- scuttleblurb - https://www.scuttleblurb.com -

quick follow-up on Charles Schwab

Original post: some thoughts on Charles Schwab [1], published Mar. 12, 2023:

In The Media Very Rarely Lies [2], Scott Alexander writes:

the media rarely lies explicitly and directly. Reporters rarely say specific things they know to be false. When the media misinforms people, it does so by misinterpreting things, excluding context, or signal-boosting some events while ignoring others, not by participating in some bright-line category called “misinformation”.

I was reminded of this phenomenon over the last few weeks after reading much of the commentary about Charles Schwab. Most of the long-form Schwab write-ups and Schwab-related tweets I read made the same point: marking all of Schwab’s securities to fair value wipes out nearly all of its tangible book value. This is factually true. The authors are not lying. But they are “misinterpreting things” and “excluding context”. As I hope I made clear in my last Schwab write-up, you can’t express a view on solvency without expressing a view on cash sorting. If no depositors cash sort out of the bank, then Schwab’s investment securities, predominantly Treasuries and Agencies, will pull to par as they mature and everything is fine. If all depositors cash sort at once, then Schwab Bank will be forced crystallize all its unrealized losses and find itself in ruin.

If you want to say “scuttleblurb, you’re delusional. I think Schwab will have to tap into the HTM bucket as 80% of deposits flee and (for whatever reason) liquidity backstops are unavailable, which in turn will convert huge unrealized losses into realized losses, impair their capital ratios, and either force them into receivership or into raising boatloads of capital on massively dilutive terms“, that’s great! This is the right framework for thinking about insolvency in this particular case.

Of course, I thought the chance of an SVB-style debacle was very low (say, less than 3%) at the time of my last post and I think the probability is even lower now with the Fed’s the Bank Term Funding Program (BTFP) [3] in place. The BTFP lets Schwab and other federally insured banks to access funds against the par value of Treasury and Agency collateral. The advances will be made available for a term of one-year at a rate of ~5%1 [4].

The day after the BTFP was announced, Schwab released its monthly Activity Highlights [5], which included the following statement:

We have access to significant liquidity, including an estimated $100 billion of cash flow from cash on hand, portfolio-related cash flows, and net new assets we anticipate realizing over the next twelve months. We believe we have upwards of $8 billion in potential retail CD issuances per month, plus over $300 billion of incremental capacity with the Federal Home Loan Bank (FHLB) and other short-term facilities – including the recently announced Bank Term Funding Program (BTFP).

To briefly recap, at year end Schwab’s immediate sources of funds included:

Cash: $40bn

AFS govies maturing in < 1 year: $22bn

Other AFS-securities: $123bn

On top of all that, they can now tap into $176bn of funding by posting HTM securities, all US agency MBS, to the BTFP.

That’s more than $300bn of liquidity against Schwab’s $367bn of total bank deposits, only $73bn of which is uninsured. In an interview with The Wall Street Journal [6] last Thursday, CEO Walt Bettinger affirmed, “There would be a sufficient amount of liquidity right there to cover if 100% of our bank’s deposits ran off,”….“Without having to sell a single security.” So the risk of a catastrophic liquidity strain that tips Schwab Bank into receivership seems very very low. And in the unlikely event that half of total deposits cash sort out of the bank and Schwab is forced to liquidate all its AFS securities, its Tier 1 leverage ratio would actually improve (from 7.1% to 8.1%): the excess capital released as the balance sheet shrinks exceeds the after-tax value of realized losses on the AFS securities being sold.

But even if Schwab can survive a deposit run, it still faces an earnings challenge. The most vigorous proponents of this view are puzzled that anyone would keep brokerage cash in deposits earning ~0% when they could, with just a few clicks, invest that cash in one month T-bills earning ~4%. The pace of rate hikes is like nothing we’ve seen in the last 40 years and with broad public awareness of inflation and rates, the consumer is likely far more sensitized to rate hikes today than they were during the far more measured rate hiking cycle of 2015-2019, which management often points to as a comp for cash sorting dynamics.

Moreover, while 80% of Schwab’s deposits are FDIC-insured and come from 34mn brokerage accounts that represent a wide cross section of the US mass affluent – making them far more diversified and stable than SVB’s, which were concentrated in the accounts of cash burning startups funded by herdlike VCs with Twitter megaphones – they are also qualitatively different from primary checking accounts that consumers use for day-to-day purchases. I suspect that the brokerage account clients that own these deposits and the RIAs who manage half of Schwab’s clients’ assets are more attuned to visible and easily attainable sources of incremental yield than the average depositor at some regional bank.

On the other hand, brokerage clients will typically maintain some minimum amount of transactional cash in their account – either out of inertia or maybe just to yolo into GameStop or whatever at a moment’s notice – so cash sorting should diminish as cash balances decline. At year-end, the average Schwab brokerage client had just under ~$15k of sweep cash in their account (down from ~$18k the year before)2 [7]. That’s about 7% of their Schwab assets. Maybe clients now feel compelled to shove a big part of that residual 7% cash allocation into T-bills to juice returns. But then again maybe the average Schwab brokerage client is not as conscientious about optimizing yield as you are.

Several readers replied to my last post with something along the lines of “even if solvency risk is off the table, with rates where they are, cash sorting will be a big headwind to earnings”, as if I disagreed. I don’t. The thesis here turns on the degree and persistence of cash sorting from current levels.

(Update – 3/26: in the original post, I used changes in avg. interest-earning assets as a rough proxy for changes in deposits. This was too noisy to be useful, especially over very short time periods like 2 months, so I deleted it. Doesn’t change the analysis. I was basically trying to get at a reasonable base assumption for changes in bank deposits in 2023 in the lead up to my bear case scenario.)

Again, this doesn’t mean that cash sorting is over (no one’s saying that, not even management), just that the degree of cash sorting diminishes as rate hikes moderate. In its monthly activity statement published March 13, following a week where everyone was freaking out over SVB contagion risk, management backed up this point with some data:

Client bank sweep cash outflows in February were about $5 billion lower than January and March month-to-date daily average outflows are tracking consistent with February. Importantly, these outflows reflect a continuation of client decisions to reallocate a portion of their cash into higher yielding cash alternatives within Schwab. Based on our ongoing analysis of these trends, we still believe client cash realignment decisions will largely abate during 2023.

Over the following days, insiders bought a ton of shares:

Source: BAMSec

I can’t remember the last time I saw so much widespread insider buying in such a short window of time. Given that banking is ultimately a confidence game, it’s possible these purchases were coordinated to signal conviction even as the underlying business deteriorated far more than management anticipated, but that’s a pretty cynical read.

But one need not be cynical to be bearish. In this anxious time, hawkish Fed behavior may carry disproportionate weight given all the attention on bank balance sheets. So let’s go a little nuts with the cash sorting and say that with the Fed rate hiking by 50 bps this year3 [8] deposits fall by 41% from year-end levels, or $150bn. That’s close to twice the net outflows that Schwab experienced last year, when rates moved from 0% to 4%+. Let’s further grant that all deposit outflows are moved into T-bills and nothing is diverted to investment vehicles where Schwab earns management fees.

In this bear case, I also assume the following:

1) the bank balance sheet never grows again

2) cash sorting outflows are funded with $40bn cash, $22bn of short-term govies, $70bn of AFS liquidations, and $18bn of BTFP/FHLB funding

3) client assets continue to grow by ~5%/year. If you’ve followed Schwab for a while you know that this company metronomically grows client assets by 5%-7%. The banking drama unfolding over the last 2 weeks hasn’t changed that. In their March 13 monthly activity statement [9], Schwab reported:

February core net new assets totaled $41.7 billion, our 2nd largest February ever (trailing only February 2021, the height of the meme stock craze). Our growth and momentum have continued into March, with daily net new assets averaging nearly $2B per trading day month-to-date.

They provided yet another update [10] 4 days later:

The Charles Schwab Corporation today announced it has seen strong inflows from clients over the last week. Over the past five trading days (3/10/23-3/16/23), clients have continued to bring assets to Schwab, with approximately $16.5 billion in core net new assets for the week, demonstrating the trust clients place in Schwab.

So let’s say Schwab’s asset management fees, trading and “other” revenue grow in line with client assets, by 5%/year.

4) As a standalone company, TD Ameritrade earned “Bank Deposit Account” fees on the client brokerage cash it swept into TD Bank. Post-acquisition, these BDA balances, which totaled $127bn at year-end, will migrate to Schwab’s balance sheet at a pace of ~$10bn a year until they are reduced to $50bn. On the transferred deposits, the 1% fees it loses on BDA balances is more than made up for by the incremental profits in gains reinvesting those proceeds at higher yields. This was the biggest source of projected revenue synergies at the time of TDA’s acquisition. In this scenario, I assume BDA balances decline along with Schwab’s deposit balances, by 41% this year. And going forward I assume transferred BDA balances, instead of moving to Schwab Bank, are parked in T-Bills.

5) Last year, with the Fed raising from 0% to 4%, Schwab’s deposit rate moved from ~0% to 0.46%. I assume that this year the rate Schwab pays depositors doubles, from 0.46% to 1%.

There are several important earnings offsets to this sorry state of affairs.

First, in response to a 40% decline in net interest income that takes total revenue down 21%, I assume Schwab cuts 5% of its expense base and grows that base by 2/3 the pace of revenue growth thereafter.

Second, I estimate that Schwab still has ~$600mn of cost synergies and (conservatively) ~$600mn of non-BDA revenue synergies remaining from the TDA acquisition.

