Deep Dive- Digital Wallets
What is a digital wallet?
With all of the fintech terminology around, before we dive in I thought it is worth revisiting the basics. A “digital wallet” is a device or service that allows electronic transactions from stored payment information, removing the need to present a physical card or cash. Such transactions could be purchasing goods and services through money deposited in the wallet or from linking a bank account from which money is pulled. The two most popular digital wallets are Venmo and Cash App.
Mobile wallets are a subset of digital wallets that typically live on your smartphone and allow you pay in stores through in-built hardware in your device. Examples include Google Pay, Apple Pay and Samsung Pay.
Due to the similarities of products, I will be narrowing the focus of the analysis to Venmo, Cash App, Apple Pay and Google Pay.
What can digital wallets and mobile wallets do?
Digital wallets all have common features with the two most popular, Venmo and Cash App, notably pushing further into traditional retail banking products. The most common feature of digital wallets is the ability to pay other people i.e. peer-to-peer payments (P2P). This was how Venmo and Cash App started and they have the largest share of the market, with bank supported Zelle also joining the fray recently.
Digital wallets have since evolved from their humble P2P beginnings into more traditional banking products such as debit cards and direct deposits. The increasing functionality of digital wallets changes the competitive landscape as they now compete with digital banks (Chime, Current and Simple to name a few) as well as the large traditional financial institutions.
Mobile wallets like Google Pay and Apple Pay allow users to store their credit card information and pay in-store using contactless technology in addition to being able to pay online through specific Google Pay and Apple Pay checkout buttons on websites. They currently do not offer direct deposits or their own debit cards but function more as a way to use existing cards that a user has.
Why have a bank account in the first place?
Bank accounts provide a way to securely store money and to make payments. These are the core features of a bank account. Storing money at a bank provides security (e.g. from theft) compared to cash and is also protected by FDIC up to $250,000 per depositor. You can often earn interest on your deposits as well which is another benefit. Once money is in your bank account, the bank provides a number of ways to spend the funds, commonly a debit card or a check book.
Until recently these banking functions were only available from a traditional regulated financial institution, e.g. Bank of America, Wells Fargo, JPMorgan Chase etc, but recently digital banks and digital wallets have emerged which provide the same functionality and often without the rent seeking fees charged by these established players.
Economics of banking
Before diving deeper into how digital wallets and digital banks are challenging the incumbents, its worthwhile revisiting how traditional banks make money. Traditional banks make money from two sources; net interest margin and fees.
To entice you to deposit money with a bank, they pay you interest, a return on the money you deposit with them and which they lend out at a higher interest rate, earning themselves a “net interest margin” (NIM). To a bank the interest they pay is the “cost” of this type of capital, with deposits typically being a high cost of capital compared to other sources available. As a theoretical example, if you deposit $1,000 into a bank account and the bank pays you 1% interest, they may aggregate your $1,000 deposit with other customers deposits (which they also pay 1% interest on) and lend this larger sum to a business at an interest rate of 5%. They bank therefore earns a net interest margin of 4%. NIM traditionally represents a large proportion of a banks profits and using JPMorgan as an example, its around 50% of their revenues (In 2019, NIM revenue was $57.2bn out of total revenue of $115.6bn).
The other source of revenue comes from a variety of fees including checking account fees, overdraft fees and card fees. Card fees are the amount the bank who issues your card earns every time you debit or credit card is swiped. It is typically referred to as interchange fees and is usually around 1.5%-2% of the transaction amount.
On the other side, banks have costs. A primary cost for a bank to operate is its cost of capital. As previously mentioned, one type of capital is customer deposits. As well as collecting these deposits, banks access other types of capital to lend at a higher interest rate. JPMorgan has a cost of capital of ~7% and this is one of the lowest in the industry.
The other main cost for a bank is its operating costs, made up of employees, branch costs, IT, legal fees etc. Using JPMorgan as an example, in 2019 its operating expenses were $76.5bn. Bank branches typically cost $2m-$4m to set up and between $200,000 — $400,000 to operate per year according to research. For JPMorgan its 5,000 branches have cost it $10bn-$20bn in set up costs and annual costs of $1bn-$4bn.
Although efforts to cut branches are ocurring, they are still used for ATMs, check processing, SME cash depositing, in-person loan negotiations and advice. Customers visit branches several times a quarter, with younger clients less often and more likely to engage with the bank digitally. Branches are often a place where customers are cross-sold other banking products and so can be profitable for the bank.
