Wednesday, September 10, 2014

Apple Pay: The Only Wallet With Potential To Gain Widespread Adoption


  • Apple Pay re-energizes the iOS ecosystem;
  • It serves as another example of Apple promoting high levels of integration across hardware, software and services in its ecosystem;
  • It has the potential to gain widespread adoption due to its ease of use, consumer excitement, hardware integration, and a huge installed user base.
iPhone 6, iPhone 6 Plus, Apple Watch, and Apple Pay, I believe the much anticipated and innovation-filled Apple (NASDAQ:AAPLevent delivered on its lofty expectations. The product set launched at the event were largely in line with expectations. While Apple Watch and Apple Pay serve as key platform enhancements and give consumers/users furthers reasons to stick to iOS, the larger screen iPhones will be an important driver of renewed growth in large screen smartphones segment.

Apple Pay - An Important Platform Enhancement

A lot has already been written and will be written in the next few days about the new iPhones, therefore, in this article I will focus more on Apple Pay, a mobile payment system designed to work with all three new products launched yesterday. The technology utilizes NFC capability, Touch ID, and a built-in Secure Element (a dedicated chip that stores encrypted payment information) in conjunction with Passbook.
The offering not only makes it easy to add new credit/debit cards with the camera, it also increases security as the credit card numbers are neither stored nor shared on the device or in Apple servers. Apple made it clear during the event that it does not store the transaction data means the company does not know what is bought and when. In addition to one touch checkout, the key selling features of Apple Pay include that no card information is shared with merchants and there is no need to enter number once it is already loaded in Apple Pay.
The service has already signed up 11 major banks, including Citi (NYSE:C), Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Capital One (NYSE:COF), American Express (NYSE:AXP). These banks collectively control about 83% of credit card transactions in the U.S. In addition, 22,000 retailers have already signed up to accept Apple Pay. Some of the names include Starbucks (NASDAQ:SBUX), Macy's (NYSE:M), Whole Foods (NASDAQ:WFM), Disney (NYSE:DIS), Sephora, Bloomingdales, etc. The company is expected to add more brand-name merchants soon. This is not it; Apple Pay will also be available at certain m-commerce sites such as Target (NYSE:TGT) and service providers such as Groupon (NASDAQ:GRPN) and Uber are also accepting it.
(click to enlarge)

Reshaping The Payment Industry

Apple has reshaped the payments industry with the announcement of Apple Pay. It opens the door for Apple to take advantage of the 200 million card transactions that occur each day (Credit Suisse estimates $1 billion worth of online transactions per day). According to a technology research firm, Gartner, mobile payment market is expected to generate $721 billion in global transaction value by 2017. This represents a CAGR of 35% from 2012. U.S. is expected to account for about 20% ($140 billion) of these transactions. Specifically within this category, mobile web payments are expected to represent 45% of total transactions (42% CAGR), while NFC is expected to represent 5% by 2017, but growing at 64% CAGR.

Potential To Gain Widespread Adoption

Of all the mobile wallets introduced so far, if any initiative has the potential to gain widespread adoption its Apple Pay. This is because of its ease of use, consumer excitement, hardware integration, and a huge existing installed base of more than 800 million users with card information already stored in iTunes. Existing mobile wallets require users to log into their phones, open up the mobile wallet app, input a password, and then tap and pay or hit a button to authorize a transaction. Apple Pay, on the other hand, requires a much simple process. It can be activated by tapping the iPhone 6 at the point of sale and holding a finger on the Touch ID sensor.
Another advantage that Apple has is its already installed huge user base. The company has more than 800 million credit/debit card information stored in iTunes, which means consumers do not have to input the credit card information again to use Apple Pay, nor do they have to trust a new brand or app. Consumers can also take a picture of their credit cards and upload it to Apple Pay. Existing wallets require consumers to enter the credentials manually before using.
The fact that Apple does not intend to store purchase information also addresses fears of consumers who are concerned about their privacy. In comparison to Apple Pay, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) Wallet stores information on consumer purchases including merchant name, date and time, amount spend, method of payment, and potentially geolocation. I also believe that the launch of Apple Pay is negative for other mobile wallets such as Google Wallet, PayPal, SoftCard. The launch of Apple Pay means consumers who already use iOS will likely settle with Apple wallet for its ease of set up and ease of use.

