MasterCard Post-IPO: Upside Growth MasterCard Post-IPO: Upside, Impediments, and Risks
Growth Impediments, and Risks Eric Grover Intrepid Ventures
NYC, July 20, 2006
Eric Grover Intrepid Ventures 402 Oak Grove Avenue, Suite E Menlo Park, CA 94025 USA +1-650-566-0247 +1-650-618-1797 (f) +1-650-533-4495 (m) Eric.Grover@IntrepidVentures.com
Council Member Biography
Eric Grover is a Partner at Intrepid Ventures, a California-based corporate development and strategy consultancy focusing on financial technology, processing and services, and payments. He has over 20 years of experience in the financial services industry serving various firms, including Greyrock Capital, BofA's finance company, Transamerica, Visa International, and GE Consumer Finance. Mr. Grover serves on the board of Nordstrom's credit card subsidiaries and is an adjunct professor at Golden Gate University’s Graduate School of Business. He has an in-depth knowledge of payment networks and financial services. His commentaries on payment networks and financial services have been published in the American Banker, Credit Card Management magazine, Cards & Payments Magazine, the Daily Deal, Cards International, Card Technology, Silicon Valley Business, and CRM magazine.
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MasterCard’s Business Market Trends IPO Implications - MasterCard Upside - Growth Dampeners and Risks > Litigation, regulation, culture, customer consolidation, governance, competition Questions & Answers Appendix
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• MasterCard is a global payment network that provides payment products and related transaction processing. • In the payment network business MasterCard’s principal competitor is Visa, a federation of bank associations. It also competes with Amex, Discover, First Data (Star), PayPal and a host of smaller regional and national debit and credit networks. • In general MasterCard does not compete with Visa in interbank processing, but rather with a range of bankowned cooperative, private and public payment processors
• MasterCard’s business has enormous intrinsic operating leverage. • Its revenue is driven by MasterCard-badged transaction volume. The lion’s share of its costs are not direct. If MasterCard doubles its transactions, incremental direct costs would be de minimis. • In contrast, if MasterCard customers such as Citi or Chase double the number of their credit card accounts, operating*, money and credit loss costs increase proportionately.
*For example customer service, collections, and many operating functional headcount would be doubled.
• MasterCard’s worldwide credit, debit and prepaid payment product market continues to grow at a healthy clip. • In the mature US market MasterCard and Visa transactions increased 13% in 2005.* • General-purpose payment card transaction growth rates in many emerging markets are sizzling.**
– – – – – – – – Brazil – 25% China – 66% India – 37% Mexico – 24% Poland – 22% Russia – 38% Turkey – 36% Ukraine – 31%
• But MasterCard’s principal rival Visa is growing faster and continues to gain share in most markets.
*Nilson Report **2004 growth rate The Nilson Report
General Purpose Card Volume 2000-2005 (in
billions of $)
Visa volume grew 123.3%, while MasterCard’s grew 98.1%
4500 4000 3500 3000 2500 2000 1500 1000 500 0 2000
Visa MasterCard Amex Discover JCB Diners Club
General Purpose Card Transactions 20002005 (in billions)
60 50 40 30 20 10 0 2000
Visa transactions increased 100.4% while MasterCard’s increased 91.5%
Visa MasterCard Amex Discover JCB Diners Club
Most Significant New Payment Network Established in Last Decade Enjoying Explosive Growth
• Paramount bank motivation for spin-off was to reduce legal liability exposure in the US on a going forward basis. • Old MasterCard versus New MasterCard • MasterCard was never managed as a business. • Independent of banks, management will have far greater flexibility and incentive to aggressively grow the business, to cultivate non-bank customers, and to compete for additional share of banks’ business (processing & payments). • The IPO has enormous implications for how MasterCard thinks about its activities, how it competes, how it grows, and how customer banks view it relative to Visa. Visa is the only competitor matching up globally.
• MasterCard has immense operating leverage, which historically was not realized. • Can accelerate growth by expanding the boundaries of existing businesses. • Can deliver more enabling services to small and midsized banks • Independent of banks, competing as a payment network, MasterCard can cultivate new non-bank customers/ franchisees. • Can pursue processing for more of its licensed business and for its payment brand competitors’ transactions • Micropayments • Commercial
• MasterCard is the only genuinely global consumer payment network available to public investors. Building payment networks is enormously difficult. • Increasing coherence relative to its larger and principal competitor Visa. • Established global payment brands. • Planet-wide contractual web of 25 thousand issuing and acquiring FIs. • Worldwide acceptance of ~ 24 million merchants • ~ 750 million MasterCard-badged payment cards • A range of credit, debit and prepaid products and supporting delivery systems. Visa is the only competitor matching up globally.
