A remarkable year for bond markets

European payment stocks had a good year in 2019, with most players in the sector seeing a decent rise in their share price. In our view, there is no reason to think this year should be any different. Even if there was to be an increase in economic volatility in 2020, as many observers argue, we expect the fundamental backdrop to remain favourable as the two structural drivers that underly the growth of the industry are still firmly in place. These are:

• The global shift from cash to electronics payments (notably cards) is far from complete. Industry estimates suggest that more than 70% of transactions are still settled in cash in the eurozone (vs close to 40% in the UK and close to 30% in the US).
• On the other hand, online payments should continue to grow steadily with figures from Statista pointing to a global e-commerce market of EUR2.5trn growing by 10% p.a. in the medium term.

The European market remains fragmented and dominated by banks

Currently, the in-store payment space in Europe remains local, fragmented and dominated by banks. Payment providers like WorldPay, Wirecard, Adyen and Ingenico have carved out dominant positions in European e-commerce with a combined market share of close to 60% but industry estimates suggest banks still control close to 50% of the overall payment flows in the continent.

This stands in sharp contrast with North America where the market has consolidated around a handful of technology companies such as FIS, Fiserv and Global Payments. Overall, we estimate that the top five payment providers have more than 75% market share in the United States, compared to less than 40% in Europe.

However, we see three reasons why the current status quo in European payments is unlikely to last.

1. Innovation is spreading from online to in-store

The first is the spread from online to in-store. In the last two decades, innovation in the payment space has been driven by e-commerce. New players like Paypal, Adyen and WorldPay thrived as they were better equipped than banks to help merchants cope with the new challenges related to customer conversion or fraud prevention.

We believe innovation is now spreading to the physical store. Traditional payment processing has become commoditised and merchants are instead looking for solutions to run their business more efficiently and improve the customer experience. They also want a unified view of their customer interactions across all channels as the lines between physical and online retail are blurring.

In a way similar to what happened in e-commerce 20 years ago, this has created an opening for new vendors. Square (in the US), iZettle (in Europe) or Pagseguro (in Brazil) have gained traction with small businesses by combining payment acceptance with innovative software solutions for analytics, customer retention or inventory management. E-commerce players like Adyen have also started to onboard large in-store retailers like H&M on their platforms.

2. Regulation is another catalyst for change

After several delays, the Second European Payment Service Directive 2 (PSD2) should come into force in the next 12 to 18 months. The directive creates new requirements in terms of security. More fundamentally, it brings an end to the monopoly of financial institutions on customer data. In other words, banks will have to make it possible for third parties to access the financial information of account holders and to initiate payments transfers on their behalf. This is likely to create additional pressure for banks on two fronts as they need to refresh their legacy IT platforms while fending off the threat from new competitors (fintech or big tech).

3. More consolidation is likely

Last year saw a step up in M&A activity in US payments. FIS bought WorldPay for $43bn, Fiserv bought First Data for $22bn, and Global Payments bought TSYS for $21bn. In a low rate environment, some of these moves might be opportunistic. However, they also reflect the need for scale in a fixed cost industry where core payment processing is becoming commoditized. In this context, we believe consolidation is now at the top of the agenda in Europe.

Banks may struggle to catch up on innovation. While financial services is one of the industries with the highest IT spend as a proportion of revenues (close to 10% according to Gartner), most of this spend is dedicated to the maintenance of legacy systems and the compliance with legal requirements leaving only little room for investments in technology. One option for banks could be to sell their payment assets altogether (like RBS did in 2010).

Another option could be to outsource more broadly and partner with third parties to bring more innovation to their customers. Obviously, it may take some time for banks there. Should these opportunities fail to materialise in the short-term, we believe we could start to see consolidation moves among the few independent European payment providers.

So, who are the likely winners?

In a changing European payment landscape, the potential winners fall into two main categories in our view. Innovative e-commerce vendors like Adyen are best positioned to go after the new opportunities unlocked by innovation. These include in-store payments (which still represent close to 80% of overall card transactions) and the provisioning of new offerings around fraud prevention, analytics or marketing services. At the other end of the spectrum, we also see value with some traditional in store payment providers like Worldline and Nexi that are well positioned to become the partners of banks as the latter start to rethink their positioning in the market.