The End of Cash?

The End of Cash?
Barrons.com
29 December 2012

The U.S. Bureau of Engraving and Printing produced 8.4 billion notes last year, including a record three billion hundred-dollar bills. Yet even while cash in circulation is growing, it is becoming increasingly marginalized for retail transactions. This year, greenbacks will account for an estimated 29% of U.S. retail payments, according to McKinsey & Co., down from 36% a decade ago.

And among the wealthy and the upper-middle class, cash is almost extinct in the U.S., having given way to credit and debit cards. McKinsey says that cash comprises just 2% of point-of-sale payments for households earning more than $60,000 a year.

Credit cards and debit cards each make up about 30% of all retail transactions.

Cash's disappearance has been slow but inexorable. Upscale merchants are doing away with cash registers in favor of hand-held devices, like the ones that are ubiquitous in Apple stores. Web-based retailers don't take cash at all. And on the highways, even toll booths are fading. Waiting in the wings is a generation of kids that have grown up with debit cards, prepaid cards, and iTunes accounts. The ATM is now as foreign to teenagers as bank tellers were to their parents.

By 2020, McKinsey forecasts cash payments could drop to 26% at the "point of sale," a category that encompasses both physical stores and e-commerce. Most of that spending will come from poorer Americans who don't have bank accounts and people who want to keep their purchases hidden. For those groups, cash will never go out of style.

Thirty years from now, if recent trends continue, cash could fall to just 10% of U.S. retail purchases.

The digital wallet won't put a hurt on the two big card networks.

Having already vanquished checks, the two big payment networks, Visa (ticker: V) and MasterCard (MA), are even more focused on displacing cash. The dominant forces in electronic payments, they've spent years laying the digital rails that connect banks to merchants. As those rails get busier, the companies are more profitable. Their stocks are the best play on the cashless society.

A wave of relative upstarts is beginning to garner attention, particularly as so-called digital wallets take hold. The eBay (EBAY) unit PayPal, Google (GOOG) Wallet, and Square are all plays on the digital wallet, essentially a locker of personal-payment data stored either in the cloud or on smartphones. The wireless carriers are also fighting to get into the game by controlling the secure chips that are becoming common in smartphones.

Visa and MasterCard have their own answers to the digital wallet, called V.me and PayPass. And when it comes to routing transactions, Visa and MasterCard will continue to sit between the merchants and the banks. For all the hype, the digital wallet does little to alter the massive infrastructure that has been built around credit and debit. PayPal and Square are new interfaces, but they're just skin deep -- basically "a new way of initiating a good old-fashioned card transaction," says Gareth Lodge, an analyst for Celent, a financial-services research firm.

With some three billion cards between them, Visa and MasterCard will continue to exact a toll on the majority of card transactions, be they credit, debit, or prepaid. "The opportunity ahead of us is even larger than it was over the past 50 years," says Jim McCarthy, the global head of product for Visa -- not least because transactions in much of the rest of the world are still dominated by cash.

"All day long, we're still competing with cash," adds James Anderson, MasterCard's senior vice president for mobile and emerging payments. "We've got plenty of running room."

American Express (AXP) and Discover Financial Services (DFS) also benefit from the shift away from cash, but their networks are far smaller, and they're not pure plays. AmEx and Discover provide financing to their customers, so they have the risks more typically associated with financial services. Visa and MasterCard are simply networks; they have no credit risk. Their revenue comes from fixed per-transaction fees, service fees based on transaction size, and fees for cross-border transactions. On a $100 transaction, Visa and MasterCard make about 10 cents.

There's little risk that Visa and MasterCard will be replaced anytime soon, either. In addition to laying the physical infrastructure, the companies have spent decades building awareness with banks, merchants, and customers, much of it gained through famous ad campaigns. The slogans are embedded in our national conversation. "There are some things money can't buy. For everything else there's MasterCard." And "Visa: It's everywhere you want to be."

"It's the trust that exists between [Visa and MasterCard's] rails and the banking institutions that allows them to reach into customers' banking accounts and subtract money," says Chuck Akre, founder and chief executive of Akre Capital Management, which has large positions in both Visa and MasterCard.

The banks like that status quo. They take most of the fees that flow through the card networks, Akre adds. "The banks, in effect, are the protectors of MasterCard and Visa's domain."

THEIR POPULARITY NOTWITHSTANDING, MasterCard and Visa are still fairly new to investors. MasterCard came public in 2006, and Visa followed two years later. The credit crisis provided an immediate test for the stocks. Investors sold off both names, which generally trade in tandem. The business models, though, held up remarkably well. In calendar 2009, Visa's revenue grew 9%; MasterCard's was up 2%. Operating profits were even stronger.

