FIS: The MCX Opportunity for PayNet
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
December 8, 2013
FIS: The MCX Opportunity for PayNet
- FIS will allow merchants participating in the MCX payments system (which we expect to pilot in 2014Q1 and roll-out nationally before year-end) to accept card payments for an all-in cost of 4 cents/transaction versus the network fees charged by Visa/MasterCard (excluding interchange) of 6-7 cents for debit and double that for credit. The all-in cost includes 2 cents paid to the bank maintaining the funding account to contribute to the cost of an ACH withdrawal (since ACH will initially be used for settlement) and 2 cents to FIS (since the NYCE network path will be used for authorization).
- Given FIS faces negligible marginal costs and up-front development costs are covered separately under a 5-year contract with MCX, the per-transaction fees will drop to the bottom-line. Our base case is for MCX volumes to reach $225 billion by 2018 (representing 15% penetration of assumed aggregate purchases of $1.5 billion – see Exhibit below). With an average $40 ticket, this represents ~6bn transactions generating earnings to FIS of ~$120 million or a lift to annual firm-wide earnings growth of 2-3%. Our estimate excludes:
- Additional fees as, over time, MCX migrates settlement from ACH to direct bank identification number (“BIN”) routing over FIS’s proprietary PayNet network which can access ~80% of US checking accounts and will allow real-time settlement as opposed to the 3-4 day settlement of ACH. MCX is likely launching with ACH because PayNet settlement requires bank permission for access to the funding account. Over time, however, we expect banks to accede; if 50% of volumes migrate from ACH to PayNet and FIS collects an incremental 1 cent/transaction in network fees, there is a further lift to 2018 earnings of $30 million.
- Potentially substantial earnings from FIS support in the design and implementation of rewards and e-coupon programs leveraging in-store merchant payment data; we expect FIS to deploy the mobile capabilities arising from its March acquisition of mFoundry which provides the backbone for Starbucks’ mobile app.
- MCX wallet-penetration beyond our 15% estimate (which is based on the 14% penetration of Target’s RED cards in the US). Overseas, real-time solutions have higher share; for example, in Australia, 70% of debit transactions settle over the EFTPOS system (which allows a consumer to select between a checking, savings, or credit account at point-of-sale). EFTPOS cards are typically also enabled for Visa or MasterCard to provide overseas utility and a domestic fallback.
- The FIS opportunity depends on consumer adoption of MCX products in a crowded market for mobile wallets. In joining MCX, merchants are asked to follow WMT’s example of committing not to support any (not-already-deployed) non-MCX mobile wallet for 3 years. Beyond this exclusivity arrangement, MCX is well-positioned to gain share as payments shift to mobile and hence become increasingly integrated with the broader shopping experience through merchant mobile apps and increasingly driven by the ability of merchants to offer personalized real-time e-coupons. Three sources of merchant advantage are:
- First, as illustrated by TGT (whose proprietary cards offer a 5% discount), merchants are comfortable with a cost of rewards substantially higher than Visa interchange provided the rewards are associated with their brand and not just a card-issuer brand; the payoff of new/retained customers, greater visit-frequency, and ticket-lift creates the business case.
- Second, merchants can source rewards more cheaply than issuers; this is the motivation for co-brand programs in the current payments environment so that, for example, United Airlines can generate a valuable miles benefit for consumers at low marginal cost.
- Third, merchants have access to SKU-level purchase data allowing for targeted and personalized rewards programs (“e-coupons”) that a mobile wallet enables and that will likely generate a higher ROI than more generic rewards programs.
- In practice, we expect merchants to work directly with issuers in the design of rewards programs so as to combine the in-store data available to merchants with out-of-store payments data available to issuers. Given a shared goal to create consumer preference both for the merchant and for the payment account of the issuer, rewards will likely be jointly funded based on bilateral and on-going negotiation. If e-couponing delivers on its ROI promise, it is possible that the merchant-funded portion of rewards will exceed current interchange rates and will be supplemented by an issuer-funded portion.
- The flexibility to negotiate such bilateral arrangements, and contractually protect the confidentiality of payments data, helps explain the decision announced in February by Chase to private-label VisaNet as well as the increasingly positive comments about the private-label businesses from COF and ADS, and the desire by DFS to build private-label capabilities.
