By RJ Towner
The Federal Reserve recently said it will appeal US District Court Judge Richard Leon's ruling that the current cap on debit card transactions of $0.21 was inconsistent with the intent of the Durbin Amendment. Between now and the appeal, it seems likely that debit card caps will remain at $0.21 per transaction.
Bad Idea from the Start?
Because Visa (V) and rival MasterCard (MA) have often been the target of regulatory scrutiny, it seems unlikely that any government-affiliated organization would show support. However, we think the Fed is well-aware of the unintended consequences of the debit card transaction fee cap.
For one, consumers lost free checking-a staple of banking throughout the growth of debit payments. Although many banks offer a number of ways to acquire free checking (minimum balances, direct deposit, etc.), there are undoubtedly consumers that have been forced out of traditional banking into different means like pre-paid cards from places ranging from payday loan shops to Wal-Mart (WMT).
The other consequence is what did not occur - lower prices. Part of Senator Dick Durbin's rationale behind capping transaction fees centered on the argument that "mom & pop" retailers would be relieved of the cost and that large retailers would generously lower prices. Yet, Durbin did not account for sticky prices, or for the likely scenario that retailers would simply keep prices flat (or even raise prices) to boost operating margins.
What Could Happen?
As is often the case with legal issues, there are several scenarios that could occur.
In our view, the most probable outcome is that the cap will stay at $0.21 per transaction (prior to the Fed's setting of debt-transaction fees, issuers were charging merchants more than double that level). Visa and MasterCard would obviously prefer a higher cap, but the $0.21 amount is certainly high enough for the firms to earn sufficient returns. Banks also would prefer a higher cap, but the likes of JPMorgan (JPM) and Bank of America (BAC) have already worked to incentivize 'uncapped' credit card spending, and we wouldn't expect them to start de-incentivizing spending as a result of any change. Retailers may not love the cap, especially considering the National Retail Federation sued over the $0.21 cap, but debit card fees are about half of what they averaged prior to the ruling, so all other things constant, retailers are making more money now.
Another scenario that makes sense involves keeping a cap but lowering take-rates on very small transactions. Given the growth of card transactions, many consumers prefer not to pay in cash, or might not even carry cash, with some paying exclusively with cards. Much of the gross margin on an item that costs just a few dollars can be eaten up by fees, so this would solve the issue for retailers. This scenario could be hard to sell to the payment companies, and we are not sure if it would even satisfy retailers.
The last scenario that we think could play out would be a new cap-either higher or lower. In our view, the odds of a higher cap are quite low. Frankly, we doubt the Fed has much sympathy for companies that have operating margins in the 50%-65% range like the credit card network providers. If this were to happen, the National Retail Federation would likely intensify legal efforts and the future of fees would remain uncertain.
In the event that the Fed goes back to the drawing table and decides on a lower fee, Visa and MasterCard are the obvious losers. However, we doubt the Fed would assign a lower cap that cripples profitability, and Visa has shown an ability to maintain tremendous operating margins in a reduced debit-card fee environment.
The beneficiaries from a lower cap (Judge Leon suggested $0.12) are also obvious: all of retail. Retailers ranging from Ross Stores (ROST) to Wal-Mart to Safeway (SWY) would be more profitable with lower debit-card expenses. However, we question just how much more profitable.
Since the Durbin Amendment was enacted, card issuers have done everything in their power to make paying with a credit card more attractive relative to a debit card. Considering the strength in credit card volumes from Visa and MasterCard, we think it is safe to assume that some spending formerly on debit cards has shifted to credit cards. Therefore, the marginal increase in profitability at the retailers that could surface from a lower cap would likely be immaterial to the intrinsic value of participants over the long haul.
Ultimately, an appeals process can take a considerable amount of time, and there isn't a guarantee that the debate will end there. The evidence underlying the argument that posits consumers benefit from lower debit card fees simply isn't there, but that did not prevent Congress from enacting the legislation in the first place. Thus, we would not be surprised if an illogical outcome does take hold.
Nevertheless, even an unfavorable ruling (which we view as unlikely) doesn't do much harm to our long-term thesis on Visa, and we are content to hold shares in the portfolio of our Best Ideas Newsletter at this time.
Additional disclosure: RJ Towner is Director of Research Development at Valuentum. V is included in our Best Ideas portfolio.