive attributes of Visa in extensive detail already. Today’s focus will be on long-term competitive threats that, some say, could eventually displace Visa or weaken its market position.
When considering future threats, it’s helpful to place them within the context of the current industry dynamics. Namely, can new technologies offer capabilities equal to or better than what makes Visa’s payments network so indispensable: (1) broad acceptance among banks, consumers, and merchants; (2) ease of use; (3) speed of transaction processing; (4) capacity and reliability of transaction processing; and (5) security of payments and card data. In essence, Visa’s solution is convenient, safe, effective, and rewarding to consumers. It’s reasonable to expect that a competing alternative would, at a minimum, need to possess all of these attributes to compete effectively.
So, the task for Visa’s would-be rivals will not be an easy one. Still, Visa, despite what many consider to be massive competitive advantages, has a potential vulnerability typically not shared by other long-term compounders: merchants - which almost universally accept card payments - would love nothing more than to eliminate or minimize the role of credit cards and related fees in selling their merchandise. Similarly, while Visa is widely recognized by consumers, it lacks the intangible brand power enjoyed by consumer companies such as Coca-Cola (KO) and Apple (AAPL). In short, while consumers embrace and benefit from the use of their Visa cards, the same may not be true if a competing alternative ever offered a more convenient and rewarding consumer experience. As a result of these factors, neither merchants nor consumers are married to the brand in the event that a better system is introduced. That attribute is a main source of risk for Visa shareholders in my view.
Still, Visa is deeply entrenched, and has been for decades. But it’s conceivable that one day that could change. So, let’s examine how that might happen. Although I briefly summarized what some have suggested as threats in my initial coverage, today I’ll present a deeper dive into one specific key risk. But first, let’s review a few of the developments which have been presented as potential threats:
- Record levels of venture capital investment in the fintech industry targeted at developing new payments solutions.
- Apple, Google (GOOGL), or other providers of mobile payments technologies which, for now, still use Visa’s payments network rails.
- Merchant alliances formed to offer new payments solutions that would reduce the fees merchants lose to credit card payments.
- Bitcoin and other cryptocurrencies.
- Blockchain technology.
Of these looming threats, one in particular catches my attention. To punctuate that concern, here are a couple of harrowing quotes for long-term minded shareholders of Visa. The first relates specifically to rival MasterCard (which is subject to all of the same threats) and comes from the 2015 annual report of the Sequoia Fund:
"MasterCard’s virtues are well-appreciated by the stock market but the evolution of mobile payment habits and the rise of blockchain ledger technology could pose longer term challenges to the company’s wildly profitable business model... We expect future returns will be more modest."
The second quote comes from Morningstar, which is admittedly still very bullish on Visa despite this admission:
"Blockchain technology, which powers digital currency bitcoin, offers ways to transfer value through distributed computing. The technology could conceivably pose a threat to any kind of centralized settlement activity."
Since the bread and butter of Visa’s business is the authorization, clearing, and settlement of transactions, realization of Blockchain’s highly-touted potential poses a highly concerning threat.
The Disintermediation Threat of Blockchain
To place this threat into context, blockchain is a distributed ledger that can process and maintain a series of data, including records of financial transactions. The data is considered decentralized since it is validated by numerous computers in various locations prior to adding a record to the chain. This means that fraudulent transactions are regarded as unfeasible in most blockchain literature.
The technology is considered to have superior security. An interview published by McKinsey & Company addresses this attribute, indicating that blockchain is “an immutable, unhackable distributed database of digital assets.” The piece went on to claim that in order to manipulate the system, an individual “would have to commit fraud in the light of the most powerful computing resource in the world, not just for that ten-minute block but for the entire history of commerce, on a distributed platform. This is not practically feasible.”
So, according to these claims, blockchain meets the security requirement needed to potentially displace or transform credit card payments networks. Besides that important step, some argue that blockchain transactions will be more transparent and less costly than alternatives. And because blockchains don’t require centralized authentication and settlement, middlemen involved in the current payments system could become defunct, removing layers from the process and threatening existing business models.
Barron’s magazine chimed in on the issue in a November 2015 piece, noting that, “The immediate impact could be a big drop in the usefulness of credit-card networks such as Visa, MasterCard, American Express, and Discover,” before going on to suggest that “it’s possible to see the emergence of a future in which the credit-card networks go away...”
With the potential of blockchain to open up lucrative parts of the payments industry to new competition, all the important players are taking notice, as evidenced by a quote from Don Tapscott in the previously-mentioned McKinsey & Company interview:
"You’ve got the smartest venture capitalists, the smartest programmers, the smartest business executives, the smartest people in banking, the smartest government of people, the smartest entrepreneurs all over this thing. That’s always a sign that something big is going on."
Still, despite blockchain's tremendous potential, it has significant limitations and challenges to overcome before it can deliver meaningfully on its promise.
Limitations and Overhype of Blockchain
Chief among the limitations of blockchain are the following:
- Power Consumption
- Inflated Expectations and Time Until Adoption
Let’s examine each of these in sequence.
Blockchain Limitation #1 - Power Consumption
In his McKinsey interview, Tapscott discusses the “massive” energy consumption required to operate a large-scale blockchain, the likes of which would be necessary to pose any realistic threat to the incumbent payments paradigm. Another source explains that their “distributed nature demands constant computational power,” and that Bitcoin’s blockchain alone commands“half the energy consumption of Ireland.”
