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Strong Manufacturing – Buy Industrial Gases

Written September 2nd, 2014 by

Industrial Gases generally and Praxair specifically are being left behind by the manufacturing related rally that has boosted values for many industrial and material names over the last two years.  Arguably, both Praxair and Airgas, through their extensive US packaged gas and merchant gas businesses should see more leverage to better US industrial production and manufacturing, than many other sectors and companies.  This logic applies also to Air Products, but to a lesser degree given its lack of packaged gas in the US.

Both this year and last year we have been disappointed with results from all three companies given the improved economy in the US, but the operating leverage is real – particularly for PX and ARG – given underutilized assets in the US and very high potential incremental margins.  Praxair’s return on capital is expected to return to its long-term trend assuming estimates are appropriate for the next 12 months (PX estimates are historically conservative) – see chart – but the opportunity is to return to the more recent trend – post the reshaping of the company in the early part of the last decade.  There is enough leverage in the US focused business to achieve this as demand improves.

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Despite the improving trend in the chart above and even assuming the lower “normal return on capital” trend, PX is out of favor, with attention focused on APD and the new management.  As we have written in prior research PX is very cheap versus APD (second chart) – despite having the greater US manufacturing leverage.

In our view the opportunity today is in PX. ARG offers a more focused US exposure without the risks of Asia, Europe and Latin America, but does not have the valuation discount.

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ABBV (and ENTA): The Corvette(s) to GILD’s Ferrari

Written September 2nd, 2014 by

We believe consensus incorrectly views GILD’s pending hepatitis C (HCV) regimen as having consistently greater efficacy than ABBV’s pending regimen; in this note we compare pivotal trial results for the two regimens side by side, and show that the ABBV alternative offers comparable efficacy

The GILD regimen is of 8 (rather than 12) week duration in some but not all type 1 patients; the ABBV regimen is of 12 week duration in all patients. Patients are required to use ribavirin (RBV) more often on ABBV than on GILD regimens. Both regimens are highly tolerable; there were no withdrawals for adverse events (AE’s) in GILD’s three main trials; across ABBV’s five main trials, two saw zero AE related withdrawals, one trial saw a 0.5% rate, one a 1.0% rate, and one a 1.9% rate

The GILD regimen is one pill once daily; the ABBV regimen is no more than three pills twice daily

On net, the ABBV regimen offers the same efficacy, at the cost of greater treatment duration and/or the addition of RBV-associated tolerability issues. Despite this narrow relative disadvantage vs. GILD, in an absolute sense the ABBV regimen is both sufficiently brief and highly tolerable – making it a viable alternative, especially for cost-sensitive payors

In this note we detail the efficacy and tolerability gap between PegIntron and Pegasys, the two predominant pegylated interferons (IFNs) that have been the mainstay of HCV therapy for more than a decade. We show that despite being substantially less effective and less tolerable than Pegasys, that PegIntron has captured 34% of global pegylated IFN sales to date

The ABBV HCV regimens are far more closely matched to the GILD HCV regimens than PegIntron was to Pegasys; accordingly barring the effect of additional competitive entrants, we would expect the ABBV HCV regimens to capture global share on par with that captured by PegIntron (i.e. more than 30%)

Allowing for the effect of competitive entrants (the first with at least comparable efficacy to ABBV comes from BMY in 2016, the second with potentially comparable efficacy from MRK in 2017), we’re confident ABBV can capture at least 20% of global sales. Current consensus appears to credit ABBV with less than 10% share of global sales

One component (ABT-450) of the ABBV regimen is licensed from ENTA; we believe cumulative royalties to ENTA should range between $900M and $3.5B. ENTA’s current enterprise value is roughly $665M

For our full research notes, please visit our published research site

Quick Thoughts: Implications for the Payments Industry of an NFC-Enabled iWallet

Written August 29th, 2014 by

Both Wired and the Financial Times are reporting that, at its September 9th media event, Apple will announce the use of NFC-enabled wireless communication in the iPhone (including for mobile payments) along with longer-range Bluetooth-enabled wireless (including for in-store location and real-time messaging/e-couponing). As discussed in our note of May 23rd, “Apple versus Banks in Mobile Payments”, Apple could have implemented mobile payments with Bluetooth, but this would not have been compliant with financial industry “EMV” standards for chip-enabled payments and would likely have made the iWallet more expensive to merchants than a card-swipe.

