A Year
In Review

by Lisa Dowling

   Wal-Mart and wireless. Mega-mergers and MLS. IP and interchange. Compliance, QSR and Check 21. These were buzzwords in 2004. How did they affect the marketplace? How will they set the stage for 2005?
   The legal action that loomed large in 2003 continued to darken the payment processing landscape in 2004, namely the class action, anti-trust lawsuit brought against the card associations by a group of retailers led by Wal-Mart. The settlement was inked in 2003 with Visa agreeing to pay $2 billion and MasterCard agreeing to pay $1 billion over a ten-year period. It was hoped this settlement would translate into lower debit rates for merchants. Did it?
   Leading legal industry expert, Holli Hart Targan, Partner in the law firm of Jaffe, Raitt, Heuer & Weiss, feels it was the most significant event in 2004 because it revealed the first chink in the armor of the associations as regards their rules and methods of doing business. The industry realized that those methods might not be the standard any more.
   �The big shops did see rate declines,� says Targan. �Unfortunately, the mom and pops did not. They may eventually but the other ramification is that merchants will be seated at the table. The Wal-Mart suit made them realize they can and now they probably will.�
   �From personal experience in talking to people, some did pass along the savings to the merchants but the vast majority didn�t,� says Michael Daly, industry watchdog. �What the case actually stated was that rate reduction was not a requirement. Based on individual processors and acquirers, what they made available did not have a big effect in 2004.�
   �For those merchants in major retailer category like Target and Home Depot, debit pricing probably moved down but the small to mid-sized merchants virtually remained the same,� says Joe Natoli, Executive Vice President of Retriever Payments. �One of the by products of the suit was public awareness. It may not have been fully understood as regards levels of interchange or how it worked, but the suit began a public awareness that may improve in the next few years.�
   Because of the lawsuit, Wal-Mart originally left Visa and MasterCard out in the cold with regard to accepting their debit cards. Then, in an unexpected move at the end of 2003, Visa struck a deal with Wal-Mart for their signature debit cards. MasterCard did not jump on the bandwagon. Because of that decision, 2004 witnessed an ongoing battle between the mega-retailer and the mega-card issuer. Heated words flew back and forth. It got ugly. Yet, when the dust finally settled this summer, Wal-Mart and MasterCard kissed and made up. Wal-Mart agreed to allow consumers to once again use MasterCard debit cards. Both parties are very tightlipped on whether their sweetheart deal involved lower rates, but as any good marriage counselor will tell you, someone has to give and someone has to take. Consider MasterCard�s SEC filing this year for its 2003 fourth quarter earnings. It reported a loss of $385.8 million, as compared to a $116.4 million net income for the previous year�s fourth quarter. Guess we know who gave.
   Hand-in-hand with the debit card antics of the associations this past year was the unpopular and continued advance of interchange rates. Interchange rates were increased and reaction was swift.
   �Whenever interchange rates go up, it makes merchants nervous,� says Daly. �It is a cost of doing business that they have to figure in. This past year, there were considerable increases in a relatively short period of time. Ultimately the consumer pays as do those merchants running on small margins.�
   �Interchange drives our industry,� says Natoli. �The lion�s share of what is collected from merchant discount rates is interchange and that goes to the issuer. Member banks drive interchange because there is strong competition regarding which cards they will represent. Traditionally, once a year, the associations would decide how much to raise interchange so they would be more attractive to member banks. However, new products evolved this past year with different kinds of cards and interchange opportunities. The member banks are now in a foot race led by Visa and MasterCard.�
   Natoli is quick to point out that that interchange used to stand at 3, 4 and 5%. Why all the complaining?
   �We forget that over the years interchange has come down dramatically,� says Natoli. �However, the situation has become challenging. It cost acquirers a lot in 2004 just to change the system. This past year�s interchange increases had many ramifications on processing and applications. A lot happened in our industry as well as in our world in 2004, hitting merchants at as time when they felt vulnerable just for mere existence. There�s also frustration from the associations on being competitive and trying to gain market share. Interchange is no-where near what it is once was, but it is clearly trending upward.�
   �In other areas of the world like Australia, the government has stepped in and tried to impose some rationality on interchange pricing and there are questions about whether we are not far behind,� says Targan. �The FTC can prevent unfair and deception practices. That�s not to say interchange is deceptive, but it is an arrow in the government�s quiver that they can pull out to examine more closely the whole interchange area.�
   Notwithstanding settlements and interchange increases, what really heated up the payment processing arena in 2004 were the extraordinary and eye-popping mergers and acquisitions. Many industry insiders see some of these corporate consummations as the most significant events of the past year. Consider these walks down the acquirer aisle � Royal Bank of Scotland and Lynk, J.P. Morgan Chase and Bank One, Bank of America and National Processing Co (NPC), First Data and Concord, NOVA and UCB, TransFirst and Fifth Third Bank Processing.
