Alvarez & Marsal

• A&M Home<
• About A&M<
• Action Matters<
• Payment Processing: A Diamond in the Rough?

Action Matters

Payment Processing: A Diamond in the Rough?

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 $90 billion industry, providing products and services in connection with every credit or debit purchase consumers make.

Having historically captured investor interest as a result of relatively stable cash flows and low capital requirements, firms in this sub sector, 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.

Action Matters sat down with Managing Director Mark Sponseller and Manager Peter Gougousis to discuss trends in this area and, specifically, how companies in the merchant acquiring and money transfer space are best positioned to capture developing opportunities.

Action Matters: What has been the impact of the substantial regulatory overhauls that have taken place recently?

Mr. Sponseller: The Durbin Amendment to the recently passed Dodd-Frank Act will have a significant impact on interchange fees charged to customers. In effect, the new legislation will place significant downward pressure on these fees, which a merchant's bank (the "acquiring bank") pays a customer's bank (the "issuing bank") when merchants accept cards using card networks such as Visa or MasterCard. Estimates suggest issuing banks could lose as much as $10 billion dollars per year in interchange fees; what remains to be seen is whether reduced interchange fees will fully accrue to the consumer or whether elements of the savings will be captured by other players in the market (i.e., transaction processors and merchant acquirers).

In addition to Dodd-Frank Act, there have been other meaningful changes to existing regulations such as those made to Regulation E, which governs electronic fund transfers, in November 2009. These changes require banks to receive consent from their customers or an "opt-in" - in order for the banks to charge overdraft fees. Historically, issuing banks have earned more than $25 billion from these fees annually and this source of revenues is likely to decline significantly as a result of the regulatory changes. What is important to note is the income from these fees has effectively allowed the banking system to offer free or very low cost checking accounts to a depositor base that otherwise would have been unprofitable to serve. A developing trend will be whether the Regulation E changes will result in a shift of a significant portion of the deposit market from the traditional banking system to other means of supporting payments (e.g., money transfer, check cashing, and bill pay shops, etc.).

AM: What are you seeing in terms of current M&A activity in this space?

Mr. Gougousis: On a year over year basis through July, the number of payment processing deals is relatively flat at 20 for the first seven months of 2010 compared to 21 in the first seven months of 2009. M&A activity hasn't really heated up in the space as investors are still digesting the recent regulatory developments. However, now may be a good time to enter or increase ownership in the merchant acquiring and / or money transfer space in order to be positioned to capture some of the longer term favorable trends impacting the sector.

AM: What are the other key trends you've identified?

M.S.: There are really three key market drivers:

The first is the impact of the Durbin Amendment. While it will likely hurt card issuing banks and its impact on merchant acquirers is still unclear, the legislation may actually benefit merchant acquirers / transaction processors, as their fees were not scoped within the legislation. Due to their roles in the payment process, these entities control the level of funds ultimately passed onto 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, 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 rules for interchange 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 contemplate this potential upside and in turn, there may be hidden value in acquiring these types of businesses.

The second is the impact of Regulation E on overdraft fees. 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 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 non-cash 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 proliferation and use of debit / credit vs. cash, there are a few emerging trends and technologies that will likely accelerate the move away from cash. These include the increased usage of prepaid cards - used as gift cards and as credit card-like instruments by those who cannot participate in the traditional credit card programs - and mobile payment technologies, which involve the use of mobile phones for transacting payments and is perhaps the hottest emerging technology in the payment processing space. These trends are likely to continue to evolve over the next few years and will generate significant new transaction volume streams for key players in the transaction processing and money transfer space.

AM: Summarize the investment outlook for us.

P.G.: 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.

Also read commentary on this topic in The Deal.