Executive Summary Margincompressionoccursatvarioustimesduringthematuringstagesofmost industries.atitscore,margincompressionissimplyareductionofoperating margins(grossrevenuelessthecostofgoodssold)andiscausedbyavarietyof factors,bothinternalandexternal,microandmacro. Thepaymentprocessingindustryisnoexception,andhasnotbeenimmune fromrecentmargincompression.overthepastfewyears,manyindependent SalesOrganizations(ISOs)haveexperiencedsignificantreductionsinmarginon bothdirectprocessingrevenuesandposhardwaresales. Thecausesofmargincompressioninthepaymentprocessingindustryarevaried andcomplexandinclude:increasedcompetition;poorsalesforcetrainingand practices;inflatedmerchantportfoliovaluations;freeterminalplacements;and changesineconomicconditions. Thispaperdefinesmargincompressioninthepaymentprocessingindustry (specificallywithregardtoisos),examinessomecausesofmargincompression andmakesrecommendationsforpreventing,mitigatingandreversingthetrend. Margincompressionforamaturingindustrymaybepredictable,butforthe savvyandattentiveiso,itcanbehighlycontrollable.
Margin Compression in the Payment Processing Industry For the typical ISO, revenues come primarily from one or both of two general and broadly defined sources: processing revenues and POS hardware sales. For a typical, mature ISO, the overwhelming majority of revenues will be derived from processing fees with little revenue derived from hardware sales. Obvious exceptions include ISOs with specific POS hardware or system sales strategies. Historically, new ISOs generated the majority of their early revenues from hardware sales while building a portfolio to generate increased, business sustaining processing revenues. In this paper, processing revenues generally refer to the operating profit generated by the gross revenue paid to the ISO by their acquiring bank or processor, after cost of goods sold (interchange, authorization and settlement fees, etc.) and before costs (salaries, overhead, sales expense, etc.). Hardware revenue generally refers to the net margin derived by the gross selling price less the wholesale price of the item sold. Processing revenue is expressed as a percentage of processed volume. For example, a merchant processing $10,000 in card volume generating $100 in processing revenue provides 1% (or 100 basis points) of margin. Origins of Margin Compression In the early development stages of the electronic payment processing industry, few merchants had POS devices. Therefore, the primary goal of ISOs was hardware deployment (POS terminals and printers, electronic cash registers, etc.). Many early stage ISOs enjoyed hardware margins in excess of 100% with leasing as a popular option for the small and midsized merchants. As deployment saturation began to develop and compress hardware margins, a second generation of hardware models along with the rapid adoption of PIN debit provided renewed deployment opportunities with ISOs still enjoying margins as high as 50% or more. During this timeframe, merchant demand for hardware grew as they sought to transition from paper to electronic capture. Additionally, integrated terminals supporting PIN debit transactions and, to a lesser extent, check processing provided easy merchant processing account opportunities to ISOs. The fertile landscape provided ISOs with strong processing margins in many cases exceeding 100 basis points on processed volume. It is also important to note that, during the industry s early stages, processing volume was a small fraction of current volumes and represented a small share of a merchant s payment acceptance mix. Industry resource, The Nilson Report, noted in its October 2009 issue that, while processing volume has increased in the last decade, merchant s fees as a percentage of processing volume have actually declined from a peak in 2005. Certainly, the continued rise of debit card 2
purchases have impacted fees, but margin compression has also had a demonstrable impact. valuations. The increased value placed on each processing account allowed many ISOs to invest far more heavily in merchant acquisition. This, in turn, led many ISOs to offer free hardware to merchants as an incentive to sign up with them, causing the virtual elimination of hardware margins ISOs experience today. General Causes of Margin Compression The causes of margin compression are extremely complex and varied. Though margin compression is typical in most industries as they mature, the payment processing industry has experienced recent margin compression due to a variety of somewhat interrelated factors. 