Implications for Visa and FIS of Structural Change in US Debit

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January 5, 2014

Implications for Visa and FIS of Structural Change in US Debit

  • Given structural change in US debit, downside risks to Visa’s multiple in 2014 exceed upside risks:
  • Growth: We expect growth estimates for network-switched bankcard debit in the US to be reset as checks, whose displacement has provided a secular tailwind, now represent half the volumes of debit versus four-times the volume a decade ago; and as alternative debit platforms rollout including the MCX merchant consortium and proprietary bank solutions such as that announced by Chase last February. Specifically, we expect CAGR in network-switched bankcard debit volume of 7% or below over the next 5 years versus 10% over the last 5 years, and CAGR in overall network-switched bankcard volume, including credit, of at most 6-7%.
  • Pricing: Given regulatory risk and likely Court mandating of dual-routing for signature debit, Visa will not be able to offset decelerating volume with increased pricing as it has over the last few years. The implication is that US revenue will show a 5-year CAGR of at most 6-7% and overall revenue growth, including the international business, will likely be in the single-digits.
  • A risk to our pricing thesis is that Visa increases the monthly “FANF” licensing fee it charges merchants (technically acquirers) for accepting its products despite the regulatory risk of further using FANF to leverage market power in credit to debit. As it is, Visa has recovered share in PIN debit even though, post-Durbin, merchants have the option to route transactions over competing networks with lower per-transaction fees (see Exhibit below). Visa offsets higher per-transaction fees by offering merchants FANF rebates in return for debit routing; lacking credit franchises, PIN debit networks cannot compete in the same way.
  • The Justice Department is investigating Visa’s debit strategy. It is hard to see how FANF is consistent with either: (i) the 2003 settlement in which Visa and MasterCard rescinded the honor-all-cards as a result of legal action by merchants claiming they violated the anti-tying rules; or (ii) Congressional intent in the Durbin amendment to increase fee competition among debit networks by giving merchants a network-routing choice transaction-by-transaction.
  • Dual routing of signature debit will create a prisoner’s dilemma; given market power in credit both V and MA will have an incentive, despite regulatory risk, to raise the base level of merchant license fees and use rebates (rather than lower per-transaction pricing) to win debit routing.

  • To protect against the possibility there is no regulatory relief on FANF, merchants are collaborating through the MCX consortium to develop their own payments network that will settle “decoupled” debit transactions over ACH and FIS’ proprietary “PayNet” network and credit transactions through private-label partnerships likely with COF, ADS, and DFS. We expect merchant-distributed decoupled debit to grow at a 5-year CAGR of 20% and the MCX relationship to lift annual earnings growth at FIS by 2-3% from current guidance of 7%.

Investment Conclusion

We see more downside risks to Visa’s multiple in 2014 than upside risks as investors reset expectations for growth in the US business given moderation of the secular tailwind created by check-substitution, the emergence of alternative debit networks in anticipation of the transition to mobile, and increasing regulatory risk on pricing particularly around merchant-licensing fees such as the Visa’s Fixed Acquirer Network Fee (“FANF”) and MasterCard’s Annual Licensing and Registration fee (“ALR”).

Over the next 5 years, we do not expect the CAGR for network-switched bankcard volumes in the US, across both debit and credit, to exceed 6-7%; the result could be meaningfully less if, as we expect, there are meaningful share gains by: (i) merchant-distributed private-label credit and decoupled debit products; and (ii) privately-settled (i.e. ON-US or, as in the case of clearXchange, ON-WE) volumes including those on the private processing infrastructure announced by Chase last February. As a result, and notwithstanding its international business, Visa’s overall revenue growth will slow to single-digits.

