Study Assails Corrosive Effects of Free Terminals on Acquiring Profits

The practice of giving away point-of-sale payment terminals, which started out as a tactic to attract salespeople, has become a huge phenomenon in the merchant-acquiring business that threatens the profitability of many industry firms, particularly smaller independent sales organizations more reliant on hardware revenues than larger acquirers. That's the conclusion of First Annapolis Consulting Inc., which in its latest annual study of acquiring-industry pricing asked ISOs and other merchant processors about the extent of the free-terminal trend. Based on responses this autumn from 19 firms large and small representing 60% of bank card volume, First Annapolis estimates nearly two-thirds of acquirers now offer free terminals, and 9% of merchants have at least one. Free terminals appeared on the scene only a few years ago, and the first companies offering them didn't give them to merchants, they offered them to new salespeople as a way to attract talent, according to C. Marc Abbey, a partner at Linthicum, Md.-based First Annapolis. The idea was that the salespeople would sell or lease the terminals to merchants and keep a larger share of that revenue stream than they otherwise would. But salespeople soon started giving their free terminals to merchants, which converted the practice into a form of price competition. Hardware sales, leases, or rentals accounted for about 8% to 10% of industry revenues a few years ago, when First Annapolis last looked in detail at that component, and Abbey surmises hardware's share has been declining since. Nonetheless, hardware revenues are still important, especially to smaller ISOs that don't have the diversified revenue sources that big acquirers do. Free terminals put even more downward pressure on the hardware side. “A sizable portion of that revenue stream is evaporating,” says Abbey. Besides the obvious effect on revenues, free terminals have a negative impact on the timing of cash flows. ISOs often fund upfront sales commissions from hardware sales, according to Abbey. If they give away terminals, they have to look elsewhere to fund sales expenses, which raises the cost of booking merchants. “Effectively you have a higher net acquisition cost, and that can be very problematic for an ISO,” he says. In fact, the higher acquisition cost might even translate into a merchant account that doesn't make any money over its expected lifetime. The acquiring business is highly competitive when it comes to offering attractive discount rates to new merchants, though merchants tend to generate more revenues over time as one-time price breaks expire and they start buying other products and services from their acquirers. It's possible that competition spawned by free terminals could spill over into other revenue streams, according to Abbey. If so, “it's going to have asymmetric implications for acquirers.” Those that will be hurt the most, he predicts, will be ISOs with commissioned sales forces and heavily dependent on hardware sales. Meanwhile, industry competition is driving up the cost of sales for most acquirers. A decade ago, back-office processing and related functions were acquirers' single biggest expense, according to First Annapolis. “Today the biggest single expense is sales,” says Abbey, who estimates sales now account for 40% to 50% of industry expenses.