1. Economic Conditions Internal Source: Nilson Report, October 2009 As the payment processing industry matured, it attracted more competition from a variety of sources: entrepreneurial startups, banks, large cross marketing programs and others. With new hardware deployment opportunities becoming limited to new business start ups and additional locations, less frequent upgrades and replacements, ISOs were forced to begin to focus primarily on their processing service offerings, which naturally lead to a focus on price. During this same timeframe, several ISOs and processors went public, attracting both institutional and private capital into the industry, which significantly increased both company and portfolio A significant byproduct of the maturation of the payment processing industry has been the exponential growth of same store electronic payment acceptance and a widening of acceptance locations. During the past decade, more and more nontraditional acceptors have come to the market. In addition, card volume as a percentage of overall sales mix has continued to grow. It has been common for certain business segments to see double digit growth of card volume while overall sales have remained flat. Like most businesses, ISOs have both fixed and variable costs. With the ever increasing volume per account, many ISOs have been able to reduce margins while maintaining flat and 3
sometimes expanding revenue per processing account. Furthermore, the predominance of three tiered pricing (i.e. qualified, mid qualified, non qualified) combined with a decoupling of interchange rates for credit and debit products by the card associations (Visa, MasterCard, Discover) and ever increasing less than qualified transactions (reward, corporate, etc.) has allowed ISOs to maintain or even lower qualified rates while still enjoying constant and sometimes increased processing margins. However, in recent years ISOs have begun offering more small to midsized businesses pass through pricing which typically generates a lower, fixed margin and eliminates margin inflation caused by debit interchange differentials and higher rates for less than qualified transactions. Traditionally, a pass through pricing model was used for very large processor based merchants. As greater transparency is created by Visa and Mastercard for their wholesale interchange rates, further pressure to adopt pass through pricing may increase. 2. Economic Conditions External The broad, country wide economic decline has caused more merchants to closely examine supplier costs, including costs of payment processing. More and more merchants have contacted their providers for rate reviews and merchants are far more receptive to low rate offers from ISOs and agents. This has led to three observable results: one, some ISOs have chosen to reduce margins to retain existing accounts. Two, merchants are far more likely to leave their incumbent provider for lower rate offers. Three, some merchants have chosen to stop accepting payment cards altogether. 3. Retailer Industry Push Back Government Regulation Over the past decade, merchants have become more vocal as an industry in raising awareness of the fees that they pay to support the acceptance of payment cards. While deep debates have been had on the very tangible benefits that merchants receive through acceptance, such as increased sales, low charge off rates vs. in house credit programs and customer convenience / satisfaction; merchants have raised fee arguments to a fever pitch thereby placing additional pressure in their community to drive down rates as an industry. As a result of retail industry lobbying, government regulation and oversight have been proposed in the past several years and has made its way in the form of governmental study into recent legislation. 4. Increased Competition/Lack of Tangible Offer In recent years, the payment processing industry has seen a significant increase in competition, and in some markets saturation, 4
partially as a result of extremely low barriers to entry. In addition to competition created by new ISOs, the industry now includes competition from companies such as Google, PayPal, Intuit (QuickBooks), Sam s Club, Costco, UPS, etc. Further, new and existing ISOs have continually expanded their sales operations and call centers. It is estimated that the average merchant receives dozens of merchant account solicitations each month. As the supply has increased faster than the demand, margins have decreased. Years ago, opening a merchant account was a difficult and hard to source service. Today, due to the competition (and the internet!), it is almost as simple and accessible as opening a new checking account. During this time of expanded competition, fewer tangible sales opportunities exist. There have been no recent POS developments to drive equipment upgrades (the most recent contactless has still not managed to leave the starting gate in the small to mid sized market) since PIN pad deployments almost a decade ago. Further, with the overwhelming majority of all payments processed through one of only a handful of processors (First Data, Paymentech, Elavon, TSYS, Global), and the ubiquity of POS terminal design and functionality, there is little to no brand differentiation available as a sales tool. In most ways, payment processing services have become commoditized, further leading to margin compression. In the classic marketing triangle of service, product, price price is generally the easiest to compete on, especially in the short term and in light of the above. According to analysis of nearly 90 merchant portfolios during the 2003 2007 timeframe by industry participant, Calpian, monthly revenues per merchant has declined in most merchant segments. The most concerning component of the analysis is that through margin compression, new merchants being sold by ISOs are at lower margins than the tenured and attriting merchants they are replacing in the ISO s portfolio. In essence, some ISOs may be engaging in a sprint to the bottom of margins. 5
