At Manole Capital, we focus all our time on FINTECH and doing bottoms up, fundamental research on financial and technology companies. As a quick reminder, we define FINTECH as “anything utilizing technology to improve an established process.”
In this quarterly version of “What We’re Watching in FINTECH”, we highlight some of the bigger takeaways impacting our industry. Some of these topics might be obscure, but we wanted to address the bigger trends and issues we are seeing in the FINTECH industry. COVID-19 has fundamentally altered businesses around the world, and companies are trying to deal with unprecedented amount of volatility and uncertainty. We will attempt to lay out the case how some of our companies are actually benefiting from this challenging environment.
What We’re Watching in FINTECH:
In “What We’re Watching in FINTECH,” we wanted to discuss some timely and interesting items. We will examine industry news flow, valuations, policy announcements, potential catalysts and more. Here’s a sampling of some FINTECH issues we find intriguing.
#1 Wirecard (OTCPK:WRCDF) (WDI):
For starters, the biggest news impact in our industry was the epic fall and ultimate bankruptcy of Wirecard, Germany’s “FINTECH darling.” Despite our heavy concentration in payment companies, we are pleased that Manole Capital never owned WDI.
Despite being a fairly controversial stock, WDI doubled in value in both 2017 and 2018 and reached a $35 billion valuation. This high-growth FINTECH business marketed itself as a “payment enabler,” between consumers and merchants. It was widely known in the industry as a marketing whiz, that was quick to publicize its vast number of strategic partnerships. In 2019, WDI issued over 100 press releases, with many greatly overplaying the significance of that relationship.
In early 2019, the Financial Times reported some unusual accounting practices at WDI. Specifically, the FT published that certain WDI’s foreign offices were forging and using backdated contracts. Understanding the financial statements of some payment firms can be challenging, as some have complex models with billions of small transactions from thousands of various customers, but this was not the first time WDI was accused of wrongdoing.
There were additional allegations of irregularities, as well as reports concerning inflated revenue and earnings. BaFin is Germany’s top financial supervisor and regulator (our version of the SEC). Its mandate is to probe allegations of criminal activities and its role includes ensuring that listed companies abide by securities law. Through all of these challenges, as one would expect, WDI management fiercely defended its business. WDI issued press releases claiming that these reports were “false, inaccurate, misleading and defamatory.” In an attempt to clear its name, WDI hired KPMG to conduct an independent investigation into their finances.
After receiving an email from a WDI employee claiming “bullying, bribery of auditors and share-price manipulation”, BaFin still did not look into the allegations. During these contentious times, instead of investigating WDI, BaFin prohibited investors from selling WDI short for two months. Eventually, KPMG investigation proved useless, as they were unable to provide clarity into WDI’s finances. WDI collapsed and began to unravel in June of this year, when its primary auditors (Ernst & Young), could not find $2B of cash on its balance sheet.
Despite its success as a public payments company, we never got involved in WDI. For starters, the rumors in 2019 were not the first to circulate on WDI. Back in 2010, the FBI investigated a WDI banking unit for fraud. Apparently, a German national was operating an illegal money-transfer business through WDI’s banking entity. Then, in 2015, German authorities raided WDI, as they looked into additional money laundering issues. In February 2016, two anonymous individuals accused WDI of money laundering and fraud. Instead of investigating the allegations against WDI, BaFin actually opened a probe into the accusers. Three months after this anonymous dossier was published, BaFin accused 37 short sellers of market manipulation and sent reports to Munich attorneys for prosecution.
Another warning sign for us was the Nilson Report newsletter. This obscure publication is considered by payment insiders to be the industry’s “bible”. It is the most trusted source of payment industry information and its annual rankings are a must read (at least for us). We always found it somewhat odd that the Nilson Report never included WDI in its rankings. Apparently, it could never get comfortable with WDI’s inability to breakdown its reported payment volumes, by different merchant type.
We have been covering our version of the FINTECH industry for 25 years. We focus on free cash flow and conduct bottoms up, fundamental research. Over the next decade, we imagine there will be multiple case studies done on WDI and what went wrong. Investors in WDI now have the scars of seeing an investment completely fail, like Enron. BaFin will receive a lot of blame as a blind regulator; as the auditor in charge of watching WDI, Ernst & Young will also suffer. However, the lesson is that opaque business models can be dangerous, whether they are public or private companies. Maybe we “missed” WDI because it was a German company, not a US-based entity. Maybe we never invested because of the continued noise and rumors in the marketplace. Maybe it was sheer luck? Either way, we were pleased never to have invested in this FINTECH “darling.”