Given the uncertainty of regulatory relief, we expect MCX to show a high level of commitment to competing with Visa and MasterCard through a merchant-controlled authorization and settlement platform. MCX will settle “decoupled” debit transactions against customer checking accounts through the ACH network initially and, over time, through FIS’ proprietary PayNet infrastructure; and credit transactions against private-label credit lines that we expect to be provided through partnership with COF, ADS, and DFS. We expect decoupled debit (that is debit distributed by merchants, including MCX, as opposed to banks) to grow at a 5-year CAGR of 20% albeit of a low base. As discussed in our note of December 8th, “FIS: The MCX Opportunity for PayNet”, this creates a meaningful opportunity for FIS and we expect the relationship with MCX to lift annual earnings growth by 2-3% from the current guidance of 7%.

Debit Growth in the US Will Slow

From 2003-2008, debit volumes in the US grew at a CAGR of 18% with the corresponding figure from 2008-2013 being 10%. The reason is that debit growth has been driven by substitution of checks (not cash which has been remarkably stable at ~20% of US consumer payments), and check volumes are now half of debit volumes versus just under four-times debit volumes in 2003 (see Exhibit 1). Over the next 5-years, we do not expect debit volumes in the US to grow at more than 7% even allowing for some cash substitution catalyzed by the convenience of mobile payments.

Exhibit 1: Composition of US Consumer Purchases by Payment Form

Source: SSR Estimates, Nilson 1031, 1008, 985, 962. Note: US personal consumption expenditure (“PCE”) will likely come in for 2013 at ~$11.55tn (up from $11.15tn in 2012) of which the purchases of goods and services will be ~79% or ~$9tn (versus $8.7tn in 2012); the balance of PCE is the estimated value of in-kind payments including food and lodging received by employees such as those in domestic service and employer contributions for group insurance. The figures, provided by the Commerce Department, are an attempt to measure consumer activity with inevitable error given merchants cannot accurately separate consumer from business spending.

Credit volumes have remained in the range of 24-27% of US consumer payments (falling towards the lower end when banks respond to economic stresses by tightening credit standards as in 2001-2002 and 2008-2009 for example). With credit volumes now at the high-end of the range, it is possible they will break out over the next few years as economic recovery combines with rich rewards programs (funded by massive interchange hikes on premium products in 2007 – see Exhibit 2), relentless issuer-marketing, and attempts by banks and networks to reserve mobile payments (through Isis, for example) as a channel for credit rather than debit. Nonetheless, we do not expect credit volume CAGR to exceed 6% over the next 5 years so that aggregate bankcard volumes, across debit and credit, will likely not exceed 6-7% and could be meaningfully less if, as we expect, private-label credit and “de-coupled” debit products distributed by merchants (including the MCX merchant consortium) are broadly adopted by consumers.

Exhibit 2: Credit Interchange on a $40 transaction

Through FANF Visa Leverages Market Power in Credit to Debit

Even allowing for 13% growth in international revenues (versus 15% in 2013 but allowing on a 5-year CAGR basis for a “law of large numbers” effect), this means Visa needs to at least hold pricing in the US to achieve aggregate revenue growth of double-digits. In practice, of course, Visa has increased pricing in the US generating revenue growth in each of the last two years of 11-12% despite volume growth, depressed by regulatory changes in the debit business, of 3% in 2012 and 7% in 2013 (see Appendix). A key contributor to these price increases was the Fixed Acquirer Network Fee (“FANF”) introduced by Visa in April 2012 as a response to the implementation of the network exclusivity provisions of the Durbin amendment which mandated that at least two unaffiliated networks be represented on a debit card and prohibited an issuer from over-riding the merchant choice of routing over available networks.

FANF has been a successful response to regulation that was intended to blunt Visa’s market power by stimulating competition in the debit network business, particularly the PIN debit business accounting for ~40% of aggregate US debit volume. In the quarter after network exclusivity provisions of Durbin went into effect on April 1st, 2012, Visa saw volumes on its Interlink PIN-debit network fall by one half to $50bn so that overall Visa debit volumes, across signature and PIN authentication types, fell just under 10% year-on-year to $267bn. With the introduction of FANF and the PIN-authenticated Visa Debit (“PAVD”) requirement that issuers and processors accept settlement[1] of PIN-authenticated transactions over the core VisaNet infrastructure (rather than Interlink), these volumes had been recovered and Visa is now holding, and in the June quarter gained, share in the PIN debit market (see Exhibits 3 and 4)..