% of Portfolios 60 50 40 30 20 10 0 Sample Size 2003-2006 2006-2007 Total Merchant Portfolios By Average Revenues (% of Total Portfolios) <$20 $20-$40 >$40 Monthly Revenue Per Merchant (Avg) # Portfolios 51 38 89 2003-2006 2006-2007 Source: Calpain 5. Poor Sales Representative Training Partially as a result of all of the previous points and the resulting margin compression, many ISOs have attempted to grow their internal and external sales staff as quickly and efficiently as possible. Proper sales representative training is a significant cost, especially in a complex industry such as payment processing, in which the learning curve is long and steep. In many cases, ISOs attempt to utilize contract sales staff, with inherently high turnover rates, which further a majority of the recruitment comes from within. All of this new agent marketing has created in essence bidding wars for agents with one ISO after another offering higher and higher agent compensation. decreases the ROI of sufficient and significant training programs. And often trainers have not been fully and properly trained themselves, adding to the problems of untrained sales staff. With lack of proper training, and misrepresentation (both intentional and unintentional), ISOs often revert to competing on the easiest attribute to copy, low price offers, furthering the industry s margin compression. 6. Increased Competition for Agents/Agent Awareness ISOs employing a typical agent/contractor model face increased competition for qualified experienced agents. Over the past decade, increased access to information provided by the internet, the Electronic Transaction Association s Transaction Trends magazine, The Green Sheet and other publications have created a far more informed agent population. Further, what was once a homegrown small industry now has a myriad of advertising and marketing outlets to attract experienced sales reps. During the early days of the agent model, ISOs relied on recruiting new agents from outside the payment processing industry. Today, In 1998, top agents could expect to receive 30 50% of the overall processing revenue. Today, 75% or more is available to agents. Some ISOs even advertise up to 100% residual compensation payments to agents. 6
The increased agent competition and significantly increased compensation to agents with no offsetting cost reductions for ISOs have created significant ISO net margin compression. Preventing and Mitigating Margin Compression While margin compression is traditionally present in most mature industries such as payment processing, there are many strategies that an ISO can implement to help prevent or mitigate margin compression. These strategies can broadly be categorized into two approaches: customer focused and internally focused. Merchant Focused Strategies Margins can be preserved and often expanded if ISOs change their focus. These changes can include: Identifying new acceptors to find merchants that your competition has not Solving merchant problems and selling value Formalizing and focusing on merchant retention Identifying New Acceptors Typical Main Street merchants receive dozens of payment processing solicitations each month by phone, in person and by direct mail making it very difficult to engage these merchants in meaningful conversation leading to a sales presentation. Rather than participating in the herd mentality, focus on bringing products and services to new and historically undersolicited market segments. With this approach, ISOs will often avoid having to displace an incumbent processor, eliminating the need to use the tired better price sales pitch which only leads to reduced overall margins. Major card brands have been very successful in penetrating many markets for payment card acceptance. As an example, over 10 years ago, it was still the exception for grocery stores or quick service restaurants to accept payment cards. However, despite the efforts of the major card brands to penetrate every conceivable market, acceptance is still not universal by all merchants in all commerce situations. Acceptance opportunities exist in many market segments, including business to business payments; mobile commerce, such as home delivery services; micro payments, such as vending machines; and recurring payments, such as utility, insurance and property management. Additionally, first time card acceptance opportunities also exist within various ethnic, immigrant and first generation businesses in many locales. Many of these businesses traditionally conduct commerce in cash and sometimes store credit, with card acceptance being a welcome addition to their payment 7
