Learn from the Credit Card Networks!

If you are building a two-sided commerce network or a supply chain finance company (and who isn’t doing the latter these days?), you will benefit from understanding the history and economics of the credit card and procurement-card (p-card) markets.

You can learn about the credit card market by reading Paying with Plastic, reading the prospectuses of Visa and Mastercard, or reading the financial statements of the public merchant acquirers, such as Global Payments, First Data (private, but still publishes financials), and TransFirst which just filed for an IPO.

Among the lessons you will learn from the credit card networks:

• How to solve the “chicken and the egg” problem
• How to massively enable “suppliers” (merchants)
• How much mature networks get paid for standards setting and providing the commerce rails (20-30 bps)
• How much mature merchant acquirers (supplier enablers) get paid for providing enablement technology, training, and taking on a little solvency risk (10-50 bps)
• How much issuing banks subsidize the use of their cards by buyers
• How many networks can survive in the long run–not many

The P-card market, the B2B cousin of the credit card market, is one of the original forms of supply chain finance.  It is a little harder to study than the consumer market, but is well worth the effort.  The best sources of information on p-cards are:  RPMG Research, NAPCP, as well as literature from American Express, USBank, and the other large P-card issuers.  The procurement card industry processes about $200 billion in spend annually and generates net fees (after rebates) of about $2 billion, so it is small relative to credit cards, but nothing to sneeze at.

The p-card industry perfected the art of subsidizing the buyer by providing corporations with rebates in return for spend.  The industry has struggled to make supplier and transaction enablement as easy as in the consumer world (partly due to the expensive fee structure–2%+ 45 days early payment), but recently the industry has tried ways to gain share in larger dollar size transactions, making p-cards even more a part of the supply chain finance game.  In fact, one way to view the current trend in the supply chain finance market is as an attempt to extend credit to the large, “middle class” of transactions and vendors.

Banks have traditionally focused their programs on the gigantic buyers and suppliers, while P-cards mop up the smaller transactions for these same credit-worthy buyers. Figuring out the right legal structure, rules, rails, and funding sources for the vast middle of the supplier market and higher credit risk buyers will take some thinking.   Much of that thinking amounts to adjusting the approach successfully modeled by the credit card industry!

Combine:

• big data,
• a great transactional platform,
• a legal structure that allows “click-through” participation
• a smooth supplier enablement program and
• access to competitive, elastic financing

and someone will create a giant business.  So far there are some contenders, but no one who has solved all of the pieces of the puzzle.

Fannie Mae. Visa. MasterCard. Premier?

Everyone once in a while, the average investor gets the chance to invest in a company that has a special relationship with the government, a unique business structure, or a special antitrust exemption.  Fannie Mae was one.  Visa and Mastercard were cooperatives owned by member banks and until recently seemed immune from antitrust issues.  Neustar is another.  (Major League Baseball and NFL franchises are examples for wealthy investors.)

My limited experience is that In most cases, these investments seem to work out just swell–unless and until–the regulatory environment changes.

Investors now have another chance to invest in one of these unique entities, this time with a B2B supply chain twist, in the form of Premier (PINC), which went public yesterday.

When I first heard that Premier was going public, I went to their website.  It took quite some time to assure myself that it was the same Premier I had known five years earlier. You see, Premier derives about 76% of its revenue from its role as a Group Purchasing Organization or “GPO”, but this is now called “Supply Chain Services”. (A GPO is a group of like-minded organizations, in this case hospitals, that band together to pool their purchasing power and negotiate contracts with their suppliers of all sorts items ranging from band-aids to hip replacements.)  In this case the GPO is owned by 181 hospitals (57% of US hospitals participate in their programs), health systems, and other healthcare organizations.

A GPO makes money by charging the suppliers it contracts with a small “contract administrative” fee.  Think of it like a slotting, marketing, or administrative fee for having access to the huge client base represented by the owners of the GPO.  The owners of the GPO use this money to run the GPO and in some cases also receive back a portion of these fees (“cash sharebacks” or “revenue share”) for each dollar they spend on the contracts.

As the GAO says:

“These fees are GPOs’ main source of operating revenue, which they are allowed to collect if they meet the requirements of a safe harbor to the “anti-kickback” provision of the Social Security Act—known as the Anti-Kickback statute—which would otherwise prohibit such fees.”  Just Google “GPOs and the GAO” if you want to learn more about this complicated subject.  The bottom line is that GPOs can collect this money if they follow certain regulations, which turn out to be, according to some, rather lightly enforced.

