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Rishi Gosalia
Rishi Gosalia

Two-Sided Markets and MasterCard's Moat: MA

December 08, 2011 | About:

The word "moat" gets thrown around a lot, so I am generally very skeptical of it. A simple declaration such as "look at the margins of the business for the past 10 years, look at their market share" is not enough to say that a company has a moat and will be able to sustain it. Often things that you can see in the financials are a result of the moat, but not the cause. It's important to understand the cause, because that's the only way you can monitor if the business' moat is growing or decaying. After all, isn't the business' ability to sustain its moat in the future (not the past) what is really important?

So, there has been a lot of talk about MasterCard (NYSE:MA) — and Visa (NYSE:V) — on this forum ever since Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) disclosed their position (really a Todd Combs position). I will start by saying that the time to purchase was a year ago when MA was hovering in the low $200 range, not today. I did an article for this site (here) on MasterCard in December 2010 when MA was at $225 that took the position that the impact due to Durbin was overblown and MA was 50% undervalued. So, today, I am not pitching you to add to MA but want to talk about the underlying reason for MA's moat given the general interest in this topic.

MasterCard and Visa operate a business model that in economic circles is known as a two-sided market. I want to use the first half of this article to talk about two-sided markets in general, and then use these ideas to talk about MasterCard's (and Visa's) moat.

Two-sided markets are economic platforms that bring together two different user groups that provide each other with network benefits. Other examples include newspapers (readers and advertisers), HMOs (patients and doctors), operating systems (end-users and developers), video game consoles (gamers and game developers), web search engines (searchers and advertisers), and social networks (web "socializers" and advertisers).

First we'll begin by going back to your econ 101 class. Usually for a market, the demand curve is downward sloping and you lower the price until value on the next unit sold makes up for the losses on sales you would have made at a higher prices. As you would expect, it makes no sense to give away your product for free because that gives up all profits on every unit sold. What makes two-sided markets special, despite what your econ 101 class tells you, is that sometimes it can make sense to give away your product for free (or subsidize them) because it could stimulate demand in an adjacent market you own that more than makes up for the subsidy.

Let me give you an example that you may not have thought of. Consider Abode's Portable Document Format (PDF) format, a standard used for universal document exchange. The PDF network consists of two sets of users — writers, who create documents using Adobe's Acrobat Distiller software that costs them $499, and readers, who view these documents using Abode's Acrobat Reader software that they can download for free. Writers, who greatly value the huge reader audience, are more than willing to pay a fee for their software. Adobe's subsidy of giving away the PDF reader for free is more than compensated by the higher demand in its writer software. Now here is an instance where giving away something for free makes sense!

Unlike the traditional markets, economics in the two-sided markets are more complicated. Dr. Marshall Van Alstyne, one of the top researchers in this area, prescribes a few factors to think about in order to make the network work correctly.

User Sensitivity to Price: Had Adobe started out charging even a small fee to the price sensitive reader group, the network would not have grown as big as it is today. Subsidize the group that is price sensitive ("subsidy side") and charge the side ("money side") that increases its demand more strongly in response to the other side's growth

User Sensitivity to Quality: Counter-intuitively, rather than charging the side that strongly demands quality, you charge the side that supplies quality. Think about the video game market. Gamers demand quality and game developers must incur huge fixed costs to deliver this quality. In order to amortize this cost, they must be ensured that the game console platform has many users. Hence the need to subsidize the gamers with a below cost subsidy. Console providers ensure that game developers meet high quality standards by imposing strict licensing terms and high royalty rates. This "tax" is not passed to the consumers: the game developers charge the highest rates the gamers will bear, independent of the royalty rate. However, the royalty rate helps weed out games of marginal quality. Once the "tax" is added, titles with poor sales prospects cannot generate enough margin to cover their fixed costs, so they never get made in the first place.

