The winds of change are blowing in the payments industry, causing ISOs to abandon traditional business models that rely on hardware sales, and embrace a more creative approach to acquire and retain profitable merchant accounts.
   In Part I of this two-part article, we'll examine what changes are bearing down on the ISO industry and how industry players are evolving to survive. In Part II we'll take a closer look at what two ISOs are doing to thrive in this new environment. Their examples hold clues for any ISO that needs to realign its business strategy with today's new and challenging market.

Winds of Change

   Just type "point-of-sale terminal" into Yahoo!'s search engine and you will see one example of the changes going on in the ISO industry today. The query brings up links to a bounty of new and refurbished POS hardware providers, virtual terminal and value-added application providers, and countless resellers of various electronic payment solutions and supplies �all vying for new merchant business. In addition, the search generates links to sites like buyerzone.com, where merchants can describe their needs by answering a few general questions on an online form, and within 1-5 business days receive free quotes from multiple terminal vendors. Five years ago this wealth of information was not so readily available.
   Easy access to competitive offerings isn't the only reason merchants are forcing ISOs to change their market strategy. Another reason is that the hardware market has matured.
   The Nilson Report stated that between 1997 and 2001, point-of-sale terminal manufacturers increased shipments in the United States by nearly 21 percent, from 1,312,098 units, to 1,586,494.
   While shipments are up, margins on hardware sales have taken a different course. "Most merchants have already acquired POS equipment that is technologically sufficient to provide the best level of interchange qualification," said Bruce Schratz, President of Payment Transaction Solutions� an ISO based in Tennessee. "Alternative providers of POS equipment, such as Internet-based sales, continue to drive profit margins downward on new equipment sales."
   To illustrate his point, Schratz noted that at his firm the hardware that is sold today is generating around 33% less income for the company and its sales agents than it did even four years ago, though the percent of hardware sales versus total business has not changed measurably since the company did not start with a significant reliance on hardware. "Today our best selling hardware is any type of refurbished equipment with a reliable warranty, and our best selling service is still credit card transaction processing followed by electronic gift card," Schratz said.
   But some margins are down more than others. "Typically, ISOs can demand higher margins for hardware upgrades and value-added applications than for base terminals and payment software," acknowledges Michelle Graff, Director of Global Marketing at VeriFone. But meeting merchant demand for value-added services, not margins, is the reason VeriFone thinks ISOs should work to implement solutions and services that will eventually result in the wholesale upgrade and replacement of aging terminals.
   Selling refurbished equipment or re-programming installed terminals might help with short-term revenue; however, over time it simply results in shifting merchant business from one ISO/acquirer to another, and it doesn't provide merchants with a migration to terminals that can support the payment and value-added applications that they want and that ISOs need to deliver to generate long-term merchant relationships.
   Value-added applications do three things for ISOs, They help attract merchants by offering new services; they improve retention by supporting more hooks into a merchant relationship; and they provide new sources of revenue through the sale of additional hardware and services.
   Hypercom agrees that ISOs are changing how and what they sell in response to slimming margins on traditional hardware sales and higher merchant expectations. "The margins on the hardware side have definitely been wider than they are right now," said Lisa Shipley, Senior Executive at Hypercom, who runs the company's ISO sales channel. "Five years ago, all ISOs sold the same thing and merchants never complained. ISO sales representatives were compensated for the short-term hardware sales and nothing more. But today, we have much smarter merchants.
   "ISOs can sell value-add applications that can produce recurring revenues to the ISO as well as the processor.
   While some of these value-added applications have a longer sales cycle, they can produce a recurring revenue stream and customer retention that is not available on a standard hardware sale. It's nice to see that certain ISOs have begun to pay residuals again to incentivize their sales force to sell long term value-added products."
   Lipman USA, a subsidiary of Lipman Electronic Engineering in Israel, saw the need for value added solutions early on, and responded quickly. In 2001 Lipman actually branded their suite of value software solutions as NURIT APPS�. Michael Danziger, Vice President of Corporate Marketing for Lipman said, "Our ISOs told us they needed two things a terminal didn't offer. They were looking for recurring revenue and customer retention. We created NURIT APPS to help our resellers do just that. This year at ETA, we will demonstrate our continued efforts on the part of our resellers."
   ISOs trying their hardest to answer merchant demands for more choices, lower costs and better service have noticed something �the sales cycle for hardware and services may be similar, but the strong merchant relationships they have acquired by offering multiple value-added services and superior support typically last longer and are more profitable over time than relationships that are based upon a quick hardware sale and basic card processing, where margins are flat and competition is fierce. After all, hardware sales deliver a nice one-time commission to the sales rep, but no long-term account profitability for the ISO.
   In contrast, ISOs that act as an advocate for their merchants are discovering that by providing and supporting value-added bankcard services that help a merchant operate more efficiently and grow over time, the merchants are more likely to stay with the ISO and to generate residual revenue that exceeds the profits of a one-time hardware sale. Satisfied merchants enjoying superior customer support and innovative payment, non-payment and value-added services from a single ISO are in turn more likely to refer other business to the ISO, adding to the overall residual benefit of the account.
   With hardware margins at an all-time low, ISOs that have turned to value-added services and long-term merchant relationships to differentiate themselves and fill the gap in their revenue are showing impressive results. The shift these pioneering ISOs are making in their business strategies is a harbinger of things to come for the bankcard industry.

