By Brandes Elitch
CrossCheck Inc.
In the first quarter of 2014, the quote, "Things are not always what they seem" from The Phaedrus by Plato, seems to take on new meaning. Now we are not so sure of things we used to take for granted. Here in Sonoma County, we count on an abundant supply of water. It takes roughly five gallons of water to make a gallon of wine, and we typically get about thirty inches of rain a year. But right now we are in the middle of the worst drought in many years.
The wine industry creates nearly $60 billion in value for the California economy and supports 330,000 jobs. We know rising temperatures from climate change can do great harm to our wine business, but we don't yet know how to deal with it.
Another thing we commonly agree upon is that some wines get better with age. However, local wine expert Dan Berger believes only 5 percent can predictably age well. To a person knowledgeable about wine, this is about trading the fruitiness of a young wine for the complexity of an older wine. It also depends on the quality of the original vintage, and of course, how it is stored – ideally at 55 to 60 degrees. Then there is gratuitous advice such as: "It's a big, bold wine," which really means, "It has 16 percent alcohol and should have a "Flammable!" warning label, or "It's a delicate wine," which really means, "It has no flavor at all." Things are not always what they seem.
In addition, we are surrounded by famous labels that typically sell above $15 a bottle, but we forget how critical the "beverage wines" are to the wine industry. For example, Gallo is positioning itself here as a premium winery, but its Night Train Express and Thunderbird are highly profitable. We take it for granted that the premium wines carry the day for the wineries, but this is not so. Things are not always what they seem.
In the payments business, Visa Inc.'s traditional model seems to be as permanent and immutable as a law of physics. But, as Paula Rosenblum has pointed out in her excellent www.retailwire.com articles, the industry is ripe for disruption. Disruption occurs when there are new technologies, new demands from seller or buyer, new regulations, and crises of confidence.
Rosenblum has noted three causative factors in her columns:
We routinely see new technologies designed to circumvent the existing payment platforms or pricing models, but we don't see much traction. Part of the reason is that consumers have to be motivated to forego the benefits and reward miles from their current cards without sacrificing the reliability and convenience that they have now. However, when consumers are unhappy, retailers think they are paying too much, and technology creates new products, disruption can and will occur. As an ISO who gets paid based on the traditional model of interchange, you might want to pay attention to these developments.
There has been much talk about Europay/MasterCard/Visa (EMV) chip cards, but the major issuers will take a cautious approach to re-issuing hundreds of millions of mag-stripe cards. Merchants who take them are going to need meaningful incentives. There are about 8 million card-accepting locations in the United States, and these merchants are not happy about buying new EMV equipment and training employees on a new system.
Even after three years of Visa's jawboning, less than 1 percent of the total Visa cardholder base (660 million cards) is EMV capable. The original deadlines set by Visa are not going to be met by everybody. Some observers, such as Celent LLC, believe merchants will need more incentives, such as interchange relief for EMV transactions, or mandating the use of PINs and eliminating signatures, and perhaps using tokenization, to address e-commerce fraud.
Recently, a contributor to Retail Systems Reseller, Richard Mader, made this point, "The loser in the interchange wars is clearly the consumer. This is because while card brands, retailers, and other stakeholders have refused to work together for the last 10 years, payment security has not been optimized, and convenient mobile wallets are not widely available."
Mader wrote that in 2009, while serving on the National Retail Federation CIO Council, he helped organize the Mobile Retail Initiative and recruited stakeholders (retailers, banks, card brands, payment hardware and software providers, and mobile network operators) to work together. He concluded, "We were never able to get involvement from banks and card brands because they would not cross the battle lines … the leadership of most stakeholders clung to their individual interests."
The solution he advocates includes settling the lawsuits and having an independent association organize discussions among the stakeholders, leading to a timeline and action plan for the next generation of retail payments.
One thing that hasn't changed is that the banks are still firmly in control. There are perhaps a dozen major issuers and a dozen major acquirers. The banks that issue cards in large scale want to sign the merchants that already bank with them, to use that bank as an acquirer (clearing the trades in-house without taking them to the floor of the exchange, so to speak). These banks will increasingly own this industry. What will be the role of the ISO going forward.
Now, Visa's business model is highly profitable, and it generates a lot of cash. It has exhibited strong growth in service, data processing and international transaction revenues. It does not take credit risk and it is not a bank. For fiscal year 2013, Visa reported an operating income of $7.239 billion on total revenue of $11.778 billion. This is a very high operating margin. The net margin is also high: 42 percent.
Visa has a free cash flow yield of almost 5 percent. These are extraordinary numbers. History teaches us that when a company has margins like these, competitors are driven to find ways to take it away. The higher the margins the more energy, funding, and power are brought to bear to do just that. These margins may be sustainable in the short term (the next five years) but not in the long term (10 years and beyond).
As for PayPal Inc., what if PayPal could emulate the large issuing and acquiring banks, and do it without Visa, to boot? Well, it can, when shoppers have cash in their PayPal accounts or link it to their banks. Then, PayPal doesn't have to clear transactions on consumers' Visa cards and pay a 3 percent fee. But for PayPal to attract money, it needs to offer the same reward structure as a bank does. You could have your direct deposit sent there, link all your credit cards, access cash, and write checks, and pay interest on money market accounts.
Then, particularly if you were a regular eBay Inc. user, you wouldn't really need another bank because PayPal would become your new bank. Moreover, PayPal would protect your banking and card information when purchasing online. Not having to pay a 3 percent fee to Visa is a huge competitive win for PayPal. This is the kind of transformation that is going to erode the Visa franchise over time.
Some things we take for granted, such as Visa's impregnable and highly profitable business model, and the role of ISOs in signing merchants for acquirers, and handling the training, installation, and customer service too – but how much longer can we take that for granted? The Green Sheet, and the Electronic Transactions Association, were founded to help ISOs do their jobs more effectively. As industry changes inevitably occur, we must continually look for new ways for the ISO to add value to merchants.
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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