Apple Pay’s Business Model Blues

There is no shortage of things to say about Apple Pay — which is why we developed an entire Tracker on the subject.

However, for all the focus on the technology powering Apple Pay, the security that keeps its payments credentials airtight, how many consumers use it and how many merchants accept it, the one thing that doesn’t get a lot of airtime is the business model that underpins it.

Of course, the essence of the Apple Pay business model is the money Apple makes on the sale of hardware – the iPhone 6/6 Pluses. Selling hardware is how Apple always makes money, and Cupertino’s hope is that Apple Pay is such a cool mobile payments app that consumers will buy/upgrade/switch their current phone to its newest Apple Pay-enabled model. Apple even made news recently when it launched its trade-in program designed to get consumers to do just that. (And it seems to be working.)

Of course, Apple’s app store is legendary and why consumers and developers both love the Apple platform. But of the $182.8 billion in revenue that Apple booked last year, only $15 billion came via the sale of apps. ($15 billion high margin dollars, mind you, but app store revenue is roughly 8 percent of the total.)

So, the real shocker when Apple Pay launched in October of 2014 was the little toll booth that Apple placed between it and the issuers whose cards are so elegantly provisioned in the Apple Pay “wallet.” That toll booth collects a small toll, 15 basis points (0.15 percent or 15 cents on a $100 transaction), from the issuer each and every time their card is used at a merchant.

And that tool isn’t going to make Apple rich.

Piper Jaffray’s low-end estimate forecasts that this fee will bring in $118 million in revenue in 2015, increasing to $310 million in 2016. On the high end, Nomura’s equity analysts estimated it could account for $1.6 billion in revenue by 2017 – two years from now.

Which in Apple parlance is pretty much bubkus, a mere rounding error at a firm that has $160 billion in the bank and is positioned to be the world’s first trillion dollar market cap company.

Now, Apple Pay’s issuer fee is controversial on a number of fronts.

First, when the carriers proposed something similar with Isis/Softcard back in the day, the issuers and merchants threw up all over it. It was a non-starter. “What,” they said. “Put a barrier between me and my customer and charge me on top of that? You have to be nuts!”

Or five years later, Apple, and all of its allure as a beloved consumer brand.

In the United States, interchange is a well accepted, if not very well liked, reality of the payments ecosystem.

But that’s not the case everywhere else in the world.

Which is controversial point No. 2.

When Apple knocked on the issuers’ doors in the U.S. and asked for a cut of their interchange revenue, there was actual interchange revenue on the table to discuss and to take a cut of.

However, as Apple is trying to expand outside the U.S., not all issuers are as enthusiastic about having that discussion. In most parts of the world, interchange revenue is as thin as a runway model. Pretty soon, as a result of an almost finalized EU regulation, credit cards in the EU will be at 30 basis points, so Apple would be taking half of that. Debit will be at only 20 basis points.

International issuers are less than interested in handing over a section of a small amount of revenue just for the privilege of letting their customers pay the Apple Pay way.

So will global iPhone 6 owners (without U.S. issuer-based cards) be paying with Apple Pay at a merchant near them any time soon?

Well ….

It Plays In Boston (And New York, L.A., San Francisco) …

As all of you inside baseball payments aficionados know well, the interchange fee is what the merchant pays to the issuing bank every time a consumer uses a card. The interchange fee is set by the card networks and represents the largest component (70 percent to 90 percent) of the fees merchants bear for accepting electronic payments transactions. How exactly that rate gets set for individual cards is based on a variety of circumstances including card brand, regions, the type of card (credit/debit), the type and size of the accepting merchant, and whether the card is physically present at a merchant or not.

That very simple explanation unleashes a torrent of surprisingly complex reactions to the concept.

• Merchants – who ultimately pay this (and all other swipe fees) – hate it.

• Issuers and card networks love it.

• Consumers don’t know and don’t care.

As a result of bullet point No. 1, there has been a long and protracted history of merchant ligation over the issue. That litigation has been largely unsuccessful.

It hasn’t stopped merchants, however, from wanting to do something about interchange – and that something isn’t about making those fees higher. For example, a large consortium of them – in the form of MCX – developed a yet-to-be launched mobile payments scheme that would ride alternative rails that would be cheaper for them to process and accept.

Sort of.

“MCX and its members have poured millions of dollars into developing their own payments network; a network that, in theory, would make the cost of accepting a payments product cheaper than it is for them now.” wrote MPD CEO Karen Webster in a commentary late last year. “You have to really be mad at the networks to take such a costly and extreme step.”

Since, of course, operating a payments network isn’t exactly free. And until MCX gets up a head of steam, merchant members would be forced to accept all forms of payment – see bullet point No. 3 above. Consumers don’t know and don’t care about interchange – they just want to use the cards they want to use at their favorite merchants.

Meaning, “This isn’t a battle being fought over security or ease of use,” John Zurawski, an executive at Authentify, told CNN. “It’s a battle being fought over interchange fees that merchants pay.”