Evolution and Revolution

   While some ISOs lament the passing of the era when uninformed merchants paid triple-digit margins for overrated hardware and unpredictable interchange rates, others see nothing but opportunities to grow and differentiate their businesses in a new environment where service�not hardware�is king.
   The hardware companies are adding value-added partners to develop solutions that add value to the merchant countertop. No longer are ISOs at the mercy of acquirers in determining what applications are certified and available.
   You've probably seen some of those developers and service providers at a recent ETA meeting. Mary Gerdts, President of the Electronic Transactions Association, reports that a large percentage of the ETA's new membership last year consisted of companies in non-traditional bankcard businesses trying to add their services, such as gift card, loyalty, secure-pay and Internet-based services, to the overall offering of ISOs. "It is more than obvious to all the players in the industry that you can't survive off of terminal sales alone. All the players must figure out how to differentiate themselves from the competition," said Gerdts.
   For example, some ISOs have turned to eProcessing Network, an ETA member selling its Palm handheld-based mobile payment solution through over 400 ISOs nationwide. Using Palm VIIx or Palm i705 handhelds, eProcessing Network's handheld payment application, the Palm.net service, and a clip-on magnetic stripe reader made by Scanning Devices Inc., card and transaction data is captured at the point-of-sale and processed by eProcessing Network, providing a complete mobile payments solution for retailers.
   In addition to providing merchants with the hardware and software required to accept mobile payments, eProcessing Network provides a secure online merchant support center where a merchant can log onto eProcessing Network's system to do reporting, control their batch, etc. eProcessing Network has deployed about 60 Palm VIIx and i705 handhelds over the past year.
   Mobile Payments have long been a core competency at Lipman. Working Closely with APRIVA and USWirelessData, Lipman ensures that the wireless tranactions from its terimals are easily processed via wireless gateways. According to Jim Poulson, Sales Vice President at Lipman, this value added service is critical to resellers. "You simply can't just dump a wireless terminal on a reseller and hope for the best. Our customers require a thorough understanding of the product and enviroment, and they need backend solutions to support their merchants' transactions. Addressing the portable solutions market, Poulson said, "Being small and mobile is great, but full function is what our customers want."
   Gerdts also said that smaller ISOs see that mom and pop shops now have PC's right at their own stores. "The ISOs recognize the PC's as an opportunity to replace terminals with software. And those same PC's can support a variety of other value-added services that generate ongoing revenue. This is one place where we're seeing a clear change in focus away from hardware sales," Gerdts said.
   The trend toward non-traditional bankcard services is so strong that in December 2002, the ETA board approved the establishment of an Emerging Markets committee,whose purpose is to monitor innovative products and services that may cross over into the payments industry via the ISO channel.
   Tony Perre, CEO of an ISO called payQuake, was assigned to be the Emerging Markets committee chairman in part because of his unique bankcard service, which is allowing the company to grow at a 70% increase in merchant accounts each month.
   "Like other traditional bankcard providers that had been fishing with the same fishing pole, with the same bait, in the same merchant lake for many years, new acquisition was flat, and competition is intense. What we now realize is that most merchants want choices and aren't willing to pay high fees any more. So I thought why not differentiate � or die. So I put the merchants in control with our Dynamic Merchant Pricing."
   Perre describes payQuake's patent pending technology as the third major phase in the evolution of the payments business. "The up-front standard fee traditional merchant account was a staple in the payments industry for 35-40 years. Things changed in 1999 with non-traditional payment providers via companies like PayPal. But PayPal offered a shared merchant account that lacked FDIC insurance, charge back rights for consumers, and other features that are typically provided to merchants by banks/ISO's through traditional merchant accounts," Perre said.
   The third phase in the evolution of the payments industry is the "Merchant Controlled Payment Technology" offered by payQuake called Dynamic Merchant Pricing, which lets merchants not only see how much they are paying each month to process credit cards online based on the payment account they have selected, but also lets merchants see what they would have paid to process credit cards using the other accounts payQuake offers. If a merchant has outgrown its current payQuake merchant account, the merchant can simply switch to another payQuake merchant account for the next processing month. The merchant can view their costs via their password-protected online control panel and switch to a different payQuake plan at any time to meet their evolving business needs.
   "From day one, the merchant should be in control of selecting a merchant account each and every month that best fits the business and financial needs of their company, but for so many years, banks and ISOs wagged the tail. Now it is up to payQuake and some other innovative ISOs to inspire merchants to try a new way of doing business."
   ISOs acknowledge that individual sales agents and small companies that have grown to understand the ongoing value of merchant account residual income are more inclined to offer very low prices on equipment to pave the way for the sale of ongoing services. In addition, ISOs are changing their compensation to sales reps to encourage them to focus on account acquisitions that generate the best overall account profitability, rather than one-time hardware sales.