Third, even after crystallizing losses on $70bn of AFS securities to meet outflows, Schwab is more overcapitalized than it was before, with a Tier 1 Leverage ratio of 8.2%. They could liquidate and realize losses on the remaining $53bn of AFS securities, reinvest the proceeds at significantly higher yields, and still be above their year-end 7.1% ratio (and well above the 5% minimum ratio set by regulators).

Fourth, with the bank balance sheet no longer growing, Schwab doesn’t need to post incremental bank capital.

When I account for these moving parts, it looks like Schwab is doing about $5.7bn of after-tax earnings in year 5 (down considerably from its current ~$8bn run-rate). In the terminal year Schwab is growing revenue by ~2% and earnings by ~3% (more like 4% and ~5%-6%, respectively, if you look past the steady BDA fee decline). At 12x + accumulated earnings + excess bank capital4 [11], Schwab is valued at ~$52/share in year 5, or ~$35 in present value terms, assuming an 8% discount rate (-34% from today’s price of $53). At $53 the stock appears to be pricing in ~$80bn of deposit outflows, followed perpetual bank stagnation5 [12].

Anyway, at a high level what my bear case is saying is that Schwab emerges from this cash sorting cycle a shadow of its former self. Interest earning assets decline by 26% this year and never recover while the spread between what Schwab earns from its investments and pays to its funding sources compresses by 25%, from 2.24% in 4q22 to 1.69%.

I think the chances of this scenario playing out are pretty remote, like less than 10%. Cash sorting will eventually settle down somewhere and the enormous ~$400bn+ of net new assets that flow into Schwab every year like clockwork supplies a natural tailwind to deposit growth. Even if just 5% of net new client assets are swept into bank deposits (compared to 7% of total client assets today), that’s still an additional ~$20bn being put to work every year at juicy incremental spreads. Plus, nearly all of deposits that leave Schwab Bank still remains within the broader Schwab complex and surely some portion of that will find its way to fee-generating investment vehicles.

But my toy bear case scenario, despite its inevitable flaws, is still useful for getting a rough sense of how bad things could get, even if Schwab turns out to be fine from a liquidity/solvency standpoint. When a company might be a good investment but there is a thick fog around earnings power, establishing some semblance of a floor can give you a sense of where it might make sense to add. I have a few points of dry powder with Schwab’s name on it in case the stock trades down to like $40s (though I often change my mind and if the stock trades down to $40 for fundamental reasons that undermine my confidence, all bets are off). But I have no more Schwab appetite beyond that. In truth, as interesting as Schwab looks to me at current prices, I will never size this up to double-digits because…well…see all the caveats in my first post. Most banks are mediocre investments most of the time but if you absolutely must own one, consider John Hempton’s rule [13] about averaging down.

Disclosure: At the time this report was posted, accounts managed by Compound Insight LLC owned shares of SCHW. This may have changed at any time since.

A tour through payments: part 1 (Visa and Mastercard)

Posted By scuttleblurb On In SAMPLE POSTS,[MA] Mastercard,[V] Visa | No Comments

I plan to spend the next month re-surveying the payments landscape, mostly updating my views on companies I’ve discussed in the past but also maybe laying some groundwork on a few new names. The next few posts will be a loosely organized jumble of thoughts. I don’t know where this is going or how it will end but I know where it should start: with the two dominant global card networks, Visa and Mastercard, which I’ve written about several times in the past and have owned on and off over the years.

Like some other companies that have held their market values this year, Visa and Mastercard are competitively entrenched cash gushers with secular tailwinds that have so far been unscathed by the macro. Cross-border volumes, which are far more profitable than domestic switching given currency translation fees and lower rebate burdens, have ricocheted back stronger than anyone expected, to about 40% above pre-COVID levels. With most of their revenue tied to payment flows, the card networks are also net beneficiaries of inflation. Over the last 3 years, Visa and Mastercard have grown EBITDA by 9% and 11%, respectively, even with Russia revenue (4% for both) reduced to 0, and I think there’s plenty of reason to think profits will continue to grow at a similar rate for the foreseeable future.

Rather than expound upon Visa and Mastercard’s moats, which are widely understood and appreciated by now, I thought it’d be more useful to discuss potential challenges. This is conviction by subtraction, seeing how much is left after chipping away the excess stone of competitive threats.

Digital Wallets

When I first began looking at Visa and Mastercard in earnest in 2016, the most salient bear case was that digital wallets would eventually disintermediate card rails. Someone like PayPal could encourage users to directly link bank accounts to their wallets, which could then be used to transact with a PayPal-accepting merchant, creating a closed transaction loop that bypassed Visa and Mastercard. And indeed, to avoid interchange fees, PayPal encouraged this behavior in its early days. Then in 2016, with customers complaining about being defaulted to ACH, PayPal agreed to present V/MA credit and debit as “clear and equal” payment instruments inside the wallet (”Customer Choice”)1 [14]. This landmark announcement preceded a flurry of integrations with digital wallet integrations all around the world.

Today every major digital wallet and bank I can think of – including Cash App, PayPal, Apple, Venmo, Grab Pay, MercadoPago, Monzo, etc. – embeds or issues Visa or Mastercard credentials. It’s easy to see why. Consumers want the assurance of knowing they can spend at just about any merchant around the world, online and offline, and earn interchange-funded rewards along the way. A digital wallet that didn’t plug into card rails would soon find themselves at a steep disadvantage to competing wallets that did.

With few exceptions, the relationship between the card networks and digital wallets is a symbiotic one. Visa and Mastercard, with their combined ~170mn merchants, enable immediate global acceptance that results in lower churn, larger order values, and more profit dollars for digital wallets. In turn, digital wallets, with their direct consumer relationships, expand distribution for card networks. Far from being a critical point of integration sweeping value away from card networks, fintechs have pulled more transaction activity onto them.

Buy Now Pay Later (BNPL)

In a BNPL-funded purchase of, say, a $1,000 sofa, the BNPL provider will pay ~$950 to the merchant and keep ~$50 for itself, then collect 4 separate $250 payments from the shopper over 4 weeks or whatever. So this is technically a loan, but as I explained in a previous post:

the easier BNPL is to use and the more ubiquitously adopted it becomes, the more it behaves like a payments network than it does a loan (unlike traditional lenders who live on net interest income, the vast majority of BNPL revenue comes from merchant fees). The more checkout pages that support Affirm the more useful it is for consumers, and a shopper who signs up for Affirm at one merchant will start using it at other merchants too. The more transactions a BNPL facilitates, the more SKU-level and repayment data they have to underwrite risk and offer a greater variety of payment options to consumers at checkout (in contrast to credit cards, which offer blunt homogenous credit terms across all purchases), fueling conversion gains and merchant adoption.

You can see how in theory the mechanics of BNPL could spool up to a competing payment network. Last year Alex Rampell, a General Partner at a16z, who set out to explain why BNPL was “an early threat to trillions of dollars of market cap – Visa (almost $500B), MasterCard ($350B), card issuing banks, acquiring banks/services (Fiserv, FIS, Global Payments, etc)?”, gushed:

But this isn’t entirely accurate. Card networks profit from BNPL in a number of ways.

First, more than 80% of BNPL installments are repaid with debit, and thanks to fixed per-transaction fees, Visa and Mastercard make more from 4 separate $250 payments than from a single $1,000 payment.

Second, BNPL providers are now using virtual cards (a single use card for a specific amount) to settle with merchants. The way this works is inside the Affirm app, a user can load a Visa virtual card for some arbitrary amount, spend that sum at any Visa-accepting merchant, and pay off the balance over time (see the illustration below):

Source: Affirm [15]

Consistent with Visa and Mastercard’s position as a platform that other fintechs build upon, any qualifying bank and fintech can leverage Visa and Mastercard open loop BNPL capabilities. Open BNPL is early but catching on, with Visa recently reporting triple digit volume growth and Affirm’s virtual card revenue accounting for 18% of revenue, up from 12% a year ago. The reason that BNPL fintechs with putative schemes to disrupt traditional card rails are partnering with them instead is pretty simple: widespread merchant acceptance. Compared to Affirm and Klarna, who combined are embedded at checkout at ~700k merchants, Visa and Mastercard are accepted by 170mn. Rather than piecemeal integrate with merchants, fintech BNPLs can partner with Visa and Mastercard and reach immediate global scale.

Admittedly, pre-loading a virtual card isn’t as seamless a user experience as having it available at online checkout. And in the case where a consumer BNPLs with Affirm at checkout and repays with ACH, the card networks are indeed obviated. But in the increasingly common scenario where the BNPL provider settles with the merchant through virtual cards and the consumer pays off BNPL balances with debit, Visa and Mastercard make money twice on the same purchase. As with digital wallets, BNPLs may ultimately reinforce rather than disintermediate the card networks.

I’m not nearly as bearish on the concept of BNPL as many others. There’s a place for it. But I also see BNPL less as something to build a company around (AfterPay shareholders were indubitably bailed out last year when Square agreed to acquire the company for an absurd 40x revenue) than as yet another feature nestled inside the portfolio of a larger financial concern. PayPal has 35mn merchants in its network and claims it can underwrite to higher acceptance and lower loss rates by virtue of having a pre-existing relationship with 90% of its BNPL users. In less than 3 years since launch, it has become the largest player in the space. Banks, meanwhile, have an entrenched customer base and can fund loans with sticky low cost deposits. By contrast, standalone BNPLs looking to bypass Visa and Mastercard have just a fraction of the merchant base to build off. And to fund receivables, they rely on securitizations and forward flow agreements, whose availability and cost is subject to market conditions.