Unlike existing mobile wallets, the iWallet will likely have broad functionality beyond payments because of integration into Bluetooth-enabled iBeacon technology which Apple has been working on with premium-brand retailers. Andy O’Dell, Chief Strategist at Clutch, over-states only slightly when he says that “the digital wallet has nothing to do with the transaction, but rather with everything that comes before and after that transaction … that’s the benefit of digital that consumers do not get with plastic … if retailers can create a solution where the plastic card (including the loyalty card), mobile, in-store and online experiences are tethered together, then we’ll have something that is game-changing”. Our note of Aug 25th, “Payments and the Convergence of Physical and Digital Commerce”, makes the case that the resulting digitization of in-store workflows and customer experiences provides a means for retailers to mount an “app-and-mortar” or “omni-channel” challenge to the digital brands such as GOOG and AMZN.

The significance of the iWallet to the financial industry is that Apple has the ability to shape consumer behavior around payments in a way that the Google wallet did not, and we expect it to catalyze consumer interest in mobile payments; it is no coincidence that Visa has just launched its digital acceptance brand, Visa Checkout. By storing card-credentials on a secure element of the ‘phone rather than on a SIM card, Apple releases the iWallet from the dependence on carrier-provisioning that undermined the original Google Wallet, and Apple can leverage 800mm iTunes accounts (versus 250 mm active Amazon accounts and 140mm active PayPal accounts). Finally, Touch ID allows finger-print risk-scoring and this identity-and-verification (“ID&V”) information can reduce the fraud risk on iWallet transactions below ‘phone transactions that are risk-equivalent to online transactions (as in the case of the PayPal wallet), below card-swipe transactions, and even below chip-card transactions (and ‘phone transactions that use Google technology to allow Android to “emulate” a chip-card).

While premium-brand retailers will likely be early-adopters of iBeacon technology to increase their appeal to iPhone customers, mass-retailers will be more cautious. They remain concerned about data-leakage from mobile wallets into the Visa/MasterCard ecosystem, and the prospect that these data will be used to steer customers to competitors. Indeed, having attempted to engage in payments data-flow at the merchant level through Google Wallet, we believe Google is now looking to engage at the network-level through data-partnership with Visa. The excellent blog from payments consultant Tom Noyes carries this comment from a “top-5 retailer”: “I think of Commerce as a highway, the payment networks are like a toll bridge. I don’t mind paying them $0.25 [i.e. the Durbin cap on debit interchange] to cross the bridge but they want to see inside my truck and take 2-3% [i.e. credit interchange] of what is inside. Hence, I am looking for another bridge”.  

These other “bridges” include the MCX payments network (enabled by FIS and whose members have committed not to accept other mobile wallets), ChaseNet, and direct-routing solutions such as those enabled by ACIW where transaction instructions pass directly between retailer and issuing bank. We expect to see these solution roll-out in the next twelve months as the iWallet catalyzes consumer interest in mobile payments and as merchants install EMV-compliant payment terminals (which can be NFC-enabled for mobile payments) in response to a network deadline of October 2015 when fraud-liability on EMV-compliant card transactions will shift from banks to retailers that do not have EMV-compliant terminals.

Quick Thoughts – Bank Launches of Digital Wallet and Checkout Products are a Threat to PayPal and Catalyst for MCX

Written August 27th, 2014 by

Banks are getting into the digital wallet and checkout business in competition with PayPal. Recent products include Chase Quick Checkout (announced in February), PNC’s digital wallet (announced in July), and the Citi Digital Wallet (announced two days ago); WFC and JPM also participate in the carrier-sponsored wallet initially branded as ISIS, but bank-branded wallets represent an important evolution.

Like PayPal, these bank products allow consumers to checkout from an online shopping trip by entering a user-name and password linked to pre-registered payment card and shipping information; there is no need to re-enter this information into a merchant website so that checkout is quicker and cart-abandonment risk is reduced. Unlike PayPal, the bank products typically leverage the Visa and MasterCard acceptance brands as the networks extend these into the digital space through Visa Checkout (used by PNC) and MasterPass (used by Citi); the Chase product is an exception in that it does not leverage these brands but rather the proprietary acceptance brand JPM is developing along with its ChaseNet network (announced in February 2013). As with PayPal, when users see the relevant acceptance brand on a merchant web-site they click through to be presented with the cards they have registered, check the accuracy of the card and shipping information, and confirm-click to complete the transaction.

