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Knowledge is Power: Show Me The Money: Part III By Bob Carr

In this third and final part of this article, I will further examine the value propositions offered to merchants today and offer my views of the effective value propositions for the future.

I believe the equipment-leasing model of financing organic portfolio growth is going to slowly whither away over the next three to seven years. Last year, First Data collected $275 million of up-front equipment monies from merchants, and much of this was used to finance its 4,800 "feet on the street" (see Part II). Assuming a 500% mark-up for each credit card lease generated by the FDC sales employees, ISOs and ICs, that means about $47,700 of leasing and sales profits was generated on average for each FDC representative last year.

The bulk of this money presumably went to the ISOs and their representatives. These same figures also might apply to the majority of the ISOs of NPC, Global, Concord, NOVA and the other large ISO-based acquirers. The proceeds of leasing revenues have fueled the organic growth of most ISO acquirers over the last 15 years. But that growth is slowing significantly, and the stock market value of the ISO-growth companies has suffered dramatically.

According to First Data Chairman and CEO Charles Fote, FDC's organic growth was 6% last year, and many of the other large ISO-based acquirers are showing growth of single digits for the first time. This is in spite of 5.1% same-store sales growth as the secular movement of payments to electronic methods continues to displace check and cash payments.

Visa acquiring grew 5.5% in 2002. To think that 4,800 people are working with a net result of growth at about the same rate as the secular rate is fairly astounding. These 4,800 "feet on the street" are merely replacing the attrition of the FDC portfolios. The same result is plaguing other public-sector companies across the board. At least FDC and Concord and Global are not showing the negative "growth" of NPC for 2002.

The leasing model of financing portfolio growth has lasted a lot longer than it should have, in my opinion. It has become less and less effective and is doomed to failure as a long-term strategy. There are stronger value propositions developing to grow a merchant acquiring business. These value propositions are (1) a return to the value offered by banking services and (2) the new proposition of multiple and value-added products with bankcard acquiring one of the primary (but not the only) products. For the sake of this article, let's look at our industry as if it were three segments - transaction processing, banking and acquiring. These are actually three different businesses within our industry with different value propositions and different financial models. The hard part is that these different models and propositions are confused in the minds of many industry observers with resulting comments and conclusions that don't make a lot of sense.

When smart people claim "this is a scale-driven business" or "this is a commodity business," they are probably referring to the transaction-processing segment of our business. As described in previous articles of this series, there is only one pure "transaction processor," and that is Vital.

The players most think of as "transaction processors" derive the bulk of their profits from acquiring. Like most ISO shops from big to small, they like to call themselves "processors." These true "transaction processors" make most of their money by acquiring, not by processing transactions at a cost of 1.5 to 2.5 cents and reselling that service for 2.5 to 12 cents to others.

Yes, pure transaction processing is a scale business and arguably can be described as a commodity. However, those conclusions are not relevant to the struggle to capture market share in the real "acquiring business" currently controlled by the four publicly traded non-banks and the remaining large banks on the acquiring scene.

Banks - The Former and Future Winners

Let's next discuss the banking component of our business. It is true that banks were the only acquirers in the beginning and that they exited the business almost completely in the late 1980s and early '90s. It is also true that a few large banks have re-entered the business in a big way and that others are considering doing the same.

It is axiomatic that if a merchant has a full-service banking relationship, then that bank has first dibs on the merchant processing business as part of that full-service relationship. Banks should be in the acquiring business and inherently have the most to gain from the acquiring relationship. They also should have the most compelling value proposition for a merchant. Why?

First, banks have the ability to provide next day funding.

Second, banks have the financial history and operating performance of their customer as well as the authority over the merchant's business in real time to analyze, track and mitigate risk.

Third, banks know the bank balances, the incoming funds, the NSF history and the liabilities of their business customers.

Fourth, banks receive the funding directly from all of the credit card sources, including American Express, Discover, Diners and JCB, as well as the bankcard acquirer.

By definition, the full-service bank (if the merchant has one) is the trusted provider of financial services. As indicated earlier in this series of articles, the average merchant location (excluding the top 230 merchants) processes about $110,000 of bankcard volume per year and pays $55 above interchange to its acquirer. If the merchant's full-service bank could meet the card-acceptance needs of the merchant in a competitive manner, the merchant should be able to get the most overall value in a single relationship from the local bank.

This is irrespective of whether the merchant has a lending relationship with the local bank. But if there is a loan involved, the addition of the acquiring relationship is a given. A bank often requires the bankcard acquiring relationship as a condition of lending the business money. Although this practice is arguably counter to the anti-tying provisions of the antitrust laws that govern all banks, I have seen no challenges to this "tying" practice, which is common throughout America.

In other words, if the local bank has loaned the merchant money and offers bankcard processing, there isn't a much stronger "value proposition" and this merchant's business is going to remain with the local bank until the loan is fully paid and the merchant's perceived need for future loans is satisfied.

In addition to loans, bankers have the ability to offer lots of other services attractive to businesses that no ISOs or sales representatives of ISOs and non-bank acquirers can offer. These services include accepting check, cash and coin deposits, offering auto loans and mortgages, issuing credit and debit cards, providing trust services and all of the other services commonly offered by banks large and small throughout the country.

