Rush for Position
By Kenneth Cline
First Data re-focused
on its core processing business just in time to ride
the e-commerce wave. But critical operational challenges
loom ahead.
Both in terms of its market share
and its strategy, the powerful First Data Corp. is seen
as a proxy for the future of the payments industry.
The Atlanta-based company's aggressive thrust into electronic
venues highlights the importance of that market and
the urgency of adapting to its new dynamics.
"There's a rush to get position
in e-commerce," says First Data chairman and chief
executive Henry C. "Ric" Duques, whose company booked
$4.5 billion of payments-related revenues in 1998 alone.
"The velocity of change in payments, with the Internet
as a specific catalyst, is mind-boggling."
Spurred on by this sense of urgency,
the 56-year-old Duques has been scrambling to meet the
challenges of the Internet Era. First he divested First
Data of non-core subsidiaries such as health care information,
cable television data services and receivables management.
Now he's positioning First Data to benefit from an anticipated
explosion in e-commerce activity, emphasizing online
bill pay along with Web site setup and processing support
for Internet merchants.
Even though some banks are experimenting
with "electronic wallets," the credit card apparently
will remain the payment medium of choice for online
customers and merchants, conferring a huge advantage
on First Data. As the nation's largest credit card processor,
it will inevitably get its share of Internet-related
payments when e-commerce surges in coming years.
Morgan Stanley Dean Witter analyst
David Togut estimates e-commerce can add 10 cents a
share to the company's earnings by 2001. First Data's
stock, mired in the doldrums since the mid-'90s, has
suddenly caught fire, appreciating 52% since the beginning
of the year. "The focus of the business has improved
dramatically," says BancBoston Robertson Stephens analyst
Andrew W. Jeffrey.
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First Data's experience provides a
window into the types of issues all payments players
will contend with in the years ahead. The company has
already contended with major shifts in its alliances,
most notably with TransPoint, the online billing venture,
and iMall Inc., the online merchant enabler. These episodes
drive home the point that while alliances appear indispensable
in pursuing e-commerce, partners must reconcile themselves
to ever-changing allegiances and business conditions,
as well as touchy control issues.
First Data itself is not usually perceived
as a threat to banking's control of the payments system.
Since it works behind the scenes - on what Duques refers
to as "the plumbing" of payments - and commands no consumer
brand recognition of its own, the company is not in
a position to steal vital customer relationships from
banks.
To be sure, there's an outside possibility
that First Data could be acquired by a nonbank technology
company. Given First Data's dominance in electronic
payments, this would directly threaten banking's position
in e-commerce. Most analysts dismiss this as highly
unlikely, however, given First Data's improving stock
valuation. Duques himself contends that resulting bank
client defections would put billions of dollars in revenue
at risk, a backlash that would also hit any potential
bank acquirer. "We have a natural antibody called 'existing
client contracts and relationships,'" he says.
Dizzy
at the Heights
While Duques may not be too concerned
about a potential takeover, he does have to navigate
some critical operational challenges before he gets
to the e-commerce Promised Land. This year, for example,
First Data is converting 42 million new card accounts
to its system, the largest such operation in its history.
And operational snafus are not to be taken lightly in
this business: First Data took a $125 million provision
last year to cover losses from a failed card processing
venture in Hong Kong. Then there's the Y2K computer
bug. First Data says its own systems are Y2K-compliant,
but problems with clients or vendors could reverberate
through the company's vast electronic network.
Longer term, First Data faces relentless
pricing pressure in its core credit card processing
business, driven in part by continued banking consolidation.
Every time one of its large clients gets acquired, First
Data faces the threat of losing that customer. Even
when First Data retains the newly merged entity's account,
margins shrink because pricing is based on volume. Margins
fell between 1996 and 1998 in both card issuer services
and merchant processing services, the two major business
lines in the card processing operation. Despite improvements
this year, "the long-term trend for us and our clients
is lower margins," Duques says.