Bank-branded digital wallets and checkout products will be lower-cost to merchants than PayPal since there is no intermediation by PayPal and, in the case of ChaseNet, no intermediation by a branded network either; PayPal has a price-advantage for transactions routed over the interchange-free ACH network but this accounts for only 20% of dollar volume, a percentage which has not risen for the last three years. Furthermore, bank wallets will quickly achieve widespread consumer adoption as they are integrated into bank-branded mobile apps that consumers are already accustomed to using for balance-checking, remote-deposit, and P2P payments. Finally, as merchants deploy EMV-compliant payment terminals at point-of-sale to manage fraud risk, and some choose to subscribe for contactless features to enable “tap ‘n’ pay” mobile payments as well as chip-card payments, bank wallets will be used at physical point-of-sale more broadly (because of the breadth of the Visa and MasterCard digital acceptance brands) than PayPal (despite its acceptance relationship with Discover and direct acceptance relationships with some merchants such as HD and Jamba Juice).

The launch of bank wallets and checkout products is a catalyst for MCX for two reasons. First, member-merchants have committed not to accept competing mobile payment brands at physical point-of-sale and this commitment becomes more difficult to sustain as consumers become used to paying with bank products first at online merchants and then at merchants who are early-adopters of the associated digital acceptance brands at physical point-of-sale. Second, the retailer concern that banks will attempt to reserve the mobile payments channel for high-interchange products is validated by the Citi wallet; at least for now, consumers can register only credit cards, and not debit cards, into the wallet. In contrast to the banks, a key goal of retailers is to use the mobile channel to steer consumers who have checking-account funds available (and so do not need pre-approved credit at point-of-sale to complete a transaction) to debit cards where interchange, for Durbin-regulated issuers, is just over 20 cents/transactions versus 80 cents for a premium credit card and, say, a $40 transaction.

Our research note of August 25th, “Payments and the Convergence of Physical and Digital Commerce” provides a more detailed treatment of the threat to digital brands, such as PayPal, as brands with an analog heritage leverage mobile for “app-and-mortar” strategies.

Relative Price & Value of pre-Phase III Pipelines for the 23 Largest Drug & Biotech Companies – Updated View

Written August 26th, 2014 by

Using patent data, we estimate the relative ‘true economic’ value of companies’ pre-phase III (aka ‘hidden’ pipelines), and then compare these estimates to the apparent market capitalization of these same pipelines. Since inception (November of 2012), our portfolios of stocks whose hidden pipeline misvaluations imply ≥20% relative share price gains has appreciated at 1.5x the rate of a comparator portfolio containing all 22 companies analyzed (equal-weighted 1.5x; cap-weighted 1.5x)

Capital markets misvalue pre-phase III (i.e. ‘hidden’) pipelines for an obvious reason: they’re hidden, at least to conventional methods of valuation. Careful analysis of patent data gives us an opportunity to see what’s hidden, and to determine whether it’s fairly valued

On average, roughly 35 percent of the largest drug and biotech (by market cap) companies’ share prices are linked to these companies’ ‘hidden pipelines’, i.e. to projects in phase II and earlier stages of development

The percent of share price explained by a company’s hidden pipeline ranges from 5 to 69 percent. The apparent economic value of the innovation in these companies’ hidden pipelines spans a similarly broad range, but in many cases the capitalization of a company’s pipeline will be low versus peers even though its pipeline contains more innovation than peers, or vice versa

Because of large misvaluations in hidden pipelines, shares of VRTX, BMY, and SNY all appear at least 20 percent undervalued. Conversely shares of ALXN, BIIB, CELG, GILD, NVO, and REGN all appear at least 20 percent overvalued (SHPG also appears >20 percent overvalued, but will be dropped from the peer group going forward, as it is rolled into ABBV)

For more information on this, and related R&D productivity metrics covering the 22 largest publicly-traded companies (by R&D spending) please visit hiddenpipeline.com

For our full research notes, please visit our published research site

Payments and the Convergence of Physical and Digital Commerce

Written August 25th, 2014 by

“Data is the weapon”

Dan Schulman, AXP

Consensus is that smartphone penetration (now over 65% of US mobile subscribers) will allow digital brands to extend their e-commerce franchises and data-enabled marketing skills to the physical environment. Google, for example, is executing its mission “to organize the world’s information and make it universally accessible” through using public and permissioned data to construct generalized maps that, like online spiders on the web, can be crawled by robots (cars, drones, glasses etc); and, of course, in this virtual reality Google’s skill advantage in data-enabled modeling of human behavior supports its commercial interests.