Providing Enabling Services to Small and Mid-Sized Banks Post-IPO
• Large card issuers wanted a sleepy, pliant utility payment network. For years that’s exactly what they got. • Giants such as Chase, Citi and BofA who contribute most of MasterCard’s revenue long worried they subsidized MasterCard’s providing payment products and support systems to smaller competitors, enabling them to compete more effectively. • MasterCard benefits from enabling smaller customers to compete and grow their payment businesses, reducing industry concentration.
• • • As a bank payment network only member banks could issue and acquire MasterCard payment products. MasterCard establishes rules defining who can participate in its payment system and how. Now independent of banks, and motivated to increase enterprise value, MasterCard can issue and acquire existing products in new non-bank sectors. Mobile-phone operators
• Payment and financial services ambitions • SimPay lesson • Immense reach
– – – – – > 2 billion cellular connections. Ovum forecasts 3 billion by 2010 Vodafone including its minority JVs has 450 million subscribers worldwide Orange 64 million subscribers Telefónica mobiles 81 million subscribers T-Mobile 83 million subscribers
• Viable issuing and acquiring channel
• Bundle credit, debit and prepaid HSA, HRA, FSA healthcare payment products.
• Have long been innovative in financial services. Participating more directly in the economics, with more flexible rules, humongous global retails such as Carrefour and Wal-Mart could make an enormous impact.
Internet portals such as Google, Yahoo and MSN
Processing Business Post-IPO
• • • MasterCard’s single biggest source of revenue is fees for interbank transaction processing for MasterCard-badged payment transactions. It processes all cross-border MasterCard-badged transactions. However, outside of the US, UK, Canada, Australia, and Italy, in most significant national markets (France, Germany, South Korea, Spain, Turkey et al). MasterCard does not process interbank MasterCard-badged transactions, much less for interbank Visa transactions. National interbank transactions are processed by a variety of bank cooperative, private and public processors. System costs are redundant MasterCard’s recently re-architected BankNet would provide superior functionality with minimal marginal cost. Can simultaneously directly cultivate banks, undercutting existing processors’ economics, while exploring acquiring existing processors.
Growth Impediments and Risks
• Industry consolidation in the US: MasterCard’s largest market
– Increased price compression on transaction processing and payment assessments (higher customer “rebates”) – Larger portion of MasterCard transactions become “on-us”
• Culture • Regulatory and legal threats*
– US litigation risk – Increasing regulatory risk in a range of jurisdictions overseas
• Constraints on independent shareholder influence over management
– – – – MasterCard Charitable Foundation Bank board members Actions requiring supermajority endorsement Bank shareholders can block takeover
• Competitive threats
*If MasterCard were to obtain modest settlements in the consolidated antitrust interchange and the Amex/Discover suits, and to receive a green light from EU and UK regulators to manage interchange as it sees fit, its valuation would increase by more than 50%.
Card Issuer Consolidation
• Card issuance in the US, MasterCard’s largest market, continues to consolidate.
– In 1990 the top ten MasterCard and Visa issuers accounted for 50.6% of all US outstandings. – In 2005 the top ten accounted for 87.9%, and BofA, Chase and Citi accounted for 64.6%.*
• BofA, Chase, Citi, and HSBC now account for ~ 30% of MasterCard’s revenue • Increased industry consolidation has two negative impacts on MasterCard:
– Buyers have increased negotiating leverage and demand better pricing (lower processing fees and assessments) and concessions on MasterCard brand prominence. – Increased industry consolidation tends to increase the number of “on-us” transaction directly reducing processing fees
• Forty years as a bank-captive association created a distinct and powerful culture. • Association culture is slow, risk averse, and not market oriented. • Lacks competitive verve. • MasterCard culture is decidedly not an enterprising gogetter culture. • Culture is hard to change.
• Assaults on the Interchange system
– Consolidated interchange antitrust case (US) – Regulatory threats (International)
• Rival Network Antitrust Litigation (US)
• What is interchange? What is its purpose?
– A pricing system used to maximize payment network value. – Can view as providing cost-sharing within a joint offering.
• What’s reasonable to include? • Who should determine what costs are reasonable to include? • How should it be determined?