Help for ISOs Turning the Ship

   While it might seem ironic that dwindling hardware margins are at the heart of these winds of change, even the largest terminal manufacturers are now in a race to partner with value-added service providers so they can offer ISOs bundled hardware/service solutions.
   Ingenico, ranked #3 in units shipped in the US in 2001 by The Nilson Report, makes no apologies for its tough strategy for penetrating the US market. "It's safe to estimate that about $100 million dollars of hardware per year is sold through the ISO channel in the U.S., but the business isn't growing, so we have to take market share away from our competitors in order to penetrate the U.S. market," said Michael English, Director of Marketing Communications at Ingenico.
   "Everything we're bringing into the US supports multiple applications to leverage the fact that in today's market hardware is becoming just a commodity and services are number one. We're making the box become more than just a payment device. We're focusing on gift card, loyalty, prepaid, check imaging and related services. We're also partnering with service providers to bundle our hardware with their software and service offering. This makes things as simple as possible for the ISO trying to sell these solutions to merchants," English said.
   Hypercom Corporation is also working to help ISOs differentiate their offerings by simplifying the sale of bundled hardware and services. "Today, we estimate that there are around 8000 independent ISOs on the street that are moving product to merchant locations. Many ISOs are pushing better service as a way to differentiate themselves from the banks and the processors who have become so big that they have lost touch with what service is all about. But the only way an ISO can really differentiate itself is to offer value- added services with the box," said Shipley.
   VeriFone says it is seeing real industry traction primarily focused in the areas of check conversion services, gift cards, and pre-paid telco. Shipley says Hypercom's most popular value-added applications are loyalty and gift card, followed by advertising and customized receipts. "Electronic receipt capture is just starting to take off, and time and attendance is further down the list, primarily because few ISOs are aware that it is available," she said.
   Recognizing the need for ISOs to have a direct line to any area in the company, Lipman encourages this with their NURIT [email protected] ISO solution. Michael Grossman, Senior Vice President, ISO Sales points out that "NURIT VIP� was designed to help ISOs with all facets of their business. They earn valuable points for sales, can train themselves on our products with Interactive Training Tools, and can contact us directly with their challenges. When you combine service, support and solutions, you help your customers meet the revenue and service challenges of this evolving industry."
   ISOs can be sure that terminal manufacturers will continue to compete with one another to provide ISOs with bundled hardware and value-added services that are easy to sell, service and maintain.
   When terminal manufacturers consider it important to demonstrate their financial stability in order to win the support of ISOs that are forging long-term relationships with merchants, you know times have changed. But even that is happening in today's market. "The larger ISOs are starting to care about which manufacturer they use because they want to know the company backing the services they are selling is financially solid," English said. "We're public on the Paris exchange so ISOs can see our numbers and know we have the resources to support the applications we are bundling with our terminals."
   With every facet of the payments industry participating in this evolution, many ISOs are left wondering how to begin moving their business strategy away from hardware sales and closer to a model that balances hardware sales with value-added services and superior customer support to achieve long term merchant relationships. Next month, Part II of this article will examine how two innovative ISOs are raising the bar on the ISO industry as they take advantage of the business opportunities presented by the current market environment.