Crypto

For purposes of this discussion, we can segment the universe of digital assets into: cryptocurrencies with no fiat backing (Bitcoin, Ethereum), private stablecoins (Tether, USDC), Central Bank Digital Currencies (China’s e-yuan; The Bahamas’ sand dollar), and non-fungible tokens (Cryptopunks, Bored Apes). Visa and Mastercard touch all these categories. Their rails serve as “on-ramps” to purchase Bitcoin, NFTs, and other crypto assets on Coinbase and other crypto exchanges and, with practically no merchants natively accepting crypto of any kind as a form of payment, as “off-ramps” from the self-contained crypto universe to the real world. For instance, when a Coinbase customer uses their Coinbase debit card to purchase a cup of coffee, Visa will convert some of the customer’s Bitcoin (or Ethe or Dogecoin) to a government-backed fiat currency that Starbucks can actually accept. Finally, when it comes to CBDCs – digital tokens issued by a central bank – Visa and Mastercard will directly settle those just as they would any other government-backed fiat currency.

The profusion of frauds and collapsing crypto prices has deflated the crazed optimism that once characterized this space. Visa and Mastercard didn’t get the memo. They’re still talking about cryptocurrencies and NFTs like its 2021. But I doubt they care as much about crypto as the skeptics and optimists who have been emotionally hijacked by it over the years. V/MA see themselves as payments infrastructure and are philosophically agnostic to whatever form factor payments take, as they should be. You can be cynical about the whole crypto complex and still agree that Visa and Mastercard should lay the groundwork for playing a role in it. There is no contradiction here. In owning ubiquitous payment infrastructure, the card networks can absorb frontier payments technologies without bearing much risk, adjusting their investment based on how things play out. In fact, it would be worse if the card networks took the strong dogmatic view that all this crypto stuff is garbage and ignored it completely, not because crypto is the next big thing but because that reactionary attitude would likely extend to other domains of innovation that may seem dumb and insignificant at first but prove worthwhile after all.

I could see stablecoins being used for certain big ticket cross border B2B, or for remittances and as a store of value in countries plagued by hyperinflation and corrupt authoritarian regimes. For those privileged enough to be living in stable liberal democracies with strong institutions and mature banking systems, crypto can do some of what the tradfi apparatus does, but it does those things much worse. It is slower and more cumbersome. The irreversible transfer of value is a bug, not a feature, in retail transactions. In the unlikely scenario that stablecoins find broader acceptance as a directly settled currency, there will likely be a long transition period where those coins must be converted to fiat to be useful and the globally ubiquitous card networks already do something similar in converting one fiat currency to another for cross-border transactions. Moreover, as Visa likes to point out, even a popular stablecoin like USDC runs on 8 different blockchains. The card networks are well placed to integrate across them, in much the same way they function as a hub across different fiat payment rails today.

As for CBDCs, assuming the end state isn’t a Soviet-style Gosbank [16] that crowds out commercial banks, we’re probably looking at some kind of public-private hybrid – with private banks handling KYC, lending, account maintenance, and other consumer-facing functions and central banks controlling the supply of digital money and financing commercial banks’ lending activities (consumer deposits would technically sit on the central bank’s balance sheet, not the commercial bank’s) – that from the consumer’s perspective largely resembles what we have today, in which case the current card networks probably remain intact, settling CBDCs like any other fiat. But I frankly don’t see the point of CBDCs, at least in the US. Americans trust that funds deposited at commercial banks are secure thanks to capital requirements, deposit insurance, and liquidity facilities backed by the Fed. And there just doesn’t seem to be enough friction in payments and access to banking services to warrant such a radical departure from the status quo.

Real-time payments

The perennial bull case for Visa and Mastercard is that their networks will capture a growing share of payment flows as electronic payments replace cash and checks. But card networks aren’t the only winners. A number of government backed real-time payment (RTP) networks, which facilitate the transfer of funds from one bank account to another in real time 24/7, has launched over the last 7 years. There are a few dozen scattered throughout the world today:

In most countries, RTPs have mostly been relegated to P2P transfers, bill payments, and B2B. But there are several notable exceptions – The Netherlands, Brazil, and India – where ease of use and commercial bank sponsorship have spurred significant person-to-merchant (P2M) use.

In the Netherlands, iDEAL is an online payment system launched by a consortium of banks in 2005 that today has more than 70% share of the country’s e-commerce transactions [17], though debit cards still account for 85% of point-of-sale transactions [18] and point-of-sale still comprises more than 80% of retail purchases.

Pix, designed and managed by Brazil’s central bank, has become the most popular form of payment in Brazil, claiming ~30% of the country’s transactions in less than 2 years since launch. It has been used by more than 70% Brazilians, who need only enter a phone number, email address, or taxpayer ID from their banking app or wallet to send payments instantly.

Source: Bloomberg [19]

With funds from credit card transactions available only after 30 days [20] to and merchant discount rates running as high as 1% for debit and 2% for credit, Pix’s instant transfers and 0.2% fees [21] were enthusiastically embraced by Brazilian merchants:

In India, Unified Payment Initiative (UPI), launched in 2016 by the National Payments Corp of India, a non-profit retail payments organization created by the Reserve Bank of India, has exploded in popularity. UPI is the payments layer of the India Stack [22], a massive government sponsored project conceived in 2009 to usher the country’s 1.2bn+ citizens into the digital economy. Over the last 3 years, with its transaction volumes have soaring by 9x, UPI has become the most common electronic payment method in India, accounting for 63% of India’s non-cash transactions2 [23]. It claims 41% share of person-to-merchant transaction value (56% by volume [24]), on pace to overtake debit and credit, which still capture 53% of merchant acceptance by value, 26% by volume3 [25].

In the US, the Federal Reserve is rolling out FedNow, in mid-2023. Were it to gain the same degree of P2M adoption as iDEAL, Pix, and UPI, FedNow would be very damaging for Visa and Mastercard, who derive 49% and 37% of respective purchase volumes from the US. Whether FedNow comes to claim the incremental flows that otherwise would have been intermediated by Visa Direct and Mastercard Send – schemes that “push” funds from one account to another and power P2P apps like Zelle, Venmo, and Square Cash – remains an open question. But the P2M flows that make up the vast majority of V/MA profits are probably secure. Banks and card networks are just woven too tightly into US payments fabric. FedNow won’t be the first RTP in the US. The Clearing House (TCH), a payments company owned by the largest US banks, launched an instant payments network in 2017 that, despite touching 75% of demand deposit accounts, has gotten close to 0 traction in retail. In the UK, where the card networks are similarly entrenched, Mastercard tried and failed to extend Vocalink to P2M transactions through its Pay by Bank app.

But that still leaves India and Brazil, two countries long hailed by both Visa and Mastercard as growth drivers. For at least the next 5 years, I don’t think there’s much to worry about. “There’s enough TAM to go around” is a tiring cliche but in this case it happens to be true. In Brazil, cash is used in 35% of point-of-sale transactions [26] (compared to 11% in North America); in India, it’s more like 80%.

Source: Boston Consulting Group [27]

The rising tide of cash-to-digital payments has lifted all boats. While Visa and Mastercard are less entrenched and face more direct competition in developing economies, those disadvantages have been more than offset by greater gains in per capita spending and electronic payments growth. In Brazil, Visa has doubled acceptance points over the last 2 years and doubled payment volumes over the last 3. India was Visa’s “fastest-growing market in Asia” in 2q22, with payment volumes now 84% above 2019 levels, even as UPI flows have grown at more than 3x the rate of overall digital payment volume over the last 5 years4 [28]. Since 2015, Mastercard’s transaction volumes in Asia, Latin America, and the Middle East have grown by ~18%/year compared to ~8% in the US. For Visa, it’s been more like ~14% and ~8%, respectively5 [29].

Nevertheless, Visa and Mastercard were unnerved by the long-term threat posed by alternative payment systems and around the time these RTP rails were taking off, both companies began to look beyond card rails and traditional P2M flows. In 2017, Mastercard acquired Vocalink, which runs the UK’s real time ACH infrastructure, and then used Vocalink’s software to power real time rails in Canada, Thailand, Saudi Arabia, Singapore, and the US6 [30]. With the purchase of Nets, Mastercard gained access to real-time account-to-account (A2A) in Europe. With Transfast, they acquired payments web that ensnared “90% of the population and over 90% of the world’s bank accounts. [31]” Visa also expanded its network to include cross-border A2A through their acquisition of Earthport, a payments facilitator with direct connections to the local ACHs and RTPs of 88 countries, connecting to 2bn end accounts. Through a partnership with Thunes, a payments platform that connects 78 mobile wallet operators across 44 countries, Visa Direct can reach 1.5bn individual wallets. Today Visa’s “network of networks” include 66 ACH rails and more than a dozen RTPs.