Checking account profitability
Data from StrategyCorps from 2013 paints a sorry picture for checking account profitability. Whilst this data is quite outdated, I believe that this data still holds true. According to the data the average checking account balance is $5,600 and produces total revneue of $413 from the below streams;
- Net interest income $252 (4.5% yield)
- Service fee $8.33
- Other Fees $7.12
- Overdraft dees $92.75
- Interchange revenue $53.43
They found the average cost to maintain a checking account to be $250 to $400 per year so it would appear they are profitable. Interestingly they found 40% of accounts to be unprofitable as these accounts are characterised by low card swipes and no additional products beyond a checking account and an average balance of $812. These unprofitable accounts produce revenue of only $92. A staggering loss on the $250-$400 cost to maintain not to mention the cost of acquisition.
This contrasts to profitable customers whose earn the bank average annual revenue of $1,650 and super-profitables who contribute $6,200 in revenue. These 10% of checking account customers contribute 54% of revenues.
It is clear that banks struggle to make profits from the average checking account which is why they rely on a host of checking account fees and cross-selling to make money.
If the large incumbent banks cannot make money from checking accounts, can anyone?
Digital Wallet Strategy
Both Venmo and Cash App are pursuing a similar although not identical path, which differs from that pursued by mobile wallets of Apple Pay and Google Pay.
As previously mentioned, Venmo and Cash App have moved beyond P2P offerings into more traditional financial services in order to increase revenues and capture more consumer spend. They now come with account and routing numbers, debit cards with loyalty rewards and direct deposit capabilities for receiving paychecks. Credit cards are also in the pipeline, with Venmo partnering with Synchrony Bank. All these features are designed to bring them each to top of wallet and replace traditional checking accounts.
Cash App offers services above and beyond that of Venmo, such as stock investing, bitcoin trading and lending. These additional services further tie users to the ecosystem creating sticky users.
Who uses digital wallets?
According to Cornerstone Advisors, Bank of America has 52m users who view the account as their primary account. Chime, the most popular digital bank, has around 8m customers as of February 2020. As a comparison, Venmo had 52m users as at the end of 2019 and as of February 2020 Cash App had “more than 30m”. The top digital wallets have more users than the top digital banks.
Given the increasing functionality of digital wallets, soon there will be little they cannot do compared to a checking account, which is why I see digital wallets as the largest competitor to both challenger banks and incumbent banks.
Quick Square and PayPal history
You cannot talk about Venmo and Cash App without acknowledging the strategic importance of each to their respective parent company. Both PayPal and Square provide solutions for merchants to accept card payments. Their businesses are built on driving total processing volume (TPV) of which they each take a cut. PayPal earns ~83% of its revenues from transaction fees. Square’s earnings are more diverse as it earns 65% from transactions fees, 22% from subscriptions and services, 11% from Bitcoin and the rest from hardware (per FY 2019).
While these companies seem similar, their origins are opposite. PayPal began back in the late 1990s allowing consumers and businesses to make low cost, effortless digital payments on the internet. Square was founded in 2009 as a POS solution for small physical merchants who wanted to take card payments. This is an important difference as it impacts the role Venmo and Cash App play and their likely success. Square traditionally focuses on smaller merchants and these businesses have been severely impacted by Covid. While the short and medium term outlook for these business remains ambiguous, the superior service Square offers combined with its business-in-a-box strategy puts it ahead of PayPal in terms of its solutions for merchants.
Both PayPal and Square have subsequently decided to expand into the area of the other. PayPal is pushing into physical retail POS solutions and recently announced it is integrating PayPal and Venmo QR codes at over 8,000 CVS stores nationwide. On the other hand Square is increasingly offering services to online merchants and helping its physical retailers set up businesses online, a business which will have been booming since lockdown began. Square offers additional services to keep its merchants on the platform which we will get into later.
The strategic importance of both Venmo and Cash App to their respective parent company goes without saying. By positioning themselves not only as solutions for merchants but also as a banking solution for consumers, they ensure they take an increasing amount of the payment pie from both sides of the market.
Mobile Wallet Strategy
Mobile wallets however started life as pure payment solutions, enabling users to store payment card information on mobile phones to be used in stores that accept contactless payments. Similar to digital wallets, you can also use Google Pay and Apple Pay to pay individuals through P2P transactions and also to pay online with some stores.