We believe smartphone penetration will also have the reverse effect: retailers with an analog heritage will mount an “app-and-mortar” challenge to digital brands using real-time, data-enabled marketing of their own. Already, as physical and digital commerce converge around mobile, CMOs have become more intensely focused on digitizing in-store workflows and keeping the resulting data out of the digital common space. The SBUX mobile app, with a core objective of preventing transaction-data leakage into the payments ecosystem, is an early example of this digital enclosure; and the control and protection of data is increasingly shaping physical infrastructure as in the case of the merchants’ payment consortium, MCX, and ChaseNet.

  • Illustrating the mobile, and more broadly “omni-channel”, business case for retailers, WAG reports[1] that customers who use mobile for shopping spend 4x the amount of non-internet walk-ins, and those using both mobile and walgreens.com spend 6x. Meanwhile, in its omni-channel push, WMT plans to match AMZN for online product-range and shipment-speed in 2016.
  • Through digitizing in-store workflows, large retailers will generate transaction data at internet-scale. E-commerce payments are expected to reach $365bn in 2016[2] and, while mobile payments (where a smartphone is used to make an online purchase) will likely be only 10% of this, mobile-influenced offline sales are projected at more than $700bn. WMT notes “the possibility of bringing the web to the store is incredibly disruptive … we have 140mm shoppers in the US and that is internet scale in the offline world”.

In pursuit of app-and-mortar strategies and a customer experience that is, in WMT’s framing, “the digital equivalent of the analog experience in store”, retailers will: (i) digitize in-store workflows; (ii) execute data-enabled, digital marketing campaigns; and (iii) view payments as strategic to marketing given the transaction data it generates and the ability of chip-enabled payments devices to act as marketing media (whether customer interaction is through a screen-enabled payment terminal or a ‘phone). The resulting winners include:

  • PAY and NCR who can support retailers, including banks, in enabling “smart” physical infrastructure to engage wirelessly with customers. The reported launch by AAPL in the iPhone 6[3] of a mobile wallet, capable of in-store navigation coordinated through iBeacons, is a likely catalyst for retailer investment in physical infrastructure as a core element of data strategy.
  • ADS and COF who can support retailers in leveraging data into targeted digital marketing campaigns. There is a secular shift in marketing from generic brand-advertising to digital channels, and a convenience-opportunity to integrate e-coupon redemption into the payments stream (through statement credits in a mag-stripe environment and pay-with-points in a digital environment). Private-label credit card issuers are well-positioned because of their retail partnerships; ADS already has strong momentum and Richard Fairbank, CEO of COF, has described the “huge opportunity to really leverage information”.
  • FIS, VNTV, and ACIW who can help reduce the risk of payments-data leakage by routing transactions directly from retailer to issuer hence by-passing the branded networks. This also saves network fees as noted by ACIW CEO Phil Heasley: “direct routing can create efficiency with issuers paying 0.005 cents/transaction vs. at least 5 cents charged by Visa.”

The integration of payments and marketing will catalyze structural reform in the card business, and a shift in the payments revenue-model from interchange, traditionally paid by retailers to issuers based on network rules, to bilateral deals for sharing the economics of collaborative marketing. The incentive for this collaboration arises from data synergy: retailers have access to the in-basket (i.e. product-level) purchase data of customers, and issuers have access to the away-spend data (albeit only at ticket-level) of customers at other stores. ChaseNet, announced in February 2013, is an early example with Jamie Dimon noting that it allows JPM[4] “to go to merchants and strike our own [deals]”; we expect other large banks to announce direct-routing schemes in 2015.

  • Visa could respond by insisting, as it has in the past (including with litigation settled in its favor in July 2006 against First Data), that transactions acquired on Visa-branded cards must be processed on the Visa-branded network. However, Durbin does not allow this insistence in debit and large banks may migrate card-spending to debit, reversing the recent trend where consumers have increasingly used credit cards for rewards not financing, if Visa resists in credit.