While this was going on, European regulators enforced its Payment Services Directive part Deux (PSD2), mandating that banks expose APIs that grant third party service providers access to customer bank account information (with the customer’s permission, of course). The regulation fueled open banking aggregators like Plaid and Tink that intermediate the flow of data from banks to any number of third party apps. Anticipating a time when open banking networks would also come to handle the movement of funds and challenge debit flows, Visa acquired Tink7 [32], the largest financial data aggregator in Europe, while Mastercard purchased US-based Finicity and Denmark-HQ’ed Aiia. For now, open banking is mostly about moving data, not money. For instance, through Plaid, a personal finance app might pull transaction data and savings balances from a customer’s bank account to deliver a personalized budget or a mortgage lender might verify income and assets. Finicity offers credit scoring for bank and fintech partners who use Mastercard’s BNPL. Consumers could increasingly use open banking to pay at online checkout or to fund digital wallets, which can then be used to pay for things, cutting card networks out of the transaction loop entirely. But in both cases you’re still stuck with the problem of merchant acceptance. An new open banking checkout button from Vyne [33] will have to compete with established buttons from PayPal, Amazon, Apple etc., and there’s a reason why just about all major digital wallet have abandoned their closed postures and opened up to the card networks.

Concurrent with their expansion into A2A, both Visa and Mastercard modified their traditional card rails to accommodate “push” transactions – so whereas in a traditional card transaction, the merchant “pulls” funds from the consumer, with Visa Direct and Mastercard Send, payments can be pushed from consumers to consumers, from Allstate to policyholders, from Uber/Lyft to drivers, from Square to merchants, from businesses to employees seeking paycheck advances.

By integrating their card networks to alternative rails, Visa and Mastercard have positioned themselves as a global payments router, replacing unwieldy bilateral connections with a single hub that spokes out to billions of bank accounts and card credentials, accommodating a wide range of different payment flows: P2B, B2B, and P2P via card-to-account, account-to-account, and card-to-card.

Source: 2020 Visa Investor Day

Whereas Visa and Mastercard span the globe, government-sponsored instant payment rails are for the most part only useful for domestic transactions. A Brazilian can’t use Pix to subscribe to Spotify or purchase a handbag in Singapore. In theory, countries could solve the cross-border problem by integrating their RTPs, but in practice this hasn’t worked out. Europe has been trying to create a pan-European payment system for more than a decade. The Monnet Project Association was shuttered less than 4 years after it was conceived in 2008 after the European Commission refused to approve the interchange rates that member banks believed were necessary [34] to make MP commercially viable. The European Alliance of Payment Schemes (EAPS) and PayFair also folded. The European Payments Initiative (EPI), conceived in 2020, was abandoned by more than half its member banks earlier this year. Meanwhile, in Southeast Asia, the vision of a cross-border multi-lateral hub – first instantiated in the central-bank backed Asian Payment Network in 2006 – has given way to bespoke bilateral integrations [35] (Singapore’s PayNow ↔ Thailand’s PromptPay; Thailand’s PromptPay ↔ Malaysia’s DuitNow, etc.). Given how hard it’s been for even regional RTP initiatives to get off the ground, it seems farfetched to think that dozens of siloed RTPs across the world will agree to common standards, either through a series of bilateral arrangements or a common global hub.

The other way card networks are protecting themselves from competing networks is by climbing up the payments stack. “Value-added services” have long been a part of Visa and Mastercard’s offerings, but up until about 6-7 years ago they were a side show that existed as an outgrowth of the core processing business and in service to it. For example, leveraging enormous mounds of proprietary spend data, the card networks help merchants and issuers detect fraud. They also offer marketing and business intelligence services that, for instance, can show a large fast food chain how much share they’re taking in a certain market compared to peers and how much of their spend comes from foreign card holders; or, for a card issuing banks, which rewards programs are resonating with customers or how their card programs rank in terms of spend or retention relative to peers. Visa and Mastercard compete fiercely for the business of card issuers, especially that of large money centers like Bank of America and Citigroup – the incentives offered to card issuing banks have climbed dramatically as a percent of gross revenue over time – and will use VAS as a carrot to retain them or to secure new card programs in lieu of incentives.

As the #2 player trying to differentiate and gain ground on its larger rival, Mastercard has been more tech-forward and earlier to explore fintech partnerships. They also placed more emphasis on services. With nearly every Mastercard issuer adopting at least one of its services, VAS accounts for 35% of revenue today (growing 25%+), up from mid-teens in 2012. But over the last few years, with intensifying competition from competing rails, Visa too is talking a big services game8 [36]

Whereas both companies once bound services to their card rails, they now treat it as a modular component that can be carried to competing rails. For example, with Token ID, Visa is applying tokenization9 [37], which drives higher authorization and lower fraud rates, to RTP and ACH, with TCH recently adopting this capability (you’ll recall that TCH’s RTP is powered by Vocalink, which is owned by Mastercard). Visa Advanced Authorization, once available exclusively to Visa issuers, is now being extended to merchants to detect fraud on e-commerce transactions, including transactions running on competing networks. Last year Visa rolled out a crypto consulting and analytics practice to help banks formulate crypto strategies (whatever that means). Mastercard’s rail agnostic services include ID authentication for transacting users (Digital ID, built on its $850mn acquisition of Ekata) and solutions that make it easier for consumers to pay bills and for small businesses to pay vendors, with all the reconciling data and documentation attached. Naturally they also have a crypto consulting business to help central banks design CBDCs.

So these value added products serve both an offensive and defensive purpose. They improve issuer retention and allow V/MA to extract more value from their entrenched card rails. But as payment flows extend beyond P2M, and as governments, especially those in countries whose payments industry hasn’t matured alongside a 4-party card system, roll out their own RTPs, a growing share of the ongoing cash-to-digital migration could be captured by competing domestic rails, in which scenario Visa and Mastercard can maintain relevance by supplying the technology that renders those rails more useful and secure.

Regulation and perception

Like any globally dominant American company, Visa and Mastercard are greeted with varying degrees of circumspection by foreign governments who would prefer their critical infrastructure be locally owned. In the extreme, foreign card rails are blocked from domestic switching, as in China and Russia. But even without outright banning Visa and Mastercard, governments can still exercise soft power by promoting local schemes. In India, Rupay – the local card scheme launched in 2012 by a consortium of major banks, some state owned – has captured the highest share of debit and credit cards, prompting one senior Visa official to remark [38]:

“The only reason RuPay has added so many is not because it is cheaper, but because there is an invisible mandate from the government to issue only RuPay cards. More than half of the cards issued have not been used. NPCI can claim to issue millions of cards. But these cards are not as a result of competition, but due to a monopoly.”

And last year, Reuters reported [39]:

…U.S. government memos show Visa raised concerns about a “level playing field” in India during an Aug. 9 meeting between U.S. Trade Representative (USTR) Katherine Tai and company executives, including CEO Alfred Kelly.

“Visa remains concerned about India’s informal and formal policies that appear to favour the business of National Payments Corporation of India” (NPCI), the non-profit that runs RuPay, “over other domestic and foreign electronic payments companies,” said a USTR memo prepared for Tai ahead of the meeting.

Yet, even with 60% share of issued cards [40] as of 2020 (up from 15% in 2017), Rupay handles less payment and transaction volume than Visa and Mastercard combined. The disparity comes from the fact that credit cards account for a disproportionate amount of spend – credit volumes exceed debit volumes despite accounting for just 10% of total cards issued – and are predominantly issued to higher income consumers, where Visa and Mastercard have 70% share [41] compared to Rupay’s 20% [42]. So while India is contributing less to V/MA’s payment flows than it otherwise would absent government-backed competition (UPI and Rupay), with cash giving way to electronic payments and consumer credit adopted by a growing middle class, the country is still additive to the card networks’ overall growth.

In the US, regulation hasn’t been nearly as heavy-handed, though the rationale behind it is less straightforward and arguably more disingenuous. The latest legislative proposal, Card Competition Act of 2022 [43], introduced by Senator Dick Durbin, prohibits banks with more than $100bn of assets from restricting the processing credit card transactions to Visa and/or Mastercard’s network. This means merchants can route Visa and Mastercard credit transactions on competing rails, introducing more competition among credit card networks that will translate to lower interchange fees for merchants. The CCA builds upon the Durbin Amendment of 2011, which you may recall cut debit interchange for certain transactions from ~1.55%-1.6% + 4c/5c to 0.05% + 21c, reducing interchange fees per covered transaction by 45% [44] on average.

Opponents of the V/MA duopoly will indignantly emphasize the huge gross dollar sums paid to banks and card networks, like: “Merchants paid $64 billion [45] in interchange fees just to Visa and Mastercard in 2018” (The Week [46]); “In 2021 alone, U.S. merchants and consumers paid nearly $138 billion in card fees” (Merchant Payments Coalition [47]); and “Swipe fees big banks charge merchants to process credit and debit card transactions totaled nearly $138 billion last year. That’s 10 times North American movie theater box office receipts in pre-pandemic 2019 and 2020” (The Topeka Capital Journal [48]). But of all the pro-merchant, anti-V/MA commentary I’ve read, I have yet to find one that mentions the obvious: that nearly all interchange fees go to preventing fraud, servicing cardholders, and subsidizing consumer rewards.