Exhibit 3: US Debit Purchase Volumes for Visa and MasterCard

Source: Company Reports

Exhibit 4: Purchase Volume on Debit and Prepaid Cards

Interlink and Maestro included in Visa and MasterCard respectively, not EFT

Source: SSR Estimates, Nilson 1028, 1005

Furthermore, Visa is achieving these share results even though PAVD has meaningfully higher per-transactions costs to merchants for unregulated issuers than competing networks. (For large issuers, per-transaction costs are largely regulated by Durbin). Specifically, for unregulated issuers, PAVD costs an average of 3 cents/transaction more than the FIS-owned NYCE network, 5 cents more than the Discover-owned PULSE network, and 7 cents more than the STAR network owned by First Data (see Exhibit 5). We believe Visa is capturing most of these interchange-differentials through charging elevated network fees to issuers whose economics, and decision-making, is shaped by interchange receipts less network fees.

Exhibit 5: Debit Interchange to Issuers not Covered by Durbin


Source: Debit Advisor, April 2012

Merchants are choosing to settle over PAVD, even though they have the option of routing debit transactions to networks with a lower per-transaction cost, because Visa offers rebates on FANF (technically assessed to acquirers but typically passed through to merchants) to merchants who do so. Merchants can opt out of FANF altogether only by deciding not to accept any Visa-branded cards including both debit and credit which is impractical except in exceptional circumstances because of the opportunity cost of lost credit-financed sales. As a business matter, then, Visa has tied debit pricing to its credit franchise. Whether this tying is anticompetitive is being explored by the Justice Department under an investigation which began in March 2012.

Regulatory Risk Will Increase if the Courts Mandate Dual-Routing for Signature Debit

The investigation will assume even greater importance if the Appeals Courts uphold Judge Leon’s ruling that dual-routing apply to each debit transaction and not each debit card (so that debit cards must be enabled for unaffiliated signature-debit networks). In this event, MasterCard will need to adjust its debit pricing or lose volume to Visa which has lower per-transaction costs for signature debit because of lower interchange. The three (not mutually exclusive) options available to MasterCard to win merchant routing are:

  1. Reduce network fees.
  2. Reduce signature debit interchange (for unregulated issuers) to at least match Visa.
  3. Raise the Annual License and Registration Fee (“ALR”) which is MasterCard’s (presently less aggressive) equivalent to FANF and then at least match Visa’s fee rebates for debit volume.

The first option is unlikely not only because it directly impacts MasterCard’s profitability but also because there is limited leverage particularly for unregulated issuers. Debit network fees are 6-7 cents/transaction so that even if MasterCard were to completely eliminate them it would not cover the current average interchange differential with Visa for unregulated issuers (55 cents/transaction at MasterCard versus 48 cents/transaction for Visa). The second option is likely unattractive because premium interchange on signature debit has helped MasterCard win network business from unregulated issuers and hence, among other things, begin to close the debit share gap with Visa (see Exhibit 3 above).

This leaves the third option and, indeed, MasterCard may take a more aggressive stance than Visa to merchant licensing fees and debit-volume rebates so as to be able to win merchant routing and maintain higher debit interchange. In short, dual-routing on signature debit will set up a competitive dynamic where Visa and MasterCard will tend to raise merchant licensing fees and bid against each other for debit routing by offering rebates; the net effect is that credit, where merchants will not have a routing choice, will increasingly subsidize debit where merchants will have a routing choice. This form of competition will raise the regulatory risk including from the current Justice Department investigation.