acceptance mix. Proper networking within these business segments can yield a solid referral source. Finally, there is renewed activity in the new business segment. Traditionally, economic disruptions and increased unemployment have lead to an increase in new business creation. The current recession is no exception. According to the 2009 release of Kauffman Index of Entrepreneurial Activity report, a leading indicator of new business creation in the United States, over 6 million new businesses were created in the United States in 2008 (source: http://www.kauffman.org/research andpolicy/kauffman index ofentrepreneurial activity 1996 2008.aspx). Since unemployment increased in 2009 and continues to be high in 2010, it is likely that the pace of new business creation will continue. Identifying and targeting new businesses can offer ample new merchant opportunities as many ISOs have been very successful contracting with startup businesses. Solve Merchant Problems and Stop Selling on Price Alone After identifying your target prospects, how do you position your product relative to the competition? Is price your primary differentiator? If so, you are creating internal margin compression. Unless you are achieving significant scale and continually improving internal efficiencies, this strategy will negatively impact your bottom line. While price is important, value is a far more important factor to all consumers, and prospective merchants are no exception. Consumers routinely pay $4 for a cup of premium coffee when a $1 cup is readily available. Car buyers shun cheap in favor of value and quality (remember the Yugo?). Merchant principals are consumers, and value is a key attribute in their decisionmaking process. Offering nothing more than a low price devalues your service and opens the door to any and every competitor offering what appears to be a lower price. ISOs can easily present value over price by simply identifying the merchant s needs. While pain points vary from prospect to prospect, all merchant prospects will have specific hot buttons. Asking probing questions (such as What do you like about your current provider? and What don t you like about your current provider? ) will help uncover their hot buttons and will help lead to a higher margin sale. Perhaps the prospect has reconciliation issues due to daily discount, or a hard to read statement? Can they benefit from an electronic gift and loyalty card program? Can a check processing solution benefit them? By asking the proper questions, you will not only lead yourself to the sale, you will become a solutions consultant to the prospect, instead of just an I can save you money offer. 8
Merchant Retention Keeping your existing merchant relationships will protect processing margins and revenues. Maintaining your existing merchants will allow you to focus on increasing your portfolio base, instead of replacing attriting merchants often at reduced margins. While there are many strategies ISOs may employ to reduce attrition, a full understanding of your portfolio makeup is needed. Merchants can be analyzed and retention efforts organized by the following factors: 1. Customer Profitability Understanding the actual, real value of your merchant accounts is vital to allow retention efforts to be concentrated on the most profitable and important accounts. This process for identifying your customers can be simple to complex. For a starting point, you will need to determine the margin per customer (billings to customers less cost of goods sold). Once you have margin established, you then need to understand all internal costs incurred in selling, boarding and servicing the merchant. Sometimes these costs can be uniquely identified down to a specific merchant, such as how often the merchant calls in for servicing or if free supplies are provided to a specific merchant. Other times, the ISO will find that costs need to be assessed to merchants on an allocation basis (total costs / divided by number of merchants) for expenses such as rent and furniture. In determining profitability, an ISO may want to acknowledge and put a financial number to extra benefits a merchant provides them such as referrals or testimonials. Once real profitability is determined, merchant accounts should be ranked or classified into profit groups such as very profitable, moderately profitable, marginally profitable, and not profitable. You might be surprised to discover that accounts previously considered moderately profitable have diminished to not profitable. By stratifying merchant accounts in this manner, retention efforts can be more efficiently focused. Keeping larger, more profitable accounts obviously requires more effort than keeping smaller accounts. Further, servicing resources (proactive visits/calls, priority call routing, free supplies, etc.) can be dedicated more efficiently to provide the greater service to the most profitable accounts. And retention efforts can be easily tracked and refined based upon success in each group. An additional goal of this strategy is to place an emphasis on promoting merchants from a particular group into the next level up. By pricing changes and additional service offerings, unprofitable merchants can be upgraded to marginally profitable, and marginally profitable merchants can be upgraded to moderately profitable. Remember, you lose little to 9
