Scale alone won't make a merchant acquirer successful. But some national accounts combined with a well-managed, properly segmented merchant portfolio can produce windfalls even for mid-tier acquirers. 
  Among the decade-long trends remaking the merchant-acquiring industry in the United States is the continued consolidation of the national merchant market. Ten years ago, almost all sizable acquirers had several major accounts in their portfolios.
  Today, just four acquirers dominate the major merchant market, and the conventional wisdom is that the market is a profit killer. The financial importance of the national merchant market is less than first meets the eye, but First Annapolis nonetheless believes that the acquirers who are players in the national market will have strategic options, over time, foreclosed to the rest of the industry.
  The national merchant market, for the purposes of this analysis, includes merchants with two million or more Visa and MasterCard purchase transactions annually. There are approximately 230 such merchants, and they account for nearly 60% of the industry's transaction volume.
  Four acquirers control over 85% of transaction volume in this segment: National Processing Co. (NPC), Chase Merchant Services (a joint venture of First Data Corp. and J.P. Morgan Chase & Co.), Fifth Third Bancorp, and Paymentech. These acquirers tend to be specialized by segment. For example, though Chase Merchant Services has 27% of the national merchant market in general, it has captured 82% of auto-rental volume and 76% of cruise lines. NPC has 40% of the national market and, for the moment, 60% of airline volume (NPC has announced plans to exit airline acquiring as current contracts expire.)
  Acquirers have been aided in building and maintaining these shares by natural barriers to entry. These merchants overwhelmingly enter into three- to five-year term contracts. Further, national merchants, of course, are demanding and often require significant customization which turns into a natural advantage for the incumbent acquirer when the service is re-bid at contract renewal. So of the 230 national merchants, probably no more than 70 to 80 come up for bid each year. We estimate no more than 10% of these merchants elect to switch acquirers and convert to new systems and operations.
  The signing by an acquirer of only one or two of these national merchants would constitute good sales performance and a relatively favorable close rate. It would take many years for a new acquirer to make significant headway in the market, at this rate.
  National merchants not only constitute a significant share of U.S. payment card volume, but in many merchandise categories, this share has been increasing rapidly. The concentration of share into the hands of large retailers has occurred both because of merger and acquisition and because of organic competition.
  For example, according to research by Bear, Stearns and Co., the share of total general merchandise sales controlled by discount retailers during the 1990s increased from 18% to 26%. Some 96% of this discount-store market share is controlled by Wal-Mart Stores Inc., Kmart Corp., and Target Corp. Wal-Mart's share virtually tripled during the 1990s and Target's doubled.
  However, the national merchant market is not nearly so important financially as its volume characteristics would suggest. Our analysis of historical and current pricing in the national merchant market suggests that net revenues have been in virtual free-fall for the past decade.
  For the early 1990s, First Annapolis estimates that national merchant net spread (gross revenue less interchange and assessments divided by sales volume) averaged about 30 basis points (0.3%), which dropped to 17 basis points by mid-decade and then dropped again to 13 basis points by early this decade. (There is no good industry data, but our educated guess is that the price competition in the national market-the decline in net spreads-is twice the rate of the rest of the industry.) This 13-basis-point net spread compares to an average for the rest of the industry in the 55- to 65-basis-point range. So though national merchants generate over half the volume in the industry, they account for less than 20% of revenue.
  Furthermore, acquirers tend to price these merchants on the margin. More specifically, acquirers price these merchants at fractions above the acquirers' variable costs, with the traditional rationale that any positive margin contribution (margin above variable costs) adds to economies of scale.
  One of the implications, however, is that these major merchants that account for 60% of volume and 20% of revenue generate only about 13% to 15% of industry earnings on a fully costed basis. These pricing dynamics have been triggered by brutal competition between acquirers and by the exercise of leverage by major merchants. But there are other threats to the segment's economics, as well.
  In 2002, Wal-Mart proposed to buy an industrial loan corporation with the stated intent of becoming a member, directly or indirectly, of Visa and MasterCard and providing merchant acquiring for itself, displacing third-party acquirers. State banking regulators subsequently disallowed the planned acquisition, but it nonetheless focused a spotlight on the strategy of self-acquiring.
  Virtually all major retailers with proprietary credit card programs have chartered commercial banks to benefit from the banks' favorable regulatory treatment. We estimate that perhaps as many as 30% to 40% of these retailers with banks also are members of Visa or MasterCard, usually to issue a cobranded card or related credit product.