#2: COVID-19 Beneficiaries:
In our opinion, COVID-19 has kickstarted two major payment changes. The first opportunity occurred by mandate, with stay-at-home orders and a shelter-in-place decree. This pushed business away from physical retailers (i.e. brick and mortar) towards eCommerce. Any online purchases have to be made with a card or electronic funding source.
eCommerce continues to grow in popularity and the shift is not showing any signs of slowing down. According to a recent eCommerce report from Adobe Analytics, online shopping in March for the US and the UK increased +25% and +33% respectively. In 2000, eCommerce represented less than 1% of total US retail sales. By the end of 2019, eCommerce has eclipsed 11% and it continues to steadily climb higher. The US Census Bureau reported that in the 1st quarter of 2020, eCommerce as a percentage of US retail sales hit an all-time high of 11.8%.
In our view, shifting consumer spending patterns are likely to better insulate and benefit eCommerce payment gateway providers like PayPal’s (NASDAQ:PYPL) Braintree, ADYEN, and Stripe. Whether this opportunity transpired because of COVID-19 or not, we believe that consumer convenience continues to point towards the secular and predictable growth of eCommerce. We believe that COVID-19 has accelerated the shift away from cash towards mobile-based payments. PSCU is a credit union organization that tracks ATM and cash usage. For the week ending on May 31st, it found that ATM cash withdrawals were down 30% year-over-year. This was the 10th straight week of declining metrics for cash usage. On PayPal’s conference call earlier this week, management commented that COVID-19 has pulled eCommerce 5 years forward. That’s what we would call a dramatic shift towards eCommerce and away from brick & mortar.
The second trend and COVID-19 beneficiary is the continued migration away from cash and coins to digital forms of payment. We have seen a significant shift by consumers and merchants towards contactless forms of payment. In late March, the Electronic Transactions Association reported a 27% increase in contactless payments. Over the last couple of months, we believe contactless usage has continued to soar.
These are secular growth tailwinds that will persist for decades. We wanted to highlight again, how these developments are impacting and benefitting our portfolio.
In our opinion, cash has a hygiene problem. We think this masked Ben Franklin perfectly captures this issue.
Over the last decade, numerous studies have been done (click here or here or here) documenting the dangerous viruses and bacteria that live on paper currency. This research isn’t new, with COVID-19, but a long-term problem that paper currency and metal coins have.
Making matters worse for currency, in today’s global pandemic environment, nobody wants to hand their card to a cashier or touch those keypads or even that dangling plastic stylus pen. This contact phobia has altered the payment landscape and the way consumers wish to transact. We believe it will accelerate the shift towards mobile and contactless payments.
While it is fairly easy to say that cash will continue to be the market share donor, it is still undecided which mobile-based payment technology will ultimately win. Whether it is NFC or QR or some other type of technology, our payment positions are well positioned to benefit from this development. The shift towards mobile-based payments has been a slow and steady process, which aligns with our view that FINTECH is more of an “evolution than revolution”. Either way, the global pandemic has dramatically increased the momentum away from cash and towards contactless forms of payments.
#3 QR (quick response) vs. NFC (near field communication):
The payment industry and networks (primarily Visa (NYSE:V) and Mastercard (NYSE:MA)) have been pushing for NFC-based applications. This technology, ultimately, ties back to a funding source, of either a credit or debit card. For NFC transactions to occur, one’s phone or card simply needs to be placed within 6 inches of a POS (point of sale) device. As examples, both Apple Pay (NASDAQ:AAPL) and Google Pay (NASDAQ:GOOG) (NASDAQ:GOOGL) utilize NFC systems, as do most recently issued plastic cards.
QR codes (pictured here), are different and utilize a 1x, unique code to transact. QR technology is increasingly gaining traction, as it can be used by those merchants that have not bothered to update their older POS devices. Merchants can easily install some software to their POS and then simply connect a cheap barcode reader. Afterwards, with consumers having their smartphone handy, merchants can use QR codes to process payments and launch marketing and loyalty programs.
The biggest US mobile payment success story has been Starbucks (NASDAQ:SBUX). Their payment app is an excellent example of QR-based technology. Starbucks launched mobile-based payments in 2014 and it continues to dominate their checkout lines. According to data from Numerator, 61% of guests use the Starbucks mobile app. App users are 2x more likely to visit multiple times a week and 10x more likely to visit multiple times a day. Clearly, Starbucks has found that mobile-based payments can help drive traffic.