nothing if you lose a marginally or unprofitable merchant due to a price increase. 2. Attrition Analysis Another important foundational element in retaining merchant accounts is to understand and track reasons merchants leave you. Attrition should be tracked by profitability group, market segment both MCC and type (such as retail, MOTO, etc.) and attrition reason. ISOs should analyze their attrition data to identify patterns within the overall portfolio or specific niche groups that might indicate products, service or pricing that needs to be addressed or improved. The greater the details, such as the types of merchant accounts, average age of account, and attrition reasons, the more valuable and actionable the data will be in understanding why merchants are leaving and developing strategies to reduce this attrition. For example, are merchants leaving during the initial year of processing? Maybe their sales personnel are overpromising or otherwise misleading merchants. Are more tenured merchants leaving? Maybe they feel forgotten or unappreciated as customers and they require more lifetime customer interaction to continually show value. The attrition analysis should also reveal common attributes within the merchant accounts retained. Is there a common baseline of services offered to these accounts? Do the merchants share common demographic attributes (i.e. MCC, processing methods, etc.)? These factors can be used to expand your offerings to attract a wider range of merchants while continuing to focus on these core factors. 3. Market Segment Analysis Certain market segments receive more competitive solicitations than others. New business start ups, independent restaurants and bars, and Main Street retailers often don t go a day without receiving a payment processing solicitation. Other types of merchants, such as manufacturers, B2B suppliers, government contractors and other hard to reach businesses typically do not receive many competitive offers. The more competitive solicitations merchants receive, the more likely they are to leave. In addition to the revenue stratification described above, retention strategies should be focused around those merchants receiving the greatest number of competitive solicitations whether by phone, direct mail or in person. 4. Services Provided It is commonly believed by industry experts that the more services an ISO can provide to a merchant, the more likely the merchant will remain with that ISO. More services also generate more margin and revenue. Are you solely a card processing provider? Add related and ancillary products and services to your 10
merchants. These products and services can include: PIN pads for retailers who do not accept debit today PCI compliance services and SAQ assistance Electronic gift and loyalty programs Online statements and reporting Check processing services including verification and/or guarantee Recurring billing and ACH processing Insurance verification services for medical merchants Increasing your account services penetration or hooks into a merchant significantly decreases risk of attrition while increasing margins and revenue. Payment processing industry trade shows, such as the Electronic Transaction Association s annual conference, as well as regional trade shows, provide a great introduction to these services and many more. Internally Focused Strategies While focusing on merchants is vital in retaining merchants and preventing margin compression, reviewing and focusing on internal factors can also aid in mitigating declining margins. Internal factors reviewed should include: 1. Reduce Costs Since margin is the difference between fees collected from an ISOs merchants and the ISOs costs (interchange, processing fees, third party servicing costs, etc.), an ISO can increase margin by decreasing costs. Review existing vendor agreements such as core processing services (authorization, settlement, etc.) and third party agreements (gateways, ancillary services, etc.). Is there an opportunity to obtain a reduction of fees due to the changes in market conditions? Are you nearing the expiration of the agreement, opening the door for renegotiation? Are there less costly alternative options? Have there been increases in your volume or transaction count? ISOs should shop on a regular basis, just as merchants do, to be certain they are receiving the best combination of services and low costs. ISOs of significant scale can often leverage a conversion of their portfolio to another provider (if the agreement allows for this) in order to receive competitive bids and often garner a fee decrease from the current provider. 2. Identify Core Strengths Determine the core strengths that you utilize to bring value to your merchants at either the point that they purchase your solutions or those they enjoy through the on going delivery of value of services. What are your strengths: technical creativity and process solution developments to 11