That is where the similarities end. Unlike Google, Apple has negotiated a 0.15% cut of each transaction as it looks to be staying in the payment space, recently adding the Apple Card to its product mix. It has also recently purchased Mobeewave to allow iOS devices to become POS solutions. This seems to be a big data play and will position Apple at the center of payments giving them control over the user experience and the ability to build an app store ecosystem around Mobeewave, their future payment platform. Apple already has a bunch of personal data that can be used to authenticate a user as well as hundreds of millions of credit cards on file from Apple IDs, allowing for a seamless experience using Apple Pay to checkout online but also for a POS solution which would could communicate to a users iOS device to verify identity. However, with recent issues in the App Store with Epic Games, regualtors will be getting nervous about their strict control of their devices and payment technology and could look open this up. Particularly in consumer friendly Europe.
Google on the other hand is moving deeper into banking products and will be offering bank accounts through Google Pay with its banking partners. Google is looking to provide cloud infrastructure to power these solutions of behalf of the regualted partner banks. Google will compete with digital wallets and challenger banks for checking account customers and has a significant advantage with distribution and a data advantage. It remains to be seen how deep into their lives users in the US will allow Google and a bank account could be one step too far. Google will have to offer something worthwhile to encourage a user to switch their checking account, an incredibly time consuming and cumbersome process.
The paths of each are different and this reflects what they want out of their forrays into financial services. Apple predominatly wants to expand its non-hardware revenue and to own the user experience whilst Google wants payments/transaction data which they can continue to leverage with advertising and marketing.
How are digital wallets and digital banks competing?
Given the previously discussed economics of the banking industry, digital wallets and digital banks can compete in four areas, higher NIM, higher fee revenue, lower operating costs or lower cost of capital.
Most digital wallets and digital banks have yet to start lending money at scale and so are not yet competing on NIM, although Cash App has recently started to trial small $200 loans to users and could become a future revenue source. They also do not have access to the cheap capital of incumbent banks due to their lack of size, reputation and balance sheet. This leaves higher fee revenue and lower operating costs as the main areas to compete against incumbents.
The main focus of competition has been lower operating costs due to their focus on digital distribution, meaning they save on branch costs and other operating expenses. According to ARK research incumbent banks spend up to $1,500 to acquire new customers compared to $20 for digital wallets. This cost advantage comes from cheaper digital and social media acquistion channels compared to previously mentioned expensive physical branches. This cost advantage means digital wallets can serve more customers profitably and is the primary way they are choosing to compete. This has allowed both Chime and Cash App specifically to target the under/unbanked population because they can profitably serve their needs.
They also can earn higher interchange fees because digital wallets are currently exempt from the Durbin Amendment. The Durbin amendment, part of the Dodd-Frank Law, lowers the interchange fee that is charged to merchants and has cost big banks $14bn in revenue. Fintechs are generally exempt from the Durbin amendment if they have less than $10bn in assets and so they can charge higher interchange fees and generate more revenue. The Durbin Amendment has been a key piece of legislation that has allowed digital wallets and digital banks to compete so far, although I believe this interchange focused business model isn’t designed for lasting success.
Digital wallets and digital banks charge none of the typical checking account fees charged by incumbents so do not compete there and is actually a point of difference that appeals to a lot of customers. The Center for Responsible Lending (CRL) found that banks collected over $11.68bn in overdraft-related fees in 2019 that it said were “abusive”.
The fact that both Venmo and Cash App are owned by larger companies, PayPal and Square respectively, demonstrates the difficulty in monetisation and the viability of their businesses being standalone. It also points to a potential lack of sustainability of independent digital banks. Venmo and Cash App benefit from the easy integration into the merchant solutions of their parent companies to become default payment methods. Both Square and PayPal are increasingly capturing data on both sides of the paments network which they can successfully leverage to give them the upper hand in their battle with both digital and incumbent banks.
It is this reason that I believe digital wallets will see more success than digital banks. Chime, Simple and Current are independent and rely only on the revenue they generate themselves, mostly through interchange fees, but they lack the financial and data resources to keep growing.
Venmo vs Cash App — Who will succeed?
As the product offering of digital wallets, digital banks and traditional banks become commoditised, the winner will be whomever can provide the best user experiece. Customers care less about who the bank is in the background but want their customer journeys to be easy and to be able to completed their “jobs to be done”.
I believe that digital wallets, specifically Cash App, will become the default banking app for the younger generation.