First Data's response is to cut costs
and promote new services. President and chief operating
officer Charles T. Fote is overseeing a reorganization
that centralizes common functions - such as human resources,
accounting and systems management - across the company's
three main business units. Elsewhere, new marketing
and risk management programs are being designed to retain
card-issuing clients. "We need to be more important
to clients. We have to use the information we have in
ways they'll be comfortable paying for it," Duques says.
First Data's renewed focus on its
core business reflects a major shift in strategy for
a company that had been acquisition-driven earlier in
the decade. Once a subsidiary of American Express Co.,
First Data began charting an independent course after
a 1992 initial public offering. Duques took advantage
of increased market capitalization to make some acquisitions,
the largest of which was Atlanta-based First Financial
Management Corp. in 1995.
FFMC was a sprawling collection of
information-based businesses, some of which proved useful
to First Data, some not. The FFMC subsidiary known as
NaBANCO helped increase First Data's scale in the merchant
processing business, while the Western Union money transfer
operation proved a stunning home run. But health care
information, imaging and receivables management units
proved indigestible. Worse, they diverted management
attention from the core payments operation. "At the
peak of its popularity with investors, the company got
dizzy at the lofty heights and kind of lost its way,"
says Mark Wolfenberger, an analyst with Credit Suisse
First Boston Corp.
The FFMC acquisition also coincided
with a profitability decline in the credit card business
generally. A surge in delinquencies followed the explosion
of card issuance that occurred earlier in the decade.
Issuers responded by selling their troubled portfolios
to the very largest players. First Data lost clients
on the card-issuing side and experienced severe pricing
pressure in its merchant processing business. By 1996,
earnings problems sent First Data's stock into a slump
from which it is only now recovering.
Duques began pruning the company in
1997 after accounting restrictions related to the acquisition
of FFMC had lapsed. The divestiture program was essentially
completed in this year's second quarter with the sale
of First Data's mutual funds processing business to
PNC Bank Corp. Meanwhile, the appointment of Fote, a
respected 24-year First Data veteran, as president and
chief operating officer in September 1998 sent an additional
signal that First Data was serious about getting its
house in order.
First Data's major business units
traditionally maintained separate support infrastructures.
But the centralization campaign "keeps expenses down
and also promotes consistent quality standards across
the company," Fote says. As a confirmation, the number
two executive points to improving margins in First Data's
card issuing and merchant processing businesses. In
the second quarter, for example, merchant processing
posted a 25% operating margin compared to 23% the year
before. "They've done a good job rationalizing the cost
structures in key businesses and re-focusing on growth,"
says analyst Jeffrey, noting that the centralization
of support infrastructure frees up resources for sales
activity.
Having slimmed down the company and
stabilized its core card processing business, Duques
can now devote more effort to long-term strategizing.
Growth
Prospects
The big question for First Data is:
where will future growth come from? First Data is already
the 800-pound gorilla in credit card processing. On
the merchant processing side of that business, the company
authorizes about 40% of all Visa and Mastercard transactions
in the U.S. Its card issuing clients, meanwhile, include
16 out of the top 22 Visa and Mastercard issuers.
Although First Data is engaged in
a constant war to sign up new clients in both areas,
it's fair to say this is a mature business. Any future
growth will occur around the edges. There is, moreover,
a real danger of losing ground to competitors. First
Data suffered a blow last year, for example, when NationsBank
Corp. acquired BankAmerica Corp. NationsBank had been
one of First Data's biggest clients, but the new Bank
of America Corp. switched its business to a subsidiary
of the old BankAmerica.
First Data offset that loss by retaining
Bank One as a client after Bank One acquired First Chicago/NBD
Corp., which did its processing in-house. First Data
further strengthened that relationship this year by
purchasing Paymentech, a rival in which Bank One owned
a controlling interest. "We've been on the winning side
so far, but that can go the other way," Fote says, underscoring
how the stability of First Data's card client base is
subject to the vagaries of bank mergers.
