Acquiring: The Zero Option

Kevin Woodward

Tech players that have entered payments aren’t looking to make their living from transaction fees. That may put traditional acquirers on edge, but two can play this game.

For as long as anyone can remember, electronic transactions have carried fees for processing. These fees have excited plenty of controversy, but they have always been there—and for the most part they have risen with the predictability of night following day.

But the advent of mobile commerce has ushered in a cadre of technology companies that see payments as a strategic opportunity to break into new markets and serve overriding priorities. Google Inc., for example, entered mobile payments not so much because it wanted to process payments as because it saw a need to collect data on real-world transactions to serve its advertising business.

Now some in the acquiring business are asking whether these companies might upend the industry by drastically reducing—or even eliminating—the fees traditional processors depend on. Google Wallet hasn’t fared as well at the point of sale as the online search giant hoped, but it raised serious questions among acquirers with its emphasis on subordinating transaction revenue to potential fees for transaction-activity data.

Indeed, companies that do just that may have many pondering a future where merchants are charged nothing for the actual payment transaction, but are assessed fees for marketing campaigns targeting their customers.

While that scenario is not daunting for these technology companies, it may cause some concern among independent sales organizations and other merchant-services companies that rely on transaction fees as a profit source. Could the zero-fee model become a widespread model? How might ISOs respond to it?

The quick hit is that ISOs and other merchant-service providers should soldier on. The zero-fee models that have been tried have done little to erode the dominance of traditional payment-processing rates, at least for now. But while ISOs in general may have little to fear from zero-based pricing in the near term, specific players will find themselves in trouble if the can’t emulate the tech outsiders by generating revenue from transaction data, experts contacted by Digital Transactions warn.

‘A Scale Issue’

LevelUp, the mobile-payments unit of Boston-based SCVNGR Inc., is one of the better-known adherents of a new model of merchant transaction services. It assesses a 2% per-transaction fee for all payments, and collects 25% of incremental sales from offers that merchants make via the LevelUp app. Square Inc. is another disruptive entrant to payments with its no-contract, simple-payment acceptance plan launched less than three years ago.

LevelUp eventually wants to charge nothing for payment transactions consumers make with its app, says Matt Kiernan, marketing director, and instead derive its revenue solely from offers it makes via the app. That day has not yet arrived, he says.

At just 2 years old, LevelUp has about $75 million in annual transaction volume, Kiernan says. He will not say when LevelUp could adopt a zero-fee option. LevelUp has about 5,000 merchants and approximately 1 million consumers registered through its platform.

“It’s a scale issue,” Kiernan says. “It’s just a matter of getting enough business to run marketing campaigns and enough consumers to redeem the offers.” LevelUp may get there, especially given merchant frustration with payment-processing costs. “We’re at a point where there’s enough adversity toward fees paid for credit card transactions,” Kiernan says.

While margin compression in acquiring is much discussed and lamented, at least one industry database that tracks payment-processing fees is not showing any ill effects from the likes of LevelUp and Square. Omaha, Neb.-based The Strawhecker Group, a consultancy specializing in the payments industry, says its database of 1.7 million transactions shows no squeeze on margins in the past year.

“We haven’t seen any evidence of anyone moving to this type of processing structure,” says Barry Davis, a senior associate at the firm. Net revenue margin is about 90 basis points, he says. A basis point is one one-hundredth of a percent.

“The small-merchant piece of the pie is large enough for ISOs to continue pricing the way they have,” Davis says. He speculates that ISOs won’t have to change their pricing significantly until the new entrants become more competitive. “It’s too early to tell,” Davis says. “When I’m at the regional acquiring shows, all eyes are on the emerging companies, for sure, and how they’re pricing.”

Persistence of Interchange

Offering below-cost services is not new in the merchant-services industry. In 2004, a mega-ISO, United Bank Card Inc., now called Harbortouch, began offering point-of-sale terminals at no cost to merchants if they signed a multiyear processing agreement. Most competitors sold or leased the terminals for hundreds of dollars. The free-terminal model favored generating revenue from the recurring transaction fees instead of from the upfront fees.

Indeed, Jared Isaacman, Harbortouch chief executive and the originator of its free-terminal program, labels such offerings as loss leaders, a familiar retailing term that means to sell one product at a loss in expectation the consumer will buy other products that have larger profit margins.

“All this means for LevelUp is it is absorbing costs in one bucket and making it up with mobile rewards,” Isaacman says. It’s a time of uncertainty among merchant-service providers as they contend with companies like LevelUp and Square, he says. The payment-acceptance industry is in the midst of a strategic shift, he says, one unlike those before. “We’ve had so many natural evolutions, some extremely predictable ones,” Isaacman says.

Merchants may one day see little to no cost for payment processing, but that does not mean that ISOs and acquirers will. “Issuers will always look to collect interchange and that means acquirers will have to subsidize fees on their own,” says Henry Helgeson, chief executive of ISO Merchant Warehouse Inc., Boston. “There are a number of merchants that are a perfect fit for offers and loyalty programs, so they will probably pick them up over time. But, there are also a large number of merchants that have no interest in these services, particularly those verticals like parking, utilities, doctors, and lawyers. These merchants may chug along for quite some time being content with how they market to consumers.”

