Processors Face Their Ups, Downs

  The bankcard industry's ongoing consolidation is turning out to be bad news for the country's two largest third-party card processors. The bigger issuers become, it appears, the better off some believe they would be processing their own transactions.
  This could become a serious problem for processors' domestic operations, as the 10-largest issuers now control 90% of the nation's card receivables ("Issuers Go on a Buying Spree," September 2005). And any decision by one large issuer to take its card processing in-house would have a huge financial impact on its processor.
  This scenario, however, has some bright spots. Small issuers continue to rely on third-party processors, and analysts have monitored the industry long enough to know that big issuers sometimes change their minds.
  "It's been a trend over the last two years," says Franco Turrinelli, a William Blair & Co. analyst. "It's a fashion, and I don't know how long it will last. Banks look at each other to see what the other is doing."
  Industry observers got a glimpse of what consolidation could mean to a processor when Bank of America informed long-time partner Total System Services Inc., or TSYS, that it would take its consumer card processing in-house following the bank's Jan. 1 purchase of MBNA Corp. The deal made BofA the nation's largest issuer, with 40 million active U.S. accounts and nearly $140 billion in managed card balances.
  BofA said it would process its consumer card portfolio on MBNA's platforms in Wilmington, Del., and at an undisclosed location in Texas. A bank spokesperson explained that BofA decided to move its consumer card processing to better serve its cardholders.
  "We will continue to evaluate the most efficient way to serve our customer base," the spokesperson says.
  BofA made its decision after comparing MBNA's processing facilities with TSYS's, says Dan Perlin, a financial analyst with Stifel Nicolaus & Co. "MBNA has a good proprietary processing platform, and from Bank of America's standpoint there was no reason to give the business to TSYS," Perlin says.
  Card-industry consolidation also has been on the mind of First Data Corp. Chairman and CEO Henry C. "Ric" Duques. Duques noted during the company's fourth-quarter conference call in late January that at one time First Data benefited from industry consolidation, but now things have changed. "There was a time in our history when the consolidation was running in our favor," Duques says. Everything consolidated was on our system."
  First Data experienced the loss of a major card-processing contract in July 2004 when Chase Card Services, the card-issuing arm of J.P. Morgan Chase & Co., announced that it was shifting its 87 million card-account portfolio to TSYS, First Data's chief rival. Chase at the time said its eventual goal was to take its card processing in-house. The decision was a major blow to First Data, said Robert Dodd, an analyst with Morgan Keegan & Co. Inc.
  David Bailis, president of First Data Financial Institution Services, which includes card processing, says the loss of the Chase contract was "a big one." Bailis adds, however, that First Data has recovered from its troubles with the bankcard industry.
  "It was a most difficult and trying period for us, but it is behind us. Life is good," he says.
  And answering his own question, Bailis said, "Sure I would like it to be better."
  Analysts said Chase's move led to the departures of several executives who ran First Data's Card Issuing Services unit. It also prompted First Data to reevaluate the business with the possibility of selling it or spinning it off. Duques announced in late January that First Data is keeping it.
  William Blair's Turrinelli points the finger at Jamie Dimon for initiating Chase's move from First Data to TSYS. Dimon, who is Chase's president and CEO, also has influenced other issuers to take their card processing in-house or at least to consider it.
  Dimon was heading Bank One Corp. when it merged with Chase in July 2004. Before joining Bank One, Dimon worked for Citigroup Inc.
  "Citigroup processes its cards in-house," Turrinelli says, "At Bank One, Dimon wanted to create another Citigroup, and he wants to continue the process at Chase."
  Chase Card Services' contract calls for TSYS to initially process Chase's card portfolio on TSYS's TS2 platform until TSYS licenses the software to Citigroup so the bank can process the portfolio on its own.
  Turrinelli also says Dimon may have influenced other issuers to do the same thing, or at least consider it, because there is a lot of "me-tooism" within the card industry.
  With ownership of the vast majority of receivables in fewer hands, issuers have grown reluctant to use third-party processors, says Theodore Iacobuzio, managing director of the executive research office at TowerGroup, the consulting arm of MasterCard International. "Large issuers want a degree of control over their credit cards, and they no longer are willing to turn processing over to a third party," he says.
  Turrinelli says Citigroup is an example of one issuer that believes it can offer better card products by using its own technology. "Theoretically, third-party processors have more generic systems, and some issuers believe their proprietary systems will give them an advantage," he says.
  The loss of major card-processing contracts has hit both First Data and TSYS where it hurts, which is in their own bank accounts. First Data's Duques told analysts in late November that "hundreds of millions of dollars have been lost on a couple of big (card-processing) accounts.
