The Secret Business Model Behind Visa and Mastercard

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1:43You're tuned in to the Investing for Beginners podcast. Led by Andrew Sather and Dave Ahern. Step-by-step premium investing guidance for beginners. Your path to financial freedom starts now. Starts now.

2:05All right, folks. Welcome to the Investing for Beginners podcast. Today, we're going to do something fun. Andrew is going to talk to me a little bit about payments. So we thought we would talk about the secret business model behind Visa and MasterCard. Some of you may be very familiar with those names, but you may not know exactly what it is they do and how they do what they do. And this is a little more in my wheelhouse. So Andrew and I thought we could chat a little bit about that. So Andrew, ask away. Yeah, happy to. Maybe for a beginner who doesn't know why should you even care about Visa and MasterCard, what has their performance been like?

2:44Give us the context on how these companies as stocks and businesses have performed. Give us a little history lesson in a short snapshot. Yeah, sure. So Visa and MasterCard, they're kind of a duopoly. They do similar things. I guess you could say they have two different focuses, if you want to just generalize, would be that Visa is more American-centric, where MasterCard is more international-centric. Visa also spends a little more time working on debit cards than MasterCard does, but MasterCard also has a very big place in the whole debit card arena as well. Both of the companies have done fairly well.

3:26MasterCard, frankly, has done a little bit better over the last 10 years than Visa has. They've been fairly good performers. They are steady, steady growers. And every earnings call is a little bit like being a weather person in Arizona. Today, it's going to be sunny and hot. Tomorrow, it's going to be sunny and hot. And the next week, it's going to be sunny and hot. Visa is going to grow revenues at 11 % or 12 % this quarter, next quarter, the following quarter, and just keeps kind of chugging along. And MasterCard has a very similar performance as well. So that's kind of like a basic overview of the company's history-wise.

4:00Visa actually was born out of what is now known as Bank of America. It was started in 1958 as a part of an airdrop. That's kind of a famous thing that happened in Fresno. Basically what Bank of AmeriCard, which is what it was called back then, they, in essence, sent out, I don't remember the exact amount now, But I want to say 100 ,000, 200 ,000 free credit cards to all the residents of Fresno, California and said, hey, have fun. And so people started using them. It was a lot of chaos. They lost a lot of money, but it proved the concept that it could work, that basically credit using a credit card was a way that people could start making payments and merchants could start accepting payments.

4:46and that's kind of how Visa kind of has evolved from there. It was actually spun out of Bank of America in 1990-something and became a public company and MasterCard kind of followed suit from a different business. And they have both become standalone powerhouses and are probably two of the widest moat businesses in the world. If you think of network effects, which we'll touch on here in a little bit, But network effects is a classic example of what Visa and MasterCard exhibit in the marketplace. So that's kind of, I guess, a rough overview of the businesses and without giving too much detail. Love it.

5:29Yeah. Thanks for keeping that digestible for us. You're welcome. So if you're a beginner, a moat is important because in the stock market and in business, competition is just crazy. And just because you have a good business today doesn't mean you'll have a good one tomorrow. So there's just countless instances in history of businesses that used to grow a lot and no longer do because a lot of times you can look back and they did not have a moat that did not have this structural advantage that created this longevity. And that's what we want in these stocks that we buy for the long term is longevity.

6:06We will get into the nitty gritty of the business model because I think that's important too. but like a broad overview of why the moat is so strong how come you and i couldn't just start our own airdrop and uh create you know the dave andrew card like tomorrow yeah right well we technically we could but to get people to use it would be a bit of a bit of a challenge the the easiest way to explain it is it's super popular visa and mastercard are super popular with customers and with merchants because the merchants all accept Visa and MasterCard cards. And we as users want to go to places that we can use our money to spend.

6:53Who has ever been to a place with IO? You go to someplace out in the middle of nowhere, for example, and they only accept a Discover card and you don't have a Discover card and you have no cash, then you You can't buy gas at that gas station. And so that makes it really, really hard. And what makes Visa and MasterCard so powerful is not only do you and I have Visa and MasterCard in our wallets, but the places that we go to spend them also accept those. So it's a two-sided network. And the more people are on the network, the stronger the network becomes. And the more people that are on the network, the more merchants are going to want to accept those cards.