First Data offset that loss by retaining
Bank One as a client after Bank One acquired First Chicago/NBD
Corp., which did its processing in-house. First Data
further strengthened that relationship this year by
purchasing Paymentech, a rival in which Bank One owned
a controlling interest. "We've been on the winning side
so far, but that can go the other way," Fote says, underscoring
how the stability of First Data's card client base is
subject to the vagaries of bank mergers.
Fortunately for First Data, there
is a source of stability in its earnings mix. Fully
a third of the company's revenues and half its operating
profits come from the payment instruments division,
which is predominately Western Union. This unit grew
revenues at a 20% rate during 1999's first half, compared
with 14% for merchant processing and 10% for card issuing.
Western Union's monopoly-like status
in its booming wire transfer business ensures a dependable
earnings stream that "offsets any leveling off in the
card issuance or merchant processing businesses," says
Fox-Pitt Kelton analyst Norman Jaffe. It also gives
Duques some resources to invest in e-commerce, which
is expected to provide another major source of growth
in the next decade.
First Data estimates that Internet
transactions will reach $40 billion by 2002, up from
$7 billion in 1998. Since about 80% of Web-based transactions
depend on the credit card for payment, First Data is
well positioned to take advantage of this expected growth.
But right now, only 1% of the company's revenues stem
from credit card transactions over the Internet. To
transform potential into reality, First Data is racing
to sign up merchants for online payment services. By
May, the number had reached 45,000, up from 3,000 in
1997.
Linked with this effort is First Data's
$11 million investment in iMall, a software firm that
designs and builds Web pages for online merchants. With
First Data doing the payments processing under a 10-year
marketing agreement, iMall has become a sort of one-stop
e-commerce enabler for merchants. In July, iMall was
acquired by Excite@Home. The iMall services will now
be marketed through Excite's portal, which receives
77 million page views per-day, compared with iMall's
own 10 million. First Data expects to benefit from a
likely increase in transaction volume.
Bill
Pay Play
First Data's other major Internet
initiative is the TransPoint venture. Launched with
much fanfare back in June 1997, this alliance of First
Data, Microsoft Corp. and Citigroup is designed to compete
with Atlanta-based CheckFree Corp. in the electronic
bill payment and presentment market. While pilot projects
proliferate at major banks, the initiative has been
slow to come to market. Duques even laughs at attempts
to pin him down on an actual launch date. "It's going
to take longer than anybody says, so as soon as I put
a date down, I'm probably going to be wrong."
But Duques also says TransPoint "will
be bigger than we think" when it finally does become
operational. Given that U.S. households generate 15
billion bills a year and that PC access continues to
grow, TransPoint's ultimate potential is huge. In any
case, First Data's e-commerce ventures give it experience
working with a diverse set of partners, including Microsoft,
IBM, Verio Inc., and Yahoo. This is a critical competency,
since most experts agree that success in e-commerce
depends on striking the right alliances with the right
partners.
For First Data, those partners include
banks, who control both the origination and settlement
of payments. When First Data directs the flow of money
across the Internet, it usually routes the funds from
one bank account to another. "The whole electronic commerce
game is going to be controlled, or gated, by the banks,"
says analyst Wolfenberger. To that extent, then, what's
good for e-commerce is good for First Data and also
good for the banking industry as a whole - at least
for now.
One reason for that zone of comfort
is that while First Data competes directly with certain
banks in a few business lines, the company does not
intrude into core banking functions such as credit extension.
And most everything First Data does in card processing
and e-commerce involves bank relationships and alliances.
There's always the outside possibility
that a huge nonbank company, say Microsoft, could acquire
First Data and claim a dominant position in e-commerce.
There is some precedent for this: First Data, after
all, was once part of American Express. Even First Data's
acquisition by a mega-bank, say Chase Manhattan Corp.
or Bank of America, would upset banks that compete with
that entity.
Duques points out that First Data,
with a $20 billion market cap, would "be a mouthful"
for any acquirer. Considering current opportunities
for growth internationally (via Western Union) and domestically
(on the Internet), he says, "I see no reason for us
not to be an independent company."
Mr. Cline is Senior Editor
of Banking Strategies.
