Profits in the payments world – 2 share ideas which could prosper

Global payments industry revenues were growing up until the pandemic. However, the lockdowns that followed kept spending at bay, leading to an overall decline for 2020. This was likely a blip on the radar, with revenue growth between 2020 and 2025 expected to work out at around 7% a year.

This has given rise to a handful of fintech companies all vying for a slice of the pie. While these disruptors are certainly interesting, they tend to be extremely highly valued. This creates a great deal of risk, as there’s not much room to get things wrong.

That doesn’t mean investors need to shy away from the sector completely though. There are a few well-established players offering a bit more stability though of course nothing is certain.

As economic conditions continue to deteriorate, it becomes even more important to find companies whose operations will withstand a bit of turbulence. Growth in the payments processing market is inevitable in the long run, as the world continues its digital shift. But near-term ups and downs can’t be ruled out if consumers reign in spending.

With that in mind, here’s a closer look at two established payments stocks that could prosper.

This article isn’t personal advice. If you’re not sure if an investment’s right for you, seek advice. All investments can rise and fall in value, so you could get back less than you invest.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Visa – give credit where credit’s due

The pandemic accelerated the transition from using cash to paying with plastic. As the largest credit card company by payment volume, Visa was at the centre of the revolution.

The majority of Visa’s revenue comes from service revenue, which is driven by transaction volumes. Data Processing revenue, for example facilitating the clearing and settlement of transactions, is a close second. Growth in this part of the business is dependent on the number of transactions rising. Cross-Border transactions, for which Visa charges a fee, also contribute a significant amount.

Payments volume by company

Source: Visa 2021 annual report.

The shift away from carrying cash has offered a welcome boost, with transaction volumes and number of transactions processed up 18% and 17% respectively. That’s a far cry from the low single-digit growth seen in 2020 thanks to pandemic spending patterns. It’s also a material improvement on 2019 levels. The question now is whether this surge in spending will continue.

The elevated flow of money through the Visa network is likely to be somewhat short lived. Revenue growth in both Data Processing and Service is expected to start tapering over the next three years, which will feed through to a similar decline in operating profit growth. This is likely the result of a more mature market.

However, Data Processing is set to deliver growth in the high double digits, and Service growth will potentially be near 10%.

The worsening cost-of-living crisis could provide a tailwind for Visa. Those who find their budgets stretched will be looking for ways to spread out payments as their bills mount up. This is playing out in the UK, where credit card lending has been growing at its fastest rate in nearly 20 years.

UK credit card lending annual growth rate

Past Performance is not a guide to the future. Source: Bank of England.

The good news is, quite a bit of this influx of cash will increase service revenue and make its way through to the bottom line. The group’s operating margins are expected to grow steadily over the next three years, to come within touching distance of 70%.

This will be helped by a rebound in lucrative international transactions, which have been depressed by the pandemic. In 2021, these types of transactions were still almost 20% below pre-pandemic levels. The margin improvements should yield free cashflow in excess of $15bn this year.

Visa’s not a hot new fintech boasting disruptive technology. It’s a rare case of a large, established business that we think should benefit from continued growth in the payments market.

Shares change hands for around 24 times forecast earnings, slightly below the long-term average, but ahead of peers. That’s a nod to the group’s dominant position and strong financials, but it could increase the risk of near-term volatility.

View the latest Visa share price and how to deal

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PayPal – the payments underdog?

PayPal makes money charging fees on the transactions it facilitates. That means increasing the amount of money flowing through the platform is essential for success.

That’s become harder to do over time. Stripping out the impact of exchange rates, total payment volumes (TPV) in the first quarter rose 15% to $323bn. This looks to be the new normal moving forward, with management guiding for 15-17% growth this year. Teasing out whether or not this is a good thing is made more complicated by the pandemic.

The start of the pandemic saw PayPal’s payment volume growth spike. But once that initial rush was over, growth slowed to more normal levels.

Past performance is not a guide to the future. Source: Company accounts 2018-2022.

PayPal increased payment volumes by 46% since the start of the pandemic. Over the same number of quarters pre-pandemic, payment volumes rose 37%. It’s clear the excessive growth seen throughout the pandemic won’t continue, but pre-pandemic-level growth is also unlikely.

As a top name in the payment processing space, PayPal’s days of signing up new users in droves are probably coming to an end. Keep in mind, 15% growth from the group’s new, higher base is no bad thing. But even that won’t be easy to come by moving forward.

The group will have to focus on building out its services to squeeze out more dollars from each client. There are pluses and minuses to this strategy.

On one hand, it’s much easier to upsell to existing customers – they’re already used to the platform and they trust the brand. But adding new services is expensive and time consuming. It often doesn’t pay off until customers start using them in large numbers.

We’ve seen the beginnings of this strategy at PayPal over the past year. Core PayPal transactions made up the bulk of transaction revenue last year, However, Braintree, a merchant payment platform, and Venmo, a peer-to-peer payment system, are making up a larger slice of the overall pie. Venmo, for example, now makes up 18% of overall payment volumes.

The rollout of new products and services in new markets around the world increases transaction expenses – the cost for PayPal to carry out each transaction. If these expenses grow faster than payment volumes, the transaction expense rate rises, making each processed payment less profitable. That’s exactly what happened in the first quarter this year.

Once these services have been adopted by a larger number of customers, you’d expect the transaction expense rate to fall – that’s what PayPal’s managed over the past four years.

Past performance is not a guide to the future. Source: Company accounts.

If the first quarter uptick in the expense rate turns into a longer-term trend, it will weigh on overall profitability. The cash-generative nature of the business means the group can stand to power through the transition. But with inflation weighing heavily on consumers’ ability to spend, PayPal’s margins could be under pressure for longer than expected.

These risks are reflected in a valuation that’s well below the long-term average. That makes PayPal one of the lowest valued choices in the payments sphere.

If the group’s able to pull off its latest strategy shift, this could be an attractive opportunity. But the payments space is crowded, and the group’s growth runway has narrowed considerably, so there are risks ahead.

View the latest PayPal share price and how to deal

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2 share ideas to survive stagflation

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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