Re-energizes the iOS Ecosystem

Apple Pay re-energizes the iOS ecosystem. The company continues to innovate with mobile payments. This is just another example of Apple promoting high levels of integration across hardware, software and services in its ecosystem. Apple's vertically integrated structure across hardware, software and services, and across multiple products results in several strategic advantages compared to peers. First and foremost, it leads to high-quality levels of integration in a manner that other platforms, including Android and Windows, lack. Secondly, Apple's seamless availability of services and software competency results in high level of usage, which makes Apple an attractive partner for new ecosystems. Lastly, since many Apple devices cover almost all aspects of its users' lives, AAPL owns a big data advantage that few of its competitors have.

Potential Use of Data and Analytics

While the Apple Pay strategy puts in-place the foundation for iTunes monetization, the company still needs to give some details around the economics of Apple Pay. For example, the details of commercial relationship with Apple, the issuers, and merchants would be something investors would want to know. Personally I would like to know more about how the card-not-present fee may or may not have been renegotiated as part of Apple Pay and how Apple is monetizing the solution. As I have mentioned before, the company categorically said at the event that it does not collect purchase data but still I would like to know the rationale behind choosing not to collect any retail information that could have proven useful as part of a broader data analytics strategy. This could also answer a related question that whether or not there is an advertising opportunity that could add a second layer of revenue beyond the pure payments opportunity.
While the company would not be collecting transaction data, it did indicate during the presentation to a larger role for data and analytics. Apple Watch is well positioned to work with applications around fitness, including Health. The Health app basically consolidates health information from various devices into one easy to use app. Apple could eventually connect users with insurance companies as part of an analytics move to lower premiums. Other than the Health App HomeKit is another area which could be a part of the data strategy. HomeKit announced at a conference in June is an Internet of Things play for Apple.

Apple Watch

Apple Watch is the company's first push into new product categories since the introduction of iPad in 2010. It is also the first product developed under the leadership of Tim Cook. Apple Watch is a perfect combination of fashion and features. The device focuses on fashion, personality, and customization, features that we do not normally associate with Apple. But when it comes to wearables, appearance is just as important as functionality.
Apple Watch is surprisingly innovative. With the combination of Digital Crown, touch screen, and haptic feedback, Apple has nailed the unique user interface for a wearable device. Especially those who have tried the Watch are particularly impressed with how light in weight it is as well as the cool user interface, touch capabilities, display resolution, wireless charging etc.
Based on the initial penetration of prior Apple devices into its user base 30-60 million units sale in the first year would not be surprising. However, assuming a conservative number of 15 million units sold in FY2015 and another 20 million in FY2016 at an average sales price of $350 could add incremental revenues of $5 billion and $7 billion in FY15 and FY16 respectively. This represents an incremental upside of about 3% of estimated total revenue for FY15 ($197 billion) and FY16 ($210 billion). Assuming gross margin of 20%, this could yield an EPS impact of $0.07 and $0.12 in each of these years.


Even before adding the new Apple Pay service, AAPL's online services growth was accelerating and the business recently became accretive to corporate average margins. Apple's wallet accelerates the trajectory of growth and profitability, which I expect to be reflected in multiple expansion in the near-term. The service is surprisingly comprehensive, spanning physical and online payments. Major U.S. banks, which account for 83% of U.S. transactions, several retailers, and online companies have already signed up or plan to partner with Apple Pay.
Apple played both the security and privacy, both key to signing up new partners, features of its payment services intelligently. Apple understands that user privacy and security is supreme and has introduced several features to address these concerns. The fact that Apple can tightly integrate its hardware with its latest OS gives it a key advantage over more fragmented OS platforms of its rivals. Apple Pay is an encouraging platform enhancement and differentiator and it should enhance user loyalty over time. While a lot still remains to be answered and I expect details from the company over the next few months, Apple Pay has the potential to become important high-margin revenue stream overtime. Both Wall Street Journal and Bloomberg have reported that Apple is taking a per transaction fee from banks.
While the focus of my article is Apple Pay and Apple Watch, it does not mean iPhone refresh is not important. In fact iPhone is still the key driver of earnings. The introduction of the larger screen phones with Retina HD displays puts Apple in a strong position as the market shift towards larger screen sizes continues. There is a large number of U.S. iPhone users who are still on iPhone 4S or earlier and this combined with high demand for larger screen phones should result in a meaningful upgrade cycle over the next year. Apple Watch also adds to this demand, as the device only works with iPhone 5 or later. Moreover, Apple Pay is only compatible with the new products launched yesterday, this potentially accelerates demand further.

