The banks and credit card companies have spent 50 years building a proprietary, locked-down system that handles roughly $2 trillion in credit card transactions and another $1.3 trillion in debit card transactions every year. Until recently, vendors had little choice but to participate in this system, even though — like a medieval toll road — it is long and bumpy and full of intermediaries eager to take their cut.

When a retailer initiates a transaction, the store's point-of-sale system provider - the company that leases out the industrial-gray card reader to the merchant for a monthly fee - registers the sale price and passes the information on to the store’s bank. The bank records its fee and passes on the purchase information to the credit card company. The credit card company then takes its share, authorizes all the previous fees, and sends the information to the buyer’s bank, which routes the remaining balance back to the store. All in all, it takes between 24 and 72 hours for the vendor to get any money, and along the way up to 3.5 percent of the sale has been siphoned away.

In the earliest days of credit cards, those fees paid for an important service. Until the late 1950s, each card was usually tied to a single bank or merchant, limiting its usefulness and resulting in a walletload of unique cards. But when BankAmericard — later renamed Visa — offered to split its fees with other banks, those banks began to offer Visa cards to their customers, and merchants began accepting Visa as a way to drive sales. Meanwhile, Visa and rival MasterCard — as well as distant competitors American Express and Discover — used their share of the fees to build their own global technological infrastructures, pipes that connected all the various banks and businesses to ensure speedy data transmission. For its time, it was a technologically impressive system that, for a price, brought ease and convenience to millions of buyers and sellers.

Money Over Time
A brief history of
currency technology.
-Bryan Gardiner
1200 BC: Shells

Rare or exotic items like shells, whale teeth, and metals were used for trade by cultures around the world because their scarcity and beauty lent them great symbolic value. (The earliest Chinese character for money was even a cowry shell.)

But today, vendors are seeing fewer benefits from paying those fees, even as credit card companies have jacked them up over the years. Credit cards were once a way for a business to differentiate itself from competitors, but now that they’ve grown ubiquitous, nearly all vendors must accept them or risk losing a huge swath of customers. According to a 2003 study in the Review of Network Economics, every sale by credit card costs a merchant six times what the same sale with cash would run. (Cash comes with its own costs, such as requiring more oversight of cashiers, upkeep of vaults, and a bank’s services to process it.)

Not that the store owner is ever quite sure how much a credit card transaction will cost. MasterCard and Visa charge hundreds of different rates - called interchange fees - for every type of card that runs through their networks; mileage cards tend to charge higher fees, for example. And if a retailer accepts one flavor of Visa, say, it has to accept them all, no matter the fee. In 1991, MasterCard had four fees, the highest of which had an interchange rate of 2.08 percent. Today it has 243 fees, and the heftiest one tops out at over 3 percent — more than a 50 percent jump. And yet the service provided has hardly grown any better, faster, or easier to access. “It seems really odd that credit card companies can continue to charge a tax on the economy,” says Aaron Patzer, founder of the financial management service Mint.com, which is now owned by Intuit. “Outside the US government, they are the only entity that has the power to levy a fee across virtually every transaction. Maybe that made sense in the early 1960s, when computer infrastructure was expensive and proprietary. But now, with cheap bits everywhere, the actual cost to do a transaction is pennies.”

There is, in other words, a massive inefficiency to be exploited. And so, an army of engineers and entrepreneurs is rushing in, hoping to do to the payment world what has already been done to the music, movie, and publishing businesses — unseat a legacy industry built on access and distribution, drive the costs to zero, undercut the traditional middlemen, and unleash a wave of innovation. Square’s Dorsey sees his company as creating a new, open system that allows users to swap funds instantly, without a series of interlopers grabbing their share. “We bring an engineering discipline to this problem,” he says. “What we want to know is, how can we get right to the source?”

Fourteen out of the sixteen transaction processing companies we cover beat consensus revenue and EPS projections in 2Q11 and most provided favorable outlooks, which leads us to believe that there may be upside to this year’s estimates. Sector earnings should average 10-15% annual growth as companies leverage a more favorable business environment, generate higher revenues, and execute share buybacks. However, the trend of higher operating expenses, which began in 2H10, continued as companies reinvested in product and services growth after an extended period of cost containment during the recession. Consequently, we think group margin expansion may be muted in the near term because of higher personnel, marketing, R&D, and G&A costs.

