Visa and Mastercard Challenged on Several Fronts

Visa (NYSE:V) has recently unveiled its new digital wallet service, branded V.me. Similar to PayPal, the new service was aimed to make mobile and online payments easier and more convenient. The service aims to compete with Google Wallet, released by Google (NASDAQ:GOOG) in partnership with Mastercard (NYSE:MA). Like V.me, Google Wallet is aimed to make online and smartphone purchases easier for consumers.

Visa and Mastercard have unveiled a number of new services and partnerships to make consumers use their payment services more frequently. It has worked. Plastic has been replacing cash all throughout America and in several countries in Europe and Asia, payment by credit and debit card has largely replaced the use of paper currency.

Many of these new services are costly consumer conveniences, such as Visa and Mastercard branded gift cards, such as those released by Green Dot (NYSE:GDOT). Another costly venture was contactless payment, branded “payWave” by Visa. This payment solution is more profitable for Visa and more expensive for vendors, since each payWave payment requires a customer’s signature and retailers have to pay Visa a higher fee for signature payments. This prompted Best Buy to stop accepting payWave in 2010.

Visa and Mastercard’s Two Values

Best Buy’s action points to a fundamental weakness in Visa and Mastercard: they are such huge players in the credit sector that they have become largely complacent charging higher fees for new services even if those services aren’t really very revolutionary. RFID, the backbone of payWave and Mastercard’s Paypass, has been around since the 1980’s. Paypal has been facilitating online payments since 1998.

Two things make Visa and Mastercard valuable investments: their overwhelming market share and brand recognition. Competitors cannot readily challenge either company because there is an enormous barrier to entry in the credit industry; a startup cannot create a new credit card network, and American Express (NYSE:AXP) and Discover (NYSE:DFS) have never been serious competition for the companies.

Due to their market dominance, there is a risk that the companies have become complacent. Neither company can afford to do this; consumers and vendors are not loyal to Visa or Mastercard, and they use credit and debit cards because they are convenient. If a cheaper, more convenient option appeared, Visa and Mastercard would struggle to maintain their dominance.

An Unlikely Competitor

Today, Dwolla isn’t exactly a household name, but it may soon be. The Iowa-based startup has created a new online payment system that sidesteps the Visa/Mastercard networks and offers users the chance to transfer money for a quarter–far less than PayPal’s fees, which are a percentage commission on the amount transferred. The transfers are instant, and can be conducted on the go using the site’s smartphone applications. According to a recent Business Insider piece, the startup is set to transfer $350 million in the next year.

For Visa and Mastercard, this amount is quaint. While Dwolla won’t replace the big cards anytime soon, it is an uncomfortable reminder that the card networks are technologically obsolete. Visa and Mastercard still dominate payment methods around the world largely due to consumer apathy and corporate complacency. However, as Bank of America’s recent flubbing of monthly debit card usage fees demonstrates, companies cannot stop being competitive and innovative, even if this means cutting operating costs while providing better services.

Future Growth and Potential Pressure

Unless Visa and Mastercard learn to live on slimmer margins and provide more convenient payment options, they may find a number of startups like Dwolla looking to replace them and more merchants than just Best Buy balking at their high fees.

Fortunately, both payment solution companies might experience increasing transaction volumes from emerging markets, bolstering their net revenue. However, this is not guaranteed; Visa and Mastercard need to break the UnionPay monopoly currently in China to access its growing domestic market for payment solutions. Similarly, the Dodd-Frank reforms have lowered interchange fees, which will lower revenues for Visa and Mastercard even without competition from upstarts.

Inevitably, both companies need to learn to live on slimmer margins before either can be an attractive investment. At the same time, growth in international markets and the firms’ global market dominance means that neither is going away anytime soon. For these reasons, both firms’ market prices are quite close to their Trefis price estimates ($353 for Mastercard and $90.05 for Visa), but this could change significantly if they become innovative again.

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