   Greg Cohen, President of Global Payments� Third Party Acquiring Division, saw the renewed interest by financial institutions into the merchant acquiring business as well as the entrance of new players or mega players in the bankcard space as paramount in 2004. Robert Carr, President/CEO of Heartland Payments Systems believes this major trend of 2004 was the acknowledgement and disposition of failed business models by investor/owners.
   �After several decades in the business, National City gave up on finding a way to compete in today�s payments world,� says Carr. �Concord�s model failed from excessive promises on PIN debit, among other things. Others failed due to excessive attrition and slow growth. The shining exception was Lynk and its acquisition by Royal Bank of Scotland, a beautiful thing to see � a sweet valuation for a successful business model.�
   Americans are always suckers for accents. In the case of Lynk, it was Scottish. With a relatively modest price tag of $525 million, the Royal Bank of Scotland swept the Atlanta-based processor off its feet and into a conglomerate that boasts the #3 spot in the world as regards merchant acquirers. Lynk joined a family that included fellow American Citizens Bank, but being a modern partner, Lynk retained its maiden name.
   When NPC put the word out on the street in mid 2004 that is was �available,� it didn�t wait long for the suitors to come calling. In a few short months, NPC pledged itself to Bank of America for a cool $1.4 billion. This was on the heels of BofA�s acquisition of FleetBoston Financial Corp. The NPC/BofA mega-deal made all the other suitors sit up, take notice and scramble for the next corporate catch.
   It seemed love was in the air among other financial institutions as well. For example, J.P. Morgan Chase gave chase to Bank One and won. Not only did this raise eyebrows but when the newly joined couple announced it would send its processing to TSYS and not J.P. Morgan�s old flame, First Data, tongues wagged up and down the boulevard.
   First Data was not to be outdone. Its acquisition of Concord EFS was consummated at a cost of nearly $7 billion. In addition to the hefty price tag, this marriage had to take on the Justice Dept who filed an anti-trust suit against the merger. As a result, First Data gained Concord but had to give up NYCE, one of the country�s largest PIN debit and ATM network. In fact, First Data may well be singing the blues as a result of other failed marriages in 2004. It lost Bank One�s processing to TSYS. It got the brush off from Bank of America and Wells Fargo as well. Could it be the belle of the ball has lost her allure? Ah love, it can be fickle�especially in this business.
   These extravagant couplings will shake the industry rankings in a way never seen before. But how will they affect the day-to-day operations of the payment processing arena?
   According to Bob Carr, the primary impact is less competition on the street and higher margins for the processors from their ISO channels. He believes mergers and acquisitions are a natural activity and, depending on one�s vantage point, can be good or bad. Attorney Targan sees the mergers impacting the options available for ISOs as to with whom they can do business.
   �These mergers limit the number of banks that are willing to sponsor ISOs into the associations,� says Targan. �The bigger the mergers, the fewer the options and programs for the smaller sales organizations. As this trend continues in 2005, there will be a smaller pool for them to do business in. On the other hand, the good thing is the economies of scale for those companies able to successfully complete mergers and acquisitions. Is it good for the rest of the industry? Maybe not. It reduces the competition for ISOs and MLS who are their clients. Reduction of competition is not always a positive thing.�
   Speaking on behalf of one of the most respected ISOs in the industry, Natoli sees a silver lining in the M&A; cloud.
   �Our organization is in an area of the industry where we are larger than most but significantly smaller than the big boys,� says Natoli. �We are able to capitalize on these acquisitions because it created concern for the good sales organizations that had to go along with consolidations they were unhappy about. These mega mergers gave us an opportunity to provide exceptional service and support to those sales groups that worried about their operations. They needed a new place for their business since the rules changed with these mergers. The mega players pushed downstream a business philosophy and model on an organization that didn�t feel the same way. They went looking for new homes in 2004.�
   Natoli believes that as long as there are several giants the competition will always be there. However, he certainly wouldn�t want to see one mega processor that can dictate fees and rates throughout the industry.