Ability to Capture Cross-Side Effects: Your giveaway will be wasted if your network's subsidy side can transact with a competitive network's money size. This was Netscape's mistake. Netscape gave away its browsers to individuals in hopes of selling web servers to companies operating web sites. But web site operators didn't have to buy Netscape's servers in order to send web pages to Netscape's big browser user base; they could easily buy a rival's web server instead.

Output Costs: Don't subsidize the product when each unit has appreciable costs. If a strong willingness to pay from the money side does not materialize, a giveaway with high variable costs can quickly rack up large losses. FreePC learned this lesson in 1999 when it provided Compaq computers and Internet access at no cost to consumers who agreed to view Internet ads that could not be minimized or hidden. Not surprisingly, few marketers were eager to target consumers who were so cost conscious. The decision is much simpler when the product subsidized is a digital good such as a Google web search, where the marginal cost of serving an additional user web search costs Google nothing.

Value Added: Even though Apple's Mac platform always commanded a premium from consumers, Microsoft was a winner that essentially monopolized the desktop operating system market. Desktop customers were attracted to Microsoft's Windows operating system because of the large number of applications that were only Windows compatible. This came about partly due to Apple's missteps and partly Microsoft's foresight. When Mac was launched, Apple's grave error was to extract rent from the software developers who developed applications for the Mac operating system by charging them $10,000 for Mac's software development kit (SDK). In contrast, Microsoft was smart enough to give away the Windows' SDK for free. By the time Microsoft went to anti-trust trial, Windows had six times as many applications as Mac!

Interfering same-side effects: Sometimes it makes sense to exclude certain users from your network. For example, many auto part manufacturers, concerned about downward pricing pressure, refused to participate in Covisint, a B2B exchange organized by auto manufacturers. Covisint stalled, as did many B2B exchanges that failed to attract enough sellers. In the face of high negative same-side network effects, network providers should consider granting exclusive rights to single user in each transaction category - and in exchange extract high concession for this rent. The network provider must also ensure that sellers do not abuse their monopoly positions; otherwise, buyers will not be attracted to their platform.

Marquee Providers: The participation of "marquee users" can be especially important for attracting participants to the other side of the network. A platform provider can accelerate growth if it can secure the exclusive participation of marquee users in the form of commitment from them not to join rival platforms. For many years, this kind of exclusive arrangement was at the core of Visa's marketing campaigns — remember ads that said "...and they don't take American Express."?

Microsoft learned the hard lesson of not to upset your platform's marquee customers when Electronic Arts (EA) — the largest developer of video games and thus a major potential money side user of Microsoft Xbox platform — refused to create online, multiplayer versions of its games for Xbox Live service. EA objected to Microsoft's refusal to share subscription fees from Xbox Live, among other issues. After an 18 month stalemate, EA finally agreed to offer Xbox Live games. Even though terms of the agreement weren't disclosed, you can bet that they were generously tilted in favor of EA.

Now that you understand the economics of two-sided markets in general, let's apply this kind of thinking to MasterCard/Visa business model.

When a consumer swipes her debit (or credit) card issued by a bank to pay for a $100 merchandise at Walmart, an entity known as the merchant acquirer charges Walmart an interchange fee in the range of 20-25 cents for the debit transaction. The setting of the interchange fee is a complicated matter and it's set by the payment network.

The merchant acquirer retains a small percent of the interchange fee and passes off a large portion to the issuer bank. The payment network charges the bank a very small transaction fee for using the network, but net they are essentially letting the bank make the most from the interchange fee, hence the banks are on the subsidy side. The payment networks also makes a very small transaction fee from the acquirer. So, even though the merchant is not compensating payment network directly, I still consider it to be the money side of the network since it's the one paying for the subsidy the payment networks are providing to the banks.

I believe that understanding the pricing model is really important for one to understand MasterCard's (or Visa's) competitive advantages to any possible threats from new entrants. When I talked to people about MasterCard, most people would just say — "plastic is a dying business, mobile payments will displace them." So, I want to address this issue.

