Credit card issuers have been using the Internet to acquire new card customers, but they might be wiser to focus on building transaction volumes, according to analyst Kenneth A. Posner.

The Morgan Stanley Dean Witter & Co. principal contends that the Internet's chief value to card companies is in potentially higher interchange income, from the fees that card-issuing banks earn when consumers make purchases. In "The Internet Credit Card Report: A Primer on the Industry and Its Role in E-Commerce," released last month, Mr. Posner predicted that an impending surge in on-line commerce could increase interchange growth from 11% a year to 15%.

Mr. Posner, 36, has covered the U.S. credit card, mortgage, and thrift industries for Morgan Stanley for four years. Before that he worked in the firm's investment banking group. He received a bachelor's degree from Yale University in 1985 and an MBA from the University of Chicago in 1991.

In a recent interview, Mr. Posner gave his views on how credit card issuers can prosper in cyberspace.

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What is the chief importance of the Internet to the credit card industry?

The key trends are on-line spending and the increase in interchange. It is our thesis that people will spend more on credit cards as they gradually use the Web for transactions, and that's going to be particularly the case with small businesses. We can talk about the Internet as a distribution channel and the Internet as a way of maintaining a relationship with customers, and that's very important, but the economics will be just people using the card more.

Some say that interchange income will not increase, because consumer spending will simply move from traditional stores to on-line stores.

It will be some of each. Right now, about 25% of what people spend in the off-line world is paid for with cards. On-line, it's close to 100%. So there should be some pick-up.

We think the bigger opportunities are with small businesses. Most e-commerce projections show that in business-to-business commerce -- small business in particular -- companies barely use cards at all. They are only using cards for about 2% to 3% of their spending, which is a couple trillion dollars a year. The Internet is teaching people to use cards more and to think about rewards programs, and it's going to have the secondary effect that when people go back to the off-line world, they'll be thinking about using their cards more.

Citigroup says it views the Internet primarily as a way to heighten interchange, but many other issuers are focused on customer acquisition. Are other card companies embracing your view?

Yes and no. A lot of the initial focus of investors in the industry has been on the Internet as a distribution channel. Everyone is aware of NextCard, and they've built a great mousetrap. The issuers that have focused on spending -- and the ones well positioned to capture it -- are companies like American Express Co. and Citigroup. They're typically the companies that have merchant relationships as well as customer relationships, and the ones that have business penetration as well as consumer penetration.

Bank One Corp.'s First USA subsidiary is one of your top picks for success on the Internet, but it has been paying greatest attention to account acquisition.

That has certainly been where the noise and smoke has been, but it's our sense that something new might be forthcoming. Card issuers have something that's very valuable they know where you spend your money. The card companies make quite a bit of money with targeted statement stuffers. And if you can move a 1% response rate up to 2%, it may not knock our socks off, but that's doubling the economics. That spending data is important, and a lot of the card issuers are trying to figure out how they can align it and use it. I'm not sure anyone is quite there yet.

The idea is to get people to service their accounts on-line, to come to your Web site and check their balance, and then be able to target special deals to people. The big issuers hope their clout will allow them to go to merchants and get attractive deals. That is very much the American Express strategy, and I believe it's the Citigroup strategy as well. So what you're doing is stimulating usage on the card.

Do you think using customer information to do target marketing on the Internet will upset privacy advocates?

The world needs marketing, and intelligent marketing is better than mass untargeted marketing. You have to respect a consumer's right to opt out, but if you can somehow figure out that somebody is more interested in a certain product than another, and you can send them that ad, it's more relevant to the consumer and it's a better use of your advertising revenue. It's the dream of all e-commerce players. I don't think politicians will blow that off, because it makes sense for everybody.

Is that where issuers will make a lot of money in the future?

We think so. We have projected credit card spending growing at about 11% a year over the next five years. With spending on the Internet, we think we might see that growth rate go as high as 15%. That's predicated on projections of e-commerce spending really ramping up in the 2001-2002 time frame. Consultants are projecting trillions of dollars in on-line spending, and if some of that hits cards, that will be incremental growth.

Your study says branding will be even more important on-line. What do you think about the new on-line brands, like Providian's Aria or Bank One's WingspanBank.com?

It's possible for new brands to be created, but it's rather tough. You need to really differentiate the product. NextCard, First USA, and Providian have all created on-line brands, and now Fleet wants to do something.

I wouldn't necessarily bet on the creation of powerful new brands in the credit card space. I would rather bet on American Express, with an existing powerful brand, being able to leverage that brand.

How will the Internet affect small and midsize issuers?

The handful of big guys are in positions to create brands, and the smaller guys will find it more difficult. Today the top 10 issuers have 70% to 75% of the market, and we think in five years it will be 90%. The Internet just continues that trend, because it creates a new competitive arena where you have to be really big and really good to compete.

We think there are two business models that will succeed in the Internet era. One is the vertical portal -- which is the ultimate relationship manager -- and the other is the manufacturer of specialty products. The vertical portal is the same concept you hear all the financial services companies talking about today: selling multiple products to the same consumer, and maximizing the value of the relationship. An example of a successful vertical portal is Schwab. It leveraged the brokerage transaction product; added in a great content in terms of news, fundamentals, and stock prices; and it's winning because it is getting real traffic at the site. We think Bank One has a good shot at that, American Express as well. Portals like America Online and Yahoo are real competitors, too. Right now those sites have great traffic and great content. They just don't have a lot of transaction dollars, which is what they need to add.

Will people trust Internet portals to handle banking services?

Initially, no. People trust financial services companies for financial products. So that's good. But over time, I think that can fade rapidly. If AOL were to come up with its own checking account, there might be some initial skepticism, but I think that would wear down.

Why is American Express your top pick?

We think it's well positioned for the ramp-up in card spending, and we have a slightly higher-than-consensus forecast for earnings growth, which is driven by that phenomenon. American Express can be a successful vertical portal. They still have some executing to do to get there, but they've got the right products -- brokerage, credit cards, and checking. They've got a powerful brand and a pretty good Web site, which needs a little more work but is starting to create some traffic.

What should credit card companies do to be successful on-line, and what should they watch out for?

Credit cards are already a remote business, so the Internet is actually a great channel for them. As with any new technology, there is a risk to falling behind. I don't see a risk from new entrants -- you have one new credit card company, NextCard, and I think that's it.

We've already seen that credit risk is a competitive phenomenon. In 1994 and 1995, you had certain issuers who weren't paying attention to the market and got stuck with more than their share of bad credits. There is sort of a hot-potato nature to the game, where everyone is trying to poach one another's customers. The Internet could accelerate that, because you're getting an immediate response, whereas direct mail can be a three-month cycle time.

We are most excited about card companies that are positioned to stimulate spending. That is the upside in this industry. We're not bearish on the lending business. We sense a little bit more margin pressure, and it's already saturated. We don't see the Internet creating upside there.

The best companies are those that don't just sit there waiting for e-commerce to fall on them, but are out there figuring out ways to make that happen.

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