New challenges await payments providers, now that the pandemic-related surge in adoption of digital payments has leveled off. Among them are questions about how the technology and use cases are likely to develop. In this episode of Talking Banking Matters, payments industry expert and McKinsey partner Roshan Varadarajan talks with Tien-Tsin Huang, the J.P. Morgan equity research analyst who covers the payments sector. The following edited transcript shares highlights from the conversation. For more discussion of the banking issues that matter, follow Talking Banking Matters on your preferred podcast platform.
Roshan Varadarajan, McKinsey: The past four years have been a wild ride for the payments and fintech sector. During the run-up to and early days of the pandemic, returns and funding for fintechs were at all-time highs, with a nearly 200 percent year-over-year increase from 2020 to 2021. However, a strong market correction has ensued, as much of the low-hanging fruit of cash-to-card conversion was snapped up during the pandemic lockdowns.
A prominent observer of these trends is Tien-Tsin Huang, who is widely regarded as a top payments analyst in the industry, having covered the sector as an equity research analyst for JP Morgan for several decades. We spoke with him recently to learn what has been going on in the payments sector and what we can expect next.
Tien-Tsin Huang, J.P. Morgan: It has been a very humbling two to three years in the payments industry. I’ve been doing this job for some decades, and until recently, I joked that investing in payment stocks is pretty easy, because the secular growth is very obvious, it drives double-digit growth, and as a result, you get easy returns and outperformance versus the broader market. But that broke during COVID, and we got a lot wrong. Looking back, I understand why: what we hadn’t seen was that the low interest rates driving this acceleration of payment space disruptors would do a lot of damage to the terminal values of legacy processors. Many of these disruptors went public and did very well, but as [interest] rates started to move, the pressure on profitability moved up, growth at any cost was no longer the story, and those companies started to break down and lose their terminal value as well.
Going forward, the card penetration story is not what it used to be. We used to get a couple points of penetration of PCE [personal consumption expenditure] every year, and that would drive high single- to double-digit growth and domestic volume. But the pandemic pulled forward two to three years’ worth of card penetration with e-commerce, and now we’re running at mid-single-digit growth in volume, in part because card penetration is now running in the mid- to maybe high 70s. The days of easy double-digit volume growth are probably behind us, and that has put a lot of pressure on these companies to find other ways to grow beyond just volume. Things like value-added services, going after newer spaces, commercial payments, and going international have become more important.
Roshan Varadarajan: As with other industries, the effect of software on the payments sector has been profound. Today, nearly half of small businesses get their payment services from software companies. We asked Tien-Tsin about how he expects this trend to play out even beyond small business.
Tien-Tsin Huang: I always say that I’m not a software analyst but that I’ve somewhat become one because just following the volume story and price is not good enough anymore. Software is becoming very important to own or partner with, to drive better sales across payments. That’s obvious today, but it wasn’t four years ago. The market has reoriented itself to like the names that are well positioned to win in value-added services and/or B2B and international. The software angle and value-added services themes are here to stay. Being a monoline payments provider in any part of the spectrum of services is not good enough anymore; you need to be able to cross-sell, do acquisitions, and expand your breadth of services. Just having depth of service is not enough. The companies that have done very well are those that have more breadth and core scale and that can produce outsize profits through those methods, whether through volume or ARPU [average return per user] extension.
Talking Banking Matters
Roshan Varadarajan: Recently, we’ve seen some wide swings in valuations for fintechs, with companies that were once valued on revenue and growth now being valued on earnings. Valuations have dropped as much as 60 percent for some companies, raising questions about the fundamental axioms that drove such high valuations in the first place. We asked Tien-Tsin what he thinks about these fluctuations.
Tien-Tsin Huang: We’ve been calling it an identity crisis; companies really have to know their identity now. Because of this chase in growth and a lot more software content coming into the sector, it was harder for the legacy processors or the incumbents to live up to that. So they set expectations that were probably a bit too high around growth, as well as margin. That’s why you saw a lot of dispersion. A lot of companies got outside of their comfort zone and tried to pretend to be something that they’re not. Close to 60 percent of our coverage has seen new leadership come in—including CEOs and/or CFOs—and you’ve seen a lot of midterm outlooks set around the time of the pandemic get updated or pulled. We’re going through some relabeling of what these companies are—which companies are truly growth companies or value companies, or margin expansion stories versus top-line stories.
