An Acquiring Paradox: Discounts Are Squeezed, But Spreads Are up

Counter-intuitive though it may be, independent sales organizations and merchant acquirers in general are seeing their spreads increase while simultaneously facing margin compression. The reason, according to a new report from Aite Group LLC assessing trends in the acquiring industry: acquirers are generating new revenues from their merchants outside of their main revenue stream, the discount rate. Acquiring-industry executives have been complaining for years about a profit squeeze. In a November 2007 report citing results of an industry survey, Aite said 73% of its ISO/acquirer respondents indicated the No. 1 challenge facing their industry was margin compression (Digital Transactions News, Nov. 26, 2007). There is some statistical support for that view, but only if discount revenues are considered. Back in 1995, the average discount rate, or the charge to merchants for card processing as a percent of the sale, was 1.87%, with 1.4% for interchange and 0.47% for the acquirer, according to a Visa report cited by Aite. Interchange is a component of gross revenue that acquirers must pass on to card issuers, so the acquirers' share of discount revenue was 25.1%. In 2004, the last year for which the Visa analysis was available, the average discount rate was 2.08%, with interchange accounting for 1.71% and acquirers' revenues 0.37%. That means the acquirers' share was 17.8% of discount revenue. But a look at the books of some industry players tells a different story?a story of growing profits, according to Boston-based Aite. Net spread, or total revenues after interchange divided by charge volume, increased from 0.242% in 2004 to 0.251% in 2005 and 0.257% in 2006, the last year for which figures are available. While discount revenue indeed may be squeezed, acquirers and ISOs are compensating by adding administrative fees, application fees, statement fees, and miscellaneous fees, and they are now selling prepaid cards and checking services to their merchant customers, says Aite analyst Adil Moussa. “They do have the leeway to sell other things, that's how they are able to increase net spread,” he says. Based on a late 2007 survey of 11 of the top 70 U.S. acquirers, Aite predicts that 76% of merchant acquirers' 2010 net revenues will come from the discount rate compared with 81% in 2006. Administrative fees will grow to 9% of revenues by 2010 from 6% in 2006, while products will account for 7%, up from 3% two years ago. Terminals will account for just 3% of revenues in 2010 compared with 6% in 2006 and 9% in 2002, Aite estimates. The remaining 5% of 2010 revenues will come from unspecified other sources, little changed from 4% in 2006. The recent efforts by Discover Financial Services LLC and American Express Co. to grow their merchant bases by enlisting bank card acquirers as sales agents also represent new charge-volume and profit opportunities, Moussa says. In all, Aite estimates U.S. acquirers and ISOs made $1.44 billion in pre-tax profits in 2007, profits that will grow to $2.26 billion in 2012 as charge volume swells. Other acquiring industry analysts such as First Annapolis Consulting Inc. have noted that processors and acquirers are diversifying their product offerings. But one real threat to profitability, especially the profitability of smaller ISOs, is the now-widespread practice of giving merchants point-of-sale terminals, First Annapolis concluded (Digital Transactions News, December 5, 2007). Meanwhile, acquirers still have plenty of merchant fruit left to pick in the U.S., though not necessarily low-hanging fruit such as mall and Main Street retailers, restaurants, and other industries that have high card-acceptance rates. Citing Internal Revenue Service data and its own estimates, Aite says 33.5 million merchants filed tax reports in 2007, but only 6.8 million, or 20.3%, accepted credit cards.