Enter Apple.

Apple keeps Apple Pay users on the standard credit and debit rails. When it launched, Apple made a point of saying how much of an advantage it was for them to embrace the payments ecosystem that is known to consumers and merchants and knows how to run a payments network.

So, it wasn’t all that surprising that issuers were willing to give up a cut of their fees in order to enlist Apple as their champion to ignite a nascent mobile payments scheme – one that leveraged the NFC technology that most had left for dead – by leveraging the powerful Apple brand – and the infrastructure that they were already a part of.

Moreover, Apple Pay users seem to favor and use credit more than debit card products. Our own PYMNTS/InfoScout Apple Pay Transaction Tracker released in March 2015 showed that 85 percent of users have at least one card registered to their Apple Pay account, and 63 percent of those cards are credit cards. At stores where consumers might have used debit more – like grocery – with Apple Pay, those transactions now show a more than noticeable tip toward credit card usage.

Which could make some merchants even grumpier as the cost to them to serve that consumer goes up.

But, as we’ve said repeatedly, if Apple Pay can drive more spending by more customers who prefer their store because they accept Apple Pay, merchants will accept Apple Pay because that’s what their consumers want to use – and don’t know and don’t care how much it costs the merchant to do so.

Making merchants just a little nervous – maybe not so much now that Apple Pay volume is low – but potentially a lot nervous if Apple Pay gets a head of steam. More consumer traction and dependence on Apple Pay, merchants have said, could put them behind a pretty big interchange eight ball at some point.

… But It’s Likely To Miss In Berlin

That, situation is very different in Berlin, Paris, London or any other European city.

“In Europe, interchange is next to nothing in several sizeable countries and going to probably be next to nothing if the regulators have their way,” Webster wrote last October. “It’s unlikely that issuers, who will get hardly anything when their cards are used, will be willing to pay Apple anything like the fees it is getting from U.S. issuers. Apple will just have to be happy selling iPhones and making money some other way. It’s hard to see Apple Pay generating the same sort of excitement from European issuers.”

And, in fact, European regulators did get their way and in March voted overwhelmingly to cap interchange fees. By a 621-to-26 vote, the move officially codified a deal that was struck in December between lawmakers and the EU Council to set the caps at 0.2 percent for debit and 0.3 percent for credit transactions. The ruling also set limits on Visa and MasterCard’s “Honor All Cards” rule. For consumer debit cards, the new rules also allow individual EU member states to set lower percentage caps and impose maximum fee amounts.

“This legislation will put a cap on interchange fees, make them more transparent and remove a hurdle to rolling out innovative payment technologies,” said EU Commissioner Margrethe Vestager, who’s in charge of competition policy for the Commission. “It is good for consumers, good for business and good for innovation and growth in Europe.”

And while these caps might be very good for all of those parties as Commissioner Vestager believes they will be – it is certainly not going to be good for Apple’s hopes of getting European issuers to hand over any part of those fees.

All of that uncertainty has certainly slowed the pace of rollout in the U.K. and Europe, despite the rapid clip sales of iPhone 6’s there. It’s hard to make a persuasive case to an issuer who is getting nothing in the way of interchange and who is faced with having to dig into other revenue buckets to write Apple a check.

… And It Leaves Beijing Cool

China’s Central Bank also forced interchange fees down to close to nothing. Not surprisingly, the Chinese banks, all part of the Union Pay system (sort of the Visa of China), aren’t excited about shelling out 15 basis points any more than their European counterparts.

Apple is reportedly having difficulty in its ongoing negotiations with at least eight major Chinese banks that belong to Union Pay. Chalk it up to that other “i” word – interchange. Quite simply, Chinese issuers are balking at a 15 bps cut of the interchange fee – they think that amount is too high. According to an employee of one large bank, they just don’t want to give up such a large percentage to Apple.

Now, this could all be just posturing and good negotiating tactics on the part of issuers all over the world. After all, Apple did persuade many of the nation’s largest banks to not only roll with their mobile wallet, but actually pay them to be part of it. And those issuer partners have even done Apple Pay one better, and created extensive advertising campaigns to highlight how much they support Apple Pay.

But a business model based on interchange that doesn’t exist in any material way outside of the U.S. makes global expansion difficult without some thought about what the right business model for Apple should be.

And that is all a function of how serious they are about payments.

Consumers don’t have enough places to use Apple Pay to make it a driver of their iPhone 6 purchase. But they’ll keep buying them because it has lots of other cool features that they do love. That means that Apple will still ring that HUGE cash register called hardware whether or not Apple Pay is a success.

But ringing the payments revenue register now – or a few years from now – will rest with the decisions they make about how they use incentives to get the right stakeholders on board. Clearly, they have the consumer — getting the banks and the merchants will take more than the other “i” word to pull off.

Of course, it could also be posturing by Apple, which may drop its fee entirely or in part as it realizes the economics don’t work out for the banks either. Remember, again – what Apple really wants is to sell phones.