Plastic or wireless, businesses don't exist just purely on technology in any two-sided market (remember the Microsoft vs. Apple example — Microsoft won the desktop operating system market despite arguably an inferior technology compared to Apple). The economics matter for them to come into existence and experience the network effects. So, let's conjure up some wireless payment company (Verizon, AT&T, Google, Apple or someone else) that is going to compete with Visa/MasterCard.

Can they get the banks to cooperate with them without Visa and MasterCard in the picture?

Why would Chase give up its huge revenue stream from the interchange fee (thanks to Visa/MasterCard) and partner up with some cute technology company? They have no incentive to do so, unless these new networks provide a compelling reason — meaning interchange fee that is healthy enough to force them to upset their big money center, MasterCard/Visa.

Where exactly is this network going to come up with this money to compensate the banks from? Either they are willing to lose billions for years or charge the merchants a fee even higher than the MasterCard/Visa's interchange fee. So, then why would merchants be enthusiastic of accepting this new technology if it costs of them more than traditional technology? I doubt banks will co-operate with the new networks if MasterCard/Visa are not part of the network.

Can the new networks compete without Visa/MasterCard and the banks?Where are they going to make the money from?

Executives at Apple (NASDAQ:AAPL) are not sitting around conjuring up new ideas to go into without having a proper model of where the revenues are going to come from, are they? So either they charge the consumer on a per-transaction basis or they charge the merchants.

Let's explore the first idea — charge the consumers. This pricing model is like Adobe charging each reader of the PDF document a 5 cent viewing fee. Are you willing to pay such a fee? You can always find suckers for anything, but I doubt that the network can grow big enough to make any economic sense with this model. Then, the only place they can make money from is by charging the merchants. It can probably get traction with the merchants only if Apple charges transaction fees that are lower than the current interchange fee (why would Walmart want to install new point-of-sale systems that accept Apple payments otherwise). But Apple has way fewer transactions when it starts out. So, it has to amortize the fixed costs of running a payment network over a much smaller revenue stream.

Let's compare this to the cost structure of MasterCard/Visa. As per data put out by the Fed in December 2010, MasterCard/Visa make less than 2 cents per transaction from the big banks (which control 80% of payments) on debit transactions, and my guess is that they make less than 10 cents on credit transactions from the big banks. Combined with the fact that they capture trillions of transactions (over 70% of all transactions), they are able to cover the costs of running a business and make healthy margins.

Apple (or any other mobile network that wants to do it on its own) basically must be willing to lose money for a long time before they can capture volumes that make the business economically viable. One may say that isn't running a payment network no incremental cost to running a voice network and the argument that Apple needs a large volume to amortize costs is incorrect? Payment networks are very different relative to voice networks. You can have missed calls on voice network, but not on a payment network. When was the last time you were stuck at a grocery line because the payment network was down? Most of the times it's because of a hold on the card, but not because the network is down.

Payment networks need to be more secure than voice networks. I have had my credit card stolen online quite a few times, but every time it happened I didn't detect the theft, but a representative from MasterCard would call me to tell me that certain suspicious transactions were detected. As per data by the Fed, the costs of running fraud detection are not something you can just ignore. Would you be willing to use a payment network that didn't have this protection?

Lastly, there is nothing from a business point of view that is stopping MasterCard/Visa to partner up with another technology that competes with the ones that goes out on its own. MasterCard/Visa can take a margin cut for a few years and subsidize the technology partner for acting as a replacement for plastic.

Who would not want to get this low-risk revenue stream that starts on day one? In fact, that is what MasterCard exactly did by partnering with Telefonica (NYSE:TEF) for mobile payments in Latin America. The margin squeeze is not even permanen, because MasterCard/Visa can probably make it up by raising the interchange fees over time.

I say both MasterCard/Visa have a moat and I encourage you to challenge my reasoning I laid out here. Agreements or disagreements?