The Long Journey Of ApplePay

There will be a great deal written and to be said about ApplePay.  Many even astute experts will assume that Apple just took a year or so to build this new payment system.  The truth be told it was a very long odyssey that spans almost a decade.  It is also a masterful act of negotiation on Apple’s part to not “disrupt”, but to work with and not against all parties in the payment system ecosystem. 

Yes, it has been a very long journey for Apple and payments.  This journey started just a few months after the first iPhone 1 was announced.  Apple took a slow and methodical approach to what will become a central feature of iOS devices moving forward.  The first patent applications that were directly related to payments began to appear in 2008, they just did not seem obvious on to just a few weeks ago [1]  One could even go to the days before Apple released the iPhone and see the foundation being constructed for finger print scanners and other security systems.  

Apple knew very early on that to have a mobile wallet it has to be highly secured.  The results was TouchID and this was primarily established with the purchase of AuthenTec [2].  The security was also extended into the very processor of the iOS device, the ARM processor.  This was achieved through the use of the TrustZone/SecurCore [3] ARM developed specifically to secure financial data.  Apple took this framework and made it the foundation of the Secure Enclave. 

Payment Card Breaches Changed Everything

The Target payment card breach was a huge turning point in the payment card industry.  Up to this point all parties of the payments ecosystem had very little motivation to change the way they processed payment cards.  The 1970’s era magnetic stripe was the primary system used in the US with dozens of startups for the last two decades spending billions of dollars to try to “disrupt” this system, all to no avail.  But the Target breach was different, it was a huge number of cards, stolen from a top 5 retailer and it was getting the attention of government regulators.  Thus in January 10th 2014 I asserted that the payment card companies would begin to support new technology that would assure the highest level of security [3].  I presented it this way:

“Apple’s Secure Enclave And Touch ID, Movie Entrance 

Like the perfect set up in a movie, Apple has arrived with a fully encrypted wallet called the iPhone.  The new iPhones use the Secure Enclave, iCloud Keychain and Touch ID to make the iPhone and Apple’s forthcoming iWallet a rather robust answer to many of these problems.  By the end of 2014, we will see the almost decade of planning Apple did to become the first true, useful and secure mobile wallet.”- January, 2014

EMV Comes To America, But Is It A Better Way To Pay? 

This set the stage for a largest shift of payment card terminals in history.  Visa and MasterCard proposed the EMV [5] standard used in other parts of the world to become the replacement of the magnetic stripe of the payment card.  The difference in the US is that PIN numbers would not be required.  Hidden in the most recent EMV standards is a system called Wireless EMV.  Wireless EMV is NFC by any other name with some extensions.  For sanity I will mean both NFC and Wireless EMV went addressing this method.   The shift first took place at the largest retailers in the US in 2013 and is taking place today.  For a vast majority of merchants in the US these upgrades will be free or very low cost.  In just about every new payment card terminal deployed in the US of course EMV is a key part of the device however most include NFC.  The reasons are simple but also complex.  EMV is slower then swiping a card in just about all studies.  But it get worse, EMV in the most secure mode requires a PIN number and this can add over 45 seconds to a transaction that formerly took place in seconds.

There are other issues with EMV, it does nothing to address the foundation cause of the Target breach.  The EMV system does not encrypt data after it leaves the card and is introduced into the merchant’s payment system.   The only way this can change is through end to end encryption and tokenization.  This means that the payment card data is encrypted through the entire payment system rendering any hack to the system useless.  Thus EMV did not present a satisfactory solution to what was the real issue with the massive payment card data breaches.  

