Acquiring: A Partly Cloudy Forecast

 

Karen Epper Hoffman

 

The recession and the shaky recovery have taken their toll on acquiring, though the business has fared better than most other industries. Now, the business could be set to soar—if factors like Durbin don’t choke off growth.

 

In an economy where even the strongest have failed to tough it out, merchant-acquiring businesses have by and large not only survived but thrived relative to other industries. And now emerging opportunities could set the stage for faster growth, provided new restrictions on the debit business don’t get in the way.

 

It’s true that companies in the acquiring arena have taken their lumps along with virtually every other segment of the market during the past nearly three years of economic recession and weak recovery. But profit-wise, these businesses have managed to keep their head above water better than many other areas of the market by a combination of agile responsiveness and consumer dependence on plastic.

 

Indeed, payments companies have been solidly outperforming the S&P 500 throughout the economic downturn, but most especially in the last two years as the difference in profitability between the two groups has widened, according to the most recent TSG Payments Index (TSGPX), released last month by The Strawhecker Group, an Omaha, Neb.-based consulting firm.

 

It says even more that the strongest-performing sector within the TSGPX was the merchant-acquirer and processor sector, with an average return of 41% since the second quarter of 2010, according to The Strawhecker Group. By comparison, the card brands sector, which also performed well, averaged 26% in the same period.

 

The TSG Payments Index includes a wide variety of payments-industry players, including point-of-sale equipment providers like NCR Corp., software providers like ACI, prepaid network providers like Green Dot, data-security resellers like VeriSign, card networks like American Express Co., money-transfer businesses like Western Union, and merchant processors and acquirers like Heartland Payment Systems, TSYS, and Global Payments.

 

“One of the reasons that the industry has done so well as compared to other [industries] is that it seems to be less exposed to the economy than others,” says Bob Loewens, a junior associate at the Strawhecker Group who worked on the research.

 

Responding Actively

 

Compared to many other business categories, merchant acquiring is “a little less capital intensive” and offers recurring revenue streams that have buoyed profitability throughout the sector, according to Loewens. Looking back at return-on-equity performance, acquiring businesses have averaged about 20% over the past five years (from 2005 through the end of 2010), while the S&P 500 averaged about 15%, he adds.

 

Kim Fitzsimmons, senior vice president of merchant services and community banks for First Data Corp., says that her company “remains healthy for a combination of reasons.” These include First Data contracts with retailers in the supermarket and petroleum sectors, “where consumers still buy, regardless of the economy,” as well as online merchants, where spending also continues to grow.

 

Also, Fitzsimmons cites consumers’ continued commitment to plastic: “Credit and debit card usage continues to outpace other forms of payment.”

 

Indeed, the total market for electronic payments made by U.S. consumers is on target to almost double from 35% of transactions in 2000 to 64% in 2013, says Mike Strawhecker, director of marketing and strategic research for The Strawhecker Group. This reflects consumers’ increased use of debit cards for smaller transactions as well as recurring payments, Strawhecker adds.

 

Paul Martaus, president of Martaus & Associates, an acquiring consultancy in Mountain Home, Ark., says, “The click business [earning a percentage for processing transactions] is thriving, although not increasing dramatically. We have successfully inculcated American consumers to use plastic to buy everything.” Hence, Martaus explains, even during the recession, while the average consumer may be spending less on each shopping trip, the net number of transactions they make has increased.

 

Also, despite the fact that more credit-conscious consumers were trying to reduce their debt by shying away from using credit cards, many of them were using their debit cards even more, according to Scott Calliham, a principal at First Annapolis Consulting of Linthicum, Md. “People just went from credit to debit,” he says.

 

The debit picture, however, could darken owing to recent legislation—a prospect we’ll get to in a little while.

 

Not that economic realities haven’t already taken their toll on acquiring processors and independent sales organizations. Factors such as merchant attrition and lower consumer spending have hit their marketplace hard. But industry observers say that the most successful acquiring businesses have not only been well-positioned, but also nimble enough to respond to the changing payments climate.

 

“In general, merchant acquirers are doing better, even though retail sales and volumes have turned negative for the first time in 20 years,” says Calliham.

 

Calliham says the more successful acquiring businesses have done well by responding actively to the market. This includes increasing pricing in some segments, tackling new merchant segments like taxis and vending machines, and launching efforts in business-to-business transactions and in mobile payments.

 

Case in point: First Data is one of the partners in the recently unveiled Google Wallet m-payments initiative, which also includes Google Inc., Citigroup Inc., and MasterCard Inc. First Data is serving as trusted service manager for the new wallet, which is based on near-field communication chips in Google’s Nexus S smart phone, but is also recruiting merchants to install the contactless readers necessary to make the service work.

 

Martaus adds that several acquiring companies have expanded into rapidly growing prepaid and gift card businesses “big time.”

 

Pain on Main Street

 

But merchant acquirers have responded by looking inward as well, seeking new ways to maximize growth through changes in their internal structure and operations. Heartland Payments Systems, for example, restructured its sales force to make it more efficient by implementing stricter performance measures, says Loewens. “If the reps aren’t hitting their measures, they’re replaced or required to take additional training,” he adds.

 

“The last couple of years have forced acquirers to look at their operational efficiencies,” Calliham agrees, adding that such introspection hasn’t come without a price. In some cases, companies are running leaner because they are “forgoing some investments that they should be making” in product innovations such as encryption, he says.

 

While the industry as a whole has performed relatively well, certain segments and individual players within the merchant-acquiring landscape have made out better.

 

Most industry observers agree that the acquiring companies that have large portfolios of smaller or local retailers have been hit harder than those that processed transactions or provided services to large national retailers.