About the author:

Rishi Gosalia
Rishi Gosalia is a private value investor based in Cedar Park, TX. Rishi currently works in a management position in the software industry. Rishi graduated from the University of Texas at Austin in 2003 as a Distinguished Scholar with an undergraduate degree in both Computer Science and Pure Mathematics.

Rating: 4.6/5 (27 votes)


Adib Motiwala
Adib Motiwala - 7 years ago    Report SPAM
Excellent article as always Rishi. Thanks for sharing.
Rgosalia - 7 years ago    Report SPAM
Thank you Adib.
Tonyg34 - 7 years ago    Report SPAM
Very timely article, as I've been trying to figure out how one of my holdings (WU) will ever make money off mobile payments, when clearly they won't be the low cost provider.

I've been trying to figure out how mobile payment options from the myriad of new entrants (GOOG, WU, on and on) create a profit for anyone.

So far as I can tell the market is divided up amongst the various card payment processors (consisting of V and MA credit/debit transactions) like First Data Corp, TSS, HPY, GPN, and FISV. These companies sell a commodified product, payment processing, and compete on value added services like fraud detection, credit valuation, and merchant acquiring. The scale of transaction volume drives margins, but cost per transaction is trending down. BAC was able to cancel its contract with TSS as the bank became large enough to handle these transactions internally for less than they could contract it out. WU is entering this fray, trying to leverage their advantage in international/cross border transactions (inked a deal with MA, of course)

These seem to be the companies vulnerable to the efforts being made by the e-wallet upstarts.

So the argument must be that GOOG can process these transactions cheaply enough to price everyone out of the market. Secondly, GOOG can not only keep track of where and when you spend, they know where you are and can prompt purchases by texting you coupons or something, and then you can make the purchase directly on the phone from the stores website and carry it out of the store without standing in line at the cashier, just show your text receipt to the security officer at the door on your way out. So again this is GOOG giving away a cool service (mobile wallet, Android, GoogDoc's, Google Earth, so on) to drive business at their core advertising / search

Honestly I can't think of any other reason.

GOOG is trying to be the acquisitor - not replicate MA's card network. How do I know? Because Google Wallet only works in locations where MasterCard PayPass is accepted.

People don't like to make two significant changes at once, how they pay and what they pay with. If they're switching from plastic cards to their mobile phones to make payments, people will want a brand they trust with their money (like Visa or MasterCard)

If anyone else can think of ways to derive a profit from mobile payment apps let me know, but it seems to about price undercutting or possibly just (in GOOG's case) maintaining brand goodwill.

At this point in the game, I don't think anyone can replicate or join the V, MA duopoly.

Sivaram - 7 years ago    Report SPAM
Another good post. I agree that Visa and Mastercard will be hard to dislodge, particularly from a global perspective.

Most moats get penetrated if the competitive product offers something radically different or is much cheaper. So, to me, it comes down to whether online payment schemes--say using a mobile phone to buy anything at any point in time--will be cheaper or more convenient than a credit card. Is the legacy cost of Mastercard higher than any upstart in mobile payment processing?

I think a good case to study is how Paypal came out of nowhere to establish itself in Internet shopping. Can the same thing happen with mobile phone payments? I doubt it but that's kind of how I see it.
Fkattan - 7 years ago    Report SPAM
Thank you for a great article, I really enjoyed reading it. I'm not clear on the sustainability of competitive advantage; as I understand it, your thesis is that the credit card's moat relies on the high cost of maintaining a global network and back-office operations (i.e. fraud detection). Hence the necessity of very high transaction volumes for any new entrant to compete effectively.

However, I can see that other players already have global networks that can be used for credit card processing, I'm thinking of Apple, Google, Microsoft, and Amazon; the incremental cost of using their existing infrastructure to clear payments does not seem to me that really protects the credit card companies.

It would be great if you can comment on the above.

Again, thank you for the article it is very informative.


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