At the end of June, Citicorp sold a credit card processing business for $175 million to a consortium composed of the venture capital firm Welsh, Carson, Anderson & Stowe; Prudential Equity investors, and the Chicago brokerage firm William Blair & Co.
The sale of the unit, known as Citicorp Establishment Services, which processes card transactions for retailers, attracted press attention mainly because of the few basis points it added to Citicorp's capital ratios.
Some analysts opined that it was another sale of a good business out of desperation to raise capital, and a long-term negative for the company.
But I would argue that the deal will have much more momentous consequences.
The sale of the merchant processing business has the potential to:
* Raise the costs of consumer purchases across the United States, that is, actually raise the rate of inflation by a few basis points.
* Create enormous profits for those capable of providing merchant credit card services.
The Nature of the Business
To explain why, I must first describe the nature of the business sold and what the consequences would be if the Welsh Carson partnership attempted to maximize returns on the investment for its investors.
The credit card business in the United States has two principal parts.
The first, well known to everyone, involves issuing the plastic cards to individuals, who have found them a convenient replacement for cash and an easy way to get unsecured credit.
The other side of the business serves the merchants who accept the cards for their goods or services.
|Acquiring' banks Get a Cut
The Mastercard and Visa associations call this the "acquiring" business, because the banks that accepted the sales drafts acquired them from merchants and profited by taking a discount on the paper.
The merchant service business has become highly sophisticated. using space-age technology that has made those sales drafts largely obsolete.
For example, a man buying a shirt in Tokyo using a Visa card can have that card validated by his local bank in the United States a few seconds after the clerk in Tokyo sweeps it through a counter-top terminal.
At the height of the Christmas season the card networks handle 200 such authorization calls each second. The funds are later transferred electronically from the merchant's bank - that is, the acquiring bank - to the card issuer's bank.
Incentive to Take Cash
The merchant side of the credit card business initially was attractive for banks, and not particularly cost-effective for the retailers.
The reason: In the early days of credit cards, merchants had to pay discounts as high as 6% for banks to accept the paper. In other words, a store would keep only $47 on a $50 card sale.
Also, the card-accepting retailer's money would generally not be available for a week, which gave an incentive to take cash or checks instead.
In addition, the merchant had to do the accounting work to ensure that card sales were ultimately paid for.
Given the fee and float opportunities, virtually every bank that issued credit cards attempted to sign up as many shopkeepers as they could. But the good times did not last.
Innovative technology companies such as VeriFone Inc. developed low-cost, high-speed authorization terminals in the 1980s that revolutionized the merchant business.
Hordes of salespeople from independent service organizations swarmed through shopping streets and malls all over the country. These so-called ISOs were middlemen, offering to deliver the technology and make merchant-processing deals for retailing clients.
Credit card issuers also embraced the terminals because they made it possible to get a reliable authorization on each transaction, a key weapon against fraud and credit losses.
Several Problems Solved
The terminals also solved the merchants' paperwork and accounting problems while ensuring prompter delivery of funds.
Efficiency and competition lowered the discount rates substantially. Continued improvements in the technology led to the rise of high-volume transaction processing companies with economies of scale that only a few banks could compete with, and profit margins eroded.
Banks that followed the old technique of looking at customer profitability instead of product profitability tended to price the merchant service by bundling its profits (or losses) with those on demand deposits, loans, payroll processing, and other services.
By 1990, the business had reached the point where it was benefiting merchants at the expense of their bankers. The float was gone.
In the most competitive markets, the discount was down to 1.85%, most of which went to pay the interchange fees set by Mastercard and Visa.
A small group of highly efficient producers - factories, really - continued t to make money, thanks to efficiencies and economies of scale.
With most banks losing money on the product, those with capital needs put their merchant businesses on the block. Chemical Banking Corp. and, before its merger, Manufacturers Hanover Corp., were far ahead of Citicorp in this regard.
Next, some well-run banks with excellent data processing capabilities made the decision to get out of the business. State Street Boston Corp. and Bank of New York Co. sold their account lists.
Finally, two major credit card issuers - First Chicago Corp. and Citicorp - decided to leave the acquiring business.
The rush for the exit, initially by smaller banks and then by progressively larger institutions, created a buyer's market initially dominated by National Bancard Co., now the Nabanco Division of First Financial Management Corp., Atlanta. What had been a highly fragmented industry began to be concentrated in a few strong hands.
An authority on the business, The Nilson Report, has published figures that suggest that the five largest companies in the field - Nabanco, National Processing Co. (owned by National City Corp. of Cleveland), the Welsh, Carson, Anderson & Stowe partnerships, National Data Corp. of Atlanta, and NationsBank Corp. - may now handle 55% to 60% of the nation's bank card transactions on behalf of merchants.
Behind them are First USA, a credit card bank that recently went public, and Innova Financial Services, both gaining in market share.
Even the industry's data and account processing is coalescing in a small number of players: First Data Corp., majority owned by American Express Co.; SPS Transaction Services, a partial spinoff of Sears, Roebuck and Co.; Total System Services, a subsidiary of Synovus Financial Corp. of Columbus, Ga., and General Motors Corp.'s EDS Corp.
Reversal Likely on Pricing
It is illogical to assume that pricing will fall or even stay static in this environment. Oligarchs are not known for their willingness to compete on price, particularly after 20 years in which prices have only gone in one direction - down.
These strong survivors are likely to raise prices. And the catalyst for this action may be the recent sale by Citicorp.
When Citicorp owned and operated its credit card division and the attendant network, it was reputedly a vigorous price cutter. The company was able to expense the cost of building the Establishment Services division over a number of years, which kept capital costs low.
In addition, Citicorp could draw on numerous sources of revenue to subsidize the business, from direct merchant fees to the interchange fees that Citicorp collected whenever its own cards were used.
And in some cases, Citicorp's card-accepting merchants also would have used the bank for deposits, loans, and other services, providing an additional profit stream.
The buyer of Citicorp Establishment Services has only one source of revenue from Citicorp merchants: the transaction-related processing fee. Unlike Citicorp, the buyers do not issue credit cards of their own and cannot sell regular banking products.
Satisfying the Investors
If it is assumed that the buyers borrowed 75% of the purchase price on, for example, a 10-year note at 8%, then the debt service cost would be enormous relative to Citicorp's old capital costs.
The new company is thus likely to raise prices on its basic service to ensure investors the required returns.
The competition then will have to make a decision either to raise prices in line with the Welsh Carson partnership or maintain prices at current levels in an attempt to woo the new partnership's customers.
Probably both events will occur. This means prices on all retail trade in the United States are likely to rise slightly.
Aided by increased market shares and higher tariffs, the new oligarchy running the merchant credit card business will fare extremely well.