The financial metrics of the transaction processing sector are attractive. These include clean balance sheets (cash heavy, debt light), low capital expenditures, strong free cash flow, 80+% recurring revenue, 6-10% organic top-line growth, and EPS growth of 10-15% on 20% operating margin. These outsource service companies operate leverageable business models that expand profitability from processing incremental transaction volume over a fixed-cost infrastructure. The transaction processing industry benefits from a number of defensive growth characteristics, such as targeting large market opportunities with low overall service penetration.

The two biggest topics of discussion in the transaction processing space this quarter were 1) high profile security breaches and 2) the final ruling on the Durbin debit card interchange legislation. In this publication, we provide readers with an overview of payment card fraud and liability as well as some of the measures taken to combat it. One of the most closely followed storylines in our space came to a head on June 29, when the Federal Reserve introduced a final ruling on PIN (personal identification number) and signature debit card interchange fees that was more favorable to, and less onerous for, the card associations (Visa and MasterCard). The interchange fees will be capped at $0.21 (up to $0.22 including charges for fraud), plus an additional ad valorem 0.05% (5 basis point) fee for fraud losses, about double the Fed’s initial recommendation of $0.12 in December. The updated and final ruling accounted for certain fixed costs necessary to process debit card transactions, which were previously excluded.

Under the new ruling, signature debit fees would be down 61% from historical levels of $0.56 and PIN debit fees would be down only 4% from $0.23. The legislation is required to be implemented by October 1, 2011. The Federal Reserve also determined that debit cards will now require at least two different networks on each card, one unique PIN brand and one unique signature brand, not two different PIN and two different signature networks as was previously considered. The rules are effective October 1, 2011, with card issuers given an extended phase-in deadline of April 1, 2012, to issue/replace newly compliant cards.

We think recent high-profile security breaches, including the compromise of credit card data on Sony’s network and a debit card breach at Michaels Stores, may have affected how banks will be compensated for fraud prevention and protection when the Federal Reserve came to its final decision on the Durbin interchange legislation. Also, Visa’s recently announced domestic initiatives to accelerate Europay, MasterCard and Visa (EMV) and Near Field Communications (NFC) enabled payment adoption shows a continued focus on payment card security in the wake of a number of very public security breaches.

In the core bank processing and application services segment (within the transaction processing universe), we project range-bound revenue growth of low to mid single digits this year and next. Though some companies are indicating a better bank IT spending environment, we still believe annual software purchases and professional service contracts may be delayed by banks, but the demand for outsourced services has remained fairly steady.

From: “Equity_Research_Liaison_Office@RaymondJames.com”
Raymond James Equity Research
Analyst(s): Wayne Johnson
[Industry Classification: Technology/Transaction Processing]

Fourteen out of the sixteen transaction processing companies we cover beat consensus revenue and EPS projections in 2Q11 and most provided favorable outlooks, which leads us to believe that there may be upside to this year’s estimates. Sector earnings should average 10-15% annual growth as companies leverage a more favorable business environment, generate higher revenues, and execute share buybacks. However, the trend of higher operating expenses, which began in 2H10, continued as companies reinvested in product and services growth after an extended period of cost containment during the recession. Consequently, we think group margin expansion may be muted in the near term because of higher personnel, marketing, R&D, and G&A costs.

The financial metrics of the transaction processing sector are attractive. These include clean balance sheets (cash heavy, debt light), low capital expenditures, strong free cash flow, 80+% recurring revenue, 6-10% organic top-line growth, and EPS growth of 10-15% on 20% operating margin. These outsource service companies operate leverageable business models that expand profitability from processing incremental transaction volume over a fixed-cost infrastructure. The transaction processing industry benefits from a number of defensive growth characteristics, such as targeting large market opportunities with low overall service penetration.

The two biggest topics of discussion in the transaction processing space this quarter were 1) high profile security breaches and 2) the final ruling on the Durbin debit card interchange legislation. In this publication, we provide readers with an overview of payment card fraud and liability as well as some of the measures taken to combat it.

