Our business is becoming one which depends on the efficiencies of size for survival. It used to be that there was sufficient margin in the business to sustain small companies. But over the last few years, margins on the most attractive parts of the product array ISO’s sell (POS terminals, processing services, etc.) have collapsed. Margins are not what they used to be and they are not coming back. Anyone who thinks margins are coming back, or that there is some new killer product on the horizon is kidding themselves.
In fact, margins will continue to fall. And fall. I don’t know where the bottom is and I don’t think anyone really does. But I do know that the bottom is not where we are today. In fact, I am not sure that you can even see the bottom from here.
A couple of years back, my company did a large study of merchant attrition. We found that at a certain cost point above interchange (all costs to the merchant considered) the difference between annual merchant attrition above and below that cost point number was 50%.
That means attrition for merchants priced above the threshold cost point was 50% higher than for merchants priced below that point. This confirms the common sense dictum that if a merchant is priced too fat, the competition will pick it off.
Here’s the issue – the threshold cost point seems to be dropping over time. I study this number frequently, and the threshold number has come down 20% in the last two years. That means card processing providers are dropping prices fast and of course, merchants are happy to go along with the trend. This is not really news, but the question is how low can any given ISO go on price and therefore margin, and still pay overhead? For many, that point is perilously close.
Basically, the price spread over interchange has been dropping at the rate of about 10% per year. For example, if the average price spread over interchange was 75 basis points in 2004, it’s now about 60 basis points. Two years from now, it will be 48.5 basis points. The revenue generated from processing $10,000 per month will go from $75 to $60 to $48.50 in four years, a drop of almost 36%. If your overhead is fixed at $100,000 per month, you needed 1,333 merchants to cover that in 2004, and now, you need 1,666, and in two years, you’ll need 2,062 – a 55% increase in the merchant base just to stay even.
For every drop in price, you have to have a corresponding increase in efficiency of your operation if you are going to have stable profits.
If margin drops 10%, your sales department has to produce 11% more customers to keep total revenues the same. That’s easy enough, I suppose. Anyone can work a bit harder and make the number stretch. If margin drops 20%, sales has to increase by 25%. That’s tougher. If margin drops 30%, then 43% more merchants are required. If margin drops 50%, then you need 100% (double) more merchants each month from each salesperson. And that’s just to keep revenues even!
How do you increase the number of merchants each salesperson produces each month without dramatically increasing costs? You can’t, not on a small scale anyway. Somewhere along that curve of numbers, the relationship between sales and profitability breaks down.
The real answer is that sales has to be more efficient, and the only way to do that is to scale it up with a massive capital investment in phone rooms, personnel, systems, reporting capabilities, etc. For an example, consider consumer credit card sales and long distance telephone companies.
The data tells me that the players in our business are willing to price their services on thinner and thinner margins. That means one
thing: scale.
Who’s driving margins down? We are, through relentlessly competitive pricing to merchants. And as we do so, we ourselves are driving the need for scale. As ISOs go from merchant to merchant re-pricing each one ever lower, slicing margins to thinner and thinner levels, we are restructuring the industry. We are contributing to a new price structure in the business which will force all the players in it to
scale ever larger to cope with the math falling margins force on us.
Every day, we are changing the rules for what it takes to be successful in this business.
Energy, product knowledge and a tough skin used to be all that were required to be successful as an ISO. In those days, POS terminal profits paid for sales staff and residuals came to the business for free. Each new merchant sign-up produced cash to fund the operations.
More new merchants meant more cash, which could be used to hire more salespeople which meant more new merchants, which meant more cash and so on. And on top of that, residuals built up over time. That was a great business model, but it’s not the way things are today.
Now, each new merchant sign-up has changed from being a cash producer to a cash user. Each new customer used to produce $500 to $1,000 at the time of sign-up, instead that same merchant sign-up now costs $500 to $1,000 each. That’s a $1,000 to $2,000 swing in profitability per merchant sign up. Not good. The more merchants you sign up, the more cash it takes. Where did the money to pay for this change in profitability come from? Straight out of ISO profits.
To survive and grow with those economics, you have to have a financial resource to pay for the growth. Someone has to write the check to pay salespeople. It used to be the merchant, now it’s the ISO’s financial backer. (Full disclosure: my company, Calpian, does this kind of financing.)
A bank, a venture capitalist or someone like Calpian will have to foot the bills to build the business. This relationship takes a while to put in place. It takes a 3 to 5 year business plan that takes into account the changing economics of the business. It also requires an exit strategy. How will you and the investor make money out of the business venture?
All this means the business changed from one which rewarded sheer hard work and persistence to one which rewards a completely different set of skills. Today, the successful ISO has got to have a plan to take on financing and scale the business to a point where it achieves sustainable profits.
Today’s best ISOs are the ones who combine their knowledge of the product with savvy financial planning and ambitious but realistic goals to achieve success – and today success means size and scale.
There’s simply no way to survive without a realistic plan to get bigger.
If we have what it takes, then we will be successful in these new conditions. If we don’t then we’ll be absorbed by someone who does.
In that sense, we are driving ourselves out of the business.
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