[1] http://analysis.openmobilemedia.com/commerce-brands/navigating-mobile-retail-revolution-part-i

[2] http://www.theatlantic.com/magazine/archive/2014/03/get-ready-to-roboshop/357569/

[3] https://www.theinformation.com/Apple-Mobile-Wallet-Talks-Heat-Up

[4] http://online.wsj.com/news/articles/SB10001424127887324338604578328352611255658

 

Please see our published research for the full note and tables.

Quick Thoughts: Cost of BAC Settlement Meaningfully Below Headline Figure

Written August 21st, 2014 by

While the headline for the mortgage settlement announced today with the Department of Justice is $17bn ($9.65bn in cash, of which $5bn is penalty and the balance remediation expense, and $7bn in consumer relief), the Q3 after-tax charge will be just below $5bn given the effects of tax and pre-existing reserves

The cost to BAC of the on-going consumer relief is likely to be at most 50% of the headline figure of $7bn, and possibly substantially less, given many of the actions (such as loan forgiveness) are part of the normal course of business (particularly given BAC has until August 2018 to disperse the relief) and others (such as loans to distressed areas) might not have occurred in the normal course but will come at no cost or a cost which is a fraction of the “credit” earned by BAC towards its consumer relief obligation.

Given the charge, we forecast a loss for Q3 of around $1.5bn (or 13 cents/share). There is negligible impact on capital ratios with the CET1 ratio falling 20 basis points to 11.8%, and we expect BAC to ask for, and get, permission for a $4bn stock buyback in the March 2015 CCAR round (as it did in the March 2014 CCAR but then withdrew after reporting in late April a $4bn error in its calculation of regulatory capital).

Given this, we see no reason that the stock will not return, during or before March 2015, to the $18 level it reached in late March 2014.

The EMV Opportunity for PAY in Terminal Apps

Written August 21st, 2014 by

“I think that the coming decade will be the most important in commerce and payments that any one of us have lived through”. Paul Gallant, CEO Verifone, Mar 2014

One of the most important changes in US payments technology is the shift in the storage medium for card credentials from magnetic stripes to computer chips (whether embedded in an EMV[1]-compliant card or ‘phone). The shift to chip technology has been accelerated by heightened industry focus on security following the Target data breach last November (because chip cards are more difficult to counterfeit), and we expect the majority of cards and point-of-sale (“POS”) terminals to be chip-enabled by the end of 2015.

The transition of US payments to chip technology changes industry structure because chips are a more versatile medium than magnetic stripes, and can be used for more than storing static card credentials. In particular, they can be used to integrate marketing offers into the payments process; as MasterCard puts it: “EMV in the physical world is a much thicker pipe [than mag stripe]… not only is it a more secure transaction but you can add more data into the stream that can drive things like offers and receipts”. In other words, chip-technology turns payment devices into more powerful marketing media.

However, there is an important distinction between chip-enabled cards and mobile ‘phones as marketing media: the former does not have a screen on which to present real-time offers to customers or receive real-time input from customers around tender and offer-redemption choices. Until mobile payments are adopted more broadly by consumers, the natural solution for many retailers will be to use payment terminals as marketing media for chip-enabled card payments that we expect will account for $1.5tn of annualized purchase volume by end-2016 (vs. less than $100bn of mobile purchase volume).

This creates an opportunity for terminal market-leader PAY (with 50% share globally and in the US of the EMV terminal market) to sell not only next-generation terminals with touch-screens but also demand-generation terminal applications such as electronic couponing and targeted offer programs. The company does not break out the specific revenue contribution from these advertising services, but services as a category (including terminal maintenance, security solutions such as tokenization and encryption, as well as commerce-enablement) now account for near-40% of firm-wide revenue of $1.8bn and are growing at a CAGR of 15% (versus less than 5% for terminal sales).

Sizing the terminal app opportunity for PAY is not easy but there is a significant opportunity for payment companies that can drive incremental revenues to merchants. We estimate annual merchant spending on advertising that can potentially be converted to digital channels at $500-600bn and there is a secular shift from generic brand advertising to data-enabled marketing with a track-able ROI (see Exhibit below). For example, ADS pitches retailers on transferring $40mm from their advertising budget to data-enabled marketing, and it would take only a few wins of this magnitude for PAY to generate a meaningful growth in service revenue given the current base of $400mm annually. There are competitive risks that:

  • Dongle-providers, such as Square and Amazon (through its newly-announced Local Register product), enable tablets for card acceptance allowing merchants to use tablet-screens, rather than terminal screens, for two-way marketing communication with customers. While this is likely for many micro-merchants, larger retailers will prefer the security solutions, including tokenization and end-to-end encryption enabled by PAY terminals. Indeed, after the Target data breach last November, the security of card data is the top priority for retailers and has helped PAY gain share. As CEO Paul Galant reported after the last quarter “we won another six clients from competitors and gained three new US clients that adopted consumer-facing[2] payments systems for the first time to prepare for EMV acceptance”.
  • PAY is unable to seize the window of opportunity as chip cards are adopted (with the processing capability for commerce-enablement functions but without display screens) ahead of mobile phone payments (which have both processing and display capabilities) to build durable software capabilities; if so, competitor app-conduits (such as Apple given the possible launch of a mobile shopping-and-payments ecosystem with the iPhone 6[3]) have a better chance to take over the support for data-enabled marketing as ‘phone screens displace terminal screens over time. In practice, we believe PAY’s current position in POS terminals gives it the opportunity to build an operating system for security and commerce-enablement apps that will survive this transition.

[1] EMV is the Europay-MasterCard-Visa protocol for communication between chip-enabled payment devices and the point-of-sale terminals.

[2] It is an EMV requirement that payment cards not leave the sight of customers meaning that many retailers, including restaurants and hotels, who are presently accustomed to taking a customer card and processing it in a back office will need to purchase new customer-facing terminals. PAY has estimated that these new customers will lift the addressable market for US terminals to 13mm from the current 10mm.

[3] See our research note “Apple vs. Banks: Update” of May 30th, 2014

 

Please see our published research for the full note and tables.

August 19, 2014 – Infrastructure as a Service: The Race Won’t Go All the Way to the Bottom

Written August 19th, 2014 by

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Infrastructure as a Service: The Race Won’t Go All the Way to the Bottom

The stakes for public cloud operators (IaaS) are huge. Annual global spending on enterprise data centers – hardware, infrastructure software, staffing, facilities, etc. – is more than $1.2T. We expect most of this will migrate to the cloud over the next 2 decades, due to the compelling economic advantages of web-scale distributed data centers, with cloud operators hosting both SaaS and customized applications. The costs and performance of IaaS are highly levered by scale and technical sophistication, factors that will force all but the biggest and best from the market with time. Currently, the 3 best positioned players – AMZN, MSFT, and GOOG – are engaged in a price war, temporarily sapping industry growth and maybe driving all 3 into losses. However, the real casualties of this war will be smaller IaaS operators, who will be uncompetitive without massive consumer cloud franchises to drive scale and sophistication. Meanwhile, we do not expect a “race to the bottom” amongst AMZN, MSFT and GOOG. Rather, as the market concentrates into their hands, we believe natural points of differentiation for each of them will allow lucrative value added services atop commodity processing and storage services. All three should be profitable long-term, with sales growing into $10s of billions before decade end. However, given a slightly richer data center cost structure and the lack of a high margin core business to cover for any losses, we are concerned that AWS will be a burden to AMZN in the near term, as it works to re-establish the confidence of investors.

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Quick Thoughts: Winners and Losers as Relentless Data Breaches Drive the US Payments Industry to EMV and a New Digital Era for Data-Enabled Fraud Management and Marketing

Written August 18th, 2014 by

Visa and MasterCard are being forced to promote EMV-standards for chip-based cards as ongoing data breaches (including those at Albertson’s and SuperValu announced on Friday) increase the risk that network inaction triggers regulatory intervention. However, EMV adoption (which makes card data less valuable when stolen rather than more protected) will move the payments business into a digital era where customer data, which is ultimately owned by issuing banks and retailers and not by the networks, becomes a more decisive success factor. MA acknowledges this in commenting that “EMV in the physical world is a much thicker pipe [than mag stripe]… not only is it a more secure transaction but you can add more data into the stream that can drive things like offers and receipts”.

We are already at the EMV tipping point with FIS announcing in its last quarter’s results that it had won the first conversion to EMV of an entire card portfolio (rather than just a high-net-worth or travel portion); given fraud tends to migrate to less secure non-EMV channels, no issuer (or, after October 2015 when fraud risk on EMV cards can shift to them, no merchant) wants to be among the last to be processing mag-stripe transactions; the resulting rush-to-EMV will generate a tailwind for businesses such as FIS and VNTV that competitively differentiate through security capabilities. We note that migration of fraud to the e-commerce environment as EMV is adopted at physical point-of-sale may overwhelm existing the risk-management capabilities of online incumbents which payments consultant Javelin has described as : “using solutions [e.g. static user names and passwords] that are more than a decade old and wholly unacceptable”; this is a potential headwind for PayPal and opportunity for new entrants, such as Chase Quick Check and Visa Checkout, using modern security techniques such as dynamic tokenization.