   �The challenges of reaching that height is staying there,� says Natoli. �The small ISO and MLS are invisible to the big guys. They take their eyes off the ball. That adversely affects our industry. That�s the downside of consolidation and we saw it this past year�
   Industry observer, Daly, commiserates with the trials of the little guy as well.
   �If you talk to small business organizations, one of their primary complaints is not always about pricing and rates, it is about service, support and getting questions answered,� says Daly. �For what you are paying, you would expect far better service. Major acquirers purchasing other acquirers causes problems, misunderstanding and misrepresentations. Rate increases were a big deal for some organizations this past year but the bigger issue was service and support. The quality of service isn�t there any longer. Part of it is due to these giant mergers and this was a big trend in 2004.�
   Another trend in 2004 was the seesaw of consolidations back and forth across the Atlantic. Flip-flopping across the pond was popular this past year as the industry saw increased influx of international investments.
   �Look at what First Data did in 2004, picking up major European companies to do processing,� says Daly. �First Data went international while it lost ground in the States. There were also major European banks that got into the U.S. market this past year. And it will continue into next year. We are going to see more trends towards European banks and vice versa. There will be more competitive bank mergers. It could get down to where people are going to have a handful of companies to work with and the big boys will be calling all the shots.�
   Like many others, Daly believes the little guys will get squeezed out. He saw that already happening in 2004.
   �It got easier for merchants to go on line without ever having to deal with a salesperson face to face,� says Daly. �You can see where we are heading. The middleman is being moved out. Look at American Express�s direct connectivity program this year. Look at VeriFone�s BlueWave website this past year. The new trend is that the more layers you have in the sales process, the less profits you will make. The name of the game is the bottom line. Someone has to lose their bottom line. Someone has to gain one.�
   For those companies that declined strategic suitors, they opted for a more open relationship � they went public. TNS, ipayments, Cardtronics and Heartland Payment Systems led the pack. IPO was good to Cardtronics. Just a few months after announcing its offering, Cardtronics acquired etrade�s ATM arm, making it one of the more powerful ATM players in the industry.
   The latest darling of the public offering set is Heartland Payments. With over $22 billion in annual transactions, here is a company that everyone wants a piece of. A tasty piece to be sure.
   �IPOs are a good way for employee-owned companies with minority investors to provide liquidity to all of the owners,� says Carr.
   �I see others going public,� says Global�s Greg Cohen. �People are looking for this from a capitalization standpoint. Exit and recapitalization strategy�can it continue to be fed? It may not be the best way. The problem with the ISO business is that when you get to a certain size, you stop growing organically and can only grow through acquisitions. However, if the acquisition is not managed properly or the costs are not handled properly, the parties run into roadblocks. Another issue is that some are limited by their geographic locales. First Data or Global, who make acquisitions outside of the United States, do more than just merchant acquiring. They have other avenues to grow revenue. When you are a Heartland or an ipayment, you can�t go international and, therefore, are fixed in certain markets. For them, IPO is the way to go.�
   �I think it is great that organizations are going public,� says Daly. �You have to get yourself into a certain position to even get there, though. This is a good trend because it certainly makes the big boys be more competitive.�
   �IPOs are a product of time,� says Natoli. �You can have a great story with wrong timing. Certain ingredients are necessary. You need differentiators. Nevertheless, IPOs are good for our industry. They give you an opportunity to grow beyond limited capability with regard to debt and equity. If you have a good track record and a good story, you can grow quicker and bigger.�
   Another trend in 2004 that wasn�t as flashy as the mega-mergers or intricate as the IPOs was recapitalization. Retriever rode that wave to the tune of $250 million from GTCR Golder Rauner, the industry�s leading man about town when it comes to investments. Just look at their little black book � Verifone, TransFirst and Iron Triangle are but a few on a long list of parings.
   Natoli sees two reasons why recapitalization is a savvy way to go. �Money is cheaper than ever from an interest rate point of view and there is plenty available,� says Natoli. �Venture capital groups look at the story and the management team of organizations in our industry and like what they have been seeing. Our country�s barometers are looking better and recapitalization is a win-win situation for organizations in various points of original capitalization. It�s an option for companies that don�t have what it takes to go public. Our industry will see more in the future.�
   Daly sees recapitalization as more of a �CYA� strategy, as in covering your assets.