  Financial Impact
  First Data has laid off 1,000 workers, mostly in its Card Issuing Services unit, to save $50 million to $60 million this year. The company also announced it is closing its plant in Macon, Ga., that prints and mails credit card statements. About 300 jobs will be lost there.
  For TSYS, BofA's decision will result in an annualized revenue loss of $140.4 million, the company says. The processor is scheduled to deconvert BofA's portfolio Oct. 6.
  "The earliest impact (of the deconversion) could be in October, and the earliest full-year impact will be in 2007," a TSYS spokesperson says.
  TSYS was scheduled to process BofA's Visa and MasterCard consumer cards through 2014. Because BofA is breaking the contract, it has agreed to pay TSYS a $69 million penalty fee, said TSYS Chairman and CEO Philip W. Tomlinson.
  Tomlinson, however, made it clear during an analyst conference call he would rather have the business. "We frankly wish we never would get the payout," he said. Despite the payout, TSYS has delayed construction of a data center and has initiated a hiring freeze.
  The loss of the BofA contract overshadowed TSYS's 2005 earnings. TSYS reported 2005 net income of $194.5 million, up 29% from 2004. Revenues and accounts on file also rose, but Wall Street yawned. TSYS's stock price fell 5.7% on the day it reported its earnings.
  Besides losing the BofA account, TSYS also will have to deconvert the Citigroup Sears Portfolio. Citigroup awarded First Data the Sears private-label card-processing contract in June after buying the portfolio in July 2003.
  "This is a challenging environment for TSYS because of what they lost," says Gary Prestopino, an analyst with Barrington Research. "It's hard to get excited about a company that will have a year of flat revenues from operations."
  Ryan Beck & Co. downgraded TSYS from "outperform" to "market perform." Outperform means the stock is expected to outperform the broader market over the next year. Market perform means the stock is expected to perform approximately in the line with the broader market over the next year.
  Tomlinson says TSYS has 75 million card accounts lined up for conversion-the largest in the company's history-and at the end of 2006, it will have 395 million to 405 million accounts on file. At the end of 2005, TSYS had 381.8 million domestic accounts on file and 56.1 million international accounts on file for a total of 437.9 million.
  With the shifting marketplace among big issuers, both TSYS and First Data are looking for new areas in which to grow their domestic card-processing businesses.
  First Data's Card Issuing Services unit, which is based in Omaha, Neb., is now part of First Data Financial Institution Services. It includes debit card processing, which at one time was part of merchant services; output services, which includes card printing, mailing, personalizing, embossing and magnetic-stripe encoding; and Remitco, which accepts cardholder payments on behalf of merchants and posts them.
  More Services
  "Historically, traditional card processing was the core of this business," Duques told analysts during the January conference call. "Now debit, Remitco and output services are becoming a larger part and more strategic for this business."
  Moreover, First Data will make a considerable sales and marketing effort "to capture the enormous opportunity within our existing client base ... by selling output services, Remitco services and debit services to those clients," he said. "Only a small portion of our client base uses all four of our services. So we believe there's an enormous opportunity because these-our clients-are very substantial financial institutions in the United States."
  Duques says it will take all of 2006 and most of 2007 to get First Data Financial Institution Services to 8% to 10% revenue growth. Although issuers may take card processing in-house, Stifel Nicolaus' Perlin says issuers will continue to outsource output services and use Remitco because it is cheaper to have a third party do those activities.
  In the case of TSYS, Tomlinson told analysts that the processor has "a lot of different pillars of growth." He spent much of his discussion during the conference call describing the company's overseas businesses, which currently contribute 19% to TSYS's revenues. Tomlinson wants that proportion to reach 30% to 35% of revenues in the next few years.
  Perlin also believes First Data and TSYS will begin processing more private-label, retail and health cards. William Blair's Turrinelli sees the same thing happening. "On the flipside, smaller issuers continue to use third-party processing because they don't have the scale to do it themselves," he says.
  BofA's and Chase's decisions to move their card processing in-house equates to what baseball great Yogi Berra called d?j? vu all over again. In his opening remarks to analysts in January, Tomlinson reminded listeners that this has happened before.
  "If you recall, back in 1988, AT&T's card portfolio was sold to Citi, and we lost that business in the year 2000," he said.
  Virginia Holman, TSYS's senior director of marketing, also noted during a visit with SourceMedia editors three years ago when she said TSYS's toughest competitors were in-house processors. At the time, TSYS had 20% of the major bankcard processing contracts. By the middle of this year, TSYS expects to have a 49% share, but the figure does not include the loss of the BofA portfolio.
  As the bankcard industry consolidates, the two major third-party processors will process more retail and health card portfolios. And they will wait for bankcard issuers to change their minds again.
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