Akre Capital was among those attracted to the stocks coming out of the recession. The selloff reflected a misunderstanding of the business, according to John Neff, a research analyst at the firm. "We thought Visa and MasterCard could move from a distressed-lending-business multiple to one that reflects the superior economics for being a pure network."

The firm avoided AmEx and Discover, Neff adds, "because we thought the lending businesses would always serve as an anchor on their earnings multiples."

Since the broad market bottomed in March 2009, Visa shares are up 198%, and MasterCard has soared 239%. The broad market is up 107% over the same period. And both stocks closed the week near all-time highs -- Visa at $148.65 and MasterCard at $483.08.

There's still room for their shares to grow. MasterCard and Visa now fetch 19 and 20 times next year's earnings estimates, respectively. Those price/earnings ratios are well above the market average, but they're only a slight premium to expected profit growth. Analysts expect Visa to earn $4.8 billion in fiscal 2013, up 14.5% over 2012 and 17% on a per-share basis. MasterCard's profit is forecast to rise 14.8%, to $3.1 billion, and 16% per share.

Both stocks could do well just by rising at the same rate as earnings. That is to say, these stories don't need multiple expansion to provide substantial returns for investors. Both pay minimal dividend yields, however -- Visa at 0.9% and MasterCard at 0.2%.

Meanwhile, the companies' performance during the recession and credit crisis essentially validated their business models. "The last time around, the models weren't tested as public companies," says Bill Carcache, who covers cards and payment networks for Nomura Securities. "People now know how resilient they are."

Carcache expects both companies to generate year-over-year earnings growth of 20% for the foreseeable future. He has a price target of $611 on MasterCard and $172 on Visa.

"Even if there's a recession, I think you'll see them with high-teens earnings growth because they have so many levers available to them," Carcache adds. Since they essentially run a computer network, Visa and MasterCard have a lot of discretion on the cost side. Most expenses are marketing related -- the kinds of things that can be easily cut when business slows.

THE DISPLACEMENT OF CASH IS, not surprisingly, creating policy issues for governments around the world. Cash is essentially a public good, provided at no cost to citizens. Electronic payments shift much of the onus to consumers. "I think the challenge for the payment system at the moment is for society and government to evaluate whether payment systems should be publicly provided, privately provided, or some combination of the two," says Scott Schuh, an economist who studies consumer payments for the Federal Reserve Bank of Boston.

The question has led to international debate over so-called interchange fees, or payments by merchants to banks for card transactions. Europe has been regulating the fees for years, hoping to level the playing field for merchants with the hope that savings will be passed on to consumers. The results have been decidedly mixed.

The issue has reached Washington in recent years, leading Congress to include interchange relief as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The so-called Durbin Amendment, named for its sponsor, Democratic Sen. Dick Durbin of Illinois, charged the Federal Reserve with setting a cap on interchange fees for debit transactions. Last year the Fed settled on a 21-cent cap, about a 50% cut.

The ruling also eliminated exclusive deals between banks and the debit-card networks, allowing merchants a choice in how they route debit transactions. The increased competition has had an outsize effect on Visa because it's far and away the largest debit network. Visa's debit payment volumes in the U.S. were down 5.9%, to $271 billion, in the latest quarter. MasterCard, meanwhile, is picking up some of Visa's business; its debit volumes jumped 13%, to $110 billion, in the quarter. Credit cards have also picked up some business after a decade spent losing market share to debit.

Carcache thinks debit will resume its dominance "once the dust settles post-Durbin."

"Debit is a form of financial discipline for consumers because they can't overspend," he says. "It's a financial budgeting tool. That's one of the reasons debit has been so popular with consumers. I don't see that going away or changing."

And debit is particularly strong overseas, where most consumers have a far lower appetite for risk.

Durbin's impact has already been reflected in Visa and MasterCard shares, which were volatile as Congress and then the Fed took up the interchange issue. More regulation is probably the primary risk for the stocks.

In the coming years, however, it's unlikely Washington alone will have much of an impact on Visa or MasterCard. Already, international markets represent 60% of MasterCard's revenue and 45% of Visa's.

The overseas markets will be the main growth engine in the coming decades. Globally, 85% of transactions are still in cash, according to MasterCard.

Paper currency has prevailed in emerging markets largely because electricity and communications infrastructures have been slow to develop. Mobile phones and wireless networks will allow developing countries to leapfrog those physical restrictions.