Banks are in a unique position to benefit from participating in the acquiring business in a serious way. The local bank knows which competing acquirers are doing business with its customers because it can review the incoming ACH files each morning and see what monies are arriving from First Data, NPC, NOVA, Concord, Global and the rest of its competitors and in what amounts. Can you imagine having better information than this to prospect for additional merchant accounts?

Banks also have a gold mine of leads with each of their commercial customers. Telemarketing works best in our industry when a bank employee or representative is calling the bank's very own customers to sell merchant accounts. Commercial bank customers normally will give an audience to the bank for their merchant business as a courtesy to their important business partner.

My point is that a bank is in the best position to offer a merchant value-added card processing. Attrition rates are lower for bank portfolios and margins are higher. Why? Merchants would rather pay a little bit (or even a lot) more to a trusted partner, especially when they rely heavily on the $110,000 of steady annual cash flow into their business from bankcards and when the potential cost savings on $55 per month of expense is not all that significant to the vitality of the business enterprise.

The bank that offers a strong merchant acquiring program in its local community is going to control the merchant acquiring business for its commercial customers - no contest. While the banking industry previously has been unable to find ways to provide that strong merchant acquiring program, new technology that will integrate core bank functions with new payment and related transaction products will change the acquiring landscape long before the end of this decade. The sea change of merchant acquiring back to the banks is what can be seen out on the horizon. It is coming.

Discarding a Failed Model

Fortunately for ISOs, there are relatively few banks that offer quality merchant programs today. The integration that I speak of does not exist today. The good news is that there is still time to kick the (formerly) easy habit of building high-attrition merchant portfolios on the back of equipment leasing and hidden-fee revenues.

Today's typical ISO "deal" is to snag a new merchant with the following "value proposition:"

  • Offer a low-ball (even below cost) rate for qualified transactions without disclosing the rate for non-qualified transactions and other fees.
  • Offer this rate with no rate guarantee period without telling the merchant it is a "teaser rate" over which the ISO and/or sales representative probably has no control whatever.
  • Convince the merchant that the equipment he owns must be replaced with a new piece of equipment (or software package) with the construct that the rate quoted will save more than the monthly payment.

That's pretty much the ballgame played out with different variations for many ISOs for the last 15 years. A merchant who bites on this "value proposition" will be stuck with an equipment lease payment for four to five years but with a rate that probably will be increased within the first year and falsely blamed on one or more of the many Visa or MasterCard interchange increases.

Of course, the low-ball qualified rate isn't really low because the non-qualified transactions, which usually include check cards, often are priced at 100 or 150 or more basis points over the true interchange variance.

The poor merchant who was told in writing that the rate was 1.29% or 1.49%, for example, does not realize the charge is going to be as much as 3.79% when a good customer presents a corporate card or frequent flyer card or signature debit card. Then, when the next Visa and/or MasterCard increase comes along with a rate increase the next April or October, the merchant's 1.29% or 1.49% rate will be increased back to what it was before or to an even higher level.

The result for the merchant: paying for an unneeded piece of equipment for the remainder of the five-year term and being stuck with incredibly high costs for non-qualified cards unless the merchant can go back to a previous processor at a previous rate.

For 15 years, this model or an offshoot of this model has been the primary driver of business from one ISO or another. Some of the large ISO-driven acquirers have stuck their heads in the sand offloading responsibility for mistreating merchants to those pesky "independent contractors" that, after all, aren't their employees.

While their heads are in the sand, the merchants get together and file class-action lawsuits, their ISOs are taken over by the FTC, sold portfolios are pirated by the very people who put millions of dollars into their pockets and the Wall Street analysts can't figure out why the industry is missing earnings calls.

The chickens have come home to roost for many failing ISO-driven acquirers in our industry. The money has been in the equipment leasing and hidden-fee game, and millions of merchants are sick of it. Merchants are sick of receiving monthly statements designed to obfuscate the true cost of card acceptance.

Merchants are looking for trusted parties with whom to do business. Banks are going to become the alternative of choice unless ISOs morph into respectable businesses offering fully disclosed pricing and treating their customers like adults - both at the time of signing as well as throughout the lifetime of the relationship.

In summary, the billions of dollars of fees collected from merchants have not funded the organic growth of non-bank merchant portfolios for the last 15 years or so. Of the $22.65 billion of acquiring fees collected from merchants in 2002, about 1%, or $200 million, went into the pockets of sales employees and ICs.

This is not enough money to pay for the cost of signing and properly servicing merchants. The money to do that has come from equipment leasing secured with false promises of cost savings on card-acceptance fees.

ISOs and banks that offer advanced value-added services and multiple products are slowly taking back the acquiring industry. The cost of offering these services and providing ongoing support to the merchant users will be borne by the merchants willing to voluntarily pay for the improved value proposition to trusted partners.

In the next article, we will discuss the economics of offline debit vs. online debit for the different merchant sectors.

Bob Carr is the Founder, CEO and Chairman of Heartland Payment Systems, the nation's largest privately owned merchant acquirer and ninth largest overall, with annual revenues exceeding $300,000,000. Heartland was recognized by INC Magazine as the 57th fastest-growing private company in America and is one of the 10 largest INC 500 companies. Bob was a Founder and Vice President from 1988 to '90 of the Bankcard Services Association, which has since become the ETA.

To learn more about Heartland, visit or, or e-mail Bob at

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