Dick Durbin thinks [49] “credit card swipe fees inflate the prices that consumers pay for groceries and gas”, which assumes that in the absence of interchange, merchants would pass the swipe fee savings to consumers. But in a 2014 study, the Federal Reserve Bank of Richmond found [50] that the 2011 Durbin Amendment capping debit interchange “has had a limited impact on prices. Averaging across all sectors, it is estimated that the majority of merchants (77.2 percent) did not change prices post-regulation, very few merchants (1.2 percent) reduced prices, while a sizable fraction of merchants (21.6 percent) increased prices”. Moreover, a 2014 study published by the Federal Reserve Board [44] concludes “that covered banks increased their deposit fees in response to the [Durbin Amendment]. While these increases are generally insufficient to mitigate all of the lost interchange income, changes in deposit fees offset roughly 30 percent of the lost interchange income”. A 2019 study published by the University of Pennsylvania Carey Law School [51] goes even further:

we find significant evidence of banks offsetting Durbin losses by raising other account fees. The share of free basic checking accounts (accounts with a $0 monthly minimum for all customers, regardless of account balance) decreases from 60 percent to 20 percent as a result of Durbin. Equivalently, average checking account fees increase from $4.34/month to $7.44/month. Monthly minimums to avoid these fees increase by around 25 percent, and monthly fees on interest checking accounts also increase by nearly 13 percent. A rough back-of-the envelope calculation suggests that banks make up approximately all Durbin losses. These higher fees are disproportionately borne by low-income consumers whose account balances do not meet the monthly minimum required for these fees to be waived.

And despite some caveats:

we can conclusively show that consumers experience immediate Durbin losses through higher bank fees, and we find limited evidence in the gas industry for across-the-board consumer gains through significantly lower merchant prices.

Likewise, in Australia, where the Reserve Bank of Australia cut credit interchange from 0.95% to 0.55% in 2003 and slashed Visa debit interchange10 [52] from 0.53% to 12c per transaction in 2006, the consulting firm Charles River Associates found [53] that the “regulations have clearly harmed consumers by causing higher cardholder fees and less valuable reward programmes and by reducing the incentives of issuers of four-party cards to invest and innovate. At the same time, there is no evidence that these losses to consumers have been offset by reductions in retail prices or improvements in the quality of retailer service. The empirical evidence thus provides no support for the view that consumers have derived any net benefits from the intervention.”

It’s fair to say that interchange is a costly fee for card-accepting merchants. But cutting it appears to impose net costs on consumers in the form of higher banking fees and lower rewards. So in a two-sided card network, interchange reduction basically amounts to a zero-sum wealth transfer from consumers to merchants. Of course, you can always argue that merchants deserve more consideration than consumers but to my knowledge no anti-interchange advocates actually make this point, presumably because it doesn’t play as well as the classic cartoon representation of a mustache-twisting cabal of banks and card networks extracting value from helpless merchants and consumers.

Consider this screechy article from The Week [46], which declares: “There is no possible moral or economic justification for these fees. Credit card companies and their bank allies are just abusing their market power to soak the rest of society for easy fat profits” and “the immense profits of Visa, Mastercard, and the card-issuing banks are sheer parasitism”.

No possible moral or economic justification? Sheer parasitism? That’s a little intense. Thanks to the card networks, merchants realize more sales volumes than they otherwise would and consumers enjoy rewards, convenience, and global acceptance. Because of continuous investments in fraud management and the collateral requirements that card networks set for member banks, you can hand your Visa or Mastercard to any one of 170mn merchants around the world, complete a transaction within seconds, and know that if you’re ripped off you will be made whole. The merchant, without knowing anything about you, can rest assured that money from your bank will reach theirs. For enabling all this, the card networks take just ~0.2% of the transaction value. That’s not a scam; it’s a marvel.

Or here’s a letter [54]addressed to members of Congress in which the Merchant Payments Coalition, a group of merchants “dedicated to fighting unfair credit and debit card fees” writes of Visa and Mastercard’s dominance of the US credit market:

This blocking of competition drives up prices for merchants and consumers, harms security and strangles innovation.

And in this edition [55] of the SITAL Week newsletter (which I enjoy and recommend subscribing to), Brad Slingerlend, who quoted from that article from The Week in apparent agreement with its premise, writes:

It’s popular to raise the golden “network effect” defense of credit cards payments. I don’t completely disagree, but the stranglehold of Visa and Mastercard in the US is causing consumers and merchants, notably small businesses, to miss out on progress and innovation, as evidenced by less than 10% consumer adoption of mobile payments [56] in the US despite their widespread use in other parts of the world.

To use the fact that Americans more often pay for things with their cards than with their phones as evidence that consumers and merchants are missing out on progress and innovation is to have a weirdly narrow definition of progress and innovation. Like you know that Visa and Mastercards are tricked out with NFC technology that allow shoppers to tap-to-pay with them in much the same way they would with smartphones? More than half of all face-to-face Visa transactions (~30% in the US, 70% everywhere else) are now contactless.

Besides, card rails aren’t even about cards anymore. Visa and Mastercard care about credentials, not physical plastic rectangles. Whether you swipe with a card or transact through a digital wallet linked to a V/MA card makes no difference to them. Americans still use cards more often than not at checkout, sure, but they do so out of habit and choice, not because grasping card networks make any other option impossible.

More generally, I find it easier to argue that card networks enable more innovation than they cripple. Much as AWS and Azure have allowed a new generation of SaaS companies to scale by eliminating the heavy upfront costs of compute infrastructure, so too have the open rails and merchant networks of Visa and Mastercard given rise to new issuers and digital wallets. The growing breadth of products from Stripe and Square are built atop payments businesses that have only scaled as a rapidly as they have thanks to the card rails. Visa powers modern card issuing platforms like Marqeta, whose APIs allow developers to customize spend preferences and manage payment programs. Even crypto exchanges like Coinbase are rendered more useful by the bridge to fiat laid out by the card networks.

As you can plainly see, I disagree with the argument that Visa and Mastercard are rapacious, innovation-stifling actors. But I understand where it’s coming from. Visa and Mastercard indeed constitute a powerful duopoly in the US. Interchange fees have an explicit and direct impact on merchant profits while the counterfactual impact on sales volumes and network security were those those fees to go away is invisible. Merchants bearing the concentrated and explicit costs of interchange are far more motivated to write letters to their Senators than consumers, who don’t even know what interchange is let alone that it funds the perks they enjoy. If your understanding of card networks is limited to news articles and click-bait editorials, you will come away with a simplistic and distorted understanding of how the payments ecosystem works, overlooking the trade-offs and compromises and flavors of coopetition that allow it to function as well as it does.

Still, perception shapes public outrage which in turn can guide regulatory interference. Sensemaking is not an antidote to misguided regulation. That the justification for CCA seems at best incomplete doesn’t preclude its passage. Durbin tried but failed to attach CCA as an Amendment to the National Defense Authorization Act this October and I don’t know where things stand today. There are various costs and complications to enforcing CCA, like re-issuing cards, re-jiggering point-of-sale software and hardware, plus what happens to a consumer’s rewards if a Visa card transaction is routed to a non-Visa network? But were it to pass into law, the Act could be more damaging to the card duopoly than the 2011 Durbin Amendment ever was. The latter regulation crushed debit interchange but didn’t cut Visa and Mastercard out of the transaction loop, nor did it have any discernible impact on their fees, which are separate from interchange. By allowing the merchant to route transactions to lowest cost networks, the CCA competes down interchange fees but also, more consequentially for V/MA, raises the possibility that payment flows will be routed to competing networks. Visa and Mastercard will naturally argue that smaller rails with fewer resources to invest in fraud management may be less secure, but even if that’s true I suspect most merchants will assume all card networks are equally safe and just go with the cheapest option.

In a battle between small merchants and a big bank/card network partnership, public officials will always side with small merchants, especially since another protected class, consumers, are too unorganized and uninformed to understand how they are being net harmed by any resulting measures. This means the threat of regulations and fines always looms in the background for Visa and Mastercard. I won’t get into it all here. Just Google “Visa and Mastercard, antitrust” or whatever and you’ll see all sorts of articles about probes and fines that have been directed at the card networks over the years. I’m not saying these punitive measures were unjustified (they may have been, depending on trade-offs you are willing to make), just that regulation is an ongoing overhang, not some one-off. But so far the card networks have thrived in spite of the scrutiny. Visa and Mastercard are like the Teflon Dons of corporate world. Nothing really sticks.

With respect to ostensible fintech threats, the card networks are more like The Blob, getting stronger as they absorb the benefits of wallet and POS innovation. When PayPal boosts checkout conversion by introducing an in-app SDK and password-free authentication, or when Apple enables iPhones to be used as point-of-sale terminals, Visa and Mastercard are indirect beneficiaries. Visa’s merchant footprint and credential count have 4x’ed over the last decade, in large part thanks to the profusion of wallets, fintech issuers, payment facilitators, and terminal form factors11 [57]. There are more direct challenges to the card rails at the infrastructure layer. But just because alternative rails exist doesn’t mean consumers will use them. Can they handle dispute resolutions and chargebacks? Do they offer 0 liability protection and dual messaging [58]? Do they have a long, proven track record of security and reliability? RTPs will get more featureful over time but as Visa President Ryan McInerney put it, “comparing an RTP transaction in 2022 to a Visa Debit transaction in 2022, let alone a credit transaction, is kind of like comparing…a landline rotary phone to an iPhone”. And while I don’t want to tempt fate, given V/MA’s global merchant acceptance and widespread consumer adoption, taking the disjointed parochial rails too seriously is a bit like wondering “is the Albanian army going to take over the world” 😉

That doesn’t mean crypto, RTPs, or BNPLs won’t capture a growing share of the incremental electronic payments. But with digital continuing to eat away at $9tn of annual cash retail transactions across the Americas and Europe, fueled by e-commerce penetration and continuing incremental advances in payments technology that alleviate friction and expand acceptance, V/MA’s carded volumes should continue to outpace PCE growth for many years to come. Moreover, the card rails are insinuating themselves into all the newfangled modes, with on and off ramps to crypto, multi-rail networks, and open BNPL enablement. Where payment flows don’t monetize directly – as in ACH and large swaths of B2B – Visa and Mastercard are instead trying to add value further up the stack.