Apple developed an elegant solution.  By securing a payment card in the iOS device inside the Secure Element and passing the payment card in an encrypted manner, three massive issues of retail payments are resolved:

  • Payment cards are always secured
  • Payment card date is always 
  • Payment card transactions will be faster then card swipes

ApplePay: The Patents Just Stacked Up

It was certain, based on over 50 patents and patent applications [1] that Apple would apply NFC [6] technology as the foundation of the retail payments system.  However the first step was to negotiate a way that the Secure Element, controlled by the cellular carriers could be replaced by the ApplePay system.  This allowed Apple and not the carriers to control the destiny of the of ApplePay.  This method was granted and endorsed by Visa and MasterCard and is called Host Card Emulation  [7] and Tokenization.  These systems form the foundation of the way ApplePay operates.  This system was originally just related to NFC but Apple has extend it’s use cases for App purchases.  

Apple was masterful in the way they negotiated with every element of the existing payments ecosystem.  In the same manner Apple negotiated with the record companies, the movie industry, the TV industry, the book industry (not so well done), the cellular providers, the auto industry and home automation companies.   Apple had to work with:

  • Visa, MasterCard, American Express, Discover, UnionPay
  • The top Banks
  • The top processors
  • The top payment card merchant service companies
  • The top payment card terminal manufactures
  • The top retailers 
  • The top App developers

The Points Apple Highlighted:

How Does ApplePay Load A Payment Card?

The loading of a payment card is simple.  You can associate your payment card on file at iTunes or you just take a picture of the card and will be encrypted into the secure element.  Apple will verify that your card is valid and you are the authorized user.  At this point 85% of US payment cards are compatible with the Host Card Emulation/Secure Element Apple is using.  More will come soon. 

How ApplePay Works At Retail Stores

From the perspective of the user: you enter into a retail store that has the upgraded ApplePay’s NFC systems, this is a trivial upgrade for just about any merchant and will cost very little or zero.   Thus to complete a purchase on the iPhone 6:

  1. Shop for your purchase
  2. Go to the checkout 
  3. Take out your iPhone and wave it past the NFC reader
  4. Confirm the default card in the Passbook screen or select another card
  5. Press your finger on TouchID
  6. The payment is complete

The transaction is completed instantly, with a receipt inserted into Passbook.   This will be many orders of magnitude faster then handing over a payment card or in the future having to use the EMV customer facing terminal.  The Apple Watch will have a Passbook app and some payment card choices, however there will not be TouhId.  To the consumer ApplePay offers:

  • Security: The card is a one time use card and can never be stolen
  • Speed: There is little effort to wave an Apple Watch or iPhone past the payment card terminal.
  • Efficiency: By holding all your payment cards and reward cards on one device, your wallet will be smaller

From the merchant’s perspective: the transaction is routed through the traditional payment systems and requires no new contracts or relationships, it all just works.  The payment is considered “card present” [9].  This is important since all other mobile wallet transactions would have cost the merchant more money once the artificial subsidy payment startups used became unprofitable.   Thus all the merchant needs to do is to have the NFC upgrade.  To the merchant ApplePay offers:

  • Security: They are not at all liable for any payment card data stolen
  • Speed: The lines will move faster because there is less delay
  • Efficiency: They will not need, nor are they allowed to ask for an ID

From Apple’s perspective:  Apple gets to become a useful service holding payment cards in the most secure system thus far established for a mobile wallet.  This will make Apple the center of the universe for payment innovation and allow for far deeper uses cases in the future. 

How ApplePay Works Inside Apps

The other aspect of ApplePay is inside of Apps.  Apple has created an API that allows merchants to receive a one time use payment card number in a very secure manner and also pass on demographic information with permission, including address.  Thus with a single touch Apple will complete a transaction and allow you to move on.  Stripe has been a valuable Apple partner and was granted early access to the ApplePay system.  The results are Stripe has created a beautiful and elegant API that allows App developers fast and easy access to ApplePay. 

Apple did not stop there, they are opening up this API to all developers and payment gateways and I predict it will be the dominate way to pay inside of Apps. 