One of the most closely followed storylines in our space came to a head on June 29, when the Federal Reserve introduced a final ruling on PIN (personal identification number) and signature debit card interchange fees that was more favorable to, and less onerous for, the card associations (Visa and MasterCard). The interchange fees will be capped at $0.21 (up to $0.22 including charges for fraud), plus an additional ad valorem 0.05% (5 basis point) fee for fraud losses, about double the Fed’s initial recommendation of $0.12 in December. The updated and final ruling accounted for certain fixed costs necessary to process debit card transactions, which were previously excluded. Under the new ruling, signature debit fees would be down 61% from historical levels of $0.56 and PIN debit fees would be down only 4% from $0.23. The legislation is required to be implemented by October 1, 2011.

The Federal Reserve also determined that debit cards will now require at least two different networks on each card, one unique PIN brand and one unique signature brand, not two different PIN and two different signature networks as was previously considered. The rules are effective October 1, 2011, with card issuers given an extended phase-in deadline of April 1, 2012, to issue/replace newly compliant cards.

We think recent high-profile security breaches, including the compromise of credit card data on Sony’s network and a debit card breach at Michaels Stores, may have affected how banks will be compensated for fraud prevention and protection when the Federal Reserve came to its final decision on the Durbin interchange legislation. Also, Visa’s recently announced domestic initiatives to accelerate Europay, MasterCard and Visa (EMV) and Near Field Communications (NFC) enabled payment adoption shows a continued focus on payment card security in the wake of a number of very public security breaches.

In the core bank processing and application services segment (within the transaction processing universe), we project range-bound revenue growth of low to mid single digits this year and next. Though some companies are indicating a better bank IT spending environment, we still believe annual software purchases and professional service contracts may be delayed by banks, but the demand for outsourced services has remained fairly steady.

The Federal Reserve Board on Wednesday issued a final rule establishing standards for debit card interchange fees and prohibiting network exclusivity arrangements and routing restrictions. This rule, Regulation II (Debit Card Interchange Fees and Routing), is required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Debit card interchange fees are established by payment card networks and ultimately paid by merchants to debit card issuers for each electronic debit transaction. As required by the statute, the final rule establishes standards for assessing whether debit card interchange fees received by debit card issuers are reasonable and proportional to the costs incurred by issuers for electronic debit transactions. Under the final rule, the maximum permissible interchange fee that an issuer may receive for an electronic debit transaction will be the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction. This provision regarding debit card interchange fees is effective on October 1, 2011.

The Board also approved on Wednesday an interim final rule that allows for an upward adjustment of no more than 1 cent to an issuer’s debit card interchange fee if the issuer develops and implements policies and procedures reasonably designed to achieve the fraud-prevention standards set out in the interim final rule. If an issuer meets these standards and wishes to receive the adjustment, it must certify its eligibility to receive the adjustment to the payment card networks in which it participates. Comments on the interim final rule are due by September 30, 2011. The fraud-prevention adjustment is effective on October 1, 2011, concurrent with the debit card interchange fee limits. The Board will re-evaluate this adjustment in light of feedback received during this comment period. When combined with the maximum permissible interchange fee under the interchange fee standards, a covered issuer eligible for the fraud-prevention adjustment could receive an interchange fee of up to approximately 24 cents for the average debit card transaction, which is valued at $38. In accordance with the statute, issuers that, together with their affiliates, have assets of less than $10 billion are exempt from the debit card interchange fee standards.

To assist payment card networks in determining which of the issuers are subject to the debit card interchange fee standards, the Board plans to publish by mid-July and annually thereafter lists of institutions that are above and below the small issuer exemption asset threshold. Also, the Board plans to annually survey the networks and publish a list of the average interchange transaction fees each network provides to its covered and exempt issuers. This information should enable issuers, including small issuers, to more readily compare the interchange revenue they would receive from each network.

The final rule prohibits all issuers and networks from restricting the number of networks over which electronic debit transactions may be processed to less than two unaffiliated networks. The effective date for the network exclusivity prohibition is April 1, 2012, with respect to issuers, and October 1, 2011, with respect to payment card networks. Issuers of certain health-related and other benefit cards and general-use prepaid cards have a delayed effective date of April 1, 2013, or later in certain circumstances. Issuers and networks are also prohibited from inhibiting a merchant’s ability to direct the routing of the electronic debit transaction over any network that the issuer has enabled to process them. The merchant routing provisions are effective on October 1, 2011. The Board’s notices for the final rule and the interim final rule that will be published in the Federal Register are attached.

