Moment of Truth

By Kenneth Cline

While CheckFree Corp. seems ideally positioned in home banking, CEO Pete Kight faces powerful competition and uncertain market demand. Can he deliver for shareholders?

As CheckFree Corp.'s earnings stutter, CEO Peter J. Kight faces a defining moment. Having spent a decade building CheckFree into the nation's leading provider of electronic bill pay services for home banking, Kight now confronts the prospect of seeing that position erode unless he can regain traction.

Just a few months ago, the outlook for Norcross, Ga.-based CheckFree appeared bright. The Internet's rapid development, and the advent of electronic bill presentment, or the delivery of bills directly to a customer's home computer, augured well for robust growth in home banking. With an 80% share of the electronic bill pay market, CheckFree was poised to reap much of the harvest.

Then, on August 11, CheckFree stunned Wall Street with disappointing June quarter earnings. More ominously, the company predicted earnings per-share in the 12 cents to 16 cents range for fiscal 1999, sharply below consensus estimates of 32 cents. The stock plunged 41% the next day, when Kight expressed his frustration to analysts in a conference call.

"It's my credibility that's going to be challenged here and I'm not very happy about it," he told them. "But our goal is to extend and protect our leadership position in an important emerging market for the long run. We will not sacrifice that position to change a near-term earnings estimate."

CheckFree's dilemma is common to all companies involved in home banking and electronic commerce. While the future seems to hold great promise -- experts expect the number of Internet users to triple by the turn of the century -- the current reality makes for tough going. Of the 30 million U.S. households now connected to the Internet, only four million actually bank online. Until transaction volume ramps up enough to allow providers to achieve economy-of-scale efficiencies, neither banks nor technology vendors can make any money. Home banking may be a necessary service offering for large financial institutions, but it still awaits a viable business model.

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Market Setback Reaching for Profitability Electronic Bill Presentment & Payment Processed by Checkfree

CheckFree's June quarter report highlighted the problem. The company's revenue growth fell short of expectations because banks have slowed their own marketing to consumers. Reasons include delays in transitioning from proprietary dial-up to full-fledged Internet banking programs and merger-related disruptions at major CheckFree customers, such as NationsBank Corp. and Wells Fargo & Co. Kight maintains this slowdown is temporary, but the news clearly has clouded CheckFree's near-term prospects. It also suggests that electronic commerce may be a riskier and longer-term proposition than many experts had thought.

The underlying danger is that consumer demand stays sluggish. "We believe that banks have now successfully attracted the more profitable early adopters, and that the commitment level to attracting less profitable mainstream users is falling short of expectations," wrote Lehman Brothers analyst Patrick M. Burton in an August 14 report.

Secondly, even if home banking does finally take off, heightened competition will likely keep squeezing profit margins. CheckFree's bank clients are demanding a share of any efficiency gains. Meanwhile, MSFDC has entered the scene. The deep pockets joint venture of Microsoft Corp. and First Data Corp. has yet to fulfill its potential*, but it brings resources to the table nobody else can match.

Other potential competitors angling to grab pieces of CheckFree's business include Princeton TeleCom, Just in Time Solutions Inc., and CyberCash Inc. "There is yet no clear winner," says Tom Roberts, vice president of marketing for International Billing Services, which represents major billers. "Although CheckFree does have momentum, we're very early into the game."

Balancing Act

The 42 year-old Kight is now facing some of his toughest managerial challenges yet. To fend off MSFDC and maintain CheckFree's leadership position in electronic bill pay, he must focus as never before on effective execution, which means staying ahead of the technological curve and relentlessly improving service quality. Secondly, and more fundamentally, he must continue trying to juggle the competing demands of profit and investment.

CheckFree spent nearly three years as a public company before it finally broke into the black in this year's first quarter, earning a paltry $57,000 on revenues of $62 million. The quarterly profit edged up to $1.5 million in the June quarter, excluding special items, but still fell short of analyst expectations. Kight, in a recent interview, says investment must come before shareholder return at CheckFree. "You should look for evidence that we're going to protect market share and our customer satisfaction above and beyond profits to the bottom line. If we do that, we'll have plenty of time and plenty of resources to address the bottom line issue."

The investment, a couple hundred million dollars worth over the past decade, has gone into a system that supports banks with "end-to-end support." CheckFree facilitates electronic bill payment and presentment while providing a detailed audit trail that allows banks to track customer transactions. To the extent that CheckFree can make electronic banking easier and more efficient for consumers and their banks, transaction volume should rise, allowing the company to reap the economy-of-scale efficiencies deemed critical to making the business viable.