But in today’s environment, predictability is not to be found, Isaacman says. Why is that?

“The revenue we make from processing could be irrelevant when compared with other forms of income, like data mining and mobile rewards,” Isaacman says. “It’s still in the end losing money and making it up on something else.”

How the current shift in payments will end up is uncertain. “It could go in different directions, and that makes it unpredictable,” says Isaacman.

While preparing for unpredictable outcomes may seem ineffectual, ISOs and acquirers should do exactly that, says Adil Moussa, principal at Adil Consulting, Omaha. “ISOs have been acting like banks,” Moussa says. “They are not banks. They have to evolve and get out of the banking model of moving money in and out and taking a small transaction fee.” Banks can do that because they have other revenue sources, he says.

Instead, ISOs might be well served by moving to a software-provider model, which is based on providing services and charging for them, instead of charging per transaction, Moussa says. ISOs might also consider a model where they provide tools to help merchants promote their businesses. One example is a restaurant food distributor that spends time helping its restaurateur clients learn how to attract customers, he says.

Better-Suited Tools

That is how Marc Gardner, founder and chief executive of the Troy, Mich.-based ISO North American Bancard, interpreted a LevelUp presentation he attended.

“It was essentially a platform to bring new customers into restaurants,” Gardner says. ISOs and acquirers might be suited to do something similar, he says, perhaps based on card-linked offers. These offers often are made by a consumer’s bank to use their credit or debit cards at certain merchants in exchange for a discount or other deal.

“Card-linked offers may be an opportunity for small- to medium-size retailers to leverage those platforms to drive incremental sales to their establishments,” Gardner says. There is a revenue opportunity for the merchant, the card-linked offer provider, and the ISO, he says.

In the near future, Gardner wants to build incremental revenue from merchants. “Where I see the opportunities within the near term is providing merchants with marketing engines, whether it’s local search, card-linked offers,” or similar tools, he says.

Marketing tools for small business have changed as online marketing has grown in consumers’ favor, he says. Formerly popular marketing tools like telephone directories and direct-mail coupons are waning, Gardner says. The opportunity is there for ISOs to step in with better-suited tools, ones that can be generated by transaction data. ISOs should understand that small businesses often lack the resources to run marketing platforms that can take advantage of local search, local offers and local social media. “We’re spending a lot of time on it,” Gardner says.

That is the vision LevelUp has, says Kiernan. “There’s so much data that could be gotten from transactions,” he says. A major distinction for LevelUp when compared to ISOs, however, is that it knows much about the consumer because the consumer must use the app to redeem offers and make mobile payments. The app can contain the consumer’s email address and social-media account names in addition to where and when the app is used and what the consumer does within the app.

Innovative ISOs will have to emulate that capability, Helgeson says. “While some acquirers and ISOs may make some short-term gains through creatively re-pricing their portfolios, we don’t believe this is a sustainable long-term strategy,” Helgeson says. “The innovative acquirers will find new ways to add value to the transaction and combine payments with offers, discounts, and loyalty solutions to help merchants generate new revenue.”

The Persistence of ISOs

Like others, Helgeson sees the opportunity in helping merchants generate customer traffic. “The reality is that if acquirers can help merchants generate sales, bring new customers in and bring existing customers back, merchants will be more than happy to pay for those services,” he says. “Payments as a standalone service has become highly commoditized and merchants have a low tolerance for new fees that don’t offer any perceived value over another acquirer offering.”

Habortouch’s Isaacman echoes Helgeson. “If you’re still trying to solve the problems of 2009 and 2010, which was giving away free terminals and getting merchants, if that’s where the struggle is today, you should be extremely concerned about the future,” Isaacman says.

His tack is to continue to offer POS systems, which merchants typically like to continue to use because they enable other services, such as inventory and pricing management, in addition to payments. “If mobile payments and mobile rewards become the primary way to get consumers into merchant locations, they will want to integrate that data into their POS systems,” Isaacman says.

Helgeson, too, sees the connection between payments and marketing. “Brick-and-mortar merchants will forgo their traditional advertising and replace that spend with more effective offers and discounts they can push out to mobile-wallet users,” he says. “This type of marketing is not only more effective and provides better visibility into marketing spend, but it usually only costs merchants money when a customer comes in to redeem an offer.”

And Moussa, the consultant, suggests that ISOs won’t need to fear that these emerging payment companies will mean their demise. ISOs won’t disappear for one good reason, he says, especially when it comes to small and mid-size merchants.

“They want to talk and sign with a real human being,” Moussa says. “Merchants do like and want the face-to-face interaction. That’s what’s going to keep the ISO and agent model in the game,” he says. “But the agent, all he can do is sell. It’s up to the ISO to develop more services so they can retain these merchants once they acquire them.”

Some patience may be in order as these emerging payments companies find customers. Just because one of them, like LevelUp, has a clever idea, does not preclude another purveyor, such as Isis, a mobile wallet backed by three major wireless carriers, from seeing success with its service, says Isaacman.

“There are numerous possibilities that could change how consumers pay at retail locations,” he says. “It’s all consumers now. If something happens with how we conduct commerce, it’s going to be because the consumer will tell merchants what they want. It will be consumers who will change how we pay in the future.”