As EMV gains adoption, retailers and banks will build data-enabled marketing and fraud risk-management strategies to leverage transaction information across physical and digital channels so as to compete more effectively against e-commerce specialists. An early example will be digital wallets that are open (in the sense of giving the customer the ability to register a variety of payment instruments, including network-branded as well as proprietary solutions) to improve visibility into customer payment behavior and hence the ability to sharpen offer and loyalty algorithms and steer purchases to preferred solutions. As banks and retailers increasingly use digital wallets to shape customer payment choices, they will look to develop new payment-routing options to control and protect transaction data (as in the case of the SBUX mobile app, for example) and to lower processing costs (as in the case of PayPal’s use of ACH, for example). ChaseNet and the merchant payments consortium, MCX, are examples involving both direct routing and new acceptance brands; by end-2015, we also expect direct-routing between large banks and retailers using unbranded solutions such as those from ACIW (at a cost to the bank of 0.005 cents/transaction vs. at least 5 cents/transaction for Visa).

  • Access to transaction data will additionally enable large banks and retailers to sharpen authentication algorithms. Indeed, we expect a wave of innovation in the use of transaction data, and ancillary data available from mobile devices such as geo-location and biometrics, for ROI-measurable improvement in fraud risk-management. As a result, the current binary distinction between card-present and card-not-present transactions will give way to an environment where transactions are scored and priced for fraud risk; we believe this has already been an important discussion between banks, networks, and AAPL around the reported launch with the iPhone 6 of a mobile shopping app with integrated payments capability.

The most successful data strategies will be those that “close the loop” by marrying “in-basket” transaction data available from the merchant with “purchase-away” transaction data available from the issuer; ADS provides an example of how much more effective the resulting data-enabled marketing can be than generic branding although we prefer AXP, COF and VNTV as plays on the shift in marketing spend from Madison Ave to payments companies. As payments data are increasingly used to support marketing, industry-pricing will shift from network-based interchange (which is ultimately based on the risk of lost sales if a retailer refuses to accept network brands) to demand-generation pricing agreed bilaterally between large banks and retailers (and based on the measured-ROI from collaborative marketing to shared customers). The shift in focus from the risk of lost sales to the opportunity for demand-generation is already evident:

  1. Target offers a 5% discount on purchases made with its proprietary RED cards because of the lift to visit-frequency and ticket-size even though this represents a substantially higher acceptance cost than on a Visa card.
  2. Level-Up, the largest open mobile payment network in the US, is looking to reduce interchange pass-through to zero by generating revenue from marketing campaigns informed by payments data; and
  3. Uber charges taxi-drivers 20% of the ticket value without distinguishing between its demand-generating and processing services.

Our core thesis is that US payments industry structure will be increasingly driven by bilateral arrangements between large banks and retailers as they look to partner around data strategies (with the Costco-Amex partnership being a long-standing example from the mag-stripe environment), and we are cautious that these partnerships will tend to disintermediate V and MA as branded networks. V and MA are responding by looking to extend the edge of their networks and data-reach beyond issuing and acquiring banks to end-cardholders and merchants so as to support data-enabled marketing at the network level; MA, for example, has commented that “one of the examples [of using the thicker EMV pipe] that we are driving is in the loyalty space where we believe the MasterCard network is a great way to close the loop on coupon redemption … and drive the ROI calculation to a very finite point.” While this may work for smaller issuers and retailers, it is likely to antagonize large banks and retailers who are looking to develop competitive advantage from data-enabled marketing rather than see it provided, like an acceptance brand and fraud risk management, as a network service that can even the playing field for smaller competitors.

  • Chase, for example, will not share the personally-identifying information or “PII” of cardholders with Visa (so that Visa knows the primary account number or PAN but cannot link that to a customer name or address); and WMT, for example, is refusing to accept any mobile wallet but the MCX solution.
  • However, other banks and retailers are less rigid with PNC, for example, being an early supporter of Visa Checkout (which does require the sharing of PII) and WAG, for example, choosing to accept the GOOG wallet.
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