– An important element of interpayment system competition. – A means ensuring/incenting a balance between and sufficient participation on the issuing and acquiring sides. – Revenue stream, generally, but not always, for issuing-related businesses. – An enabler of issuer innovation and differentiation. – Practically, a means of wooing payment product issuers, and enabling them to fuel benefits and rewards incenting incremental usage, which is the principal driver of MasterCard’s revenue.
US DOJ versus Visa USA and MasterCard International
• Nabanco Decision (1984): Nabanco sued Visa, charging that the interchange system was anticompetitive. Court upheld (1) relevant market was all retail payments, cash, checks and cards, (2) Visa did not have market power and (3) interchange system was necessary and enabled the bankcard payment joint venture to work. Held until DOJ suit 12 years later. US DOJ asserted that Visa’s and MasterCard’s “exclusionary rules” preventing member banks from issuing competing network payment products violated US antitrust laws. DOJ also challenged “dual governance” of Visa and MasterCard by the same banks. DOJ won on rules; lost on governance On Visa-MasterCard appeal on rules, Second Circuit affirmed in 2003. Final decision effective October 15, 2004 - 2004 decision refined relevant market from Nabanco to more narrow general-purpose card electronic payment networks. Network competition important. - Decision held that MasterCard and Visa have market power.
• • • •
The Wal-Mart Case
• • • • • A seven-year titanic battle between more than 5 million merchants, and Visa USA and MasterCard International, challenging the honor-all-cards rules. Litigation did not directly challenge interchange fees. However, it sought to demonstrate competitive harm of interchange fees. A major aspect of the case was the court’s decision the certify a class of merchants as plaintiffs. Historically merchants have been hindered in negotiations by their inability to act collectively. Settlement ended honor-all-card rules, lowered off-line debit interchange by a third for 8 months, and resulted in payments of ~ $2 billion by Visa and $1 billion by MasterCard* to the plaintiffs and their attorneys. The court retained jurisdiction and now sits as a long-term regulator of the debit card industry. Merchants waived claims on related conduct prior to January 1, 2004. The settlement put blood in the water for plaintiffs’ attorneys.
*MasterCard paid a disproportionate share of total.
Interchange and No-surcharge Rules AntiTrust Suits in the US
• Market power in two-sided payments markets and implications. • Merchants perceive themselves as aggrieved and able to influence interchange through litigation (in the US) and through regulators (in many jurisdictions abroad) • Plaintiffs’ attorneys clever, rapacious, and highly motivated. • Merchant plaintiffs have a solid argument under the Sherman Antitrust law that MasterCard was a conspiracy of banks imposing fixed prices (through the interchange system) on the market and restraining trade. • Merchant plaintiffs filed an 11th hour supplemental complaint* 2 days before the IPO which in many respects is at odds with their initial charges.
A Damages Framework
• • • • • • • Merchant plaintiffs must establish they were harmed. US Anti-trust law and policy are market oriented. Plaintiffs must persuasively make the case interchange was higher than it otherwise would have been because of the alleged bank conspiracy fixing prices. Market benchmarks are problematic, for the merchant plaintiffs. Amex’s implicit interchange rate has long been considerably higher than MasterCard’s. Amex’s discount rate ~ 255 basis points While Discover’s interchange rate was and continues to be lower than MasterCard’s, to compete Discover has been steadily increasing its interchange rates. Discover discount rate ~ 173 basis points The best benchmark would be MasterCard’s actions now that it is not controlled by banks.
– Good business rationale to raise interchange – Moreover, raising interchange would bolster MasterCard’s defense in the consolidated interchange suit
The Regulatory Assault on Interchange
• • • • • • • • • EC Competition Directorate UK OFT Australia RBA Spanish Central bank Mexican Central bank New Zealand Commerce Commission Polish Office of Competition and Consumer Protection The Netherlands Competition Authority Et al
What Does the Regulatory Future Hold?
• There has been a lack of affirmative defenses. • Beneficiaries (cardholders and issuer business models) have been quiet. • Merchants increasingly perceive themselves as aggrieved and able to influence interchange. • Plaintiffs’ attorneys and regulators are highly motivated. • Legal and regulatory assaults on interchange pricing and practice in jurisdictions across the globe are likely to continue. • Proactively addressing these challenges will be increasingly important to the economic viability and character of MasterCard’s business worldwide.
Independent, can MasterCard stymie regulation in the works and potentially rollback regulation extant. Needs to reframe the terms of debate in the public (and political!) arena.