7:35And it just becomes this kind of self-reinforcing flywheel of the more people on the network, the more merchants accept it, and kind of the round and round it goes. And that's why having these cards in your wallet is so important. And it's really, really, really, really hard to replicate. And American Express is another card that's very popular out there, but they have what's called a closed-loop network. In other words, you can only use American Express cards where American Express cards are accepted. And if they don't accept a Visa card, you can't use the Visa card at that merchant. And you can't transact as a Visa card on American Express network.

8:17And so it's its own separate closed loop network. And it's very powerful and the cards are very, very popular. But that is kind of a separate business. Now, along the way, there have been companies that have tried to do this. Discover, which I mentioned. Diner's Card, which was one of the first ones. Square slash Block slash XYZ has been attempting to do this all along, but they actually use Visa as their scheme as well. And others along the way have tried and failed. And so this is what makes Visa and MasterCard such a powerful network. As much as people want to unseat it, it's really, really hard to do.

8:55yeah would be hard to i don't know how many merchants that are in that network but hundreds of thousands i convince maybe like even a hundred merchants to start accepting my card and then yeah to be able to match a mastercard or a visa pretty hard uh for me one of my light bulb moments for kind of understanding visa's business model was the whole rail like thinking of it as rails can you explain the rails and also how visa makes money what exactly is going on when i swipe a visa card yeah that's a that's a great question so how the rails work is try to think of it as kind of a four-party model i think is the easiest way to think about it so you have the card holder which is us you have an issuer who gives you the card which is most cases is your bank so if you bank with JP Morgan or Bank of America, or in my case, Ally.

9:55When I go to Ally and get a card from Ally Bank, a debit card, for example, they give me a card that I can use to make payments. We also have the merchant. So that's the person you're going to buy from. So if you go to a grocery store and want to buy some food, that is the merchant. And then you have the acquirer processor, and those are the people that actually process the payment. When it can get confusing, and this is where people will sometimes get confused is acquire a processor can also be the issuer of your bank. So JP Morgan has JP Morgan Chase. They have a processor as part of the bank.

10:32So not only will they give you the card or the credit card, they also will make the processing payment. But the easiest way to think about it is Visa and MasterCard is the network that allows all of this to happen. So what happens is you as the cardholder go to make a purchase. You make the purchase, The money goes over the rail from the merchant through Visa and MasterCard as the air quote toll road that authorizes the payment, make sure that the credentials are accurate. And then it goes to the bank. The bank says, okay, yes, Andrew has the money to buy this Coke Zero. And then the money gets routed back to the merchant and they accept the money into their account.

11:17And Visa enables all of that to happen. Now, the amazing thing about all this is two things. Number one is Visa is, this is where a lot of people get confused about Visa or MasterCard. So I'll just kind of put this out there right now. They are not a card. They are only the processing network that allows all this to happen. When you have a Visa or MasterCard, they don't transact any of the money. They just allow the money to move over the rails or the electronic system from point A to point B and back. And so what happens is when you process your card, all that happens in microns of a second. And we all get irritated when it takes more than two seconds for this to happen.

11:59But it happens pretty much instantaneously. And it all happens behind the scenes. And that is what Visa and MasterCard do. Now, where Visa and MasterCard make their money is they make pennies on each transaction. So the more dollars that transact over the network, they make a very, very small amount of that. So, for example, if you transact$100, Visa and MasterCard will take maybe two to three cents of that that they will keep. The vast majority of money actually goes to the merchant bank because they're the ones actually accepting the vast majority of the risk for this transaction. Visa and MasterCard have little to no risk involved in this because they're not actually holding the money the bank is or the merchant is.

12:48And so those are the people and the merchant acquirer also gets a small cut of this. But out of$100 transaction, maybe$2.5 to$3 may come out off the top of that, that the merchant gets the$97 and the rest of it gets split up between the other parts of the players of the network. But Visa and MasterCard only get a very, very small portion of that. But because they're transacting trillions of transactions a year, it adds up to$30,$35 billion in revenue in a year. So it adds up quick. Yeah, amazing how big Visa and MasterCard are as businesses. Yeah, massive. So just to recap then, I'm going to use my favorite, the ice cream shop.