CheckFree's shareholders, meanwhile, will just have to grip the rails and ride out the inevitable ups and downs. "We're certainly going to have sustained profitability," Kight says. "But this is an emerging market and people shouldn't expect seamless and smooth quarter-to-quarter growth."

Bank Aggregators

Like most emerging markets, the electronic bill pay and presentment business is fraught with confusion. Business models proliferate as players emerge, disappear, and join in shifting alliances. Just within the past 11 months, CheckFree itself has announced joint ventures with two former rivals, Integrion Financial Network and Visa U.S.A.

Most of these companies have aligned themselves with one of two basic approaches: the "aggregator" model or the "direct" model. In the aggregator format, a customer logs on to one Web site -- normally a bank although it could also be a financial services management "portal" such as Quicken.com. With a few clicks of his mouse button, the customer then views his current outstanding bills and authorizes payment. Behind the scenes, a service bureau such as CheckFree or MSFDC handles the disbursement and settlement.

The direct model, on the other hand, requires the consumer to visit individual biller Web sites to accomplish these transactions, going to Sears, say, for one and Wal-Mart for another. Utilities in particular tend to favor the direct model, although most experts think the aggregator format will win out in the end. CheckFree began its own corporate existence in 1981 as a facilitator of automated clearing house direct debits for utilities.

Then, in the early '90s, Kight decided to reposition CheckFree as a "trusted agent brand" for bank aggregators. He says he concluded that consumers desired a "single log-on," or one place on the computer where they can carry out financial transactions, including bill payment. He also believed banks would become the critical intermediaries in electronic commerce. "People will be looking to their bank to manage more of their funds or, at minimum, use the bank to keep track of the majority of their assets."

But working with the banks has not been easy. Some larger institutions, most notably Citicorp, had invested heavily in proprietary home banking systems and were reluctant to allow an outsourcer like CheckFree to intrude on their turf. "There are definitely times when I look around and I'm pretty frustrated that there are always pockets of industry people who seem to have some illogical challenge to CheckFree being in this business," Kight complains. "They're not doing it. But they'll stand up and argue emotionally that CheckFree shouldn't be doing it."

A big threat seemed to loom in 1996, when some of the nation's largest banks formed Integrion to craft an industry-wide approach to electronic commerce. Integrion has since frittered away some of its momentum due to internal disputes. Late last year, Integrion agreed to turn its bill payment fulfillment and customer services operation over to CheckFree on a joint venture basis, to Kight's great relief. "There clearly was a potential that Integrion could have been a stumbling block if we hadn't figured out how to work together," he says.

Kight removed another rival from the game in May when CheckFree and Visa U.S.A. (another bank-owned organization) announced plans to build a new electronic payment and remittance infrastructure by the end of this year. Essentially, the joint venture gives CheckFree access to Visa's ePay electronic payments pipeline, which had been a direct competitor to its own routing system. Using ePay's direct debiting capability will enable CheckFree to provide billers with guaranteed funds from ePay's direct debit customers, a development that should encourage more billers to sign up for electronic bill pay.

Deep Pockets Threat

MSFDC will likely prove a more troublesome competitor. This alliance, unveiled in June 1997, combines Microsoft's software expertise (and massive financial resources) with First Data's skill at transaction processing. Even though many banks instinctively distrust Microsoft as a potential financial services competitor, MSFDC has been able to sign up several prominent institutions for its pilot projects, including Banc One Corp. and KeyCorp. As is typical in the fluid world of electronic commerce, Banc One and KeyCorp have hedged their bets by remaining CheckFree customers.

"CheckFree's going to sign up some billers and MSFDC's going to do it. Our customers don't care who's behind the scenes," says Paul Ayres, KeyCorp's president of online services.

Kight tends to dismiss MSFDC as ineffectual, noting that the venture has yet to progress beyond the pilot stage with its bank clients. CheckFree, meanwhile, enjoys a solid head start, having established relationships with 40 of the top 50 banks. It reported a 99% client retention rate for its fiscal year ending June 30, despite "escalating noise from competitors."

"Banks don't take it lightly having to move services from one provider to another," says consultant Chuck Hieronymi, managing director of the financial services group at Dove Associates. "In many respects, the business that Pete Kight has at CheckFree today is his to lose."