• • • • • • • • ACH-based low-cost payment products Amex Berlin Group China UnionPay Discover First Data PayPal Visa
The 11th Hour Supplemental Complaint
• Two days before IPO the plaintiffs in the consolidated antitrust interchange suit lodged a supplemental complaint against MasterCard alleging post IPO, the payment network will continue to be anticompetitive and restrain trade and further that freed from restrictions operating overtly as a bank consortium, that its conduct may be worse. While there are aspects of MasterCard’s governance that will dilute the influence of independent activist shareholders, post IPO, in the US, MasterCard will not be a conspiracy of banks fixing prices. It will be a business competing to serve its bank customers, and to cultivate new markets. Plaintiffs now suggest MasterCard will raise interchange fees and that that will be “output-reducing”. In pursuit of profit and increasing output, MasterCard should raise interchange fees. That would be the most immediate move MasterCard can take to woo issuer customers away from Visa and to fuel rewards programs incenting incremental use from existing cardholders, increasing the output of MasterCardbadged payment transactions. Moreover, increasing interchange now, would utterly undercut the merchant plaintiffs’ argument they were harmed because interchange fees were higher than they otherwise would have been during MasterCard's history as a bank-controlled payment network. Charged IPO is a fraudulent conveyance insofar as MasterCard did not receive consideration for giving up its ability to assess banks for extraordinary costs such as a settlement or trial loss.
Parties’ Interests and Likely Courses of Action
• Merchants – Want to pay less, but really do not want bare bones, least cost, payment network.
– Small – Giants – Going forward can get much of what they want through negotiation.
• Plaintiffs’ attorneys – Want a juicy settlement. • MasterCard – Don’t want to cede control of interchange system. Don’t want catastrophic trial loss. Would like to close the book on litigation. • Banks – Don’t want trial. Want to avoid catastrophic outcome. • Government
– Notwithstanding recent Congressional posturing, intervention not likely.
Though far from certain, settlement likely.
Damages, From De Minimis to Catastrophic
– Pre January, 2004 claims waived. Reyn’s Pasta Bella decision clarified the scope of merchant plaintiffs’ Wal-Mart settlement general claims release – Post May, 2006 Sherman antitrust conspiracy charge gutted.
• Banks are defendants • MasterCard could well prevail at a trial, however there would be an element of Russian roulette in going to trial. • Post IPO MasterCard has fixed the alleged Sherman Antitrust Act violation. It should be free and clear of antitrust interchange litigation for its conduct going forward. • Former FTC Commissioner Tim Muris suggested damages trebled could approach a trillion dollars. How he gets there. Why it’s preposterous. • Catastrophic trial loss? Unlikely to see a catastrophic outcome
• The Federal Reserve said it does not believe it has the authority to regulate the bankcard payment networks and that in any event it prefers that interchange disputes are best resolved between private parties.
– Alan Greenspan said the Federal Reserve did not have the authority to regulate the bankcard payment networks – Donald Kohn at the May, 2006 Chicago Federal Reserve Conference on Payments Innovation said that a resolution between the private parties was best.
• However, central banks and competition authorities in a range of jurisdictions overseas take a very different view and have taken an interest in regulating the bankcard payment networks.
– Regulators, to varying degrees, are treating MasterCard as a public utility – Imposing a cost-based framework analyzing interchange. – Regulators take cues from each other
EC Competition DG
• Challenged by Visa and MasterCard’s interchange pricing and practice. • Visa received a 5 year* exemption for cross-border interchange fees by agreeing to:
– Employ a “cost-based” approach – Cap credit and “deferred” debit interchange fees (declining to .7% in the 5th year) – Make interchange fees “transparent.”
• MasterCard objection still outstanding. • June, 2006 the EC Competition DG charged MasterCard with breaching EU antitrust rules by setting interchange fees, thereby restricting competition between banks. MasterCard must submit written objections by October.
EC Competition DG
• MasterCard has ceded the regulators’ cost-recovery interchange framework. This is a mistake. • Statement of Objections issued against MasterCard’s cross-border interchange fees, claiming:
– MasterCard able to set excessive interchange fees. Ergo, MasterCard has market power. – MasterCard’s interchange fee methodology does not qualify for an exemption because its cost study was not rigorous and there is a lack of “transparency. – But for the fact that in Europe banks retain effective control of MasterCard, MasterCard should push back.
• But for the fact that in Europe banks retain effective control of MasterCard, MasterCard should push back.
*To the extent the EC Competition DG reduces or eliminates barriers between national European payment markets that advantages MasterCard against national payment systems.
