Business people everywhere are trying to determine what 2004 will bring:
- Inflation or deflation
- Growth or stagnation
- Job growth or unemployment.
In the merchant processing business, I think 2004 will be seen as a year of consolidation. Here's why:
It appears that fundamental economic trends are headed in the right direction. In the second half of 2003, the economy started to pick up. That momentum has not translated into significant job growth as of yet and even if it does, the good news for the merchant processing business is that it will take at least six months to follow.
New retail merchant creation, upon which many ISO's depend, is a function of job growth. Without a lot of new jobs in the economy, there is less new spending and without that, why would an entrepreneur open a new retail store?
With new merchant creation down, POS terminal sales have been soft for at least a year. This decline has hurt many ISOs dependent upon profits from terminal sales/leases for their livelihood. An ISO who is not able to cover basic operating costs through predictable monthly residual payments is vulnerable to such a downturn and will need to raise capital to sustain his/her business.
The business model for many small and medium-sized ISOs is based on profits from equipment sales covering overhead until residuals grow enough to cover overhead. The trouble is that as the organization grows, the overhead grows along with it, and the break-even point stretches off into the future.
My own experience is that the real break-even point within the traditional ISO business model is somewhere between 10,000 and 15,000 merchants depending on how much overhead has to be covered, merchant pricing, average residual per merchant and other factors. ISOs have to get to this level before their business can withstand downturns.
Merchant processing is a business requiring scale at all levels. Everyone knows that processing transactions in larger and larger volumes has driven down the average cost of each transaction to the lowest levels in history.
Customer service also benefits from scale. It takes about one full time customer service agent to handle somewhere between 2,000 and 3,000 merchants. So an operation with 10,000 merchants would require between 3 and 5 customer service staff.
Without scale, the typical ISO business model is going to have a tough time. ISOs may see attrition exceed sales in 2004. When that happens, costs are rising faster than revenues and the ISO must raise capital or sell assets, if they are to stay in business.
Another issue that dogs ISOs is attrition. As soon as you add some merchants, others cancel. This is a natural phenomenon. ISOs must factor attrition into any business plan. Unfortunately, merchant bases shrink over time and some faster than others.
I have noticed that there are two drivers to merchant attrition going out of business and poaching by other ISOs. You can predict attrition with some accuracy with two variables sales volume and price spread. Low sales volume is the leading predictor of a merchant's business viability. A merchant with less than $2,000 in card volume per month is twice or three times as likely to fail as a merchant with more card volume. In addition, a high price spread is the leading predictor for poaching by other ISOs. A price spread in excess of as little as .50% on large merchants and 1.0% on smaller merchants will nearly double the natural attrition rate.
Some ISOs measure attrition on a net basis including their monthly additions of new merchants. But this math is incorrect. Measure your attrition the real way as a percentage of your static customer base. Attrition is the number of canceled merchants divided by the number of merchants in the customer base before new sales are added in.
Taken together, these three hurdles lower or slower new merchant creation, lack of scale, and merchant attrition, can constitute a lethal combination for smaller ISOs with less than 10,000 merchants. Many ISOs may be forced to exit the business or raise capital to stay in business!
There is an old maxim in the acquiring business: "If you are not growing, you are dying" ISOs who start to see their portfolios remain flat or even shrink in terms of merchant count should start looking for opportunities to raise cash (convert portfolios to cash, bank loans, etc.) or shrink costs. And that means consolidation of the ISO universe into fewer players. It also means that ISOs just starting out in business will have a harder time hitting that critical break-even point.