But some analysts are less sanguine about the long-term challenge facing the company. "CheckFree's principal threat clearly is the MSFDC combination," says Raimundo C. Archibold, with J.P. Morgan Securities Inc. "You can't discount MSFDC's ability to compete, given the resources and relationships they have."

Meanwhile, the heightened competition has already exposed one serious weakness in CheckFree's armor -- its pricing structure. After years of shoveling money into the black hole called home banking, some of CheckFree's bank customers are anxious to reduce their costs. They expect CheckFree to pass along its back office cost efficiencies as transaction volume rises.

"That will forever be a continuous pressure on us," Kight acknowledges. "If I can't take advantage of my significantly better economy-of-scale efficiencies, then I deserve to lose the business."

A flash point for criticism is CheckFree's long-standing policy of charging most of its banks on a per-subscriber as opposed to a per-transaction basis. While CheckFree assesses some institutions 50 cents a transaction, the usual fee is $4 per retail subscriber per month. Banks had no trouble accepting this when transaction volume was low. But as volume picks up, "that pricing model becomes more difficult to justify. It certainly encourages the financial institution to look at technology to control costs," says Richard Bell, senior analyst with the Tower Group.

Banks such as KeyCorp and the former CoreStates Financial Corp., for example, have adopted technology that allows them to either route bill payment transactions to less-expensive service bureaus, or alternatively to process the transactions in-house. Some analysts look at this trend, combined with the number of pilot signups MSFDC is attracting, and conclude that CheckFree's prices will inevitably have to come down, pressuring the company's profit margins.

Others counter that CheckFree's drive for economies of scale can reduce costs enough to compensate for lower margins. "The concerns that people express are focused specifically on the price side without taking into account the cost side," says J.P. Morgan's Archibold. "We expect pricing to decline over time, but we don't believe it will become draconian. The cost side, meanwhile, will probably decline more rapidly."

Kight defends the subscriber-based pricing as necessary to defray CheckFree's huge upfront investment in bill payment infrastructure. "We wish it was a lower cost to us as well," he says. Even so, the executive concedes, "in the long run, we're headed towards a much smaller subscription fee and more of it being transaction-based."

Quest for Volume

Even if Kight is able to maintain his bank client relationships, he still has to worry about the billers. This is particularly important now that bill presentment has emerged as a viable technology, finally closing the loop between consumer, bank and biller.

Under current bill payment schemes, customers can ask their banks to pay certain bills, but the aggregator (actually someone like CheckFree, behind the scenes) has to rely on the customer for the correct account number. When a biller's file doesn't match up with the customer's, the biller can't credit the payment and the customer gets a dunning notice. For that reason, Kight's biggest short-term challenge is to sign up the largest possible number of major billers before competitors do. "The sooner we get the leaders to market, the sooner the rest of the industry will follow," Kight says.

CheckFree has so far signed agreements or is in negotiations with nine of the nation's top 25 billers. In June, for example, the company announced that AT&T's residential customers would be able to use its service to pay their bills on the Internet. Analyst Cato D. Carpenter at BT Alex. Brown Inc., in a First Call report, heralded this as "an important psychological win" for CheckFree. Kight says he will unveil more such partnerships this year and predicts that home banking customers will be able to view two or three bills on their PC screens by year end. "Getting two or three bills on line is going to bring in that next wave of consumers," he says.

Kight's comments underscore how CheckFree's future is bound up with customer adoption rates in home banking. Already, 60% of CheckFree's revenues come from electronic bill payment and presentment, the rest provided by divisions that sell payments-related software and processing for electronic investing. The Internet revolution is expected to provide the catalyst that enables electronic bill pay to reach critical mass as a business. International Data Corp. projects the number of Internet users in the U.S. will reach 163 million by 2000, up from an estimated 50 million last year.

If a substantial portion of those people sign up for home banking services, CheckFree could finally earn back the hundreds of millions of dollars it spent developing a technical infrastructure. J.P. Morgan Securities estimates the electronic bill payment and presentment market will expand to $2.3 billion by 2001, up from $80 million in 1997. Such growth should eventually allow CheckFree to generate the economies of scale deemed critical to its success.

But first Kight needs to navigate past the disappointment created by CheckFree's June quarter earnings report. He plans to do that by sticking doggedly to his game plan. "The more we can get the banks' costs down, the faster they will move their customers on-line," he says. "And the faster they do that, the bigger this market will become. This is a business model we believe is going to be successful for us and our bank clients."

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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