13:33Ice cream shop with a Bank of America account. Dave comes in with his Ally Bank account or Ally Bank your Visa card from your Ally Bank account can you walk through that example one more time we have the ice cream owner with Bank of America account and then you come in with your Ally Visa card yeah so I walk in with my Ally Visa card and I want to buy an ice cream cone from the ice cream shop and let's say it's$5 it's premium ice cream So you pay$5 for the ice cream. The merchant is charging us, Dave,$5. The$5 is going to come out of our bank account at some point in the network. Along the way, it's going to go through what's called a merchant acquirer or a processor.

14:22And if that is the card bank, that's Ally Bank, who could be processing the payment, then they're going to take, let's say, maybe just for ease, a dollar. They will take out of the transaction. Then the money will go to Visa and MasterCard who are going to authorize the payment. They're going to route it. They're going to clear it. And they're going to make sure that everything is copacetic on a security level, so a fraud level. Then it goes to Ally Bank. And then Ally Bank will say, yes, Andrew has$5 to buy this premium ice cream. Then the money goes back to Visa and MasterCard. and then it gets routed back to the merchant.

15:07As it's getting routed back to the merchant, then Visa and MasterCard will take their pennies, let's say five cents off of the transaction. So now when we pay for the ice cream, Andrew, as the purchaser of the ice cream, is paying$5. The ice cream shop is going to receive$5 less a dollar less five cents. So in their bank statement, They will see a$3.95 charge that they will receive as payment for the$5 of ice cream. Now, that's a lot bigger markup than really happens, but I was just trying to use that as ease of convenience for explaining how all that works. So each part of the process along the way will take a little bit of a chip of it.

15:54And that's how these people will all make their money along the way. There's got to be different revenue strings for Visa, right? not just this one that we're talking about. Yes, for sure. Yeah, for sure. So Visa basically breaks down, Visa and MasterCard have similar breakdowns, but I'm going to focus on Visa. So Visa has four segments that they classify for the revenues. They have service revenues, they have data processing, they have international transactions or cross-border, and then they have what they call value-added services. So service revenues is the money that they make on exactly how this whole transaction we just talked about.

16:34So the ice cream shop example that we used, the five cents that Visa would get for that transaction, that would fall under the service revenues. So this is basis points on purchase volume. So they get very small amount of money for all the money that's transacted on the Visa network. Not just the individual, but it's like a batch. So$100 million gets transacted yesterday. And so Visa would make a small proportion of that. So that's one surface level of their revenue. The next level is data processing. So this is where Visa will actually transact the payment. So they will run it through their transaction processor and they will earn per transaction fees on the authorization, clearing, and the settling of the payment.

17:24So one thing I forgot to mention, when we go through the ice cream example, the$5 that we are paying for that ice cream, the$3.95 that the ice cream shop receives, in a lot of cases, they won't actually receive it. We're on Thursday now. They wouldn't receive it until Friday or Saturday at the earliest. So there's usually a lag time between the time that the transaction is processed and the money actually comes out of the merchant bank or the acquirer bank and goes to the merchant. And so depending on the scheme and who's processing and how much transaction they have, it could be a day or two or it could be the next day.

18:04Some processors will charge you a little bit more to get them faster. But all that to say, this is also a part of Visa's revenue model is they get a percentage on the purchase volume. They also get a percentage on transaction fees. So all the money that goes into transacting. The third level is what's called the international transactions or cross-border. So this is the highest margin one. And this is the one that is tied to travel. It's also tied to e-commerce. So travel is easy to think about. If Andrew and I take a trip to Italy, for example, who wouldn't want to go to Italy? If we go to Italy and we buy a bottle of wine while we're in Italy using our Ally Visa card, then we will be charged a higher fee.

18:54We won't. The bank will be charged or the processor will be charged. Sorry, the merchant will have a higher fee that they will see because it's a cross-border transaction. Visa will get a higher percentage of that transaction. So instead of maybe pennies on the dollar, maybe they get 10 cents on the dollar. So they get a higher margin for that transaction and they make more money on these transactions. The same rule applies for e-commerce. So if I was to go online and buy a Real Madrid jersey for my daughter from Spain, there would be an e-commerce or a cross-border fee that would be charged. And that's a higher fee.

