Thursday, September 11, 2014

Apple Pay - Taking A Bite Out Of Payments


  • The big benefit to Apple is to secure and grow its embedded customer base.
  • The real value is in continued upgrade cycle as Apple continues to make new devices we can’t live without.
  • Payments will be profitable, but it shouldn’t change the earnings in itself.
How a card transaction works now. You spend $100 on your card. You swipe your card, the merchant acquirer (company that puts the terminal in the merchant location) sends the card information to the network (Visa, MasterCard, Discover, AMEX, etc.). The network sends the information to the card issuing bank (C, JPM, BAC, etc.). The bank makes the credit decision (approve/deny) and sends back to network that sends to the merchant and you sign and leave the store.
The bank puts the $100 transaction on your monthly statement. The merchant receives $98.00. The card issuing bank keeps $1.60. The card issuing processor (it could be themselves or a 3rd party company) keeps $0.10. The network keeps $0.05. The merchant acquirer keeps $0.25. So $2.00 in fees for $100 spent. These are general numbers - they change based on a number of factors from the type of merchant you are to the type of card you have to the way the card was used (on-line, over phone, in person, etc.).
What Apple is doing? Arming consumers. With near-field communication or NFC and a very easy way to use the phone as your payment device, Apple (NASDAQ:AAPL) is getting a new payment tool into the hands of consumers. To do this Apple needs merchants to upgrade the devices at the point-of-sale to NFC readers. This has been coming, but the process has been slow as it is a cost to merchants for the new machines and a cost to banks to issue new cards with NFC chips. However, banks want this to eventually happen as it should reduce fraud on the bank, as well as being a more secure type of transaction (they have unique ID and authorization that can't easily be stolen).
How are they getting it done (and getting paid)? By saying they have 800 million iTunes accounts lends influence and credibility to merchants (there are about 400 million credit card accounts) that they will get more traffic if they upgrade their systems (this is a benefit for VeriFone NYSE/PAY that sells the hardware). The banks will be happy as they get all these new devices that can be used for payment. Now, banks pay for the cards that are sent to consumers. They can outsource this to companies like TSS and First Data. So, banks should be willing to pay Apple to put the chips in phones - this should be pretty neutral to banks as they are exchanging one cost with another (depending). This might be bad for the card creation end of the business - but this is probably very small part of the overall business.
Another revenue option while disrupting PayPal. NFC also should reduce fraud. If that is the case, banks might be inclined to do some revenue sharing with Apple. The easiest way to think about a possibility is with on-line transactions. Once Apple develops a one click check out link connecting the NFC transaction over mobile, it might be able to negotiate the interchange rate with the issuing bank. Now, merchants pay more to accept cards not present (over the phone or internet) meaning they might get $97 for every $100 sent. This is due to fraud associated with these types of transactions. As the fraud is reduced, banks can lower these rates and split the savings between Apple and the merchant. Merchants get more, and Apple also has a way to make money. As the adoption of such a toll takes hold, other on-line payment solutions companies will face increased competition (think PayPal and eBay NYSE/eBay).
Still another revenue option, but likely away off. With the NFC transaction, the merchant acquirer, Apple, the network and the bank do not know what you actually bought. Rather, they know you spent XX dollars at a specific merchant. One possible option in the future would be to partner with merchants to get better understanding of what people buy. Apple can likely bring email addresses associated with the account coupled with the inventory system from the merchant. This will allow merchants to more directly target customers with offers, a service merchants have been willing to pay for. This provides the potential for Apple to extend the business services associated with Apple Pay.
It's not about the money... In thinking about the economics, we admit we're making some broad strokes. From the payments perspective, there is roughly $4 trillion in electronic payments in the US. Should Apple devices be used in 20% of transactions (a guess) and Apple is able to command 15bps in fees (higher than the networks currently get) the revenue from this business could be $1.2 billion. Assuming a 50% after-tax margin, Apple would get $600 million (or $0.09 per share). For comparison, iPhone sales in 2011, 2012, and 2013 were $46.0bn, $78.7bn and 91.3bn. While that is global sales, we suspect US sales of iPhones were around $35bn. At a 40% gross margin, 10% operating expenses margin and 35% tax rate, 2013 EPS contribution from US iPhones was $1.04. The iPhone 6 is expected to sell 25 million units. This would roughly represent a 10% market share of the US market.
… It's about the installed base. When looking at potential contributions, we believe that the bigger goal for Apple is to become more ingrained within consumers. With 91% of Americans owners of cell phones, we believe that Apple is more interested in growing its market share, in part by making the consumer more dependent on the hardware. This is especially appealing if the upgrade cycle hovers

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