The common theme for a lot of companies that didn’t bounce back was being more monoline oriented and lacking the ability to expand growth beyond just around volume. Operating expense is another big piece of it: we became so conditioned to these companies expanding margins because incremental margins are so high. But a lot of the management teams will say now that investors are asking hard questions around operating expenses and headcount and whether the returns justify them. The tolerance for spending without return or acceleration in growth is just not there today. Also, with leverage getting back to more normal levels, there are more questions around capital allocation and the balance between buying back stock and doing acquisitions. If you’re going to do an acquisition, are you going to buy a fixer-upper where there’s opportunity to expand margins and enhance returns, or are you willing to accept some margin dilution and buy a structurally faster grower? There’s no right answer to that right now.
Roshan Varadarajan: The payments sector is evolving rapidly, raising questions about the future mix of attacker and incumbent. The promise of embedded finance, which could be a multibillion-dollar opportunity, has been slower to materialize than many of us who follow the sector expected. We asked Tien-Tsin what he expects of the future market composition and the role of embedded finance.
Tien-Tsin Huang: Outside of outright owning software themselves, which is still possible, and/or getting a stronger connection with ISVs [independent software vendors] or marketplaces, it feels like they [payments companies] need to run toward wholesale processing and win on scale. That’s not a bad place to be. But a lot of these companies survived the big retailers consolidating into Amazon, Kroger, and Walmart, for example, and there are still plenty of SMBs [small and medium-size businesses] to support. The same goes for the wholesale providers: if they could provide more products and services to assist these ISVs to do things like embedded finance, payroll services, or other types of value-added services, there’s a lot of opportunity there. A lot of these companies are promoting capital, lending, invoice acceleration, or factoring. These are all opportunities to become the operating system for small and midsize businesses. Why not provide lending capital and other services for such businesses?
There are challenges, of course. The investment community puts a lower value or multiple on that kind of earning stream. So there’s a lot to prove here from an underwriting perspective, but everyone wants to bank their users [provide banking services to them]. And, whether it’s on the consumer side or on the small-business side, there’s a capital opportunity for all of them, and we’ll see how much ARPU expansion that drives, but I think that’s absolutely in the playbook. I’m a believer in this whole theme of banking your users, whether it’s a consumer or small business. It’s just a question of the quality of the underwriting, and that will dictate valuations.
If you can rally your employees around the same metrics that the investors are known to scrutinize the company against, that’s a win.
Roshan Varadarajan: Today, commercial payments account for more than half of global payments revenue and a significantly higher percentage of the opportunity from a flows perspective. However, to date, there haven’t been that many large-scale commercial payments businesses. Even fewer reach the public markets. Many of the household payments companies are consumer or small-business oriented. We asked Tien-Tsin to share his thoughts on why this is the case and whether he sees a tipping point in the future of payments companies to scale their commercial offerings.
Tien-Tsin Huang: We studied B2B over 20 years ago and wrote about how big the TAM [total addressable market] is and the huge opportunity it is. We could probably apply some of those stats from 20 years ago and still tell the same story, but we’re finally starting to see some movement, with more ERP [enterprise resource planning] standardization across verticals and among small-to-midsize businesses. We’re seeing more opportunity to do a one-to-many model across B2B, like we saw with enterprise and EDI [electronic data interchange] and those markets. I think there is opportunity in more standardization around these financial systems and ERP systems.
That’s part of it, but the rest of it is that the acceptance cost around B2B and around card-based business payments is too high. The trend of doing more negotiated or variable-ized rate models to promote acceptance on the supplier side is something we’re watching. These have helped break down some resistance and low virtual card penetration. It feels like we’re still at a pretty slow pace, but I think there’s a lot of opportunity. It feels like, at some point, we’ll see some interoperability and or consolidation, and maybe banks will be involved in that.
Roshan Varadarajan: The intersection of payments and consumer lending has taken on new dimensions with buy now, pay later (BNPL) products growing over 20 percent per year over each of the last four years. Despite the growth of these products, questions persist about the sustainability of the business model. We had Tien-Tsin talk about the long-term outlook and sustainability of buy now, pay later and pay-in-four models.
Tien-Tsin Huang: I’ve always liked the product and the idea of it, dating back to the layaway plans. It feels like it’s an interesting option for consumers that want to choose to pay that way transactionally. If you look at some of the successful BNPL firms, it was a pathway to becoming a consumer platform, or to a [digital] wallet, or to become a payment type. Being just a stand-alone installment provider was not necessarily the answer, but I think if you can package that to be the shoehorn for a bigger consumer platform, that’s interesting. And we’ve seen some big shopping consumer platforms partner with or own some of the installment providers.