Blockchain Limitation #2 - Governance
Tapscott identifies another blockchain “showstopper” as governance, saying that if there is a failure to develop leadership and a governance system similar to what was created in the early days of the internet, blockchain may fail to develop any real utility. A Gartner article also emphasizes that blockchain has “no clear structure for decision making,” and that personalities and agendas drive the direction of the Bitcoin blockchain. With respect to perceived centralization, Gartner explains that the computing power needed to operate blockchain is now concentrated in four large Chinese organizations, of which any two could combine forces to control the distributed ledger.
Blockchain Limitation #3 - Scalability
Vice President and Gartner Fellow David Furlonger says that, “in its current form, blockchain suffers from significant limitations in scalability, governance, and flexibility.” Because of the electrical power required and the design of current processes, no more than seven transactions per second can be verified (compared to thousands per second for Visa). A Goldman Sachs report cited in Barron’s concurs that five to eight transactions per second is the limit under the blockchain technology currently in use.
Blockchain Limitation #4 - Inflated Expectations and Time Until Adoption
If anyone has a grasp of the evolution of emerging technologies, it’s Gartner. The technology consulting company even has a model for measuring the stages of development of new technologies. In Gartner’s “Hype Cycle” blockchain has reached the “Peak of Inflated Expectations.” From there, Gartner expects it to decline into the “Trough of Disillusionment” before gradually settling into the “Plateau of Productivity” after the kinks have been worked out and its real-world use cases are better understood.
Still, Gartner predicts that less than one percent of blockchain’s full utility has been realized and that it could transform numerous industries. Interestingly, it names manufacturing, government, healthcare, and education as industries most likely to see change soonest, not financial services.
The net effect of the newness of the technology’s development and its multiple limitations is that mainstream applications of blockchain won’t emerge until five to ten years into the future, according to Gartner. With the uncertainty surrounding the technology and expected long time horizon until widespread adoption, much could happen in the intervening years. Fortunately, Visa openly acknowledges the risks and is taking steps to position itself for a successful transition.
Visa Partnerships and Adoption of Blockchain
In its exceptional premium service coverage, Morningstar points out the bull argument that Visa needs only to adopt new technologies to maintain its competitive advantage over rivals. Similarly, in a recent Seeking Alpha article also discussing blockchain’s impact on Visa, Quinn Foley argues that up-and-coming payments technologies are more likely to partner with Visa than displace it.
With that in mind, Visa is already researching and experimenting to determine how it can integrate the new technology. A TechCrunch article discussing the possible commoditization of payments processors (which use credit card networks) praises Visa’s leading example for maintaining its position in the payments ecosystem through experimentation, commitment to adopting new technologies, and willingness to back key industry startup companies.
Indeed, Visa is partnering with blockchain startup Chain for a business-to-business payments service capable of almost instant transaction settlement; transactions which would travel across Visa’s network. It’s a small but offensive step by the company to facilitate future growth by adopting the technology.
Another article highlights a Visa job posting for a software engineer responsible for “developing a secure, scalable blockchain network” and for researching “blockchain, QR code, virtual currency, and many other emerging payment technologies.”
Lastly, a blockchain research report from Credit Suisse predicts that there is limited risk for credit card payments networks, and that the decisions of the companies behind mobile payments to use existing payments networks only strengthens the position of the companies operating the existing network rails. Likewise, similar research from Citibank argues that blockchain isn’t a disruptive threat but rather complementary technology that can be adopted by existing networks.
Mitigating Factors and Possible Outcomes
While the emergence of blockchain should be considered a valid concern for shareholders, there is also much to allay any related fears. First of all, the technology community promoting the potential of blockchain clearly hasn’t sorted out exactly how the technology could come to replace existing processes that already work rather well. Second, blockchain in its current form has many limitations that seem to diminish the perceived threat to credit card networks. Third, even if blockchain comes to displace or otherwise disrupt Visa’s business model, the timing of this will likely be at least five to ten years into the future. Fourth and lastly, Visa is already taking steps to understand and adopt the technology to reduce the risk of disruption and perhaps even open up another growth pathway or bolster its current network.
Some of the possible outcomes as I see them are:
- Blockchain is overhyped and its limitations prevent it from ever seriously challenging the deeply entrenched current system.
- Blockchain provides a promising new solution which Visa can adopt for its own purposes to maintain a strong competitive position. This outcome could conceivably alter the current fee structure for Visa, either positively or negatively.
- A new blockchain solution is offered by a competing firm, gradually gains scale, and ultimately relegates Visa to a lesser role in the industry or causes its technology to become obsolete altogether.
The result of my research is that I remain an enthusiastic shareholder of Visa stock. But I’ll be watching future developments carefully. How do you see this story unfolding?
- Can blockchain overcome its limitations to become a viable alternative to current payments networks?
- What are some key strengths or vulnerabilities of the current credit card networks that make them either susceptible to disruption risk or insulated against disruption risk that is posed by blockchain or other emerging technologies?
- As a Visa or MasterCard shareholder, do these risks concern you?
I look forward to continuing this journey with you as a long-term minded Visa shareholder. And, as always: Be Virtuous!