UK Office of Fair Trading (OFT)
• • • • • • • UK Retailer Association complained to the OFT that interchange fees on UK credit and charge cards infringed on the 1998 Competition Act. OFT has said that card issuing banks receive an “unjustifiably” high fee on every MasterCard credit or charge card transaction in the UK. OFT questioned the appropriateness of recouping credit losses and grace periods (interest costs) through MasterCard’s domestic interchange fees in the UK. September 5, 2005 OFT decided MasterCard UK Members Forum (MMF) agreement deterred issuers and acquirers from negotiating interchange and thereby reduced merchant acquirer competition. OFT ruled MIF was “a tax on retail transaction”, that payment guarantee, grace period (interest free period), loyalty schemes and advertising should be unbundled. June, 2006 OFT overturned on appeal by the Competition Appeal Tribunal. OFT to refile.
Reserve Bank of Australia (RBA)
• RBA decided to regulate MasterCard, Visa and Bankcard “credit card systems” with respect to interchange fees, access and “no surcharge” rule. • RBA conducted a broad and aggressive investigation and challenge into interchange pricing and practice. Regulatory zeal originated with October, 2000 report by the RBA’s Payment Systems Board on debit and credit card schemes in Australia, published by the RBA and the Australian Consumer and Competition Authority. • Report concluded:
– No basis for interchange fees in ATM, debit card or EFTPOS sectors – Problems in pricing of credit card payments, acceptance and access.
Reserve Bank of Australia
• The central bank is charged with ensuring the safety, soundness and efficiency of the payment system. Giving a regulator a mandate to enhance efficiency is a license for regulatory mischief. • ANZ, Commonwealth Bank of Australia, National Australia Bank and Westpac control roughly four fifths of the issuing and merchant acquiring markets. • August, 2002 RBA announced plans to:
– Permit merchant surcharging – Broaden access for credit card companies (enabling non-banks to issue bankcard branded payment products – Make interchange fee setting arrangements more transparent, “objective” and tie to a cost-based benchmark(s)
• 2003 RBA mandated interchange fee reduction from ~.95% to .5%. • The unintended, but not surprising, consequence was that the principal unregulated payment network Amex gained market share. • 2006 RBA Vice Governor Phil Lowe floated idea of “zero interchange.”
Amex and Discover Suit
• • • • • • • From MasterCard’s 1996 approval of its Competition Programs Policy (CPP) until the final 2004 DOJ decision banks participating in MasterCard were not permitted to issue Amex and Discover products. DOJ held this was illegal under U.S. Antitrust law. Amex and Discover’s case* is that MasterCard’s prohibition harmed their business. During those 8 years they would have done some business with and through U.S. banks. How much is arguable. Damages would be profits not realized, trebled. Pre 1991 (the date of Visa USA’s by-law prohibition) US bankcard banks were not forbidden from issuing Amex and Discover. Outside the US, banks, for the most part, were free to issue and acquire Amex products. Amex had ~ 75 bank relationships outside the US when the DOJ brought its suit. Most US issuing relationships – Citi, BofA, MBNA, and HSBC - struck by Amex have been in exchange for not suing or for dropping its suit. Amex value proposition.
– – Can provide higher interchange, therefore high-spending transactors converted from MasterCard could be more profitable for the issuing bank. Strong loyalty and rewards programs.
More difficult for Discover to establish that it could have generated significant business from MasterCard member banks from 1996 through 2004 and therefore was harmed. Discover acceptance network was (is) weaker than MasterCard’s domestically and nonexistent internationally. From a bank issuer’s perspective the economics of Discover products were (are) inferior to MasterCard’s. It is hard to see damages being enormous. Morgan Stanley’s Ken Posner argues a settlement is likely because none of the parties will be keen to publicly divulge the economics and performance of their programs.
*October 27, 2005 held that MasterCard not a monopoly. Argument is that MasterCard banks and MasterCard conspired to restrict competition by excluding Amex and Discover should prevail.
The Charitable Foundation
• Bad corporate governance incarnate, insulating management from independent shareholders’ influence. • Provides psychic compensation to management • A significant block of shares guaranteed to remain in hands friendly to management for decades. • Foundation will hold 17% of MasterCard’s voting shares. Will hold its shares for 10 years, at which point it will have to disburse ~ 35% of them. 20 years hence it will still hold 30% of shares MasterCard donated as part of IPO. • MasterCard initially plans to give the foundation $40 million and is prepared to make further donations to support its operating costs and perhaps more charitable activity.
– The foundation siphons off after-tax money which otherwise could be spent pretax growing MasterCard’s business, or disbursed to shareholders via dividends. – Foundation management will be beholden to MasterCard. It is hard to imagine it would vote its shares against management.
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