The viral nature and network effects of digital wallets with their P2P roots provides a low cost, sticky platform to attract customers, which has been seen by the rapid growth in users of both Venmo and Cash App in recent years. Both have larger user bases than digital banks and almost all incumbent banks which is a great achievement in a short space of time. The success of Cash App’s Twitter marketing campaigns and partnerships has lowered its CAC to $20. Combined with the absence of expensive branch networks means the payback period for Cash App is a little over 4 months. In contrast, according to ARK, a retail bank pays $925 to acquire a checking account customer and will become profitable after 8 years. Additionally, ARK research shows that traditional banks cannot profitable serve customers with balances below $6,600, unlike digital wallets which need initial balances of $145. This is part of Cash App’s strategy to target the under/unbanked.
Why Cash App not Venmo?
The growth of Cash App is superior to Venmo and it looks like from the user chart above that its number of users will pass the number of users than Venmo has relatively soon. Venmo users are typically a little older and more affluent whereas Square initially targeted the under/unbanked who had been poorly served by traditional banks but are expanding to target similar users as Venmo.
Cash App has a bunch of additional services that differentiate it from Venmo, such as investing and bitcoin trading which it can cross sell to the users that join the platform due to the network effects of P2P. Bitcoin counted for just almost half of Q2 2020 revenue, up from 11% for FY 2019 and so represents a significant element of revenue for Cash App given the assocaited fees and spread it earns. Cash App is also trialing lending users $200 which could lead to a high margin lending business if rolled out more extensively, especially with the demographic of its users who use credit cards and other expensive forms of credit. Like Cash App, Venmo offers direct deposits, but hasn’t announced number of customers taking up the service whilst Cash App is estimated by Credit Suisse to have 1.2m customers signed up for direct deposits, a huge increase since Covid and compares very favourably to Chime which has an estimated 2m.
Cash App also benefits from its ownership and the great job it is doing for its merchants to a larger degree than Venmo. Square is making its merchants even more sticky by providing payroll and lending services through Square Capital based on their card sales data. Square took part in the governments PPP program and in Q2 it facilitated $873m in PPP loans to 80,000 small businesses. This not only generated a 5% fee, $44m in revenue, but also increased the stickiness of current merchants and possibly brought more onto the platform. 60% of its PPP loans had never before borrowed from Square.
Cash App has faster growth on its side as well as a richer product set to entice and keep customers as well as ownership with a better value proposition for merchants.
Closed loop nirvana
The advantage of Cash App compared to Venmo is also that it can better leverage the relationship its parent Square has built with physical merchants to create a closed-loop network for commerce. Data from US Department of Commerce put e-commerce spending at 16% of total retail sales in 2019. This will have dramatically increased due to Covid, with estimates that online spending in May was +77% yoy. This would still put ecommerce at 28% of total retail spending. The foothold that Square has with the other 72% of physical retailers positions them well to benefit from their shift to digital. PayPal is certainly no loser, but Square definitely has the advantage, especially with its business-in-a-box offering.
Cash App users could spend directly with merchants that use Square’s POS solutions without leaving the Square ecosystem and potentially cutting out the middlemen who all take their cut. With a QR code based payments system or something similar, there would be no need to swipe a card and use the Visa/Mastercard network and thus Square would be creating a network of its own.
This holy grail of a closed loop system could mean that Square reaps rewards from both sides of the market and cut out other middlemen. It could charge merchants for processing transactions without having to share it with payment gateways, payment faciliatators, Visa/Mastercard, acquiring banks or issuing banks. Because it wouldn’t need to share any of its revenues, it could be very price competitive for merchants, lower than the typical ~2–3% charged to merchants currently. It could also entice Cash App users to pay with their balances, utilising QR codes or similar technology, by providing increased cash back or loyalty rewards for this payment method only. Cash App already has Boosts which provides instant discounts when using the Cash App card but could build it out further. Some discounts offered via Boost can be 10% as they leverage their data advantage and direct relationship with both parties to align incentives.
Visa and Mastercard operate open loop systems that allow many other financial institutions to join, which means it is very scalable. Banks acquire the consumers and merchants which is a key point. Visa has no direct relationship with either party and leaves it vulnerable to being disintermediated as it is more difficult to know what your end customers want the further away from them you are. Thus the relationship between the card networks and banks is fragile with their divergent incentives to own different elements of the payment stack.