Mobile payments work best when both consumers and merchants see a tangible benefit. Consumers love the convenience of this mobile app, as purchases generate those valuable Starbucks stars. Starbucks also benefits, as it speeds up their check-out lines and lowers their transactions processing costs.
For those merchants that cannot bring the POS to the consumer (i.e. restaurants), QR codes can become a more convenient form of payment. All a consumer needs to do is scan the QR code printed on a bill using his/her mobile phone. Then, consumers will not need to hand their plastic cards (and those valuable 16-digit codes) over to a complete stranger to process in the back of the restaurant. Also, restaurants will be able to implement their sought after loyalty and marketing programs. Once again, we view this is as solution to problem and a “win win” for all involved.
Outside the US, China has been the biggest advocate for mobile payments and QR code technology. China’s payment market is dominated by two entities, Alibaba’s (NYSE:BABA) Alipay and WeChat Pay. Both use QR technology and have been quite successful with Chinese consumers. However, Chinese regulators have recently mandated that these mobile networks keep the bulk of customer funds in commercial bank accounts and that all payment transactions must be cleared through the government’s platform. That kind of control occurs in China, but it will never work in the US.
It is interesting that PayPal, one of our three dominant payment networks, is helping advance the use of QR codes in the US. PayPal owns Venmo, the wildly popular P2P (peer-to-peer) payment application. Within the Venmo app, consumers can now scan a QR code to help facilitate payments. Leveraging their trusted brand, PayPal might just be the next company to embrace and succeed with QR codes.
So, QR codes can become an attractive alternative to NFC usage, but this was not their original intent. QR codes were created in 1994 by Denso Corporation to help the Japanese automotive industry track inventory and parts. While using QR codes for payment applications work well, there are a few technical barriers. We will address the problems and vulnerabilities of QR codes in another note, at another time…
Lately, Visa and MasterCard have been active on the acquisition front. In January, V purchased Plaid for $5.3 billion. In June, MA purchased Fincity for just under $1 billion. These two deals fall somewhat outside of the network’s traditional competency of handling card payments. Plaid and Fincity are infrastructure plays, handling the connectivity between various financial entities. Whether it is a start-up FINTECH app or a bank or brokerage firm, these companies help “connect the pipes.”
The Manole Fintech Fund purchased Plaid in December of 2018 and we described it to clients as a “financial plumber.” That is probably not the description the company uses on its website or what it used to justify that $5+ billion price tag, but the analogy worked for us. There are thousands of apps being developed and many seek access to financial information or a funding source. These two companies are looking to connect, in real time, these apps to that valuable third-party financial data. Want a couple of examples? Fincity technology powers well-known apps like Quicken Loans Rocket Mortgage and credit scoring services like Experian’s (OTCQX:EXPGF) Boost app. Plaid has high-profile customers like P2P app Venmo, mobile trading app Robinhood, robo-advisor Betterment, and cryptocurrency exchanges like Coinbase and Gemini.
The payment networks want to expand from just processing traditional card payments into this new era of “open banking”. Open banking can be described as a safe and secure way to give certain providers access to a consumer’s financial information. APIs (application program interfaces) are the fundamental building blocks of open banking and permit the transfer and communication between various entities in the payments ecosystem. There needs to be a set of protocols between software and network infrastructure and the payment networks want to control this process. With newly built FINTECH apps, it is important for them to connect to consumer bank accounts. Why? Just as Slick Willie Sutton explained why he robbed banks, “[It’s] because that’s where the money is!”
Plaid and Fincity help all types of companies build FINTECH’s global trend and it is strategically important for both V and MA to become that trusted intermediary. Just as V and MA are the network or “rails” for card transactions to “run on, their goal is to become a trusted intermediary to safely connect FINTECH apps back to that prized financial information.
#5: nCino (NASDAQ:NCNO)
Over the next few months, as conditions continue to improve, a number of companies will look to raise capital and conduct an IPO. The FINTECH space remains quite attractive and nCino’s July 14th IPO is a perfect example of how “hot” this sector has become. The first-day return on NCNO was a whopping 196%. That’s right. It climbed nearly 200% on its first day of trading.
Founded in 2012, and headquartered in Wilmington, North Carolina, NCNO provides cloud-based software to firms in the financial sector (i.e. banks and brokers). It operates in 10 countries and has 21 customers paying over $1 million annually for its product. NCNO has a solid customer base, which includes TD Bank, Trust Financial (the combined SunTrust Bank and BB&T), and Santander Bank. NCNO’s motto is that it was “created by bankers, for bankers” and that its software enables financial institutions to succeed in today’s competitive environment. What does that mean? Well, we dove into NCNO’s S-1 filing to figure out more about this new FINTECH company.