  It is not a huge leap for these retailers to utilize their banks and card-association memberships effectively to do merchant acquiring in-house, especially considering the new generation of transaction-processing software options now available. The impact for acquirers would be to undermine the scale dynamics in the national merchant market. It would not require more than a handful of the largest merchants to in-source for the scale benefit of the segment to decline materially.
  Similarly, if the U.S. Department of Justice ultimately prevails in its antitrust case against Visa and MasterCard that the card associations are appealing, American Express Co. could come out a winner. In that case, a federal trial court struck down association rules barring Visa and MasterCard members from striking deals with AmEx, deals in which banks could issue AmEx cards. If that ruling is sustained, AmEx may be able to shift issuing share from bank cards to its own products. Because American Express is a direct acquirer and processor in the national segment (as opposed to using third-party acquirers as intermediaries), any shift in share on the issuing side would also put under pressure the scale national merchants generate for acquirers.
  These financial and marketplace dynamics all beg the question of why the four market leaders and the six or eight second-tier players make the considerable investments to sell, sign, and service these demanding large merchants. We believe there are three principal arguments regarding the overriding strategic importance of this market segment.
  * Scale: Everyone involved in the acquiring business understands that it is fundamentally a scale business, and unit costs have been demonstrably falling on average 7% to 9% a year for 15 years or more. However, much of this improvement in expense reduction has resulted from efficiency improvements rather than scale, per se. In all of First Annapolis's quantitative analyses, the size of an acquirer is actually a poor predictor of its cost structure.
  Short-Run 'Diseconomies'
  This observation is counter-intuitive, but it results from the fact that many of the tactics acquirers have used to gain scale have generated diseconomies over the short run. Global Payments Inc. has five front-end platforms, all from acquisition. NPC operates two back-end platforms. First Data Corp.'s First Data Merchant Services unit operates five back-end platforms in various parts of the world, mostly due to acquisition.
  All of these organizations no doubt have strong rationale for their platform decisions, but they are sub-optimal in raw scale terms. The strategic implication, however, is that these acquirers and others have significant scale gains in their futures as they rationalize their systems and operations over time.
  We see an acceleration in price competition and related tactics as these acquirers and others continue to drive costs. In an environment emphasizing the renewed importance of scale, it is difficult to see a company as competitive on cost in the long term without having a presence in the national merchant market. This does not imply that all acquirers should pursue national merchants, but it does imply that if you are not a player in the national market, your strategy better not depend on cost competitiveness.
  * Market Dominance: Acquiring long has been a sales-oriented business. That is, acquirers with the most effective sales organizations have been the most competitive. And in fact, many acquirers have organized by sales channel and have business units focused on independent sales organizations vs. direct sales vs. agent banking vs. telesales, etc.
  However, for several years now, many acquirers have shifted their focus to more of a segment-driven approach. Acquirers have targeted merchant segments and have pursued specialized products and services customized for these segments. This strategy has often evolved where an acquirer developed specialized products and services for one or several large merchants and then migrated the technology downward into the mid market and regional merchant market. This strategy can lead to high share and related branding advantages, retention, and pricing power. As a strategic matter, if an acquirer is not the cost leader and does not have superior technology, then segment specialization is one of the very few options available to develop long-term defensible niches.
  It is our contention that segment specialization will become a strategic necessity in the coming years. In many of the industry's largest segments, it is simply not possible to dominate the segment without playing in the national merchant market. Again, this phenomenon does not, per se, argue for all acquirers to pursue national merchants, but those that do will have greater segmentation options. If you are not competitive on the national level, your targeting decisions should consider the percent of the segment concentrated in the hands of the very largest merchants.
  * Product Proliferation: There has never been a period of more rapid innovation in payments as the last two to three years. New payment products ranging from card types to access devices to information-based products have come to market. Much like any consumer product, the vast majority of these products will not be commercial successes, but undoubtedly a small subset of the innovations will be central to the industry's future.
  The revenue streams an acquirer must count on similarly are diversifying. In short, the strategy of offering multiple payment products to merchants, meeting their needs broadly, is likely to be an increasingly important aspect of acquirer strategy. Transaction processing being a scale business, very many of these products will require the initial scale that only national merchants can provide. The acquirers who dominate the national merchant market will have greater opportunity to commercialize new payment products.
  Of course the conventional wisdom about national merchants is still largely correct. Such merchants are highly demanding and extremely price sensitive, and making inroads into the business is no mean feat. Nevertheless, the strategic options available for those who succeed may be worth the bet.
  Charles Marc Abbey is a partner at First Annapolis Consulting Inc., a Linthicum, Md.-based consulting and mergers-and-acquisitions advisory firm. He can be reached at marc.abbey firstannapolis.com.
 

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