 

First Annapolis Consulting issued a survey in mid-2009 indicating that, for the first time ever, same-store sales on Visa and MasterCard at small and medium-size retailers fell. The drop was 4.9% from January through May of that year. For the research, First Annapolis surveyed 17 acquirers—nine bank acquirers and eight non-bank processors, which accounted for more than half of all U.S. card-based payments. Such a decline had not been recorded “even in past recessions,” First Annapolis said in a release at the time.

 

Acquirers with many clients among the Main Street merchants not only had to contend with slumping transactions as consumers eschewed pricier local stores for national discount outlets, but also with rising merchant attrition. Between the end of 2008 and May 2009, the loss rate stemming from business failures among small to medium-size merchants nearly doubled from 0.92 basis points to 1.73 basis points, according to the First Annapolis research.

 

“If you’re a Chase [Paymentech] or a First Data or a Fifth Third and most of your clients are tier-one retailers, you’re doing well,” Martaus says. Acquirers with portfolios heavily concentrated in the mom-and-pop or specialty retail businesses took a bigger hit, Martaus says.

 

While pay-per-click processing maintained its allure, there has also been a benefit for big acquiring companies that have hedged their bets and stayed diverse. Fitzsimmons says that First Data has stayed strong by being “in the position to handle the click from the issuance of the plastic, to the authorization and processing of the transaction, up to and including owning our own debit network, Star.”

 

Indeed, while processing transactions for big-box merchants may have provided a somewhat more stable stream of business, Strawhecker points out that that segment also tends to provide the thinnest margins. He argues, therefore, that it still pays off for acquirers to go after a more diverse merchant base.

 

Merchants Stabilize

 

Independent sales organizations, an important and traditionally profitable link in the acquiring chain, have been hit even harder in recent years.

 

For starters, Martaus says, the overall pool of available customers for their services has diminished. “It used to be a zero-sum game. To get a customer, I could just take him from someone else,” Martaus says. But with a shrinking market of smaller merchants requiring such services, “there are fewer and fewer opportunities out there.”

 

A low barrier to entry—compared to being a larger acquirer or processor—has also made the ISO business ripe for competition, putting more pressure on remaining ISOs to offer price concessions, compressing earnings, Martaus adds.

 

“ISOs were affected the most by the recession,” Calliham says, because they lacked both the easy referral source that bank acquirers have through their business-banking units and the scale of the larger non-bank processors. Calliham believes it’s affected the sales strategies of the ISOs by making them more disciplined and somewhat more conservative in terms of picking sales partners among more steady trade associations and independent software developers, for example.

 

While most industry observers agree that segments of the acquiring business may never fully return to the halcyon days before the 2008 financial crash, there are hopeful signs that the overall business is on an upswing.

 

The continued shift from check-based to recurring electronic payments will help increase transactions, The Strawhecker Group’s Loewens says. And, while consumers may not have returned to their pre-financial-crisis spending levels, Fitzsimmons says First Data is seeing growth.

 

She adds a cautionary note, however. “Consumer spending behavior continues to evolve as a result of the financial crisis,” she says. “While we’re encouraged by the steady pace of volume growth and the rise in consumer confidence, it’s too early to predict if the market will return to pre-2008 growth.”

 

Although First Annapolis has not repeated its 2009 research on same-store sales, Calliham says that, based on anecdotal information and other market indicators, acquiring opportunities are improving. “After shutting down various outlets…and attrition, the merchants themselves have finally hit a plateau,” he says.

 

Also, Calliham sees more acquirers adding new products and services that are likely to boost profits. Martaus also sees acquirers looking into new offerings in mobile payments, micro-marketing, special reporting programs, and cash-management services—ancillary services that not only provide another revenue stream, but also make the acquirer’s service stickier to merchants.

 

Strawhecker says “there are still markets in the United States yet to adopt electronic payments.” He sees potential opportunity for acquiring growth in the business-to-government, government-to-consumer, and business-to-business arenas, “where volumes are huge and largely untapped.”

 

Durbin’s Shadow

 

Meanwhile the Durbin Amendment—which would set caps on debit card interchange fees and is slated to go into effect this month—could also have a profound impact on the acquiring market outlook, both positive and negative.

 

Congress passed the amendment last year as part of the massive Dodd-Frank Act. In December, the Federal Reserve released preliminary regulations to implement Durbin, including a 12-cent cap on debit interchange, well below the average 44-cent fee. The board, which has received thousands of comments on its proposal, was set to publish final regs in July. “We will not know how Durbin will impact First Data until the final regulations are announced,” Fitzsimmons says.

 

Since acquirers pay interchange to issuers and then build the cost into their pricing to merchants, Durbin’s restrictions could fatten acquirers’ bottom lines, at least in the short run, if the processors pass on only a portion of the savings. “In the short term, [Durbin] could be a win for acquirers and ISOs,” Strawhecker says

 

Calliham also points out that the Durbin legislation raises the opportunity to offer new pricing and routing options. “Acquirers can offer least-cost routing services dynamically and charge for it,” he adds.

 

But ultimately, analysts agree that the profit benefit will be short-lived, since merchants will demand that they receive the full benefit of lower interchange rates. “The market is going to dictate what happens,” Calliham says.

 

Martaus, however, sees more dire consequences.

 

“Durbin could crush things,” he says. “The industry will change in ways no one can foresee.” With the advent of Durbin, Martaus believes issuing banks are likely to start charging customers for the use of debit, which in turn may force buyers away from their growing dependence on plastic. Already, some banks have indicated they will cut back on debit rewards programs and start levying account fees because of Durbin.

 

“Consumers will go back to using gold or cash or wampum or some damn thing,” Martaus says.