Ensuring that users continue to spend from Cash App by making it as easy as possible to transact both online and offline is vital to growing the two sided ecosystem that will enable Square to dominate payments and commerce.
What is the prize? $100bn valuation
Before we get into the size of the market and what is at stake, I thought it would make sense to give a brief overview of the current valuations of PayPal/Venmo and Square/Cash App.
FT Partners provides a comparison chart (above) showing the valuation metrics of traditional banks and I have put together recent statistics on digital banks as well as digital wallets for a comparison. The valuation estimate for Cash App is from Bernstein and Venmo’s is my own estimate based on Venmo contributing 17% of TPV for PayPal and the same of its market cap. This is a conservative number given Venmo is experiencing higher growth than the remainder of PayPal.
Paypal is currently valued at $220bn which is 12.4x 2019 revenue and 81x operating income with $712bn in total processing volume (TPV). In an updated Q2 2020 earnings FY 2020 forward guidance was updated with +20% revenue growth, putting its forcast 2020 revenues at ~$21.3bn. Based on these updated numbers the company is trading at 11.5x revenue. Extrapolating their 2019 margin would mean a valuation of 76x operating income currently. TPV is expected to be $890bn for 2020.
As mentioned previously, as of Q2 2020 Venmo accounted for 17% of TPV but was growing at 52%, almost 2x TPV growth in Merchant Services. Venmo was expected to do $300m in revenue in 2019 as per CEO Dan Schulman from Q1 2019 earnings. In Q2 2020 he mentioned Venmo revenues are outperforming with 60% yoy growth during July. Using this estimate, we can expect Venmo revenues of $480m for 2020. If you use Venmo’s share of TPV or revenue, both ~17%, as its share of PayPal market cap, you get a valuation of around $50bn.
Square has a market cap of $61bn and reported FY 2019 revenue of $4.7bn with net income of $375m. This values the company at 13x its 2019 revenue. As of Q2 Square’s core business performed poorly with TPV -15% and associated revenue streams also performing poorly. Despite this the stock soared nearly +200% over the past six months. Annualising Square’s $1.92bn Q2 revenue (they provide no forward guidance) gives forcast 2020 revenue of $7.7bn. This is unlikely given the largest contributor to revenue in Q2 was bitcoin trading and is unlikely to be sustained for the entire year so a modest discount of 25% would still have revenue +23% from 2019 to $5.75bn. With these projections Square is valued at 11x estimated revenue.
One bright spot for Square is Cash App, with its huge growth yoy with revenues +361% to $1.2bn and transaction revenue +216%. The performance of this business segment has undoubtedly carried the company recently and contributed the majority of its recent share price run up. Bernstein Research estimates Cash App alone is worth $40bn, which is over half of the value of Square and it is easy to see why.
In its most recent investor update, with data through 2019, Cash App reported $30 in annualised revenue per user (ARPU), excluding bitcoin revenue and a payback period for its June 2017 cohort of acquired customers of less than 12 months. This payback period turns into a 5.5x profit on acquisiton costs after 2.5years. As a side note, Square generates around $85 to $90 ARPU so Cash App still has legs in terms of user monetisation.
ARK research estimates the number of digital wallets will approach 200m by 2023 and the space could be valued at $700bn, if each digital wallet user is valued at the same $3,400 that traditional bank demand deposit account users are. With Cash App’s latest user count of 30m, it would put a $100bn valuation on this business segment alone and value Square even higher. According to the research, Cash App adds ~10m users every year and so by 2023 it would have 60m users and its value would be over $200bn.
Survey data found that users stick with their bank account for 14 years, which given the $30 ARPU Cash App currently generates would put the LTV of Cash App at $420. However this ARPU metric has doubled in two years and also excludes Bitcoin revenue. By 2023 the ARPU figure could be as high as $120, which would give an LTV of $1,680. Combining this figure with Cash App’s current user base values the company at $50.4bn and using the projected 2023 number of users, values it at $100bn.
The value quoted by ARK of $3,400 comes from cross-selling additional products to users which remains to be seen if a digital bank can do this as effectively as the incumbent banks. Based on the chart above from ARK, a more realistic value for a digital bank customer is around ~$2,700 which would value Square with 60m users at $162bn.
What will be key to track is the number of people that utilise direct deposits as this is an important metric to determine if Cash App is a primary bank account for users.
(Note: that I own about $25 of Square stock at the time of writing)