Morningstar Magazine - December 2017/January 2018 - 66

Investors

Digital Demand
Amid a sea of change, titans Visa
and Mastercard hold fast.

SECTOR RAP

Laura Lallos

The payment industry is one of the fastest-growing
and most profitable areas in the financialservices sector-and the most rapidly changing.
A recent Financial Services Observer from
Morningstar Research Services1 assesses the
opportunities and potential threats for the industry
that influence our analysts' economic moat
ratings and valuations. To explore the changing
landscape, I spoke with lead author Jim Sinegal on
Sept. 25. Our conversation has been edited for
length and clarity.
Laura Lallos: What trends are driving opportunities

in the payment industry?
Jim Sinegal is a senior
equity analyst with Morningstar
Research Services.

Sinegal: The first is the decline of cash
around the world. Electronic payments make
sense for consumers, businesses, and
governments. That's a long-term trend that's
only accelerated lately. Second is the
growth in consumer spending. The more people
spend around the world, the better it is for
payment companies.

Another trend is that business-to-business
spending is moving to digital means. There are
a lot of companies around the world that
still have someone signing checks and mailing

them out every month. As that changes, payment
companies should benefit.
The United States, Europe, and China account for
the bulk of the growth. What are the differences among
these markets?

Sinegal: People get excited about the faster
growth in a lot of the smaller emerging
markets, but the three big markets are where
innovation starts. These markets will drive
developments in the payment sector over time.

China is farthest ahead on the technological
front. In China, people skipped the bank account
phase and went right from using cash to
using phones and financial tech companies for a
lot of their banking needs in addition to payments.
Alibaba BABA and the other big tech players
in China control a lot of the commerce, and they're
holding a large percentage of consumers' money.
The U.S. is most favorable from a regulatory
standpoint for well-established payment
companies. It's hard to break the status quo,
because the regulators are loath to change
the existing payment infrastructure and because
there's a very well-established system
based around Visa V, Mastercard MA, and the
other U.S.-based companies.
Europe is the most aggressive on the regulatory
front. Regulators are trying to make it easier
for startups to access bank accounts and make
it cheaper for consumers and businesses
to send money back and forth.
Will Visa and Mastercard retain their wide moats?

Sinegal: Their dominance is very difficult
to break. People in the U.S. think about Visa and
Mastercard in terms of domestic spending,
but a lot of the business is based on international
spending. Think about their advertisements:
at the Olympics, the World Cup, global events
where people are traveling and spending
money across borders. That's where Visa and
Mastercard make a sizable percentage of
their money, and that global network is the hardest
to disrupt. There are regulatory factors. There
are issues getting banks around the world to agree
on standards and systems. That keeps Visa
and Mastercard in a great position when it comes
to both growth prospects and profitability.
How might regulation affect Visa and Mastercard
in Europe?

Sinegal: Visa and Mastercard handle a lot
of the cross-border traffic in Europe. Right now,
Visa and Mastercard have a stranglehold on
transferring money from one bank to another. PSD2
(the second Payment Services Directive) allows
third-party providers to direct banks to send money
to each other-and they have to do it at very
low cost, and they don't necessarily have to use
the Visa or Mastercard system.

There's still a high hurdle: Consumers and
merchants must adopt those sorts of technologies.
But from a regulatory front, it does make
things a lot easier for competitors, because banks
now have an incentive to open up their systems.
What is the competitive environment like in the U.S.?

Sinegal: It's been very difficult for companies like
Apple AAPL and Google GOOGL to compete
on the financial-services side of things because
of the regulatory environment. In the U.S., the
laws separating banking and commerce are much
tougher. So, these companies are partnering
with existing financial-services companies, rather
than attempting to go it on their own.

Apple Pay demonstrates how difficult it is to get
consumers, merchants, and banks all on the
same page. Merchants don't like paying the fees
that come with Visa and Mastercard. But it's

1 Sinegal, J., Vuong, S., & Aguilar, J. 2017. "Payments by the Numbers: Fifteen Trends in Three Regions Drive Our Sector Thesis." Financial Services Observer. August.

66

Morningstar December/January 2018



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