merchants? Is it after sales support through incredibly trained support staff? Is it providing your merchants superior analytics on their cost of acceptance such they can reduce overall acceptance costs? Regardless of what the strengths are, they should be used to further differentiate your offerings from your competitors, while adding value to your clients. By distancing yourself from competition it will put less pressure on price and therefore less pressure on margins. 3. Evolve Your Offerings ISOs should conduct regular analysis and audits of their product and service offerings. Is your offering stagnant? When was the last time you introduced a new product or service to your existing merchant base or your sales staff? Has your products and service offering to merchants kept pace with their evolving product and service needs? For example, ten years ago, data security compliance was not a key topic for large merchants, however, over the past decade it not only is key for large merchants, but has now gone down market to small markets. Has your offer kept pace with your competition? Your competition is certainly looking to outpace you. As evidence, a brief review of the many industry periodicals highlight new innovation that your competition is bringing to the marketplace. 4. Enhance Sales Force Training Proper sales training sometimes takes a back seat during periods of rapid and aggressive sales force expansion, primarily due to limited financial and time resources. However, despite the payment processing industry s complexity, proper sales representative training is vital to both efficient merchant acquisition and maintaining sufficient processing margins. Historically, the use of contract (1099) sales representation has been popular among ISOs as a lower cost vehicle to grow its sales force. Too often, ISOs have minimal oversight to the sales training, selling tactics and pricing models utilized by these contractors as they are not employees. However, ISOs should review their training programs, test competencies and ensure consistent delivery of the ISO s selling proposition. For example, if the ISO s products and service offering is based upon a very consultative sales approach through a clear understanding the merchant s payment processing needs and goals, but its sales distribution channel has not been effectively trained to carry its message or desired approach to the market, it will not likely meet its objectives as intended. Instead it might result in a vastly different approach of selling by its sales distribution channel barking, low prices, low prices, low prices! Several suggestions of enhanced sales training are product and services, sales and selling proposition. More specifically, products and services training is about how the products 12
and services work and the benefits that are provided to the customer. Sales training can entail how to prospect, engage and close an opportunity. The sales proposition training educates sales representatives on the ISO s marketing message to its prospects and customers. The selling proposition is the market based positioning that enables the ISO to be uniquely different from that of competitors in the payment processing space. It is imperative that the sales channel, whether it is contractors or employees, understand the selling proposition so it can effectively communicate it to prospects and clients. Today, through technology, a number of lower costs sales training programs can be developed. Several technology examples include long distance classroom learning over the internet, push based tutorials delivered to sales professional s desktops or mobile phones. These training tools can be used to train, certify and periodically recertify a sales representative s knowledge on existing products and services, new products and services or the sales process and selling proposition. Summary / Conclusion Although many ISOs report a recent increase in margin compression, there are many strategies that may prevent it. By changing market focus, ISOs have the potential to tap into newly established and rarely sought after merchants. In addition to less competition in selling to these individual merchants, there is also a great opportunity to build profitable referral relationships and grow the overall portfolio. With existing economic conditions, there are many startup businesses to solicit. ISO sales reps can demonstrate their value to both potential merchants as well as their employer by abandoning the ʺlowest priceʺ selling proposition and developing a strategic partnership with potential merchants. This not only drives the merchant to sign and retain the relationship, but generally leads to higher margin earnings. After the relationship is established, there are a number of strategies that can be used to prevent margin compression. Those strategies can be developed by routinely analyzing merchant profitability, merchant retention and the need for more updated services and offerings. Internal practices factor into controlling margin compression as well. It is important to routinely examine costs, identify and build upon the strengths of your company, analyze and update offerings and continually improve sales training. Taking into consideration both internal and external factors, ISOs undoubtedly have the ability to influence margin compression. 13