Statement by Chairman Ben S. Bernanke

Statement by Vice Chair Janet L. Yellen

Interim final rule (114 KB PDF)

Final rule (761 KB PDF)

2009 Interchange Revenue, Covered Issuer Cost, and Covered Issuer and Merchant Fraud Loss Related to Debit Card Transactions (134 KB)

Raymond James Equity Research
Analyst(s): Wayne Johnson
[Industry Classification: Business & Industrial Services/Transaction Processing]

We think the trends in the global electronic payments industry are positive and the Greenfield opportunities in this industry warrant investor attention. Market share gains by electronic form factors at the expense of traditional mediums such as cash and check still represent a meaningful growth opportunity for payment card service providers in the U.S. and overseas. For example, we size the worldwide merchant acquiring service revenue market opportunity at $45.9 billion this year, growing at a 7% CAGR to $64.4 billion by 2015. We believe a $12 billion domestic merchant acquiring service market opportunity exists, which could expand at a 5% CAGR. However, we also estimate if alternative electronic payment form factors are adopted, like mobile payments and other innovative, enabling services, the domestic merchant acquiring business could expand by 50%, or an incremental $6 billion. Approximately 40 billion transactions, 37% of total U.S. consumer retail purchases, or $1.8 trillion in annual domestic retail sales, were still paid by cash and check in 2009. Furthermore, payment card processors enjoy a large and growing market opportunity by enabling e-commerce businesses globally.

We think the domestic E-commerce payment service revenue opportunity could exceed $5 billion by 2015 and on a global basis could exceed $25 billion in 2015. Worldwide there are 4-4.5 billion mobile phones in use and roughly 250 million, or 6%, are Internet-enabled, but by 2015 750 million, or 15%, could be eCommerce capable smart phones. In the U.S. 74 million, or 26%, of the 285 million cell phones are Internet-enabled, but that figure could double to 158 million, 55%, by 2015. Large e-commerce-oriented companies like PayPal (owned by eBay), Amazon, Google, and the payment card associations such as Visa and MasterCard are designing mobile payment applications for widespread use. The global financial crisis in 2008 caused a contraction in consumer lending with revolving credit card lines reduced by 20-25% from 2007 peak levels. Consequently debit cards have become the payment medium of choice for U.S. consumers with transaction volumes exceeding those of credit cards at the retail point of sale. Moreover, the shortage of consumer credit has stimulated the adoption general purpose reloadable prepaid cards, which provide an attractive electronic payments alternative to the 15% of Americans who do not have a bank account.

The domestic and international payment card industry has been under the scrutiny of government regulators and the most impacted party is the card issuer. Last year, the U.S. government passed the Credit CARD Act of 2009 restricting interest rate increases on credit cards. Regulation E, which went into effect July 1st 2010, forces debit cardholders to opt in for overdraft transactions. The recently passed Durbin Amendment (part of the Dodd-Frank financial reform bill) seeks to regulate debit card interchange fees received by card issuers in the U.S. On the international legislative front, SEPA (Single Euro Payment Area) is designed to flatten and standardize the processing cost of any payment card transaction in Europe by treating all payment cards issued in that region as domestic. We believe the financial metrics of the Transaction Processing sector are attractive, including: clean balance sheets (cash heavy, debt light); low capital expenditures; strong free cash flow; 80+% recurring revenue; 6-10% organic top-line growth; and EPS of 10-15% on 20% operating margin. These outsource service companies operate leverageable business models that expand profitability from processing incremental transaction volume over a fixed-cost infrastructure.

The Transaction Processing industry benefits from a number of defensive growth characteristics, such as targeting large market opportunities with low overall service penetration. We have designed this in-depth, top-down electronic payment discussion for investment professionals who are interested in exploring many of the sector topics that may impact the business and stock performance of participating companies. We postulate on the condition and future of the following categories of the transaction processing industry: credit, debit, and prepaid card processing; e-commerce; mobile and alternative payments; transaction security; electronic bill presentment and payment (EBPP); and money transfer.

Product: Colored receipt paper rolls
Company: POS Supply Solutions

Features of Colored receiptpaper rolls include:

• BPA-free thermal paper, all color rolls
• Unique branding tool for merchants
• Ideal for special promotions, holidays
• Color adds built-in security feature
• Stock item presents an affordable solution

A vibrant merchant sales tool is now available through POS Supply Solutions, a longtime provider of credit card terminal and POS system receipt paper rolls that run the gamut from thermal to single-ply and carbonless two-ply options. The company has just rolled out a new line of receipt paper rolls in a colorful spectrum of blue, green, pink and yellow.