Disclosure: At the time this report was posted, accounts managed by Compound Insight LLC owned shares of MSFT. This may have changed at any time since.

[MTCH] Match Group

Posted By scuttleblurb On In SAMPLE POSTS,[MTCH] Match Group | No Comments

Online dating has easy parallels to other online social experiences that if taken too seriously can lead to dubious outcomes. A dating app is like social media in that there are lots of people broadcasting themselves, making connections, and seeking validation. You might “like” a photo on Instagram as you might right-swipe on a photo in Tinder or Bumble. So as Tinder, Match Group’s largest property – accounting for 66% of paying users (”payers”), 60% of revenue, and 80% of EBITDA – ballooned to ~75mn monthly active users, it must have seemed only natural to consider human relationships in a more abstract, all-encompassing way. They could not only mediate romance but “social discovery”, “interest groups”, and eventually, “social entertainment”. They could foster connections that “span geographies, demographics, relationship status and genders in ways that dating services cannot, effectively providing a much larger addressable market than dating”.

Source: Match Group; 1q21 Investor Letter

When Meta began to push entertainment over friend graph content and talk a storm about the metaverse, Match maybe felt that that was something they should think about too. Those thoughts eventually crescendo’ed into the $1.7bn acquisition (8x revenue) of Hyperconnect in 2021, the largest in its history. Hyperconnect got 75% of its revenue from Asia and operated through 2 brands: Azar, which enables one-to-one live video chat, and Hakuna, a multi-party live streaming app. Its advanced video technology could, Match believed, create a “metaverse-based experience” for social discovery and be integrated into its portfolio of apps. Meetic, a European dating app owned by Match, used the technology to launch “Live Rooms”, where small groups of people could hang out and shoot the shit. In Hyperconnect’s “Single Town”, user avatars ambled from one virtual location to the next. We now know that these metaverse ambitions, which may have seemed reasonable in the disco fog of the post-COVID orgy, were a massive overreach.

The expansion never made much strategic sense. Match was trading off a dominant position in the growing niche of online dating for a subscale position in the amorphous expanse of social media, where it was pitted against impossibly strong competitors. And you can see how an app with a reputation for facilitating hookups, when combined with a virtual goods economy and video streaming, could degenerate into a pretty unsavory place.

More than that though, people appear to want to represent different selves in different platforms. The stuff one feels comfortable sharing with potential mates on Hinge will differ from stuff they share with friends on Facebook or with colleagues on LinkedIn. Facebook Dating, which can pull in Instagram Stories and add Instagram followers and Facebook friends to “Secret Crush” lists, has famously flopped since launching in 2018. Hinge, the second largest Match property, contributing 8% of payers and 11% of revenue, soared even after it stopped leveraging Facebook’s social graph to match singles. Bumble’s derivative offerings – Bumble BFF for discovering platonic friends and Bubble Bizz for developing professional relationships – don’t appear to have gotten much traction.

In short, dating apps have failed to compete with other social graphs on their own terms and IRL friend graphs don’t appear to bring meaningful advantages to online dating. This doesn’t mean certain social media mechanics can’t be carried over to dating apps. Tinder’s “Explore” tab, where users are organized by shared interests and relationship intent, seemed like a reasonable idea: a low risk way to efficiently sort matches on an app where users typically don’t provide any profile information beyond photos. But it was designed in the spirit of casual virtual hangs and hasn’t made any lasting impact on Tinder’s flagging user growth.

Dating apps are a utility. Where they go wrong is in positioning themselves as social hubs rather than as tools that take the burden off tired swipe thumbs. The functional orientation of dating apps is reflected in the way they monetize. Facebook is concerned with remaining relevant to younger audiences only in the sense that engagement drives ad revenue, so they’d rather have more of it than less. They aren’t thinking about demographic mix through a zero sum lens. Because Meta can personalize what it injects into a user’s feed, it is the amount of relevant content that matters, not the relative mix of men vs. women or young vs. old on the platform per se. So the two-sided network effects of social media are instantiated as engaged users on one side and advertisers on the other.

By contrast, the two-sided network effects in dating apps are expressed within the user base itself. The vast majority of revenue that any dating app realizes comes from men, who outnumber women by ~2x-3x1 [59] and pay in order to improve their odds of securing dates with them. While engagement matters, where that engagement comes from is just as important. Dating apps try so hard to create compelling experiences for women for the same reason that bars offer them free drinks and bouncers block you and your boys even as they wave in a large bachelorette party. Single men will swipe right on just about anyone. There is no need to cater to them. If anything, barriers are required to keep them from upsetting the gender balance too much and bumming out women, who are not only fewer in number but tend to be far more parsimonious with right-swipes besides.

Tinder popularized a number of features that catalyzed its explosive rise just as smartphone adoption was taking off. Sparse profiles requiring nothing but photos made it easy to onboard. A freemium revenue model made it easy to trial. The “swipe” was suited to casually filling interstices of time throughout the day. But just as critical to Tinder’s success was the double opt-in feature, where both parties had to swipe right on each other before private messaging could commence, a feature that helped dam the deluge of unwanted messages from random guys, which was a big problem for women on Gen 1 desktop dating sites like Match.com [60] and OkCupid (though this continues to be a major issue, with ~2/3 of women under 50 on dating apps experiencing harassment [61] in one form or another).

So with online dating, we have a setup where men, fueled by the dopamine release triggered by the variable rewards that come from the unpredictable timing of matches, compete with one another for the prize of securing dates with a scarce supply of women. This looks an awful lot like gaming. In this Time article [62] from 2014, Tinder’s co-founder Sean Rad explains “We always saw Tinder, the interface, as a game….What you’re doing, the motion, the reaction.” You might even hypothesize that gaming is an outgrowth of the same competitive instinct, honed through evolutionary pressure, required to win mates. It then seems natural that Match’s latest CEO, Bernard Kim, spent 6 years at Zynga and close to a decade at Electronic Arts, and that before Bernard came on board, Match was replicating monetization dynamics pioneered by online gaming.

There was a time when online games made money through a “play to win” model where players had to purchase expansion packs and fancy gear to stand a realistic shot of advancing. But buying your way to victory seemed unfair and today most monetize through a combination of advertising and cosmetic in-game purchases that enhance a player’s experience without improving their chances of winning. Advertising never took hold in online dating. It’s a tiny part of Tinder’s revenue. I guess there’s not much data to target against. On the other hand, a la carte (”in app”) products are a meaningful source of revenue for Tinder, comprising ~25%-30% of its total. But unlike skins purchased in an online game, Boosts (which allows you to be one of the top profiles in your area for 30 minutes) and Super Likes (a blue star you can tap on someone’s profile that lets the other person know you really like them and prioritizes your profile on their card stack) in Tinder are purely functional.

The most enduring gaming franchises have avoided the hit driven paradigm that used to characterize the space by fostering communities. A gamer can earn status in those communities by procuring badges with skilled play or even by purchasing expensive skins that signal commitment or whatever. Dating apps aren’t like that. These are utilities, not communities. There is no signaling value or bragging rights to securing dates. The rewards from doing so are private. And I’ve got to imagine that spending boatloads of real money on Tinder Coins that you use to acquire virtual collectibles and buy your way to the top of card stacks could backfire? You don’t want to appear desperate or mark yourself as someone who takes online dating too seriously. That’s a turn off for women. There’s a reason your subscription status isn’t displayed on your Tinder profile and I can imagine that Boosts and Super Likes might dilute your prospects if women know you purchased them. I suppose part of the reason everyone on Tinder has a quota of Super Likes, regardless of whether they buy them or not, is so it’s not obvious to someone who receives one that the sender paid for it.

The analogy to gaming breaks down in a more fundamental and obvious way. There are no skills to master. Interesting photos that highlight facets of your personality can move the needle a bit, but whether you are right-swiped or not is primarily a function of your physical attractiveness relative to that of the swiper. In real life, where there are opportunities to flex other assets besides looks – intelligence, sense of humor, kindness, social status – over a sustained period, whether that be at school, with friends, or in the workplace, you will find plenty of couples who are mismatched on attractiveness. But in raw stranger-to-stranger encounters, particularly on Tinder where pictures are pretty much all you have to go on, physical appearance will be the dominant filter.

It used to be that Tinder assigned you a desirability score based on the mix of right and left swipes you received relative the scores of users swiping you, among many other factors. Users with similar scores made their way to each others’ card decks. Eventually, as Tinder scaled and accrued more user data, that competitive ranking system gave way to one where users in your card stack are similar to those who were right-swiped by people who tend to right-swipe the same profiles as you, which is apparently how Hinge matches users [63] too. In either case, though, you more or less end up in a matching pool with people who are comparably desirable. And that’s a good thing. If you’re a 2 in the looks department, you do not want a card stack of Margot Robbie’s. You may think you do, but you don’t. You may as well spend your time rating photos on “Hot or Not” because you will almost never get right-swiped. Online dating is nice in that it conveniently introduces you to mates while removing the embarrassment of in-person rejection. It also creates a rather efficient market that kills the dream a little for everyone.