- Beyond e-couponing, mobile payments have catalyzed the coordination of merchant action through MCX because of the promise that PIN-authenticated mobile payments can reduce fraud risks substantially below those of signature-authenticated payments on a mag-stripe (or even, in an EMV world, on a chip). MCX views Visa as having been relatively slow to sponsor these fraud-reducing technologies in the US because of its investment in authorization infrastructure for signature-based transactions and, until Durbin, because of issuer preference for premium interchange on signature-based debit.
We expect FIS’ relationship with MCX to generate $120-150 million in incremental annual earnings by 2018 from core processing alone (i.e. excluding incremental earnings from supporting the design and implementation of rewards programs leveraging mFoundry’s experience with the Starbuck’s mobile app). The lower end of the range assumes all MCX transactions are settled over ACH while the upper end assumes 50% are settled over FIS’ proprietary real-time PayNet network. Given current pre-tax earnings at FIS of ~$1bn, MCX will lift annual revenue growth by 2-3% from current guidance of 7%.
This note addresses the opportunity for FIS in point-of-sale (“POS”) payments with particular focus on the partnership with MCX. We note that MCX will initially use ACH, and not PayNet, for settling transactions but we believe this is an interim phase to ensure ubiquitous access to checking accounts. Over time, as banks permission direct BIN routing, we expect MCX to migrate settlement from ACH to PayNet which offers real-time funds versus the 3-4 day settlement window of ACH.
A brief overview of FIS’ broader business is provided in the Appendix. We expect FIS’ experience with the EFTPOS system in Australia (which, in October, hired FIS to build a centralized payments hub or “switch” to replace the current patchwork of bilateral connections between retailers and issuers) to be helpful in its implementation of the MCX system in the US.
What is PayNet?
PayNet is FIS’s proprietary payments solution allowing for real-time movement of funds (by direct routing based on a bank identification number or “BIN”) whether a transaction is initiated by card, check, or P2P application (see Exhibit 1). Presently, PayNet is processing a minimal 500k transactions/month but we expect this to increase meaningfully as financial institutions look to compete with the real-time capabilities of clearXchange (sponsored for P2P payments by BAC, JPM, and WFC) and to improve on the 3-4 day settlement time for ACH transactions.
There is a particular opportunity for PayNet as merchants (including the MCX merchant consortium) look to provide point-of-sale (“POS”) access to consumer payment accounts without involving the fees and rules of the branded payment networks. Whether merchants and MCX can achieve consumer penetration of their mobile wallets will be important to the success of PayNet as will the willingness of banks to permission PayNet to settle transactions against funding accounts using direct BIN routing. Pending these permissions, MCX will settle through the ACH network (but use the real-time capabilities of NYCE for transaction authorization).
Exhibit 1: PayNet Integrates FIS’ Account Access and Payments Capabilities into a Real-Time Network
Source: FIS Marketing Materials
How will MCX use PayNet?
We understand the initial launch of MCX will not use PayNet at all but rather use NYCE for transaction authorization and ACH for settlement. The specifics are that a customer registers a normal bank-issued debit card or checking account (through providing a blank check), and FIS will then tokenize the payment credential and associate it with a QR (quick response) code provisioned into the customer’s MCX mobile app (which can be either stand-alone or accessed via API from the a retailer-managed app).
At point-of-sale, the POS terminal will scan this QR code from a customer’s MCX-enabled mobile app triggering an authorization request based on the associated token which FIS will resolve into either the BIN (if the customer registered a debit card) or ACH number (if the customer registered a checking account). The transaction authorization request, and funds-verification, will traverse the NYCE network path and, if it results in an approval, the debit to the funding account will settle through ACH. The bank-owner of the funding account will receive 2 cents to cover the cost of the ACH withdrawal and FIS will receive 2 cents so that the all-in cost of the transaction to the merchant will be 4 cents.
The advantage of using the NYCE network-path in the authorization process is that there is real-time funds verification so that the settlement risk of the Target RED debit card (where there is no real-time funds verification) is partially avoided. The advantage of tokenization is that it means merchants do not need to store payment account information so that there is less risk of theft and fraudulent use. The other advantage of tokenization is that FIS/MCX control transaction routing and, indeed, we expect settlement to shift over time to PayNet from ACH so as to reduce ACH fees (although FIS will reasonably expect a cut of the savings) and, perhaps more importantly, allow for real-time settlement (eliminating the risk that the funding account is depleted between the time of authorization and settlement).
