While the credit crisis, significant regulatory reforms as well as changing trends and technologies have created mounting challenges to investing in the financial services sector, one facet of this market is proving to be a bright spot amid the turmoil: payment processing -- a $100 billion industry. For every credit/debit purchase consumers make, there are several parties involved in each transaction behind the scenes. The card issuing bank (for example, Bank of America Corp.) that supplies the consumer with the credit/debit card, the merchant acquirer that processes the transaction (for example, First Data Corp.), the card association that verifies underlying data (for example, MasterCard Inc.) and the merchant (for example, Wal-Mart Stores Inc.). In addition to credit and debit transactions, money transfer companies send customer remittances across the globe (for example, Western Union Co.). Having historically captured investor interest as a result of relatively stable cash flows and low capital requirements, firms in this subsector, particularly those developing best-in-class technologies to take advantages of market changes, are increasingly looking like attractive investment targets for both strategic and private equity buyers.
However, the number of payment-processing deals is relatively flat at 20 for the first seven months of 2010 compared to 21 in the prior-year period. Given most of the changes affecting the subsector are relatively recent, M&A activity hasn't really heated up as investors are still digesting recent regulatory developments. Now may be an ideal time to enter or increase ownership in the transaction-processing and money transfer spaces in order to take advantage of longer-term, favorable trends impacting the sector. There are three key market drivers supporting this opinion.
The first is the impact of the Durbin amendment on interchange fees. This amendment recently passed into law will have a significant impact on interchange fees charged by the issuing bank when merchants accept cards using networks such as Visa or MasterCard. Though it will likely hurt card issuing banks, the legislation may actually benefit merchant acquirers/transaction processors, as their fees were not within the scope of the legislation. Due to their roles in the payment process, these entities control the net proceeds ultimately passed on to merchants on each transaction, and in turn may be able to capture a portion of the interchange reduction driven by the Durbin amendment. Given the magnitude of the impact of the amendment (potentially $10 billion in interchange fees per year), capturing even a fraction of the interchange reduction should contribute a significant boost to revenues and profitability for players in the sector. That said, since the Federal Reserve will not finalize interchange rules for another eight months, the impact may not be felt until mid- to late 2011. As such, current entry valuations for acquisitions made in the merchant-acquiring/transaction-processing sector may not fully take into account this potential upside, and thus, there may be hidden value in acquiring these types of businesses.
The second is the impact of Regulation E on overdraft fees. This change requires banks to receive consent from their customers ("opt-in") in order for banks to charge overdraft fees. Historically, banks have earned more than $25 billion annually from these fees, and most in the industry believe this source of revenue will decline significantly due to the regulatory changes. Faced with the loss of substantial overdraft fees, banks may stop offering free checking and may even seek to reduce their customer base particularly as it relates to lower-balance customers who as a class will now be less profitable. This will either occur through outright exit or through the use of higher service charges and fees levied on these customers. To the extent a substantial number of customers leave the traditional banking system, this may generate substantial new volume opportunities for those in the money transfer space, which should have a significant favorable impact on their bottom lines. As with the potential impact from changes in interchange fees, it is not apparent if the broader market has recognized the potential favorable impact Regulation E changes may have on the valuations of those operating in the money transfer space.
The third relates to emerging trends and technologies. Clearly, we've seen a steady shift from paper to plastic in transacting purchases. The benefit of this to the processing space is simple -- plastic or other noncash means of payment necessarily involve some form of processing, and thus movements away from cash as a medium of exchange favorably impacts processing revenues. In addition, due to the greater usage of debit/credit versus cash, there are a few emerging trends and technologies that will likely accelerate the move away from cash. These include prepaid cards and mobile payment technologies. Emerging trends show an increased demand for prepaid cards and other credit card-like instruments by those who cannot participate in a traditional credit card program (for example, the underbanked, those with poor credit) resulting from a movement away from cash as a means of payment for certain marketplace transactions, most notably as gifts and at the state level for things such as toll road payments, etc. In addition to the trend in prepaid card usage, perhaps the hottest emerging technology in the payment-processing space is the use of mobile phones as a means for transacting payments. The recent significant proliferation of mobile phones ensures that a consumer almost always has it on hand. Additionally, in emerging markets where many do not have a computer, there is a higher likelihood individuals have a mobile phone. These factors are contributing to issuing banks and payment networks aggressively marketing mobile payments to both new and existing customers. We believe these trends are likely to continue to evolve over the next few years, generating significant new transaction volume streams for key players in the transaction-processing and money transfer space. Those entities that have developed solutions involving these technologies will likely experience attractive growth in future periods.
Identifying an industry prior to when growth accelerates is obviously the greatest challenge in investing. As a result of recent regulatory changes, other emerging trends and technological developments, it appears we are currently at a point of inflection relative to growth opportunities in the payment-processing sector. The precise evolution and impact of these factors will likely develop over time, which may suggest the present time is best to identify and invest in the hidden gems in the merchant-acquiring/transaction-processing/money transfer space in order to reap outsized returns in future periods.
Mark Sponseller is a managing director and Peter Gougousis is a manager with the transaction advisory group of global professional services firm Alvarez & Marsal.