Within algorithmically determined matching constraints, Tinder is still monetizing off similar “pay to play” tactics that gaming companies abandoned due to the deleterious effects on the broader ecosystem. The analogy here isn’t great, as ~3/4 of Tinder’s revenue comes from subscriptions, whose benefits include things like “unlimited rewinds”, “see who likes you”, “passport” (where you can match with users in other cities), and “hide ads” that shouldn’t degrade the experience for other users:

Source: Tinder [64]

But Super Likes, Boosts, and Unlimited Swipes – which are bundled into subscriptions, with Superlikes and Boosts available as a la carte purchases to boot – crowd out consideration for non-paying users and disrupt the match order that Tinder’s algorithm might otherwise find optimal.

Of course, social media also wrestles with an inherent tension between monetization and user experience. But compared to Instagram, which has as many ways to keep users engaged as there are varieties of entertaining content (not to mention, a relevant ad can be as compelling as organic content), a dating app has far fewer moves on a far smaller surface area. There are this many singles in a 10-20 mile radius and the job is to match those singles as efficiently as possible. That’s pretty much it. The post-matching experience is unpredictable and entirely outside Tinder’s control. There is no date rating system. You can understand why Tinder and others were tempted by metaverse experiences. And monetization is confined to short-term subscriptions and boosts because users don’t expect to spend a year or even months on a dating app, even if they ultimately do. This goes hand in hand with the classic tension of online dating as a business. The better the service is, the sooner you’ll be off it, and so subscribing on an annual basis feels like paying more for a worse product. That’s why “churn”, while almost certainly through the roof, isn’t relevant in the way we traditionally think about it. Even Tinder subscriptions feel less like subscriptions than they do product sales.

The other challenge is that while match liquidity begot by network effects is the governing moat for a dating app, it doesn’t lead to winner take all outcomes as there are many vectors along which network effects can be spun. While Tinder may be the largest dating app on the market, with 8x as many payers as Hinge and 4x as many as Bumble, it co-exists alongside a very long tail that encompasses a wide variety of apps catering to different races, religions, sexual orientations, and sensibilities. Even mainstream competitors like Hinge and Bumble successfully counter-positioned against Tinder by emphasizing serious relationships. Hinge (”designed to be deleted”) requires responses to prompts and demands 5 times the 3-4 minutes it takes to sign up for Tinder. Bumble is like Hinge but with strong brand messaging around women’s safety and empowerment that is reinforced by product mechanics (women are required to send the first message).

Dating apps inspire no brand loyalty. They aren’t held together by friend or interest graphs that keep users from experimenting with competing apps. People will typically multi-home across 3 or 4 apps at once, re-creating network liquidity across them to some degree. Features like voice texts, video, badges signaling seriousness of intent are easily replicable. All this has created the conditions for an unstable industry structure, with market shares radically shifting every few years, as chronicled in this video [65] from Data is Beautiful.

Since it was incubated within IAC in 2012, Tinder has gone on to become the most popular global dating platform, with around 75mn monthly active users (to put this in perspective, in the year of the iPhone’s debut, the largest dating site, Plenty of Fish, had about 8mn MAUs). According to Pew Research, 46% of US online dating users, including 79% of those between the ages of 18 and 29, report having used Tinder at some point:

But like so many apps before it, Tinder too is now wrestling with stagnant user growth. They are trying to combat this headwind by appealing to Gen Z users and women who might otherwise be drawn to more substantive connections on Hinge and Bumble, with marketing campaigns that de-emphasize its reputation as a casual hook-up app. But brand marketing that tells users what you hope to be known for will not work if the product is still grounded in low-friction onboarding and shallow swipes, and altering the core product or requiring users to invest more time on profiles upfront risks alienating existing users and further constricting top-of-funnel growth.

With a series of CEOs and product managers arriving with a plan to revitalize what they correctly recognized as a stale user experience and then resigning after failing to do so, it’s hard to escape the feeling that Tinder may just be out of moves when it comes to user growth, that Match’s most significant cash cow is now in senescence, following the all too familiar path of every other dating app that exploded in popularity only to slip into irrelevance. Management has long talked about optimizing for revenue rather than either payers or revenue-per-payer per month (RPP). Even so, bears will point to the mix of revenue growth increasingly coming from RPP at the expense of payers as evidence that top-of-funnel expansion and payer conversion have gotten much harder to come by. They will say that Tinder has matured to point where a greater mix of revenue growth must now come from extracting more value from the payers it already has.

A salient example of this is Tinder Select, a $500/month membership tier that was rolled out to the most active 1% of users in September. By now, we’re all familiar with the extreme tail in mobile monetization. In gaming, a small fraction of users will spend boatloads on cosmetic features for status and social connectedness. The top 1% accounts for half a publisher’s revenue or whatever. But I’m not sure think Tinder is amenable to nearly the extreme monetization tails you see in gaming. There are no status awards to win, no community to impress, and limits on how much Tinder can improve your matching prospects or date experiences. And if Tinder Select is that good at matching you with the right mate, well, you’re not going to be paying for very long. From an avid payer base of ~104k (1% of 10.4mn total payers), how many actually go for this and over what stretch of time? Do you get to, say, $50mn (5% of LTM EBITDA) by assuming 10k members at $500/month for 10 months? 20k members at $500/month for 5? My intuitions fail me here.

The concern is not that the online dating market is tapped out but that the subset of users drawn to casual swipe mechanics largely is, and management’s range of motion is constrained by the casual, low friction on boarding that made Tinder such a viral sensation in the first place. Over the years, they’ve introduced all sorts of initiatives (Swipe Night [66], Explore, Hot Takes [67], Vibes [68], video chat, the “Starts with a Swipe [69]” marketing campaign) whose impact on engagement, while promising at first, ultimately proved ephemeral. Tinder can play around with different monetization tactics on a given set of product features, but this only goes so far. At some point they’ll need to find durable, product-led ways to expand the efficient frontier, improving match quality and swipe efficiency across the board, expanding the top-of-funnel by appealing to Gen Z users, and attracting more women so payers can enjoy higher hit rates without unduly damaging the experience for non-paying users. They’ve announced a few so-so sounding things, like quizzes and prompts designed to add texture to profiles and more curated profiles for women, but I’m not sure why these rollouts should work when so many others like it have failed.

I’ve viewed Match’s prospects through a pessimistic lens thus far. But the company has several things going for it too.

First, while historically even once leading online dating sites abruptly lost significant share in a matter of years, that share loss occurred in the context of a rapidly expanding market. Share loss does not necessarily imply an imploding user base (consider that between 2014 and 2019, Tinder lost several points of market share even as its MAUs grew 44%2 [70]). Match Group consolidates its atrophying legacy brands (namely, Match, Meetic, OkCupid, and Plenty of Fish) and its nascent ones (namely, BLK, Chispa, and The League) in a single segment (”Emerging & Evergreen”) that is declining low-single digits. Its non-Tinder revenue in 2016 – which basically reflects all the old stuff, including a full year of Plenty of Fish – was about $950mn. Based on management’s limited disclosures, it looks like those brands did around ~$650mn in 2022 and maybe ~$590mn this year, implying ~6%-7% annual contraction over the last 7 years. So while Match’s musty brands have declined, they’ve done so at a more measured pace than one might think, especially considering that, as desktop native apps, they were on the wrong side of a generational platform shift. I don’t want to minimize the structural challenges. Those legacy properties saw revenue declines accelerate to 11% over the last 2 years. I only mean to point out that just because a dating app fades out of conversation does not mean it step-functions to zero.

It’s also worth setting aside historical comparisons to just consider whether it would even make sense to launch a new mainstream dating app today. How would you do it? Tinder found product-market fit with swipes in 2012. Hinge was founded at about the same time, Bumble just a few years later, both counter-positioning against Tinder with serious relationship intent. There are and will continue to be countless niche dating apps but I feel like Tinder, Hinge, and Bumble pretty much have the mainstream segment covered. I’m not sure what new product innovation you’d launch from scratch today on mobile that hasn’t already been tried to draw the marginal user away from the liquid networks spun up by those established brands. That all three are all successfully pushing price testifies to the absence of viable alternatives.

Second, while bears will interpret Tinder’s emphasis on RPP gains at the expense of payer growth as evidence that Tinder has saturated its market and is now resorting to value extraction, a more charitable interpretation – the one management obviously encourages analysts to take – is that Tinder’s past payer count was inflated by sub-optimal monetization. With aggressive pricing having now shaken out the weak hands, Tinder is building off a somewhat lower, reset base and can deliver a more even contribution from payers and RPP going forward. There is some early evidence of this, with payer losses attributable to US price hikes dissipating in 3q23, even with RPP growing by 8% q/q.

In 2q23 management launched weekly subscriptions in the US, which had the predictable impact of immediately juicing payer numbers, some of whom then churned off. But those declines should also settle over the next few quarters. We’ll see!

Third, to some extent Tinder’s durability is born out by the instability of its management. Tinder is now on its 6th CEO since 2015, Match Group is on its 4th. Various product managers and marketing officers have come and gone along the way. Former employees consistently complain about abrupt shifts in product strategy brought about by crazy turnover in the executive ranks. And yet, amidst that chaos, Tinder has 11x’ed revenue and 6x’ed payers.

On the back of Tinder’s vertiginous rise and with Hinge following in Tinder’s wake, Match Group’s EBITDA and free cash flow (including stock-based compensation and excluding a significant litigation settlement in 2022) have grown by 22% and 20% per year, respectively.