We looked at NCNO’s technology and user interface; it all appears to be solid. To summarize NCNO’s business, it is a single platform to help banks do loan origination and open up accounts. It is also one of more than a dozen firms that are striving to compete with Fiserv (NASDAQ:FISV), Fidelity National (NYSE:FIS), and Jack Henry (NASDAQ:JKHY) in the core processing business. Our analogy on the core processing business is that it is the “central nervous system” for a bank’s infrastructure or back office. Having covered this particular industry for over 20 years, we have come to appreciate the “stickiness” of this business. Once a bank chooses a core processing system, it is extremely hard (and unlikely) to ever replace that technology provider.
While NCNO claims to have an addressable market opportunity of $10 billion, we believe the real addressable market is much smaller. NCNO has some nice products and features, but we do not believe there is anything terribly revolutionary about their offering. At the end of April, according to its S-1 filing, NCNO had 81.6 million shares outstanding. At a first day closing price of $92 per share, NCNO had a $7.5 billion market capitalization. We do not believe this is a fair or reasonable valuation, but it seems like the retail market has become enamored with certain buzzwords like cloud computing, FINTECH and SaaS (software-as-a-service). Take a look at their website at www.ncino.com and let us know your thoughts. We simply do not believe this type of valuation is justified, considering its current or even potential future business. Could we be wrong? Absolutely! It won’t be the first or last time for that…
NCNO generates no free cash flow and it is not expected to be profitable for several years, maybe not until 2023 or 2024. Over the last three fiscal years (ending January), it has experienced an increase in non-GAAP operating losses; ($15) million grew to ($19) million and was a ($20) million loss last year. Like many start-ups, NCNO reports non-GAAP earnings; it adds back the amortization of intangible assets, as well as all stock-based compensation expenses. If we add those non-cash expenses back, it would increase their operating loss by ($7.5) million last fiscal year.
Over the next several weeks, sell-side analysts will launch coverage of today’s latest FINTECH “darling.” We fully expect many to have raving reviews of NCNO’s addressable market. We understand why NCNO decided to go public and capture this opportunity. However, from our viewpoint, there is nothing particularly enticing about this FINTECH business, especially at this lofty valuation. We run concentrated portfolios of FINTECH businesses and we plan on remaining picky on which companies we invest in. In our opinion, nCino would be better called “In-sano”.
Before you rush out and attempt to short NCNO, realize that it is a very difficult “stock to borrow”. We are on the Schwab platform, TD Ameritrade’s, as well as Interactive Brokers. On IB, the “cost to borrow” has declined from 86% down to 42% today. On average, our costs to short a stock are typically about 25 basis points. Anything that high, simply does not make it a viable option for our hedge fund.
Recent Proprietary Manole Capital Research:
Over the last few months, we have worked with roughly 10 interns. With schools getting upended, closed and then shifted online last spring, many of these students did not have the opportunity to find summer employment or further their learning in the asset management business. This wonderful group of interns is currently studying at Lehigh University (4), the University of Tampa (3), Indiana University (1), and the University of Florida (1). We broke our interns into four distinct teams and had them conduct our 3rd annual Gen-Z financial services survey.
Why do we continuously focus on Gen-Z? Well, this “internet generation” will be critical to understand over the next few decades. The three most influential events of their lives are the September 11th terrorist attacks, the Financial Crisis and now this COVID-19 global pandemic.
Gen-Z (those born after 1995) and Millennials (born between 1980 to 1994) now exceed 20% of the US population and will make up roughly 50% of the US workforce by 2040. How will businesses engage, target and attract this group?
We received answers to our series of questions from 247 respondents. Nearly 60% of our responses were female and 40% were male. Those that answered our questions come from 28 different states and attend 33 different colleges and universities. Our target audience was Gen-Z and we successfully hit that mark as 95% were between the ages of 18 and 22 years old.
Like our prior Gen-Z surveys, this year’s notes specifically target the thoughts and insights on four specific areas. We are attempting to understand how this audience will bank, conduct its payments, and invest going forward.
We published 44-pages of Gen-Z research on Seeking Alpha. If you wish to read those notes, just click on the below links.
Banking (click here)
Brokerage (click here)
Payments (click here)
Digital Currencies (click here)
Thanks for your interest in our proprietary FINTECH research. If you want, just click on the “follow” link and join the Manole Capital team. Thanks!
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Disclosure: I am/we are long V, MA, PYPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.