In migrating settlement from ACH to PayNet, FIS will need bank permission for direct BIN routing. As MCX gains traction, we expect this to be part of a much broader negotiation between merchants, acting both individually and collectively through MCX, over the acceptance terms for all card payments including those on Visa/MasterCard branded products. Issuers understand this with a strategist at one leading issuer commenting to us: “Presently, negotiation of the key terms of card acceptance – fraud, chargeback, fees, and rewards – are typically intermediated by Visa; with mobile, we expect to move to bilateral negotiations with merchants”.
A critical component of bilateral negotiations between merchants and issuers will be around interchange. The merchant complaint around interchange is that it funds loyalty programs associated with bank-issuer brands, not with merchant brands. As the 5% discount offered by Target on its proprietary cards illustrates, merchants can be commit substantially more funding to rewards programs than Visa/MasterCard interchange amounts (which reach a maximum of just over 2% of transaction value on premium credit cards) provided the funding contributes to their relationships with customers and not solely the issuer relationship with customers.
Indeed, the promise of mobile payments is that leveraging payments data (both the in-store SKU-level data available to merchants as well as the out-of-store basket-level data available to issuers) to target and personalize e-coupons will generate measurable return-on-investment (“ROI”) substantially in excess of that from generic brand programs. If so, we expect a meaningful portion of the $500 billion spent annually by US merchants on branding and promotion to be funneled to e-coupon programs so that spending on these programs may comfortably exceed total interchange payments currently running at ~$60 billion/year. Furthermore, if e-coupon program influence consumer preferences not only around choice of merchant but also around choice of payment product, issuers have a motivation to provide additional funding.
In short, the shift to mobile payments will likely lead the current paradigm of network-intermediated interchange to be replaced by bilateral negotiation between issuers and merchants over jointly-funded rewards programs. In this negotiation, merchants will not be passive price-takers but rather advantaged participants (because of their access to SKU-level payments data which can inform e-coupon offers and their ability to cost-effectively source rewards) focusing not so much on reducing card acceptance costs as on managing the ROI from investment in card-linked offers and e-couponing.
We believe the result of these bilateral negotiations will be card-linked offers that have substantially higher perceived-value to consumers, particularly in debit, than today’s interchange-funded rewards and will enable merchants to steer consumers towards the payments products they actively support including the MCX mobile wallet. While it may take some time to design and implement these card-linked offers, MCX has gained breathing room by asking member-merchants to commit for three years not to accept non-MCX mobile wallets (with already-deployed wallets having grandfather status).
Appendix: Overview of FIS Business
FIS reports its business in three segments (see Exhibit A1): the Financial Solutions Group (FSG) which provides the infrastructure and software applications to run core banking processes for financial institution clients including deposit and lending systems, customer management systems, retail delivery systems (including online and mobile channels, branches, and call centers), and fraud and risk management systems (including authentication analytics); the Payment Solutions Group (PSG) which provides the infrastructure and software applications to run core payments processes including electronic funds-transfer, card and check processing and authorization (including check-imaging), and bill-pay; the International Solutions Group (ISG) with particular strengths in India, Brazil, the UK, and Australia.
FIS has provided long-run guidance for 4-7% revenue growth (including double-digits from ISG), margin expansion so that profit-before-tax grows at 7% or above, and capital-return to lift EPS growth to 12-15% while paying a dividend generating a 2% yield. For the nine months through 2013Q3, FIS reported 4% revenue growth (4% in FSG, 3% in PSG, and 7% in ISG) and will likely meet long-run guidance for EPS growth for the full-year through capital management (see Exhibit 3).
Exhibit A1: FIS Revenues by Reported Segment
Exhibit A2: Guidance for 2013
Organic revenue growth has increased in 2013 as banks, having restored capital adequacy levels, have invested in infrastructure to meet increasingly burdensome regulatory requirements and to match, through FIS, the scale advantage that larger competitors would otherwise enjoy. We expect revenue growth to increase again in 2014 as banks look to match, through FIS, the connectivity and network advantages that larger competitors (and, particularly, the big-3 of BAC, WFC, and JPM) will otherwise enjoy.
- A motivating factor was to make it easier to coordinate system upgrades and, in particular, a migration to EMV.
- FIS will the NYCE network path but not the brand. Nancy Langer, EVP at FIS has commented of the MCX architecture: “It is operating within the same processing infrastructure as NYCE; however, it is its own network. Think of it as an MCX version of the NYCE network.”↑