I’m not going to weigh in on the use of the term “kickback”–after all, everyone receives “kickbacks” for using credit cards or “p-cards” whose costs are borne by the merchants. (Where did you think all those airline miles were coming from?)  It’s the nature of pricing in “two-sided” markets.  But here is what I will note:

• 57% of hospitals is a lot of buying power.
• Not many people feel really sorry for the medical device and pharma folks who are paying the fees.
• Premier reported revenues of $869 million for the year ended June 30, 2013 and net income of $375 million.  That is not a typo.
• Net fees charged for the GPO seem like they might be around 1.25% which is not outrageous relative to what a sourcing and procurement organization costs.  (The “safe harbor” provision that the government offers requires fees to be less than 3%.)
• Premier, to its credit, has developed 24% of revenue from its Big Data type businesses.
• Finally, I’m not sure, but I think this will be the only public “pure play” GPO owned by the buyers.  I think MedAssets is not owned by the buyers and Novation is private.

All in all, I like this one–until the Feds come calling!

PS.  I know I was not going to write about the stock market any more, but IPOs are back to the 2007 level and B2B enterprise software is hot, so it is rather unavoidable.  It’s a great time to be a B2B Enterprise software wonk.

The Right Metrics for ICs, including “Gross Yield”

In preparation for the last post on pricing, I was reviewing the annual reports and presentations from a wide variety of Industry in the Cloud (IC) providers.  Doing so reminded me of the importance to ICs of tracking the right metrics and, equally important, ignoring the clutter.

Great ICs, marketplaces, networks, etc. are laser-focused on what drives their profitability and are crystal clear in how they measure and communicate these metrics to employees, investors, and platform participants.  When you evaluate the financials of these great performers–including all of the payment networks (e.g., Amex, MasterCard, Visa), to DealerTrack, to eBay, they transparently report on the operational metrics that drive the financial results.  Often the metrics are a liquidity measure like Gross Merchandise Volume (GMV), sometimes the key metric is payment volume, sometimes it is the number of trading relationships, or volume/transaction per relationship.  For each successful IC there are slightly different metrics, but what stands out is the clarity by which these metrics are communicated.

For example, take a look at the investor presentation for DealerTrack, an IC in auto retailing that I have previously written about.  (In full disclosure, I have since bought the stock.) They lay out every key metric that drives aggregate demand and separate transaction from subscription revenue.  They report every key operational metric over a long period of time, so you can see their progress.

By the same token, I see annual reports and presentations from struggling ventures and very often they either intentionally obfuscate the operational metrics, or seem unable to settle on which metrics are the keys drivers of profitability.  This is, of course, a huge red flag.  In the case of some the very small venture capital deals I see this is entirely understandable. A new venture often has a hypothesis of 2-3 possible ways to extract value from its platform and is not sure which will work until it tests the proposition with customers.  As long as the venture’s management team recognizes that getting this learning is the next step, and treats the next phase of growth as a learning experiment, this issue can be managed.  But for mature platforms, not being able to articulate the core operational metrics that drive the financials and show them over time is unacceptable.  It means management does not know what it is doing, or more likely that they do not like what they see and do not want you to see it.

ICs extract value from their platforms in a variety of ways (including subscriptions, transaction fees, relationship fees, advertising, etc.) and from multiple sides of the platform.  On the surface, this may make ICs hard to compare.   A useful, simple technique for evaluating the health of an IC’s business is simply to add up the IC’s revenues from all sources and divide this the best aggregate measures of the IC’s activity. This aggregate measure could be $$ throughput, documents transacted, or a measure of active relationships.   The resulting measure is basically the IC’s “gross yield” per dollar, per doc, or per relationship, as the case may be.  Understanding where this gross yield has been, or is projected to go, is a great indicator of the IC’s health.  Yield may come from buyers, suppliers, intermediaries, etc., but the total of “take” of the IC is a great bottom line.

It could be argued that many public companies or private ventures do not like to disclose their key operational metrics publicly for fear of over-sharing their secrets to success with competition.  Perhaps the best ICs, networks and platforms are able to disclose these metrics because they have reached a size and strength where they can “afford” to be clear on these metrics–as their positions are now less assailable.  In other words, clear metrics may not be the cause of an IC’s strength–they may be the result!  Perhaps there really is only correlation, but no causation.

This is certainly possible, but my experience has been that it is very difficult to have one set of metrics for investors/the public and a different one internally.  Employees and managers start to read the press clippings, lose focus, and get confused very easily.  Too many metrics, or not enough, spoils the broth.  I can’t prove that having clear operational metrics causes success and not vice versa, but it sure feels that way!