Key Points
- Despite a challenging operating environment, the macro picture has been one of remarkable resilience for both consumers and SMBs.
- The demand for banking tech which began during the pandemic has continued to be strong as community banks and credit unions catch up with larger incumbents in the space.
- Fintechs are responding to market disruption by embarking on strategic reviews, leading to more focused product roadmaps with a greater emphasis on profitability.
- With depressed valuations for both large public companies and challenger brands, sponsors and strategics are freeing up cash flow and working capital for accelerated M&A activity.
There’s no doubt that 2023 has presented a challenging operating environment for financial services companies and fintechs, with high-profile bank failures causing depressed valuations and general market unease. But what’s surprising is just how resilient consumers and SMBs in the space have been, reveals Dan Perlin, Head of FinTech and Payments Research, following this year’s successful Financial Technology Conference.
“Despite a lot of questions around bank failures, financial services firms continue to spend and many of these companies saw record sales pipelines.”– Dan Perlin, Head of FinTech and Payments Research, RBC Capital Markets
“When we look at all the data that came out of the conference, it felt like the macro environment was a bit more stable than the headlines were suggesting,” says Perlin. “Despite a lot of questions around bank failures, financial services firms continue to spend and many of these companies saw record sales pipelines. That is counterintuitive to the narrative in the market. We have seen some elongation in the sales cycle for larger enterprises, but that’s more of a factor in the services space than in fintech,” he adds.
“If you look at the aggregate numbers, consumer spending did decelerate by about 500 basis points, but it’s holding up pretty well as a result of strong employment. Discretionary spending also slowed, despite the travel and hospitality sectors holding up well. Inflation put severe pressure on the consumer early on, but it’s beginning to abate and we’re starting to see transaction growth. Inflation has been a net positive for the payment space, and relative macro stability is underpinned by a strong employment backdrop. It’s been a pretty good shock absorber.”
Banking tech in demand as smaller banks play catch-up
During the pandemic, banks had to rapidly pivot to digital and mobile. The result was the realization that there were efficiencies to be gained in back-office operations. At the same time there was a shift towards a more modular banking model that offered customers a wider range of choice for engaging with financial products and services. This has run alongside a significant shift of banking services onto the cloud.
“Banking’s not fully in the cloud yet, but it’s getting there,” says Perlin. “During the pandemic banks learned that there were just so many things to win. There’s been a huge demand for technology, especially in the community banking and credit union space because there are just so many tangible benefits. These sectors have been behind the curve for years and now they’re catching up to the big banks and becoming more competitive with them.”
“Looking at the broader environment, software continues to be integrated into all areas of fintech. What businesses are looking for today is a single platform or provider, so things aren’t as fragmented as they once were. They’re looking for more integration to drive better business outcomes, not just more efficiencies. That means things like adding payments with working capital, intelligent inventory management, increased customer engagement tools to build loyalty, and data analytics. Obviously, AI will be a big part of this theme.”
The drive for more streamlined solutions and improved outcomes will see software integration build momentum in the space. “The key message I would send is that software integration within all things fintech is going to happen over the next five years,” says Perlin. “We’re already seeing it happen and the end markets are demanding it. They’re realizing that the businesses that are going to win are the ones that are going to drive better outcomes, not just some back-office efficiencies.”
Strategic reviews lead to increased focus on profitability
Turbulent times don’t reward businesses that stay still, so many companies in RBC’s fintech universe are seeking to refine their strategies. “We’re seeing lots of strategic reviews in the space,” says Perlin. “A lack of access to capital and the rising costs of capital has caused businesses to refocus. Management teams are really focusing on KPIs and whether to split up businesses to have the appropriate shareholder base and the appropriate amount of capital invested in them.”
With capital harder to come by, companies are thinking more strategically about how to unlock value. There is now more emphasis on customer acquisition and sales conversions. “A lack of access to capital has really narrowed the product roadmaps for so many companies, and there’s now a far greater focus on profitability,” says Perlin.
“In the past, a lot of companies focused on too many things or were too stretched. Looking at our universe of companies, we’re seeing more focused innovation. And SMBs are figuring out how to run their businesses so much better. How do they get an individual into the store? How do they reduce cart abandonment? How do they get net-new sales? This new focus on simplicity and transparency is starting to resonate with investors.”
“As supply chain cost inflation issues get better it’s likely to generate better free cash flows in the coming quarters.”– Dan Perlin, Head of FinTech and Payments Research, RBC Capital Markets
Free cash flow sets the scene for M&A
High inflation and supply chain constraints have driven up costs, which puts a squeeze on companies’ ability to generate the free cash flow (FCF) that managers need to drive shareholder value. Perlin reports an increased push to generate FCF and notes improvements in the operating environment. The net result looks set to be increased M&A activity in coming quarters.
“These businesses have always had a big focus on free cash flow,” says Perlin. “Across the board we heard from the conference that companies are working on better working capital as well as cost containment efforts. A lot of the supply chain costs embedded into these companies were very high but both inflation and supply chains are starting to improve. That’s creating better comparisons.
“As supply chain cost inflation issues get better it’s likely to generate better free cash flows in the coming quarters. That’s something we’ve been hearing universally. Previously, the big players have always been able to generate plenty of free cash flow, but the smaller ones have struggled. That’s changing pretty dramatically now.”
With depressed valuations for both public companies and smaller challenger brands, Perlin sees both financial sponsor and strategic M&A picking up pace in the second half of 2023 and beyond. “A lot of companies that went public are down by 60% or 70% from their IPO, so it’s possible we’re going to see some of those companies getting bought back in,” he says.
“At the same time, some of these innovative companies that were disruptive to larger incumbents are now a lot cheaper as well. So the strategics who have free cash flow and strong balance sheets are probably going to go after them. We’re seeing a lot of spin-offs occurring in the space designed to free up capital for M&A, so I think it’s going to be an incredibly busy 12-18 months for M&A for both sponsors and strategics. There’s plenty to go around.”
