Going Against The Tide

  The accepted wisdom is that smaller merchant processors cannot compete with such giants as First Data Corp. or Vital Processing Services LLC and that acquirers are better off letting the big boys process their transactions. Ronald R. Nation doesn't buy it.
  Nation is president of Denver-based First Horizon Merchant Services, which recently completed a two-year project to bring its processing in-house. He says First Horizon, formerly a Vital customer, now more quickly can introduce new services that set it apart from competitors. And if First Horizon comes up with a good idea, Nation knows his company's competitors will not benefit from it the way they would if the innovation were provided by an outsourcer like Vital.
  "We didn't want to be part of a service bureau which provided the same products and services to our competition," Nation says. "That environment also fosters a hierarchy approach in which more attention is given to the processor's top-volume customers."
  While there is hardly a wave of merchant acquirers taking their processing in-house, there remains a hardy band of financial institutions that insist on handling transactions for their own retailers.
  As long as that's the case, even smaller and mid-sized merchants will be wooed by acquirers offering new features and more personal service than they might get from the big-volume processors. And acquirers that do outsource their processing will find themselves competing with companies that do not have to wait in line at the outsourcer's door for new ideas to be implemented.
  In fact, some observers believe more merchant acquirers are likely to bring their processing in-house if banking industry consolidations continue, allowing more institutions to bulk up their transaction levels to a point that allows them to support state-of-the-art data centers.
  "Many banks got out of acquiring when the issuing side of the card business took off in the 1970s and 1980s because it is a low-margin activity," says Regan Wong, who is a director with TowerGroup, a Needham, Mass.-based financial-industry research and consulting company that MasterCard acquired in 2004. "But as the issuing market matures, institutions again will turn their attention to the acquiring space. And it may make sense for them to do their own thing as the industry condenses and banks begin seeing additional transactions."
  However, Wong notes, it will be difficult for institutions to justify a move to in-house processing without a guarantee of large volumes.
  Some banking heavyweights, such as Bank of America Corp. and U.S. Bancorp, have grown their transactions through acquisitions. U.S. Bancorp in 2001 increased its already healthy volumes and processing capabilities by purchasing Atlanta-based merchant processor Nova Information Systems. And BofA bolstered its operation when it announced in July that it was purchasing all the outstanding shares of National Processing Inc. for $1.4 billion in cash. National Processing was 83% owned by Louisville, Ky.-based National City Corp.
  BofA said the newly combined Bank of America Merchant Services unit would have nearly $250 billion in annual processing volume.
  Product Perception
  The bank's motivation, observers say, is the potential to generate revenue. "Merchant acquiring is not a core competency of most banks, but BofA carved it out as a freestanding profit center," says Tom Dailey, a Chicago-based payments consultant and a former Discover Financial Services senior vice president who headed up the company's merchant network. "They look at it as a core product rather than just one arrow in a quiver of services available to merchants."
  Bank of America and U.S. Bancorp would not comment for this story.
  Other entities that handle their own processing, including First Horizon Merchant Services, which is a subsidiary of First Tennessee Bank NA, and First National Merchant Solutions, which is owned by First National Bank of Omaha, have a fraction of the volume of the largest financial institution acquirers. But the companies still keep their activities internal to have more control over operations, company executives say.
  First Horizon already was supporting its own transaction-authorization and data-capture activities. After completing the conversion to in-house processing, it now additionally handles settlement, clearing, merchant reporting and other capabilities.
  While Nation will not reveal First Horizon's budget for taking the processing in-house, he says such conversions "always cost more and take longer than expected." Among the acquirer's expenses was the hiring of additional programmers to write software and maintain the technology.
  All First Horizon activity is generated from about 40,000 merchant customers in the U.S., Canada and the Caribbean. Third parties, however, still handle about 10% of the volume because some retailers did not want to connect to a new processor, in this case, First Horizon.