FOR ALL OF THE TECHNOLOGICAL advances in the U.S., it is woefully lacking in payment security. Most of Europe employs a "chip and pin" system that makes it much harder to steal card numbers. In the U.S., magnetic strips are still the primary technology. They're vulnerable to rudimentary scanners that can easily pick off numbers.

"The U.S. has basically become a magnet for fraudsters," says John T. Williams, who covers payment firms for UBS. "All the fraud migrates here to the U.S. because of the current physical infrastructure of our card system."

Visa and MasterCard are pushing U.S. retailers to upgrade to the global standard by 2015. The move will require a wave of upgrades for payment terminals. Some retailers will probably use the deadline as a reason to replace cash registers with smartphones and tablets. Others will upgrade to more sophisticated registers. A big winner from this upgrade wave will be VeriFone Systems (PAY), which has equipment installed in 20 million locations around the world (see accompanying story at end of the article.).

Nordstrom (JWN), the upscale department store, is already picking up on Apple's (AAPL) lead, using mobile point-of-sale terminals in place of cash registers. Its sales associates walk around with smartphones that can swipe credit and debit cards, while searching Nordstrom's inventory all across the country. The company says the system provides a better customer experience.

"We see the future point of sale in our stores as essentially completely mobile," says Colin Johnson, a spokesman for Nordstrom, whose newest full-line store opened in Salt Lake City in March. It has 150 point-of-sale devices, three times the number of cash registers.

WHILE CASH IS NOT GOING AWAY anytime soon, it is not expanding the way the Bureau of Engraving and Printing's numbers suggest. While the U.S. printed $359 billion worth of paper money in fiscal 2012, $303 billion of that was in $100 bills; that's not cash that Americans use for everyday purchases. In fact, economists at the Federal Reserve estimate that over 60% of all C-notes are now held overseas.

The surge in Benjamins could also be a one-time event. Many of them went to replace old ones, according to Fed data, while up to half, printed with a new, more secure design, are still sitting in bank vaults waiting to be introduced.

When they hit the street, don't expect consumers to fill up their wallets. Cash's day is just about gone. 

Beaten-Down VeriFone Could Climb 35%

Change is usually accompanied by anxiety. With the emergence of the digital wallet, investors are taking it out on VeriFone Systems, the dominant maker of payment-card terminals found on retail counters. Among the top 1,000 U.S. retailers, VeriFone has 70% of the terminals. Investors are worried the business could evaporate as merchants use smartphones and tablets to accept card payments.

Always a volatile stock, VeriFone has had its shares cut in half since April, to a recent $28.70. Investors are now valuing the stock at just nine times fiscal 2013 earnings, versus a 10-year average of 18. VeriFone's fiscal year ends in October.

The reality is not so dire. The end of cash and the growth of the digital wallet creates uncertainty for VeriFone, yes, but there's plenty of opportunity, as well. The company is enabling card payments in taxis, for instance, a cash-only business until recently. "Folks are running for the exits on this stock, even though they should probably do the opposite," says John T. Williams, a UBS analyst, who upgraded VeriFone shares to Buy in December.

Square, the San Francisco start-up, is at the forefront of the fears. The company gives retailers "dongles," or miniature card readers, which attach to smartphones and tablets. In September, Square said it was processing $8 billion in payments annually. Most of Square's merchants are small and new to electronic payments. Eventually, these merchants will need more-sophisticated equipment. That's where VeriFone enters the picture. "In many ways, you could argue that Square is enabling future VeriFone customers by bringing these micro-merchants into the world of card acceptance," Williams says.

VeriFone will also benefit as merchants upgrade their systems to comply with new security protocols. Europe and Canada have already upgraded to the "chip and pin," or EMV, standard, and their payment systems are much more secure.

In the U.S., the upgrades are taking awhile to play out, as they did in Europe. "Everyone delayed it until they had to," says Mark Kopinksi, American Century's chief investment officer for global and non-U.S. equity, who has closely tracked the digital wallet and evolving payment systems. "You didn't get a big push into EMV until the deadline." In the U.S., the deadline is now fast approaching, and MasterCard and Visa are making rule changes that will effectively require merchants to employ the standard by late 2015.

Williams thinks that security upgrades could drive an additional $50 million to $60 million in revenue for VeriFone in each of the next five years. He sees overall revenue growing 10% in fiscal 2013, to $2.1 billion. Analysts expect VeriFone earnings to grow 19% this year, to $360 million, or $3.27 a share. The stock deserves a P/E of at least 12, which would put shares at $39.