The EMV Opportunity for PAY in Terminal Apps
SEE LAST PAGE OF THIS REPORT Howard Mason
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August 21, 2014
The EMV Opportunity for PAY in Terminal Apps
“I think that the coming decade will be the most important in commerce and payments that any one of us have lived through”. Paul Gallant, CEO Verifone, Mar 2014
- One of the most important changes in US payments technology is the shift in the storage medium for card credentials from magnetic stripes to computer chips (whether embedded in an EMV-compliant card or ‘phone). The shift to chip technology has been accelerated by heightened industry focus on security following the Target data breach last November (because chip cards are more difficult to counterfeit), and we expect the majority of cards and point-of-sale (“POS”) terminals to be chip-enabled by the end of 2015.
- The transition of US payments to chip technology changes industry structure because chips are a more versatile medium than magnetic stripes, and can be used for more than storing static card credentials. In particular, they can be used to integrate marketing offers into the payments process; as MasterCard puts it: “EMV in the physical world is a much thicker pipe [than mag stripe]… not only is it a more secure transaction but you can add more data into the stream that can drive things like offers and receipts”. In other words, chip-technology turns payment devices into more powerful marketing media.
- However, there is an important distinction between chip-enabled cards and mobile ‘phones as marketing media: the former does not have a screen on which to present real-time offers to customers or receive real-time input from customers around tender and offer-redemption choices. Until mobile payments are adopted more broadly by consumers, the natural solution for many retailers will be to use payment terminals as marketing media for chip-enabled card payments that we expect will account for $1.5tn of annualized purchase volume by end-2016 (vs. less than $100bn of mobile purchase volume).
- This creates an opportunity for terminal market-leader PAY (with 50% share globally and in the US of the EMV terminal market) to sell not only next-generation terminals with touch-screens but also demand-generation terminal applications such as electronic couponing and targeted offer programs. The company does not break out the specific revenue contribution from these advertising services, but services as a category (including terminal maintenance, security solutions such as tokenization and encryption, as well as commerce-enablement) now account for near-40% of firm-wide revenue of $1.8bn and are growing at a CAGR of 15% (versus less than 5% for terminal sales).
- Sizing the terminal app opportunity for PAY is not easy but there is a significant opportunity for payment companies that can drive incremental revenues to merchants. We estimate annual merchant spending on advertising that can potentially be converted to digital channels at $500-600bn and there is a secular shift from generic brand advertising to data-enabled marketing with a track-able ROI (see Exhibit below). For example, ADS pitches retailers on transferring $40mm from their advertising budget to data-enabled marketing, and it would take only a few wins of this magnitude for PAY to generate a meaningful growth in service revenue given the current base of $400mm annually. There are competitive risks that:
- Dongle-providers, such as Square and Amazon (through its newly-announced Local Register product), enable tablets for card acceptance allowing merchants to use tablet-screens, rather than terminal screens, for two-way marketing communication with customers. While this is likely for many micro-merchants, larger retailers will prefer the security solutions, including tokenization and end-to-end encryption enabled by PAY terminals. Indeed, after the Target data breach last November, the security of card data is the top priority for retailers and has helped PAY gain share. As CEO Paul Galant reported after the last quarter “we won another six clients from competitors and gained three new US clients that adopted consumer-facing payments systems for the first time to prepare for EMV acceptance”.
- PAY is unable to seize the window of opportunity as chip cards are adopted (with the processing capability for commerce-enablement functions but without display screens) ahead of mobile phone payments (which have both processing and display capabilities) to build durable software capabilities; if so, competitor app-conduits (such as Apple given the possible launch of a mobile shopping-and-payments ecosystem with the iPhone 6) have a better chance to take over the support for data-enabled marketing as ‘phone screens displace terminal screens over time. In practice, we believe PAY’s current position in POS terminals gives it the opportunity to build an operating system for security and commerce-enablement apps that will survive this transition.
Exhibit – Estimates for 2014 Advertising Spend
Source: Winterberry Group
Overview: Mass EMV Adoption Begins in the US
The US is on the cusp of mass distribution of chip-enabled (“EMV”) cards to replace mag-stripe cards. In its last quarter report, FIS disclosed it had won the conversion of a 10mm card portfolio believed to be the first mass conversion in the US (rather than targeted conversion for the high net worth and travel segments). Given that fraud will tend to concentrate in mag-stripe cards, there are “tipping point” dynamics so that the Aite consulting group expects 70% of US credit cards and 40% of US debit cards to be EMV-compliant by end-2015; presently, there are approximately 580mm credit cards and 600mm debit cards in circulation.