History Suggests Merchants Cannot Rely on Timely Regulatory or Legal Relief

The call that Visa’s debit pricing policy will be constrained by the Courts or regulators has historically not been an easy one to live with. This is despite the fact that, as a business matter, it seems clear Visa has market power in credit (merchants cannot refuse Visa credit cards without the risk of lost sales) and has used this market power to force merchants to accept debit products that are more expensive than competing offerings and, in the case of signature-authenticated products, carry higher fraud risks. As context, and for possible precedential value, it is worth briefly reviewing the history.

The first debit cards (essentially ATM cards that could be used at point-of-sale by merchants equipped with a PIN pad) involved no fee to merchants and sometimes generated a small payment from the account-holding bank because of the costs saved versus a paper check. It was only when Visa entered the debit business in the early-1990s, with a signature product that worked like a credit card (except that it settled against a checking account rather than a pre-approved credit line) that merchants were assessed an “interchange” fee which Visa passed through to the account-holding bank to create an incentive for banks to distribute debit cards to customers.

Signature-debit products from Visa and MasterCard gained share from the original PIN-authenticated products because they leveraged the acceptance infrastructure and brand for credit products (and, in particular, did not require merchants to install PIN pads), and now account for ~60% of the debit market. Indeed, with availability of this acceptance infrastructure guaranteed by the “honor-all-cards” rules (requiring that merchants accepting Visa credit cards also accept Visa debit cards), Visa incented issuers to put its debit cards in the hands of consumers by steadily raising interchange which reached $1.35/$100 in 1999 versus just 10 cents or less for competing PIN debit networks.

Merchants responded to the rising costs of debit cards by arguing that the honor-all-cards rules represented illegal tying of credit products (where they argued Visa enjoyed market power) to debit products (where they argued the tie restricted competition), and achieved a settlement on the Court-house steps in 2003 with Visa agreeing financial damages and to rescind the honor-all-cards rules. The history is relevant because, through FANF, Visa is using its market power in credit to gain a pricing advantage in debit the PIN networks. A key difference from 2003 is that then the tie was to signature-debit products only (since Visa’s PIN debit product was separately branded as Interlink) while today the tie is across both signature and PIN debit products (since PAVD is Visa-branded).

The difference is important because the debit environment has evolved to favor PIN debit firstly because PIN-pads are near ubiquitous (versus merchant penetration of ~15% in 2000) and secondly because Durbin regulation has equalized interchange across signature and PIN debit for covered issuers. Whereas before these issuers preferred signature debit (because the premium interchange more than offset higher fraud costs), they will now tend to prefer PIN debit and likely shape consumer behavior over time by charging consumers more for signature debit transactions than PIN debit transactions. (Facing lower interchange, banks are piloting consumer charges for debit use).

Regardless, the approach taken by the Justice Department towards Visa’s strategy in PIN debit, and FANF in particular, is likely to profoundly affect the evolution of the US debit market. Given the investigation began over 18 months ago, we expect news during 2014. In the meantime, merchants are taking independent steps to shape the debit industry, and payments industry more generally, through the MCX payments consortium and, in the case of Target and Starbucks for example, individual initiatives. MCX is not about promoting just another wallet but about using the transition to mobile payments, and associated lability of consumer habits, to create an entirely new payments infrastructure with rules and pricing set by merchants rather than by Visa.

MCX is committed to a Merchant-Sponsored Payments Network

Given the stakes, we expect MCX to be highly committed to promoting consumer adoption of “decoupled” debit products (initially settling over the ACH network but migrating over time to FIS’ PayNet network) and private-label credit products its private-label credit products (with issuer partners that we expect to include COF, ADS, and DFS). Unlike a bankcard (which is tied to an account managed by the distributing bank), a decoupled debit product can settle against any demand-deposit account designated by the consumer. The Target RED debit card, which now accounts for 6% of sales at US stores, is the best known example; the consumer provides Target with account details (through providing a cancelled check) and permissions Target to access the account via the ACH network to settle transactions; customer authorization for a transaction is provided by swiping a Target-issued card.