  Cost Vs. Service Quality
  While he would not divulge transaction figures, Nation admits that First Horizon cannot match the volume and the lower processing costs of the largest third-party vendors. As a result, the company's strategy is to compete on service quality instead of price.
  But First Horizon still expects to cut its processing expenses by taking all operations in-house, Nation says. He adds that company revenues are increasing between 20% and 25% annually. "The market is growing about 15%, so as long as we stay ahead of the curve the in-house move will remain a great decision," he notes.
  Also emphasizing its performance capabilities to win customers is Omaha, Neb.-based First National Merchant Solutions. The acquirer positions its merchant processing as just one of many services in a broad package of offerings that includes cash management, commercial lending, consumer financing, cobranding of credit cards and other products.
  Diana Mehochko, First National Merchant Solutions president, says the company also is leveraging First National Bank of Omaha's reputation as a stable, privately owned institution to attract retailers that are concerned about the prospect of changes in service quality from future industry mergers and acquisitions. The bank has had the same owners since 1857 and began processing transactions in 1953.
  "Pricing is only one component in doing business," Mehochko says. "Processors that sell on price will eventually lose because it does not enhance the relationship with the customer."
  First National Merchant Solutions supports close to 162,000 merchant locations. In 2004 the company processed 460 million payment transactions accounting for sales volume of $31.3 billion.
  Mehochko says First National Merchant Solutions benefits from not having to rely on the schedule of outside vendors to initiate database upgrades. Such adjustments could include changing pricing levels or creating applications to add additional information to statements.
  Will other acquirers of similar size take their processing in-house? Some analysts doubt it. Dailey notes that most institutions will have to spend heavily to create internal capabilities, while First National Merchant Solutions is able to compensate for its relatively modest volumes by already having a processing platform in place.
  "The required infrastructure is so immense that it is difficult for more acquirers to bring systems in-house," he says. "Unless they have a killer application that is going to give them a great competitive advantage, banks will be reluctant to invest the necessary capital when the return is questionable and they could offer the same set of services on a private-label basis."
  Portfolio Needs
  Indeed, Bipin Shah, president and chief executive of Genpass Inc., a Fort Washington, Pa.-based payments processor, says in-house processing only makes economic sense for institutions with huge merchant portfolios and that already have the required front-end and back-end operating systems.
  "The cost is too great for banks with small portfolios because it is too hard to get rid of the fixed expenses," he notes. "Most institutions are not big enough to bring down the unit costs."
  Analysts estimate it would cost banks tens of millions of dollars to deploy and operate in-house processing platforms. Expenses include the personnel necessary to maintain the necessary hardware and software, provide customer service, handle chargebacks and dispute resolutions, and keep abreast of regulatory mandates.
  Smaller acquirers likely would have unit-processing costs of between 4 cents and 9 cents per transaction, Shah says, while the largest vendors with the greatest economies of scale are able to charge customers as little as one cent per transaction.
  And though institutions that handle their own processing can customize statements and give clients other differentiated products, their higher operating expenses usually outweigh the benefits, Shah adds. "Going in-house gives banks greater control over their operations, but the advantages often are not worth the cost," he says.
  Shah and other industry observers only expect the largest banks and a handful of smaller acquirers with footholds in the market to keep their processing in-house. "There won't be many acquirers jumping into the business that aren't already operating in the space," says David W. Lott, a director at Collective Dynamics LLC, an Atlanta-based management-consulting firm. "It is very complex and requires a critical mass of volume in order to reach levels that will enable companies to make a profit. There is money to be made, but it's not a low-hanging fruit."
  And it can be daunting for acquirers to try to match the price and service levels of the largest third-party vendors. First Data Merchant Services, a unit of Greenwood Village, Colo.-based First Data Corp., in 2004 processed 19.8 billion transactions from 4.1 million North American retail locations. First Data in 2003 had volume of $664.7 billion that was generated from 12.3 billion transactions at 3.1 million locations. Volume figures for last year were not available.