19:33And that, again, gives Visa a higher percentage or a higher margin. And then the last one is what's called value-added services. And this includes things like tokenization, fraud and identity, dispute, consulting, risk, open banking, remittances. It's a hodgepodge of a whole bunch of different stuff that Visa adds as a way to encourage more usage of their rails. And so they offer different add-ons that people can pay for to get a higher level of fraud or identity, for example, or get higher levels of risk to make sure their transactions go through. What if you could get a 25 % match on every dividend you earn?

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22:00Just use code CashApp10 when you sign up. And don't forget this part. Send at least$5 to a friend in the first two weeks. Terms apply. Cash App is a financial services platform, not a bank. Banking services provided by Cash App's bank partners. Bitcoin services provided by Block Inc. brand. For additional information, see the Bitcoin disclosures at cash.app.legal.podcast. What's the best way to get started in the market? Download my ebook for free at stockmarketpdf.com. Yeah. Okay. That's cool. Is there a segment of those? You mentioned before. Is there one that makes you most excited? One that has been growing better?

22:38So the cross-border is the one that probably gets the most notice because it's the highest margin. And a lot of people get really excited about that idea. Visa and MasterCard have both talked a lot about that through the years, about really trying to encourage that. But I think the thing that I get the most excited about is actually the value-added services. And this is the segment that's actually growing the fastest for Visa. If I look at Fiscal's financials and you look at those four segments, over the last 10 years, the value-added services has grown around 14.2 % for the company, whereas services and data processing have grown at 10.3 % and 13.1%.

23:20And cross-border has grown at 12.6%. So the value-added services is the one that's actually growing the fastest, and it's actually the one that Visa has been talking about the most. and a lot of it is because they see the writing on the law. They see that there is still a lot of room to grow for the other two parts of the business, but the value-added services and the cross-border probably have the biggest opportunities for the company. And I'll touch on the international for just a second. The cross-border, one of the reasons why the company thinks cross-border still has a really long ways to grow is the usage of cash globally is still really high.

24:00I was kind of doing some research looking into this and places like Latin America, other parts of the world, you're seeing anywhere from 50 % or more higher usage of cash still in this day and age. And MasterCard released something, I think a day or two ago, talking about the usage globally of cash is still over 50 % globally. And so that tells me that there's still a really long runway to go before we not eliminate cash. I don't think we'll ever eliminate it, but certainly reduce the importance of it. Places like Asia Pacific, for example, they actually have a much lower usage of cash than other parts of the world.

24:40And that makes them maybe less attractive to a Visa and MasterCard in this particular realm, just because there's not as much growth opportunity there. But when you think about the value-added services, that's really where the rubber meets the road. And so one of the aspects of the value-added services is something like remittances. Brett and I talked about on our show a while ago, we talked about Wise and Remitly. And those are two companies that are very, very prominent in the whole remittance area. Well, Visa Direct is another player in that field. And if you're not familiar with Visa Direct, you don't feel bad.

25:19It's not a global name yet. But it's very similar to like here in the United States, something like Zelle. It's very similar to Zelle where it's a push service where you have to go into your account and send money to people as opposed to people requesting money from you. And so that's what's happening with a lot of these remittance companies. Visa Direct is working to try to compete with those people. And to me, that is one of the things that I think is a really huge opportunity, not only for Visa and other remittance companies, but there's a really big push right now to make cross-border money or sending money to each other a lot easier than it has been.

26:03And if you've ever used Zelle, you understand how clunky it can be. And so I think there's a huge opportunity for that. So Valley Added Services, to me, is probably the thing I'm most excited about when it comes to Visa. Not only for, it goes to one of the global things that Visa really wants to push. And I'll get off my soapbox here in just a second. They really want to be a player in all kinds of moving money, not just transacting money from merchant to consumer and back. So those are called C2B, so a customer to business. they also want to be B2B and they also want to be account to account.

26:44So they're working hard to try to generate more payment flows is I guess the best way of putting it and trying to branch out so they have other opportunities for revenue. Yeah, B2B just seems, I don't know. I mean, I have a limited perspective on it, but just from what I've seen in my limited perspective, it's not impressive. C2B really has, it's a very efficient thing and B2B is a little different. Yeah. Yeah, for sure. Yeah, for sure. You know, the thing that Visa is trying to do and other businesses are trying to do is this kind of idea of helping businesses, helping them with cash flow. So one of the biggest struggles, I'll use a restaurant, for example, because I'm familiar with that and it's easy to imagine.