As payments transition to mobile devices and become integrated with marketing, we expect merchants to aggressively issue and promote decoupled debit products (as a means of controlling and protecting transaction data and informing e-coupons and loyalty programs) with the MCX consortium likely piloting in early 2014 and rolling out nationally by end-2014. We expect these decoupled debit products to be embraced by consumers and to show a 20% volume CAGR over the next 5 years (albeit off a low base) for three reasons:

  1. Rewards: Decoupled debit will offer meaningfully more valuable rewards than bank-issued products because merchants will see the rewards as part of brand-building and customer-marketing rather than a cost of doing business with the branded networks; e-couponing, in particular, offers the potential for more accurate return-on-investment calculations than traditional branding and merchandising budgets. First Data has estimated these budgets for US merchants at $550 billion so that a diversion of 12% towards marketing that is integrated with payments would equal the entire amount of fees spent by merchants for card acceptance across both debit and credit products (see Exhibit 6). This potential redirection of funds, particularly as mobile payments and hence e-couponing gain momentum, is likely to be transformative for US consumer payments and decisively shift the balance of power to merchants because of their status as advantaged rewards providers (both in terms of having the in-store transaction information which supports targeted and personalized offers and in terms of the ability to source these offers at low cost).

Exhibit 6: Card Acceptance Fees Paid by Merchants in 2012

  1. Distribution: We expect merchants to aggressively use their point-of-sale and point-of-service interactions with consumers to promote the adoption, activation, and utilization of decoupled debit products. By way of example, having forgotten my Target RED debit card on a holiday shopping trip, I was treated to the following exhortation from an associate: “Use it, use it, use it; don’t let the card companies take us all!”.
  1. Security: An irony of the Target breach between Nov 27th and Dec 15th last year is that it reveals the risks of “swipe and sign” procedure that is typical in the US versus the “chip and PIN” procedure typical in the rest of the world. As shown in Exhibit 7, card losses in the US run at nearly three-times the rate in the rest of the world because of signature-authentication which facilitates the use of a counterfeit card (since a fraudster needs to have the PIN as well as the card for in a PIN-authenticated environment). In part, this is because even overseas the mag-stripe is used as a fallback on chip cards, and fraudsters will pay for data stolen from this fallback stripe over overseas cards for use in the US. The transition to chip cards in the US will tend to level the playing field (although not completely for as long as the US allows chip-and-signature rather than standardizing around chip-and-PIN as overseas) but fraud losses will remain meaningful since chip cards can be scanned by using an electronic device to intercept the card terminal communication (including the PIN).

Exhibit 7: Fraud Losses on General-Purpose and Private Label Cards

Source: Nilson 1023

While merchants are not liable for fraud losses on card-present transactions (although, beginning October 2015, there will be a liability shift for EMV cards to those merchants that do not have chip readers), the Target incident illustrates how severely a merchant can be affected if customers lose confidence in point-of-sale security; indeed, the weekend of Dec 21st, Target offered in-store shoppers a 10% discount as an inducement to return after the news of the breach and, at the urging of the Attorney General, one year of free credit monitoring. The more secure solution, possible on a chip but not a mag-stripe, is tokenization where a transaction is authorized based on a limited-life (and even one-time) number that, even if intercepted, cannot be used by a fraudster.

While the bank and branded networks announced tokenization plans mid last year, we believe a key motivation for the MCX consortium to promote decoupled debit is to reduce the risk of disruption to shopping from card data theft by implementing its own tokenization project.

Appendix: Visa Revenue and Volume Growth

Exhibit A1: Summary

Exhibit A2: Supporting Data

  1. PAVD did not represent a new network capability (since cash advances on credit cards are PIN-authenticated) but rather a new set of Visa rules to mandate use of an existing network capability for debit transactions.
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