  First Data also operates joint ventures with major financial-institution acquirers in which the parties share ownership of the merchant accounts. The processor, for example, partnered with J.P. Morgan Chase & Co. to create Chase Merchant Services. First Data handles the core processing, and both parties share in the management of the business, which includes the setting of sales, marketing and product-development strategies, says John Shlonsky, First Data Merchant Services president.
  Shlonsky would not reveal how many similar alliances First Data is supporting. The vendor also offers a wide range of products and services, including gift cards, couponing and loyalty programs, and the company is positioning itself as a "consultative" partner that provides sales expertise and customer service, he notes.
  Outside Support
  "A processor's advantage comes from supporting the ever-changing market of new payment products," Shlonsky says. "The core banking business revolves around lending relationships and deposits, and it is unclear if financial institutions will have the appetite to make the necessary investments in technology and infrastructure to handle all types of payments."
  And, regardless of their capabilities, acquirers with in-house processing systems still often contract with outside vendors for some functions. Vital Processing Services, for instance, frequently provides front- and back-end processing, including clearing and settlement services, to in-house acquirers, says Cathy Corby Parker, Vital senior vice president.
  Vital also deploys terminals, offers statistical analysis, runs help desks and develops chargeback applications. The vendor additionally supports specialized applications, such as pay-at-the pump functions at gas stations.
  "There is always something an institution can't do because no one can be all things to all people," Parker says. "Many bank processors will look at outsourcing more of their needs as the operating requirements become increasingly complex."
  Parker says Vital is able to maximize its operating efficiencies by routing transactions through a single platform. Many processors use disparate operating systems that are located in different geographic regions.
  Vital in 2004 processed 3.4 billion authorization transactions, and cleared and settled 2.7 billion transactions from more than one million retailers.
  Institutions with internal systems, but without the volume to compete on price with the largest processors, are taking a variety of steps to remain relevant. In addition to providing a wider range of products and services, some are bundling their acquiring functions with other bank products to offer customers a stronger package of offerings with more flexible pricing.
  "The goal is to recoup some of the high cost of the processing services while creating stickiness to the merchant relationship," Collective Dynamics' Lott says.
  He notes that bank-owned processors also primarily concentrate on signing up small and mid-size retailers. While large merchants will generate more transactions, they also have the leverage to demand lower processing fees, resulting in razor-thin margins for the acquirers.
  And while processors with a plethora of smaller retail customers must maintain large sales and customer-service staffs to manage tens of thousands of merchant accounts, the financial impact from losing any one client often is minimal, he says.
  Acquirers that take their processing in-house, or even switch third-party providers, however, also can expect steep conversion expenses. Merchant terminals that dial into processors' back-end systems, for example, typically would need to be manually reprogrammed at a cost of between $20 to $30 per device, Dailey says.
  Weighing Options
  "Modification fees often are very high, and they could wipe out any price advantage an acquirer might realize from changing processing systems," he notes. "A switch only makes sense if the acquirer is going to stay in the situation long term."
  But more transformations are likely to occur. Dailey notes that 15 years ago almost every large merchant acquirer operated an internal processing system before outsourcing with First Data and other high-volume and technology-savvy vendors. But some institutions are again weighing the advantages of going in-house.
  "This has been a very cyclical sector, and the pendulum has been swinging back lately to more banks considering whether they want to do things internally," Dailey notes. "But it is a small-margin business, and many people outside the acquiring portion of the bank don't get too excited about it."
  Indeed, until merchant processing starts to generate a substantial portion of an institution's revenues, bank management is likely to focus on other concerns.
  Acquiring activities frequently account for less than 5% of an institution's income, analysts say. And banks in many instances primarily offer the services to accommodate the requests of their retail customers rather than because they expect a large payback.
  But as institutions increase their transaction base through mergers, acquisitions and other means, in-house processing will warrant greater consideration.
  "There may come a time when the expense of using a third-party processor will compare closely to the cost of an institution doing the activity in-house," First Horizon's Nation says. "And that is when it may make sense for a move."