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					Acquiring

Behind the ISO Consolidation Trend

John Stewart
Lately, the market that serves merchants’ electronic payment-acceptance needs has become a hotbed of
M&A activity. Here’s why—and how the rollups are reshaping the ISO business.
When First American Payment Systems LP announced in October that it was buying Certified Merchant Services
Ltd., the deal interested most observers because of CMS’s troubled history, including an investigation of the
company by the Federal Trade Commission. But the transaction pointed to an underlying trend with much more far-
reaching implications for the industry: a steady consolidation of companies in one of the most critical markets
supporting consumer payments—that of independent sales organizations. The forces driving this merger-and-
acquisition activity, and the consequences it will have for transactions companies generally, are only recently
becoming clear, but one thing is certain: The ISO market is undergoing swift and fundamental change, and the ripple
effect of that change is touching everything from products and services to processing technologies to company
valuations.
   Sources interviewed for this story agree that most of the consolidation is taking place among the mid-sized
operations, though no one has firm numbers on how fast these ranks are merging into fewer, larger players. These are
companies that may or may not acquire transactions, that is, drive terminals and pass transactions on to settlement
processors—a function commonly called a “front end.” But they typically do provide back-office support services,
including transaction-intensive work like chargeback and retrieval handling, statement and billing processing, and
customer service, to armies of merchant-level salespeople who peddle payment-acceptance to retailers. Indeed, if
ISOs were to be ranked by dollar volume processed annually, the sweet spot for acquisition-minded players would
cover the $500 million to $2.5 billion range, sources say. These are the companies most likely to be vulnerable to the
market forces unleashed by consolidation, and hence most likely to be looking for a cash-laden exit. “Larger players
will have a better cost structure relative to the rest of the pack, with more resources, and will be more able to respond
to tactical (technology) issues,” says Marc Abbey, a partner at First Annapolis Consulting who studies the transaction-
acquiring market.

A Sellers’ Market
The most immediate consequence of the latest M&A wave is that ISO valuations are shooting up. “ISO pricing is
higher now than it has been for a long time,” says Robert Carr, chief executive of Princeton, N.J.-based Heartland
Payment Systems. Indeed, TransFirst Holdings Inc., a Dallas-based, venture-capital-backed ISO that has been actively
seeking out and making acquisitions, says it has seen multiples rise 20% in the past year, to as much as four times net
revenue. “It’s a sellers’ market right now,” notes Thomas P. Staudt, an executive with New York-based private equity
firm Welsh, Carson, Anderson & Stowe and a former banker and ISO executive.
    Fueling the rise in valuations is a flood of new money into the ISO business. Interest from private-equity firms in
this market is nothing new. After all, ISOs offer a steady stream of revenue from transaction services that’s hard to
find in other investments. But lately the flow of venture capital has turned into a torrent. In large part this is because
pension funds and other large investors have soured on the post-bubble stock market. More recently, however, the
economies of scale inherent in the business have become clearer to the investment community as more and more
acquirers and ISOs operate as third parties independent of banks. “The scale benefit has always been there, but was
not as well-defined as it is now,” notes Andrew Rueff, vice president for mergers and acquisitions at TransFirst,
which has acquired five sizable operations in the past few years, including BankAmerica’s agent-bank portfolio.
Rueff controls a war chest of $135 million backed by Chicago-based venture-capital firm GTCR Golder Rauner LLC,
which also holds major stakes in VeriFone Inc. and Genpass Inc. About $90 million of that fund is still available for
acquisitions, and TransFirst is scouring the landscape as it prepares for an initial public offering, expected within a
year.
    Even outsiders have been buying their way into the ISO game lately. Intuit Inc., most noted for its accounting
software for homes and businesses, last year acquired Innovative Merchant Solutions LLC, a Calabasas, Calif.-based
ISO. The deal is expected to beef up Intuit’s offering for small businesses. Indeed, the M&A frenzy has caused phones
to ring at target ISOs large and small. “I get a call a week” from potential buyers, says Carr of Heartland, which at $22
billion processed annually ranks among the larger ISOs. So far, Carr’s not interested. Nor does he want to buy. ISO
prices, he says, are just too high these days.
    But the flood of new capital isn’t the only thing driving the consolidation wave. Some companies are looking five
or so years into the future, and what they see is a business defined in no small part by the unrelenting pull of emerging
technologies. For example, some experts predict that brick-and-mortar merchants will increasingly want to send
transactions from the point of sale over TCP/IP connections, rather than across conventional dial-up lines. Some
terminal manufacturers have already developed Web-capable devices. With Web connections, processors can deliver
a broader range of services to merchants more efficiently than on land lines, including data collection to help fight
fraud, as well as bundled services like check authorization combined with credit and debit. “There’s clearly a need to
improve the quality of the tools for merchants,” says Gwenn Bezard, an analyst at Celent Communications, New
York. He reckons there are about 17,000 IP terminals installed and working now at the point of sale. By the end of
2005, he conservatively estimates there will be 250,000 (chart, page 15). Moreover, by the end of next year, about
10% of all point-of-sale volume will run across Web connections, he projects.