“What brought about this development was demand from our customers,” said Stephen Enfield, President of POS Supply Solutions. “In this day and age, where everything is so competitive, you want to try to stand out in the crowd. Businesses can make a big impact by choosing to print on colored paper rather than white.” Research has shown that color enhances brand recognition and customer recall, he added.

Extra layer of security

One obvious application for colored receipts is holiday or seasonal promotions. To illustrate the point, Enfield said, “In the Boston area, because there are a lot of us Irish folks here, if they want to do a green paper for St. Patrick’s Day or pink paper for Valentine’s Day, they might want to do some timely promotions” using colored stock.

He said some merchants use colored receipts as a security enhancement when issuing printed tickets or redemptions, printing a different color each day. “That way, they know if it’s printed on yellow paper, that’s good for redemption today,” Enfield said. “But, if [customers try yellow] tomorrow, it’s not going to be any good.” Merchants can print a custom logo or return policy on the receipt rolls as well.

Another reason cited for color rolls being more secure is the lack of accessibility, compared to generic white rolls. Enfield said it is not uncommon for thieves to fraudulently duplicate generic white receipts, exposing retailers to fraudulent returns. To prevent fraud with certain types of receipts, POS Supply is working to develop advanced security features including thermochromic inks that change color in response to temperature variations, scratch and secure inks designed to change color when scratched and void pantographs containing hidden messages that become visible only when copied.

BPA-free colors

Regarding the potential toxicity of bisphenol A (BPA), a chemical reportedly found in 40 percent of thermal paper receipts, Enfield noted that eliminating BPA from such receipts is a priority for him, and the colored receipt paper rolls available through POS Supply are all BPA-free.

“I’m actually on the EPA Advisory Board,” he said. “We really take that seriously and are working with the paper mills to get as much BPA-free paper as we can. We stock a pretty broad lineup of BPA-free thermal paper rolls. At some point, hopefully all of our thermal paper will be BPA-free.” (For more information on the issue, see “Are thermal paper receipts toxic?” The Green Sheet, Sept. 13, 2010, issue 10:09:01.)

Custom options

POS Supply currently offers colored receipt rolls in two standard sizes for the payments industry: the 2 1/4″ roll fits standard credit card terminals, and the 3 1/8″ roll fits POS system printers. At some point, the company plans to offer a high-yield, micro-size paper roll for handheld wireless payment processing terminals. It will incorporate a thinner paper roll and core to reduce the frequency of replacements.

“I foresee, with additional demand, we’ll go ahead and offer perhaps neon colors or other colors,” Enfield said. “We do custom colors as well. If someone needs a particular color for a particular application, we can certainly do that.” POS Supply also sells preprinted paper rolls, custom size rolls, various paper grades and security paper rolls. Minimum orders start at five cases.

POS Supply Solutions888-431-5800
www.possupply.com/paper-rolls/colored-paper-rolls

Recent data suggest the employment outlook across major U.S. industrial sectors is positive. That’s right. Positive. Early forecasts indicate stability in certain sectors and renewed interest in others set to rebound as the economy strengthens. Shifting employer confidence levels reflected in hiring activity is a key indicator of economic health. For merchant level salespeople and ISOs, upward trending segments can signal new opportunities. An ADP National Employment Report indicated seasonally adjusted private-sector month-to-month employment grew by 297,000 in December 2010, with the service sector adding 270,000 new jobs, the largest monthly gain in the report’s history.

The Bureau of Labor Statistics Jan. 7, 2011, report showed nonfarm employment, including public sector jobs, also grew by 103,000 in December, with the largest increases occurring in leisure and hospitality and health care. Positive projections In the Manpower Employment Outlook Survey, United States, Q1/2011, over 18,000 randomly selected employers were asked, How do you anticipate total employment at your location to change in the three months from Jan. 1 to the end of March 2011 as compared with the current quarter? (The current quarter was the fourth quarter 2010.) “The first quarter survey results reflect the strongest hiring expectations since the fourth quarter of 2008,” said Melanie Holmes, Vice President Community Investment for Manpower Inc., which has published employment outlook surveys since 1962.