Bank issuance of EMV cards will trigger merchant installation of EMV terminals because, in October 2015, network rules around liability-shift take effect so that when a customer presents an EMV-compliant card that a merchant accepts with non-compliant point of sale (“POS”) technology, the merchant (rather than the issuer as is typical for card-present transactions) and will bear the fraud risk. As a result, over 80% of terminals shipped in the US are EMV-compliant and the number of active EMV terminals will rise from 1.5mm at end-2013 to 12.5mm by end-2017 largely as a result of the natural replacement cycle, but with some pull-forward effect in 2014 and 2015 as indicated by the steeper slope of the graph in Exhibit 1 below.
Exhibit 1: EMV-Compliant Terminal Penetration the US
Source: Business Intelligence, Aite Group
By end-2016, we expect over $1.5tn of card payments to be EMV-compliant of which meaningfully less than $100bn will likely be mobile (see Exhibit 2). This means there will be near $1.5tn of payments made using chip-based cards that have the processing capability to integrate electronic coupons and loyalty offers into the payments stream but not the ability of a ‘phone-screen to display these offers to customers and enable real-time redemption at POS. For many merchants, the solution will be to use payment terminals as marketing media which creates an opportunity for market-leader, PAY, to sell not only next-generation terminals with touch-screens but also demand-generation terminal applications such as electronic couponing and targeted offer programs. The company does not break out the specific revenue contribution from these advertising services but services as a category (including terminal maintenance, security solutions such as tokenization and encryption, as well as commerce-enablement) now account for near-40% of firm-wide revenue of $1.8bn and are growing at a CAGR of 15% versus less than 5% for terminal sales.
Exhibit 2: Mobile Payments will Grow Rapidly but Remain Dwarfed by Card Payments of Over $4tn
Source: Business Insider
PAY Shifts to Payments-as-a-Services (“PaaS”) to Support “Smart” Terminals
After appointing a new CEO in Oct 2013, as Paul Galant took over from Doug Bergeron, PAY’s stock has recovered (see Exhibit 3) as management has improved execution (through product rationalization and improved efficiency) and directed the company strategically towards levering its leadership position as a manufacturer of terminals (with a 50% share of EMV-capable terminals globally and in the US) towards SaaS as these terminals are increasingly “smart” in the sense of providing security (through tokenization and encryption, for example) and delivering targeted marketing offers and, when media-enabled, digital content.
Exhibit 3: NTM Forward P/E for PAY and S&P500
Given the intense focus among large retailers to protect against data breaches, and make sure that none of their customer data is in the clear, there is strong momentum in the US business as PAY works strategically with CIOs to improve payments security and this will likely continue at least through early 2016 as retailers anticipate and respond to the EMV-related fraud-liability shift in October 2015. An important aspect of EMV compliance is that cards must not be taken out of sight of customers so that there is a need for new customer-facing terminals in a number of verticals including restaurants and hotels; PAY estimates that this will increase the addressable market in the US by 30% to 13mm terminals as well as creating a revenue bring-forward effect with US terminal shipments likely to run at 3mm annually in 2014 and 2015 versus a normalized run-rate of 2.5mm.
It is important not to over-estimate the impact of this revenue bring-forward on PAY’s aggregate results since the company generates over 70% of revenue outside the US and near-40% from emerging markets, and there is secular growth as POS penetration increases around the world (see Exhibit 4).
Exhibit 4: System Penetration Globally
The Terminal App Opportunity
As part of its PaaS initiative, PAY is investing significantly in a terminal app platform, which will offer proprietary as well as third-party software, and in the data analytics to support proprietary commerce-enablement apps. The company hired Vin D’Agostino in January 2014 from his position as head of payments strategy at Chase to build the commerce-enablement business, and already has some platform scale through the Verifone Digital Network (“VNET”) which presents targeted offers to customers in NYC taxis and at gas stations. PAY’s ambitions to in advertising are evident from three quotes from CEO Paul Galant:
- “Verifone’s position in consumer-initiated card transactions will enable us to play a significantly important role in closing the loop with contextual marketing, digital advertising, couponing, loyalty, and social media”
- “If you have great terminals and you can connect them up with payment as a service into a platform and a network, then you sure would want to distribute terrific applications for merchants to use in order to drive the next dollar of revenue. And applications like being able to burn American Express reward points in real time at the point of sale [as consumers can currently do through Verifone’s card acceptance technology for NYC taxis]. That’s kind of cool. Or being able to convert currency, important for certain kinds of merchants. Loyalty, couponing, targeting offers, all of that stuff is very important and we have the footprint to make it all real.”