   �To be able to expand their business, recapitalization is the only choice for some companies other than being bought out,� says Daly. �Look at the banks that are dropping out of this arena because they can�t compete with the big boys without spending a great deal of capital. It takes a lot of money to sustain growth,�
   Notwithstanding all the mergers, acquisitions, IPOs and recapitalizations, Heather Randall, Partner in Ambiron, a leading provider of information security services in payment industry, saw an equally significant trend in 2004, namely increased accountability on the part of companies regarding security breaches.
   �Whether or not companies wanted to do it, the FTC began taking great interest in 2004 regarding compliance and started fining companies for not living up to their own security policies.�
   Randall sees a positive impact in the industry with increased accountability. It has created heightened awareness and companies have become more wary of it.
   �In the past year, we experienced more and more companies contacting us to discuss increased accountability,� says Randall. �They�re thinking about integrating certain policies and are asking our opinions and advice. Companies became more proactive in 2004. They�re taking a more forward approach to security and adopting it as a competitive differentiator in this industry.�
   Along similar lines, legal expert Targan recognizes another noteworthy event of 2004�the increased scrutiny of ISOs, MSPs and merchants by the associations and the government.
   �Increased scrutiny has prompted sponsor banks to improve their due diligence in doing business with ISOs,� says Targan. �This will flow downhill and have strong ramifications. ISOs will have to produce more detailed financial records not just on the company itself but also on their principals. Onsite visits will increase. Compliance was big in 2004. It�s an issue that must be addressed or it will sneak up on many organizations and catch them from behind. The industry will definitely feel the effects of this new scrutiny.�
   Randall, as well, recognized the trend towards increased scrutiny and compliance in 2004.
   �The FTC, the government and the card associations are enhancing their watchdog policies,� says Randall. �Financial fraud and identity theft were the fastest growing concerns in 2004. The positive impact is that companies started taking steps to go beyond compliance. They began questing whether they were doing the best job to protect their merchant data. We saw companies not only making more of an effort by seeing regulations as being more effective, but also adopting compliance as being helpful to the industry.�
   Not to be outdone by money, mergers and making the grade, technology also took center stage in 2004. Internet Protocol (IP) saturated the scene while wireless terminals danced their way to diva status. Bluetooth expanded in a big way and WiFi became the acronym of the hour. QSR caught on in fast food outlets across the country.
   �The biggest thing to hit in 2004 was IP connectivity,� says Cohen. �Within the next five years, we will no longer see dial transactions. IP is the greatest thing our industry has since electronic draft capture.�
   �Wireless was hot in 2004,� says Daly. �It will continue to be hot and that�s a good thing for the industry. Everyone is going to want to do it. The equipment costs are a bit higher but they are becoming more competitive. For the POS market and major retailers, it is going to be high-speed Internet access. Everyone wants the fastest transaction.�
   Natoli saw proprietary gateways and wireless storming the 2004 gates.
   �The big thing this past year in technology was acquirers using their own gateways rather than processors,� says Natoli. �With the development of in-house connectivity to the processors, we don�t have the same issues of getting card approval, check conversion or leasing. Merchant approval improved this past year with proprietary gateways. Wireless made a big push as well. Changes in technology made these terminals operate more consistently in 2004. Regarding QSR, 2004 saw more interest and more business from that segment than ever before. The movement was due to technology, pricing and speed. Expanding the pie to include QSR is a smart thing. We�ll see a big push to micropayments in 2005, to be sure.�
   The buzzword that is closing out the year is certainly Check 21. The jury is still out on the verdict but opposing camps are forming quickly.
   �Check 21 is a major issue and has the potential to be one of biggest disasters in the industry,� says Daly. �Banks are trying to put the squeeze on merchants in terms of imaging to make them responsible for transactions. Check 21 has the potential of a major glitch where millions of customers could have their checks bounce. Then there�s the major glitch of providing paper support when discrepancies arrive or there is alleged non-payment of bills, say with utility companies. I see major headaches with Check 21. I don�t think it will go as quickly and quietly as predicted. It will eventually become an industry standard but with problems at the onset.�
   �Check 21 is going to change the check and banking industry,� says Natoli. �It will create increased awareness of conversion and truncation. We are going paperless and going to the ACH mode. Yes, the jury is out on the impact but anything that helps merchants and banks be more efficient is a good opportunity for our industry.�
   Finally, what did all the events of 2004 mean for the feet-on-the-street? How did MLS figure into the mix in 2004? Did they get lost? Were they unaware of what was happening at the top of the food chain?