Installments and BNPL fit very well as a piece of a broader breadth of services for a consumer platform. Last year, the installment players did well. They had outsize returns, though they came at it from lower baselines, but the installment or lending companies performed quite well. This will be another year of tests; if employment starts to fade, we’ll see how the underwriting holds up. It does feel like they found firmer footing, but I think we, as an investment choice, prefer that to be a part of a broader solution.
Roshan Varadarajan: Cross-border money movement also is an area that has seen evolution in recent years, given historical pain points around cost, lack of transparency, and overall timing of transactions. Fintechs historically focused just on creating a front end for consumers to send money, bringing transparency to the process. More recently, though, we’ve seen fintechs innovating on actual money movement, creating infrastructure that is faster and cheaper, in addition to being more transparent. We had Tien-Tsin talk about how fintechs are shaking up this piece of the payments sector.
Tien-Tsin Huang: Cross-border is right up there with B2B and some of the higher-growth opportunities, which is interesting. That wasn’t the case three to five years ago. With more players getting local payment licenses and creating these platforms, it does feel like it’s going to get more competitive from a pricing and spread standpoint. They will still need to have an advantage around distribution and security, though. There are fears around TAM and around pricing pressure with more competition. The understanding is that there’s a lot of growth opportunity because there’s a need. But I think the hotter spaces seem to be fairly well served, whether you’re a front-end or platform provider, and the market seems to be discounting more competition. Some of it could be cyclical, as we come off the pandemic and FX [foreign-exchange] volatility.
Roshan Varadarajan: Following the fintech funding frenzy of 2020 and 2021, there’s a likelihood that many of those companies funded will not live to see their original vision or valuation. And as this happens, it may create opportunities for more M&A, both from strategic payments companies and from private equity sponsors, especially if there’s movement in the right environment. We asked Tien-Tsin whether he expects to see more consolidation or M&A in the next few years.
Tien-Tsin Huang: We expect more in the way of consolidation. It’s a big debate though: Are you better off buying something that’s growth accretive but margin dilutive? Or are you better off driving margin-focused-type fixer-uppers? These are real challenges that you didn’t really worry about seven years ago. A lot of companies probably regret their choice of stock buybacks over opportunistic buying and deals. There are always deals that don’t initially seem significant or logical, but when you look back, you realize, wow, those were game-changing deals that in hindsight were needed despite short-term impact. What these companies do on the M&A front will tell a long-term story that we’ll come back to and be able to reference for a very long time.
Roshan Varadarajan: The payments sector is emerging from a decade-long era focused almost entirely on growth. As the sector matures, companies are increasingly expected to achieve growth targets while simultaneously improving margins. And managing the messaging with investors is becoming more nuanced. We asked Tien-Tsin to talk about how companies can best handle investor relations, especially when facing growth or margin target misses.
Tien-Tsin Huang: First, companies really have to know their identity. We’re all into benchmarking, but sometimes you have to focus on what you are and what you’re good at and go back to basics. The other thing I’ve learned over these past couple decades is that if you can rally your employees around the same metrics the investors are known to scrutinize the company against, that’s a win. If everybody’s rallying around the same metrics, and there’s a broader understanding of what needs to be accomplished or where they fall short, and that’s a better alignment with the stock price, that’s good for the culture of the company. If employees understand that this is where they need to hustle and where they’re going to be held accountable, I think that’s a win.
Roshan Varadarajan: After the payments sector’s incredible decade, there are questions about how much more runway is left, given that so much of growth stemmed from sudden adoption of digital payments. We asked Tien-Tsin how he sees the future of the sector.
Tien-Tsin Huang: The best days are probably behind the group from a growth perspective, but as long as these companies can reinvent themselves, and knowing that commerce is increasingly going to become digital and global and the touchpoints and channels are going to get more complex, there’s still an opportunity to serve and to provide trust and safety in digital payments. I still think there’s a lot of outsize growth—twice-GDP-type growth—that’s available over the next ten-plus years. We’re seeing some of it develop, like the networks going into value-added services, and what they’re doing with marrying their legacy roots with more modern software. I think we’ll get back to outsize growth. It’s just not going to come as easy.
Roshan Varadarajan: After the payments industry’s incredible decade of growth and recent years of volatility, more change seems inevitable. It’s likely the sector will face difficult times as cash-to-card conversion slows. However, another wave of technological innovation is on the horizon with real-time payments, cross-border payments, and commercial payments. And on the consumer side, a future that further links loyalty, commerce, and payments seems near. Also, tens of billions of dollars continue to pour into the payments sector each year. Here at McKinsey, we’re looking forward to seeing how the next wave of innovation and growth across the payments sector evolves.