- “Our next-generation terminals and operating system will help drive incremental commerce across physical, mobile and online channels, with instant reward redemption, loyalty programs, couponing and targeted offer programs, to name just a few”.
Sizing the terminal app opportunity for PAY specifically is not easy but there is a significant opportunity for payment companies that can drive incremental revenues to merchants. We estimate annual merchant spending on advertising that can potentially be converted to digital channels at $500-600bn and have noted in earlier research (see, for example, “The Challenge to Digital Brands as Banks and Retailers Build Data Strategies for Mobile” dated August 10th) that there is a secular shift from generic brand advertising to data-enabled marketing with a track-able ROI. ADS, for example, talks about how its pitch to retailers is to transfer $40mm from their advertising budget to data-enabled marketing; it would take only a few wins of this magnitude for PAY’s “LiftRetail” product (see Exhibit 5) to generate a meaningful growth in service revenue at PAY which is currently running at $400mm annually and represents near-40% of firm-wide revenue.
Exhibit 5: The “LiftRetail” Demand-Generation Product from PAY
A first competitive risk to PAY is that dongle-providers, such as Square and Amazon through its newly-announced Local Register product, enable tablets for card acceptance allowing merchants to use tablet-screens for two-way communication with customers. While this is likely for many micro merchants, larger retailers will prefer the security solutions, including tokenization and end-to-end encryption enabled by PAY terminals. Indeed, after the Target data breach last November, the security of card data is the top priority for retailers and has helped PAY gain share. As CEO Paul Galant reported after the last quarter “we won another six clients from competitors and gained three new US clients that adopted consumer-facing payments systems for the first time to prepare for EMV acceptance”.
- Amazon is a fiercer competitor in the dongle market than Square because it has a large audience of 240mm accounts globally and can drive demand to retailers prepared to pay for customer delivery. However, beyond Local Register and customer mobile ‘phones, it does not have access to in-store screens so that presenting an app through the PAY platform likely makes sense.
- Indeed, until mobile apps are more broadly adopted by consumers, retailers and card issuers (particularly issuers of private label cards) will likely deliver targeted offers to customers through proprietary apps on the PAY platform.
A second competitive risk is that PAY is unable to seize the window of opportunity as chip cards are adopted (with the processing capability for commerce-enablement functions but without display screens) ahead of mobile phone payments (which have both processing and display capabilities) to build durable platform capabilities and proprietary software applications; if so, competitors will have a better chance to take over the support for data-enabled marketing as the marketing medium shifts from terminal screen to ‘phone screen. Apple’s likely entry into mobile shopping and payments with the iPhone 6, and ability to drive demand from 800mm active iTunes accounts, is a particular threat. However, PAY’s current position in POS terminals gives it the opportunity to build an operating system for security and commerce-enablement apps that will endure even as it loses control of display-screens to ‘phones.
A third risk, more financial than strategic, is that revenue growth disappoints in 2016 given the terminal pull-forward created in the US ahead of the EMV deadline of October 2015 for a shift to merchants of fraud liability. While there is a headwind, it is not likely to be that material given we estimate terminal shipment in 2014 and 2015 at an annualized rate of 3mm vs. the normal replacement cycle of 2.5mm and given that the US accounts for less than 30% of PAY revenue of which near 40% is accounted for by services rather than terminals. Finally, the earnings impact will be offset by an increase in margins as the revenue-mix shifts to services (with a margin of 43% vs. 35% for terminals) and as product-rationalization and efficiency-initiatives raise the terminal margin towards the 40-50% range achieved by Ingenico.
- EMV is the Europay-MasterCard-Visa protocol for communication between chip-enabled payment devices and the point-of-sale terminals.
- It is an EMV requirement that payment cards not leave the sight of customers meaning that many retailers, including restaurants and hotels, who are presently accustomed to taking a customer card and processing it in a back office will need to purchase new customer-facing terminals. PAY has estimated that these new customers will lift the addressable market for US terminals to 13mm from the current 10mm.
- See our research note “Apple vs. Banks: Update” of May 30th, 2014
- Of the 17 issuers covered by Aite’s survey, all said they would issue chip-and-PIN cards, eight plan to issue contact-only cards, and five plan to issue dual-interface cards that can be dipped in a contact reader or used to tap ‘n’ pay at an NFC-enabled contactless reader.
- Fraud costs amount to approximately 0.1% of card purchase volume (double the rate in 2007) or $6bn annually
- PAY’s encryption product, VeriShield Protect, is the de facto standard for 8 of the top-11 US acquirers handling 84% of US transaction volume.