    Going for a Slice of a Growing Pie
    (merchant-acquiring revenues, in billions of dollars)
   Source: Celent Communications



   But most prominent among the advantages of switching away from dial-up is cost. TransFirst’s Rueff figures that
Web networking shaves processing costs from a nickel or so per transaction to a range of 1 cent to 1.5 cents. While
the cost to build a front end these days has never been lower, ISOs running front ends built before the mid-’90s
confront a massive cost to regear those systems to support Web transactions. Celent Communications estimates that,
for larger processors, the investment required to replace existing infrastructure with new gear that can support open
systems like Linux or Windows ranges from $30 million to $100 million. Given even a fraction of that kind of
money, Rueff and others reason that ISOs’ most cost-efficient route to the Web is likely to be via acquisitions, even at
current valuations.

Beyond Credit Cards
Not that all ISOs are likely to make deals to acquire this technology. For them, changing out thousands of merchant
terminals is too great a bet to make on an IP trend they’re not sure is going to happen, never mind rebuilding the front
end. “It takes a long time to move 4 million merchants in any direction,” notes First Annapolis’s Abbey. Adds a top
executive with one acquisitive ISO in the south: “I don’t see any service or product that’s so monumental in impact
that it’s worthy of retooling the point of sale.” But even these skeptics see other reasons for acquisitions related to
ways in which the business is changing. Many ISOs that don’t acquire transactions are nonetheless looking to add
capacities to support new products and services, like PIN debit or check conversion, or entirely new markets, like
quick-service restaurants or medical offices. Many are also simply looking to build out into regional and even national
reach. Again, that puts acquisition targets on their radar screens. “We’re looking for things with distribution channels
and sales forces in place,” says Neil Randel, chief executive of Fort Worth, Texas-based First American. “There’s no
shortage of opportunity.”
   Indeed, the thirst for added value may in the end drive more ISO M&A than anything else. Merchant portfolios
bring economies of scale, but companies with built-in service or product-support capability that’s missing at the
acquiring company bring instant credibility, not to mention differentiation in the marketplace at a time when
transaction processing has become a commodity. “If you’re going to add value you have to do more than credit card
processing,” says the executive at the southern ISO. He’s looking for companies with capacity and expertise in
check conversion, online debit, and transactions for Internet merchants.
   But not all of these acquisition strategies will go without a hitch. ISOs will in particular have to be cautious about
the bets they place on new technologies and services. Take check conversion at the point of sale, for example. A few
years ago the so-called e-check phenomenon, in which cashiers run paper checks through scanners that pick up
routing data from the magnetic-ink-character line, was “all the rage,” says Celent’s Bezard. By converting paper
checks to electronic funds transfers through the automated clearing house, e-checks promised to cut costs and speed
up settlement times. Today only four top 100 chains are using it, and only two of those are beyond pilots. It turns out
the technology carries much more appeal for smaller retailers, where it can be bundled with check authorization, than
the larger chains, where the installation costs are higher because of the multiplicity of lanes and stores (page 6).
“Many ISOs have bet on new technology like check conversion, but check conversion remains marginal at the point
of sale,” warns Bezard.

The Big Get Stronger
Nothing, though, seems likely to take the steam out of this charging M&A market any time soon. Some of the
probable outcomes of consolidation are likely to be positive. Larger, more resourceful firms will be better equipped to
introduce or augment existing services, and to react more forcefully to changes in technology at the point of sale. At
the same time, the constantly growing army of independent merchant-level salespeople will probably help hold ISO
pricing in check. Heartland Payment, for example, maintains a dedicated sales staff 725 strong, but this is so much the
exception among ISOs that Carr regards the in-house sales force a competitive advantage.


Terminals Running on IP Connections




Source: Celent Communications



   But other consequences will not be so positive, particularly for smaller ISOs. They are at risk of being
steamrolled, say most observers, unless they can take steps now to cut costs or form joint ventures—or decide to cash
out. Says Abbey of First Annapolis: “Over the next few years there will still be a lot of opportunity for players to
build up a business that’s sellable, but over the long term there won’t be a lot of companies that stick around.” Among
his recommendations for smaller companies: Search out ways to concentrate business with fewer vendors to gain
purchasing clout. Says he: “Analytical market discipline will be more important.”
   These smaller ISOs may have some time. Merchants are slow to change processors, and the build-up of
competitive advantage among the newly formed, larger entities will be a matter of years rather than months. But
nobody can long escape the laws of the economies of scale. This advantage seeps through every layer of the company
as it adds more merchant volume and runs it across a fixed-cost processing base. Indeed, notes Randel of First
American, which has backing from New York-based Lindsay Goldberg & Bessemer LP and expects to have fully
absorbed a cleaned-up CMS by June 30: “Just the ability to process chargebacks is more efficient.”

				
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