In the example case of a Target app transaction a consumer just shops as normal.  When they are ready to check out, the cardholder just needs to presses TouchID to complete the transaction.  

In the case of OpenTable, Apple Pay allows for the payment of the meal with a simple press on TouchID.  No need to present any payment card after the meal.  

Apple: A Payments Facilitator 

The pure brilliance here is Apple does not reqiure a merchant to change merchant account providers and the existing systems work as they always did.  This is in radical contrast to the "disruption" model that just about every payment startup used.  Apple’s path to work with, rather then against all parts of the payments infrastructure is the only reason even a company of Apple’s size was successful.  If Apple approached this all with the idea they wanted “to own both sides of the transaction” like most payment companies, they would have met with high resistance.  

Apple does not process any payments, Apple does not issue any payment cards, Apple will be a facilitator to the existing system and in the process improve it and change it in a remarkable way.  Apple will securely holds the payment card, tokenizes it and use various technologies to pass it on safely during a transaction.

It all started with the announcement of the iPhone 5s when Apple first held meetings with banks and Visa and MasterCard.  They wanted to present a new method for mobile payments that was far more secure then any method in history.  They also wanted to request a wholesale cost for these transactions to be lower.  Finally they asked for a rebate, a sharing in the card issuing bank's profits for creating this method.

All of this was a monumental task because Apple needed to gain approval by numerous participants.  They had to convince the card issuing banks that for many reasons it was in their best interest to support Apple's new methods.  Most do not understand that about 85% of fees that merchants pay will go right back to the card holder's payment card issuing bank.  Apple had to get the top 10 banks to agree to earn less money and offer Apple a portion for the value they offer.  Apple also had to convince Visa and MasterCard, but that was the easy part.   For all this work Apple will receive a portion of the Interchange Fees from the payment card companies and thus the merchant nor the consumer pays more for using ApplePay.

Apple receives revenue from the card issuing bank’s Interchange Fees.  Merchants and consumers do not see any increase.  Merchants can choose any provider. 

Just The Beginning, There Is More Coming For ApplePay

The ApplePay we see today on September 9th, 2014 is not the ApplePay we will see in a year or more.  ApplePay is like the iPhone 1 and is just the first step of a much larger journey for Apple and payments.  I am certain that the desire to not try to cause merchants to change merchant account relationships and retailers not to change the systems or processes they have built will be the foundation to the success.  We will see Apple present new extensions that will use far more refined and richer experiences as Apple begins to integrate the back end of retailer’s POS systems.  This will include data sent to the ApplePay user based on the transaction inside of a real and effective receipt system.

We will also see the introduction of iBeacons when used with ApplePay.  This will be a huge next step for ApplePay and will move a huge step forward for ApplePay 2.  

To be successful, ApplePay needed the widest acceptance at the widest number of merchants and I am 100% certain, this was the best path on this long ApplePay journey.  Wait till you see whats up next!

It Just Works: ApplePay Magic

From the perspective of the typical iPhone or Apple Watch user, they will experience what many will see as Apple Magic.  It will all just work with even less asked of you then prior payment methods include just swiping a payment card.  When Apple gets done adding even more rich features and layers, it will be hard for most people to want to use any other method.  ApplePay I think, will become as exclusive to the new iOS devices as the Apple white headphones were to the iPod and later the iPhone 1.  This will stand out as a clear sign that you are a new Apple iWallet user.  There will of course be a prestige and status element attached to this all, and that is no accident.  We will see this interesting and dramatic way to pay become almost iconic over the next few months.

I have always said that with mobile wallets, we will all vote with our wallets, literally.  We needed the reason, the premise to want to use any new way to pay.  I think ApplePay is the first system to be worthy of crating a true evolution in payments.  With ApplePay, Apple will forever changed the way pay for goods and services. There will be less and less reasons to present your payment card.  Your iOS device will take care of it all and it will just work.  

An Amazing Journey

I think history will record that ApplePay was the largest advance in payments since the invention of the magnetic stripe payment card.  We have come so very far since Dothea Perry accidently invented the modern payment card in the early 1960s while ironing her husband's crisp white IBM shirts [10].  How far we have journeyed since that evening in 1960.

Specimen of the first payment card from IBM.


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