The Green Sheet Online Edition
June 28, 2010 • Issue 10:06:02
Margin compression: What's goin' on?
In Sonoma County, Calif., 40 percent of our economy is based on tourism and agriculture. A big part of that is wine. There are over 200 wineries right in our backyard, so to speak. Heck, there are 20 wineries on my street! The wine industry is going through some margin compression right now.
As local wine expert Dan Berger wrote in his column at www.vintageexperiences.com, "Many wineries are in default to banks, close to it or have balance sheets that are significantly unbalanced. I hear about a winery for sale every few hours. ... Consumers are trading down and discovering that carefully chosen $15 wines were about as appealing as the $30 to $50 wines. In some cases, they were more appealing."
Some people think that when the economy comes back, the upscale consumers will too, but frankly, that's just not going to happen. And this is not confined to California. Another local wine expert, Richard Thomas, wrote that in Australia, wine is cheaper than Coke - and water. He said, "A giant surplus is being produced, and export sales are way off, because of the strong Aussie dollar, which is close to parity with the U.S. dollar. Not too long ago, the U.S. dollar was worth $1.50 Australian."
Margin compression is good news for wine drinkers but bad news for winemakers. Only a few years ago most of the very expensive wines were on allocation, and you had to know someone to get a case. How quickly things have changed.
Music download debacle
Take the music industry. Like it or not, illegal downloading is here to stay. Local writer Gabe Meline said, "It was born of the music industry's decision to kill the LP and increase its profit margin 1,000 percent by foisting the digital technology of CDs on music fans, the same technology that eventually made possible the MP3 and the RapidShare files, and the torrents that the recording industry hates so much."
Ten years ago, album sales hit their peak: 785 million. Last year, only 489 million albums were sold in the United States, according to Nielsen SoundScan. The Seattle Weekly newspaper reported that this includes 1.1 billion tracks downloaded legally, but that this pales compared to the 40 billion tracks the International Federation of the Phonograph Industry said were downloaded illegally in 2008.
The paper went on to quote singer Laura Viers: "That's just a sea change that's happening, especially with younger people. They don't even feel guilty about downloading music for free."
The irony is that our cultural environment is more hostile to the major labels than to the people who download all their music for free. What has happened is that the traditional business model of major labels, producers, distributors and local record stores has been permanently disrupted. The margins haven't been compressed; they've been eliminated.
How this applies to payments
There is no question that margins have changed in the payments industry; the only question is whether this is temporary or permanent, and what the best way is to restore profitability for ISOs and merchant level salespeople (MLSs).
The Electronic Transactions Association published a 13-page white paper, Margin Compression, which is downloadable for free at www.electran.org. Here are some of the salient points.
First, hardware margins, long a mainstay for ISOs and MLSs - particularly with new merchants - have been virtually eliminated. ISOs used to fund their operations by putting a terminal and printer on a five-year, noncancellable lease at a multiple of three or four times their cost and selling the lease paper.
But no more. One theory is that so much public and private capital was poured into the industry in the last 10 years that the ISOs were awash with money, and this caused them to offer free hardware to attract merchants. Once merchants know they can get terminals for free, it is difficult to get them to agree to pay for them.
A second trend is to offer "interchange plus," or "pass through" pricing, which, the white paper states, "generates a lower, fixed margin and eliminates margin inflation caused by debit interchange differentials and higher rates for less qualified transactions."
Third, retailer industry push-back has had an effect, although this is primarily seen at the top 200 retailers.
The corollary to this is the recent noise about the need for more government regulation and oversight, culminating in the recent so-called Durbin Amendment to the U.S. Senate bill addressing financial regulatory reform. It calls for the Federal Reserve to set prices for interchange transactions, as well as establish an interchange fee without consideration of factors like risk, fraud, network construction, maintenance and data security.
This effectively establishes government price controls (perhaps the biggest no-no of Economics 101), but there is something else to consider. Financial crises, like the one that fostered this legislation, are complex. Years later, reasonable people cannot agree on what caused them. Also, the Fed has always deferred to banks, which have had plenty of subsidies and bailouts, but it has never done a good job of protecting consumers.
The Fed still hasn't accepted responsibility for the financial meltdown, caused by its having allowed excessive growth in the money supply and lax, even incompetent, regulatory oversight. It would be a stretch to say the Fed has learned from its errors. I am sure everyone in our industry would agree that allowing it to price interchange is an outrageous idea.
Challenges to meet
The fourth concept is that the payments industry has no barriers to entry and is saturated with too many salespeople.
This is only going to get worse as many "nontraditional" players, such as Google, Intuit, the social networks, big-box retailers, mobile providers and others we haven't even thought of yet start offering merchant accounts. "Years ago, opening a merchant account was a difficult and hard to source service," the white paper states. "Today it is almost as simple as opening a checking account."
Further, there are only five processors that will handle ISO business, and there is no differentiation of terminals, functionality or brand. Payments have become a commodity.
The report is honest and touches on some unpleasant topics: MLSs have high turnover, and many are not properly trained. ISOs have paid too much to agents: in 1998, an MLS might get 30 to 50 percent of processing revenue; today, some ISOs pay 100 percent residuals. Customer service is another issue that resonates with merchants.
The report identifies ways to deal with margin compression. Of great importance is to solve the merchant attrition problem, which can often exceed 20 percent. It calls for finding new markets, such as business-to-business, mobile, home delivery, micropayments and recurring payments.
The obvious strategy is to stop selling on price alone and focus on solving merchants' business needs. This is about knowing how to sell, something all businesses grapple with every day. There are no easy answers. The ISOs that survive will identify their core strengths, evolve their offerings, hire better people and train them intensively - and change market focus.
At least with wine, you can enjoy the benefits of margin compression, but in the ISO world, it is a harsh reality that doesn't seem to benefit anyone.
Brandes Elitch, Director of Partner Acquisition for CrossCheck Inc., has been a cash management practitioner for several Fortune 500 companies, sold cash management services for major banks and served as a consultant to bankcard acquirers. A Certified Cash Manager and Accredited ACH Professional, Brandes has a Master's in Business Administration from New York University and a Juris Doctor from Santa Clara University. He can be reached at email@example.com.
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