So on the one hand, you could characterize Match as a directionless company plagued by years of inconsistent product direction and mismanagement. On the other hand, what better demonstration of product-market fit than Tinder sextupling payers despite said mismanagement, to say nothing of the stunning traction at Hinge? Match and Tinder’s current CEO, Bernard Kim, has been in place for almost 18 months. It has yet to be seen whether this ex-gaming executive proves a good fit for a dating app. But so far he’s made what I think are sensible moves in retiring Tinder Coins, swearing off big-ticket M&A, dropping the metaverse blatherskite pushed by his predecessor, and pursuing less radical blocking and tackling maneuvers around monetization and product experience.

Fourth, Hinge is one of the fastest growing mainstream dating apps on the market and Match owns it. They paid somewhere around $25mn in 2018 for an asset whose revenue is today run-rating at $400mn, having grown by 43% from a year ago.

In the 5 years since Match acquired a majority stake, Hinge has gone from the 13th most downloaded app in the US to the 3rd [71]3 [72]. It has exploded in popularity across continental Europe – its download rank improving from #21 to #3 from May ‘22 to Mar ‘23 in Germany and surging to #2 in France, behind Tinder, just 3 months after launch – and is among the top 3 most downloaded dating apps in 14 countries.

Hinge caters to those with serious relationship intent and demands more time of users upfront, so I doubt its user base will ever catch up to Tinder’s. But by virtue of drawing serious daters, Hinge should have more pricing power. I estimate Tinder’s US RPP to be ~$26, implying that Hinge, which does $27 from a user base heavily concentrated in rich Western countries, probably has a lot more room to grow (by comparison, The League, another dating app owned by Match Group, which admits members based on social status, educational attainment, and professional accomplishments, does more than $100).

Hinge’s unexpected success segues to another key point. While Tinder is by far its most significant banner, it is buttressed by a long tail of apps in Match’s portfolio, each catering to a different user base – snobs (The League), African Americans (BLK), Latinos (Chispa), Christians (Upward), single parents (Stir), serious daters (Hinge), gay men (Archer). Within the mainstream apps, there is even a plausible “lifecycle” narrative where users engage most on Tinder in their early-20s, then age into more “serious” apps like Hinge and Bumble in the late-20s and early-30s. Alongside those are apps targeting Asian markets (Pairs, Hakuna, Azar) and old school properties like match [60].com, Plenty Of Fish, and OkCupid that are being gracefully harvested for cash. Most of these properties will amount to nothing, but it’s hard to say which ones. Success in online dating business is hard to predict. Match spent $575mn on Plenty of Fish, which ultimately went nowhere, and $25mn for Hinge, which has become a top 3 dating app by revenue.

But thinking of Match Group as a portfolio of call options with random, binary outcomes is probably too simplistic. Despite chaos in the executive ranks, the company seems to have a knack for profitably growing brands. Match.com [60] was for years the leading dating site in desktop. Tinder was incubated at IAC and grew to become the dominant dating app globally under Match’s ownership. Hinge did just $5mn in revenue the year it was acquired by Match and now, less than 5 years later, is run-rating at $400mn. Archer was built in-house and is close to rivaling Grinder’s US weekly downloads just months after its limited rollout.

A skeptic might retort that we don’t know the counterfactual, that Match is just riding the wave of colossal success that these banners would have experienced as standalone companies anyways. Fair! While there are some lesson and tactics shared across them, Match’s properties generally operate independent of one another (their flagship apps have different code bases and even different headquarters), which stokes the perennial concern that another app could launch out of left field today and steal Tinder’s users. But again, the highest-revenue generating dating apps in the US today (as far as I know) – Tinder, Hinge, Bumble, Grinder – were all founded more than 10 years ago, in the early days of smartphones. As long as mobile remains the dominant platform, it’s hard to see a startup introducing a novel angle of attack that siphons users away (AI girlfriends maybe?).

Given that dynamic, the natural exit strategy for a pre-revenue dating app that is starting to gain traction in some niche is to sell to Match. Even if you are of the opinion that Match isn’t operationally responsible for the success of its apps, they’ve at least put resources behind the right ones. Consider that, what, hundreds of US dating apps have launched since the mid-‘90s? Is it just coincidence, having nothing to do with resource allocation or execution, that 2 of the 4 highest monetizing ones in the US happen to be part of the ~45 that Match owns? Maybe, but I doubt it.

Match Group is for now a bet on Tinder. But as a vehicle of diverse apps catering to a broad swath of niches, managed by a group with a strong track record of acquiring and profitably nurturing the industry leaders, it is also a bet on the online dating category as a whole. I think you can feel good about the latter. In the Western world, the cultural taboos around online dating have more or less fallen away. By 2017, more heterosexual couples in the US met online than through any other channel, with a new S-curve for online dating forming at around the time smartphones took off.

Source: Disintermediating your friends [73]: How Online Dating in the United States displaces other ways of meeting (Michael Rosenfeld, Stanford University, 2019)

In the Middle East and Asia, online dating is far more stigmatized (in Japan, for instance, Tinder users will commonly post pictures of flowers and landscapes instead of their faces) and monetizes at lower rates to boot. But even if adoption is never as widespread there as in the US, I suspect it will continue to trend the same way.

The number of dating app users globally grew by ~8% a year from 2015 to 2022 and I see no reason why growth should meaningfully slow.

Even in “mature” markets like North America and Europe, 57% of adult singles have yet to try a dating product.

Source: Match Group (1q22 shareholder letter)

In theory, Tinder also has room to grow, with only 24% of single 18-34 year-olds counting themselves active users. Another 35% are lapsed users and another 41% have never used Tinder at all.

Source: Match Group (8/2/22 investor letter). 2021 surveys and research. Percent of respondents that have ever used a dating app or site (single, and not in a relationship), excluding China.

All dating platforms must contend with success translating into users pairing off and leaving the platform. But this headwind is offset by new, larger cohorts of 18-year old’s who are going to be pulled to the most liquid network like the cohort before them, and lapsed users who reactivate their accounts when those relationships don’t work out.

In summary, Match Group is a vivarium of dating sites targeting a broad swath of interests and demographics. Its marquee brand, Tinder, is showing signs of user stagnation, but revenue growth has accelerated from 4% to 10% over the last 2 quarters on the back of significant price hikes and the introduction of weekly subscriptions, a rate of growth that it expects to maintain next year. Payer declines are moderating as users adjust to the changes, with management expecting a return to sequential growth by the middle of next year. Whether they can pull this off, let alone return to mid/high-single digit growth will depend on top-of-funnel growth, which they are trying to improve with product and marketing initiatives. I think they’re in a tough spot here for reasons I discussed. Hinge, meanwhile, is on fire. Last quarter they grew payers by 33% even as RPP advanced 8%. With just half the number of payers as Bumble and RPP at US Tinder levels, I suspect there is lots of runway for both metrics.

The msd revenue declines at Evergreen and Emerging (22% of revenue) should moderate somewhat as the segment continues to mix toward the fast growing Emerging concepts, which growing 40%-50% a year, partially offsetting the declines of legacy banners. Match Group Asia (9% of revenue) has reversed its y/y contraction and is now growing low-single digits as Azar, 2/3 of Hyperconnect’s revenue, is now growing 20%/year on the back of “AI-enabled” algorithmic matching (whatever that means), offsetting the continued weakness at Pairs (the largest dating app in Japan) and Hakuna. Meanwhile, operating margins have expanded from flat at the time of acquisition to around 10%. While Hyperconnect did not live up to Match’s metaverse ambitions and management would probably take back the acquisition if they could, it brought some advanced technology that can be leveraged across Match’s other brands and it doesn’t hurt to own a platform that is tuned to the cultural sensitivities of what could prove the largest addressable region for online dating.

Finally, last year Match paid $623mn to app stores, a huge sum compared to its $965mn of EBITDA. I wouldn’t buy shares on the expectation of massive fee relief, but maybe keep this option in your back pocket for a rainy day.

All things considered, I can appreciate how many think the stock looks attractive here at 18x trailing free cash flow, 14x EBITDA. To put things in perspective, Match has around the same market cap and only 25% more enterprise value than it did at the end of 2017, when Tinder was doing just 1/5 the revenue and Hinge wasn’t even part of its complex. At 40x free cash flow it was arguably overvalued back then but at less than half that multiple today I think you can make a reasonable case that the stock has overshot to the downside. Assuming 8% growth at Tinder (0% payer growth / 8% RPP growth), 27% at Hinge (18% / 7%) growth, 3% at Match Group Asia, 15% contraction at established brands, and 25% growth from emerging ones, blends out to ~9% revenue growth over the next 5 years. With so much of that growth fueled by pricing at Tinder, we could see a doubling of EBITDA that drops down to ~$4.5 in per share cash earnings (including stock comp). At 15x-20x + accumulated cash, the stock compounds between ~19% and 25%.

At the same time, that’s all just playing with numbers. I can’t say I’ve got strong opinions one way or another about the extent of Match’s pricing power, its ability to drive user growth, the efficacy of its marketing initiatives or pending product refreshes or really anything! Hinge is often pitched as a “hidden” asset that will become more appreciated as it makes up a larger part of Match, but I’m not sure how much long-term signal we can confidently glean from current results. Fade rates can be much steeper than investors appreciate. Tinder was growing by more than 40% just 4 short years ago, about as fast as Hinge is growing today. But then again, singles need to go somewhere to find dates and where else if not Tinder, Hinge, or any one of the dozens of apps in Match’s complex?

Disclosure: none of the accounts I manage own shares of Match Group