By Brandes Elitch
CrossCheck Inc.
For the last 20 years, Sonoma County wineries have produced what our local wine expert, Dan Berger, calls "mammothly constructed red wines, with impact, power, and pizzazz, and a slathering of oak, high alcohols, and softness." This is what American consumers seem to prefer when you are talking about a $50+ bottle of wine. They want something natural and organic that fits their notions of what a good wine should be – without additives or enhancements (except perhaps sulfur dioxide as a preservative).
But things are not always what they seem. Winemakers are not required to list all ingredients they use in addition to grapes and yeast. Due to genetic variations in taste buds, many consumers can't discern the effects of additives anyway. They habitually buy the same brands, and a few brands dominate the landscape. You could say a similar situation exists in the payments industry. It's all about branding.
Visa Inc. and MasterCard Worldwide are brands. The heavy lifting is done by the issuing banks that underwrite consumer and business credit cards. This is called "credit risk," and it is very real.
Bank regulators would expect a bank to have much less than 1 percent of its loans on nonaccrual, or they would come under some intense regulatory supervision. However, a large credit card issuer might have 4 percent of its loans on nonaccrual – a big difference.
The card issuing business is dominated by a handful of large commercial banks and a few nonbanks. The barriers to entry are insurmountable – you would have to have millions of cards outstanding to make a go of it. When the brands were "Associations," owned by the member banks, the large issuing banks ran the show.
It's not an exaggeration to say the acquiring side – what ISOs do – was an afterthought for the brands. In fact, The Green Sheet was started to give ISOs the information they needed to run their businesses, because the brands ignored them.
These brands don't actually process transactions; that is done by the large processors - again a business of very large scale. Just to be clear, Discover Financial Services and American Express Co. operate differently. They are brands, too, but they carry their own credit risk, and they process their own transactions, which is why they are exempt from Durbin Amendment debit card pricing caps.
Now let's take a look at how Visa and MasterCard get paid. Keep in mind that electronic payment solutions account for more than 60 percent of the personal consumption expenditures (PCE) in the United States. PCE as a percent of actual disposable income in the United States (the amount available after taxes) has been about 94 percent in the last few years. So we're talking about a lot of volume.
Keeping it simple, I'll use a $100 transaction amount. Let's assume the average fully loaded rate a merchant pays is 2.5 percent. The card brand would get 12 cents. The bank that issued the card used would get $1.50. The processor would get 11 cents. Finally, of particular interest to this audience, the acquirer and the ISO would get 77 cents to share.
The card brands are surprisingly profitable. Visa has a total value of close to $150 billion, yes, billion. Its share of market is almost 15 percent, according to CSIMarkets Inc. data. Visa's net profit margin rose from 27 percent in 2008 to 40 percent in 2012.
One analyst, Alexander Poulos, characterized Visa as "a cash flow machine with miniscule capital expenditure requirements and a balance sheet devoid of any long-term debt." This advantage allowed Visa to triple its dividend in the 2008 to 2012 period. About 40 percent of Visa revenue comes from assessment fees, 30 percent comes from transaction fees and the remaining 25 percent comes from cross-border fees.
More than half of Visa's gross dollar volume is generated in the United States and is evenly split between debit and credit cards. Visa has long-term contracts with over 600 financial institutions and accounts for 22 percent of all personal consumption expenditures in the country, according to Trefis analysts. This is a mind-boggling statistic.
MasterCard went public in 2006. Since then, its stock has gone up 1,400 percent (this is not a misprint). For MasterCard, the average compounded annual dividend growth over this period has been 31 percent. Nearly 40 percent of MasterCard's revenue is generated in the United States. Assessment fees account for 30 percent of revenue, transaction fees account for another 30 percent and cross-border fees are 25 percent.
Consumer credit cards account for half the gross dollar value processed, debit cards account for 40 percent, and commercial credit cards account for 10 percent. MasterCard charges an authorization, settlement and switch fee of about 8 cents per transaction and a connectivity fee of 8/10 of a cent.
Trefis estimated that if disposable income in the United States in 2019 is $13 trillion, and MasterCard retains its market share of 10 percent, the company could generate $1.27 trillion in gross development value (GDV) in the United States. MasterCard charges an assessment fee of 0.098 percent of the GDV processed for a client. If it maintains this fee structure, it could generate over $1 billion in annual assessment fee revenues from the United States by the end of the decade.
It is unlikely these margins will be threatened by a price war between the card brands; there seems to be a duopoly. Also, the risk is very low that a new player will enter the market as a direct competitor, but I predict that a host of new competitors will erode the brands' profitability in a variety of ways.
ISOs will find the distribution of Visa's business interesting, because this is where ISOs live. There are about 7 million card-accepting merchants in the United States. I estimate that the top 200 merchants generate about half of Visa card sales volume. At the bottom, there are perhaps 6 million small merchants, who process a small share, less than 10 percent of overall sales volume.
(Keep in mind that there are another 15 to 20 million very small merchants who don't take cards now).
Perhaps another 40 percent is spread over a much greater number of larger merchants, sometimes called small to midsize enterprises (SMEs), probably less than 500,000 merchants. ISOs typically deal in the SME space and are somewhat marginalized when it comes to very large enterprises, who can deal directly with Visa. It is questionable whether it's worth it for an ISO to spend time chasing micro-merchants – that is to be determined.
In terms of valuation, publicly traded companies in the payments space, such as Heartland Payment Systems Inc., Vantiv LLC, Total System Services Inc., WorldPay and Global Payments Inc. seem to have an earnings before interest, taxes, depreciation and amortization multiple of between seven and 10.
Of course, these five firms do not employ all the bankcard salespeople; many smaller firms exist, too. By contrast, Visa has a price/earnings ratio of 28.9 for 2012, an estimated 23.67 for 2013 and an estimated 20.2 for 2014.
For Visa and MasterCard to have gotten off the ground, two things had to happen: banks needed to get credit cards into consumers' hands and ISOs had to convince merchants to accept bankcards as a form of payment. Thus, ISOs have always been in a symbiotic relationship with Visa and MasterCard.
But when you look at the profitability and multiple for these brands, you can understand why so many new players want to get a piece of this. They will do it not by challenging Visa directly (the large retailers will do that), but by offering new forms of money that are not interchange based – at least not at these levels.
I don't mean Bitcoin. I mean new ways and incentives for the consumer to buy something. Visa and MasterCard are powerful brands, very powerful, but great brands have to reinvent themselves at some point. It will be interesting to see if this happens, and how. If these changes come about, how will you, as an ISO, be affected?
Since the beginning, ISOs have hitched their wagon to the Visa brand, and the Visa cost structure has in many cases handsomely rewarded ISOs for signing merchants to take cards with the Visa brand.
How will the new entrants create a revenue steam for ISOs – or will they? That is the question.
Brandes Elitch, Director of Partner Acquisition for CrossCheck Inc., has been a cash management practitioner for several Fortune 500 companies, sold cash management services for major banks and served as a consultant to bankcard acquirers. A Certified Cash Manager and Accredited ACH Professional, Brandes has a Master's in Business Administration from New York University and a Juris Doctor from Santa Clara University. He can be reached at brandese@cross-check.com.
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