Digital Garage Inc (4819)

Riding the wave of Japan's cashless payments growth

Why is this interesting?

Japan, traditionally reliant on cash, is rapidly embracing cashless payments. In 2022, cashless adoption reached 36%, with the Japanese government setting a target of 80%. Cashless transactions are expected to grow 8-10% annually, with some forecasts suggesting even higher rates.

The question is: what’s the best way for public market investors to capitalize on this trend?

I believe Payment Service Providers (PSPs) are the prime beneficiaries and offer one of the best exposures.

• PSPs enable merchants, both offline and online, to accept various cashless payment methods, including credit cards, mobile payments, and others.

• They are indispensable partners for merchants, acting like toll gates for cashless transactions.

• There are scale advantages in this business, which is why the top three players (GMO Payment Gate, SB Payment, and Digital Garage) account for more than 70% of the market and will continue to consolidate it.

Within this sector, my top pick is Digital Garage. The company is highly undervalued. Its payments subsidiary, Digital Garage Financial Technologies (DGFT), alone is worth the company’s entire market cap of ~120 billion yen. The company also holds a large amount of financial assets, including a venture capital portfolio and a 20.35% stake in publicly listed Kakaku.com.

Overall, Digital Garage is trading at a 40-50% discount to my estimated combined NAV of 200-240 billion yen.

There are signs that management is willing to address the discount. They have indicated plans to downsize the venture capital portfolio and shift focus to managing external capital. Management has also sold off a small stake in Kakaku recently. More capital being freed up and used to boost shareholder returns could unlock value.

Activist pressure could also accelerate this timeline. Engagements with activists including Oasis and AVI have resulted in some positive changes, and future interactions may result in more shareholder-friendly actions being taken.

Japan’s cashless payments landscape

Japan has historically lagged in adopting cashless payments, but it has been steadily catching up.

There are two main drivers for the increase in cashless transactions:

1. Growth in online shopping.

2. Increased use of cashless payments for offline transactions.

The breakdown of DGFT’s transactions shows that while online transactions continue to grow, offline transactions have been the main driver of cashless payments growth in recent years.

Regular visitors to Japan may have noticed this change. Five years ago, cash was still widely used at convenience stores and restaurants. However, during my visit to Japan in March, I saw firsthand that cashless payments have gained significant traction at offline venues, especially compared to pre-COVID times.

Understanding the cashless payments value chain can be confusing due to the various players involved. The diagram below (source: GMO PG) shows how the pie is split in Japan.

• International brands: Visa, Master Card, American Express, etc.

• Issuers: Entities (mostly banks) that issue cards to consumers. Issuers capture a large share of the pie due to their significant consumer acquisition and marketing expenditures (e.g. providing points and benefits).

• Acquirers: Work with the international brands, representing them in specific locales with the goal of acquiring merchants. Sometimes, acquirers are also issuers — for example, the megabank groups perform both roles.

• Payment Service Providers (PSPs): Help merchants accept various payment methods and provide the software and infrastructure for processing transactions.

One might ask, what is the difference between acquirers and PSPs? The best way to think about this is that PSPs are like agents for merchants, while acquirers are like agents for international brands. They serve different masters.

So the question then becomes — how do PSPs serve merchants and what value do they add?

The value propositions of PSPs

What’s unique about Japan’s cashless payments landscape is that it’s extremely fragmented. The image below shows all the different payment methods accepted at a Seven Eleven store (39 payment methods!)

There are five major credit card brands (Visa, Mastercard, AMEX, JCB, Diners Club). In addition, a myriad of mobile payments is offered by both Japanese companies (Rakuten, LINE, PayPay) and foreign companies (Google and Apple). Telecom companies have their own payment methods (au Pay, docomo pay). There’s also prepaid e-money like Rakuten Edy, Pasmo, and Suica. To accommodate the increasing number of foreign tourists, there are Alipay, WeChat Pay, and Kakao Pay.

How do merchants accept and interface with all these different payment methods? This is where the PSPs come in.

One-stop “plug and play” solution

One of the key value propositions of PSPs is offering merchants a “plug and play” solution for all these payment methods. A merchant that doesn’t work with PSPs would have to individually negotiate and sign merchant agreements with each payment provider. This process is time-consuming and simply impractical for most merchants, especially in a market like Japan.

PSPs offer merchants a single point of contact for all payment-related needs and troubleshooting. This streamlines operations, reduces time spent on managing and invoicing payment networks, and simplifies the entire payment process.

Aggregator

But PSPs do even more — they act as aggregator of merchants, leveraging the scale of their network to negotiate for improved Merchant Discount Rates (MDRs) with acquirers. This gives merchants better rates than they could negotiate on their own.

Here’s a simple example. A small merchant might be quoted a 3.2% MDR by an acquirer, while a large merchant might get a 2.8% MDR. Large PSPs, however, can negotiate a 2.5% MDR due to their aggregated scale. The PSP might take a 0.5% spread as commission, which means merchants will pay 2.5% + 0.5% = 3%. This is still cheaper than the 3.2% that the small merchant could get on its own.

Payments infrastructure (software)

PSPs serve as a key part of the payment infrastructure. They handle the interface between merchants and the relevant payment networks.

For example, they capture customer payment information at the Point of Sale (POS) and securely route it to the appropriate network (Visa, Mastercard, etc.) When the transaction is verified by the issuer, PSPs send authorization responses back to the merchants, relaying whether the transaction is approved or denied.

Adjacent service offerings

Importantly, in all of this, PSPs handle payment data. Payment data is valuable and can be used for a variety of purposes. Leveraging this access to data, PSPs also offer adjacent services to merchants, including financial services such as working capital loans and Buy Now, Pay Later (BNPL), as well as digital marketing services. By using their payment services as a foot in the door, PSPs have expanded into these adjacent services.

As you can see, PSPs are indispensable to merchants in the payments ecosystem.

Competitive landscape

The top three PSPs in Japan account for more than 70% of the market share and have been consolidating the market.