   �I don�t think MLS got better or worse,� says Daly. �They are in a holding pattern and that is not good. If you are not moving forward, stagnation is as bad as moving backwards. Because of all the changes in 2004 like consolidations, compliance and rate increases, the playing field has become more difficult for agents to find revenue-generating avenues. So many MLS are also bed hopping and that is not good for the industry. Those that are staying put are doing so because they just don�t know where to go.�
   �The amount of information that flooded 2004 through various forms gave MLS real opportunities to take charge of their own destiny,� says Natoli. �They need to continue be careful in that they explore those opportunities fully and not just in one vertical area. 2004 was an opportune time to be a sales rep. As long as you can look, analyze and understand the information, you�ll succeed. It is challenging to disseminate it all. Maybe someday our industry will evolve to some sort of certification of sales reps to help them and help our industry.�
   Finally, how do these industry experts differentiate the best and worst events of 2004?
   �I don�t see just one event but the constant innovation of the payment industry in terms of new products and services as the best,� says Targan.
   �The best event of 2004 was the emergence of new regional associations and meetings,� says Daly. �They brought more to the marketplace on a regional basis and made it more plausible for people to get involved.�
   �I think the economy was the best thing to happen to our industry in 2004,� says Natoli. �People are feeling better even though there are still great concerns about our international struggles in Iraq and Afghanistan. Consumers are feeling more comfortable about spending.�
   Then there are the worst events of 2004:
   �The fallout of the Wal-Mart litigation in so many forms was pretty bad,� says Targan. �People had to go back and amend their merchant agreements. From a nuts and bolts approach, what a pain.�
   �One of the worse events was the charges filed against ipayment,� says Daly. �It put a major black eye on an aggressive group of people who had an extremely successful IPO back when IPOs were non-existent. ipayment stimulated the market for more IPOs. The allegations left a bad taste in peoples� mouths, despite the fact that they are only allegations at the moment.�
   �As far as the worst events of 2004, I think the aggregation of payment transactions by acquirers caused problems, meaning that a lot of acquirers looked to create their own gateways and the cost of support and upkeep was and is underestimated,� says Cohen. �Say 10,000 merchants are dialing into your host and it goes down. That�s a disaster and it can and will happen. Manufacturers are selling boxes to enable this aggregation of transactions without warning their customers to the pitfalls and negative issues. To save a penny, it is not worth it.�
   �The worst event of 2004 was the lawsuits,� says Natoli. �From a merchant standpoint, when you have that kind of negative press, it puts a black mark on the entire industry. Sometimes people are guilty only by association and that means it gets harder to do business. We have to standardize some of the offerings to avoid this negative impact.�
   �Even as companies became more savvy, the bad guys got smarter in 2004,� says Randall. �Information security became an arms race in 2004. The hackers got better at their craft. The ongoing struggle got harder to fight.�
   As for the next year, here�s what some of the professionals predict for 2005:
   �From a legal perspective, we�ll see increased compliance requirements from the government a la FTC, whether as a result of a lawsuit or from Visa and MasterCard,� says Targan.
   �2005 will see continued scrutiny or continued push towards overview by the associations,� says Cohen. �I see more options from processors� standpoints and more mega-competitors. A lot will depends on what some of these players do. We are going to have to come out with new distribution channels. We will see new money in the industry and continued money from outside the industry. I predict non-traditional money input. I also see the littler guys getting squeezed. The cost of entry will increase with compliance issues. We�ll see a lot more VARs becoming resellers and, if that happens, who will need a MLS? I see more kiosks taking place of people and a lot more different ways to do more automation and faster transactions. Wherever you play in the industry, you will have winners and losers. You can only share the pie in so many different ways.�
   �I see a lot of technology improvements and more competitiveness in the industry,� says Daly. �On the downside, I see the big boys really coming out after smaller players and after the merchants. On the litigation side, I have a gut feeling that the FTC and other government agencies like the Justice Department, as well as Visa and MasterCard, will be coming after the industry to clean house.�
   �2005 will see a greater incorporation of all aspects of security,� says Randall. �We will see more innovative ways of incorporating security into products, processing and procedures.�
   �I predict we will see from this past year�s consolidations a number of opportunities for smaller organizations to grow,� says Natoli. �I see sales groups looking for additional benefits from processors and acquirers. I see growth in the check and debit segments. I believe processors will focus more efforts on auxiliary products in their offerings. Everyone will want to get a better and bigger piece of the pie.�
   �My prediction for 2005 is that it will be another very interesting year,� says Carr.