Wednesday on CNBC, Patriarch Equity CEO Eric Schiffer called Apple (NASDAQ:AAPL) Pay a "disaster" with transaction growth having slowed to an annual rate of just 2%. As many know, Apple Pay was one of the company's biggest bets on services within its hardware/software ecosystem, and according to Schiffer, there is no real convenience or advantage to using Apple Pay over credit cards, and its failures are a big reason for pressure on AAPL stock.
Granted, with Apple receiving just $0.15 for every $100 worth of transactions, Apple Pay was never going to be a significant growth driver for Apple, not with its current business model. But still, the slowed growth and lack of widespread consumer adoption illustrates a failure to innovate at the company. Nevertheless, there is still one way that Apple can take these failures and make them an actual success, a simple move that could create meaningful growth to Apple's bottom line and a real headache to Visa (NYSE:V) and MasterCard (NYSE:MA).
Compete directly against Visa and MA
Anyone who follows Visa, MasterCard or the payment processing industry in general knows that the two companies have built a duopoly in this particular segment of the financial sector. This in turn has given both companies significant pricing power over merchants, where merchants must pay whatever fees that Visa and MasterCard set, which is largely believed to be around 3% of the total transaction.
Furthermore, the payment processing space is one that requires a very large, delicate ecosystem, but once it is established, the maintenance costs are minimum. That's why SG&A costs compared to revenue have consistently fallen over the last six years and why profit margins have risen over the same span.
MA SG&A to Revenue (TTM) data by YCharts
With MA and Visa having an operating margin of 54% and 65%, respectively, the big question is what Apple must do to replicate this business. The answer, surprisingly, is not that much. There are three things needed to compete with MasterCard or Visa in the payment processing arena.
What AAPL needs to succeed
First, the company must have banks that issue its cards. In the U.S. especially, it is almost universal that when your bank issues a card, it is either Visa or MasterCard. This takes care of usage with debit and bank issued credit cards, and then the processor often issues its own credit cards with various rewards attached.
Second, the company must have widespread consumer usage. This is quite easy for Visa and MasterCard when every bank in the U.S. and most around the world are issuing one or the other's card.
Third, the company must have merchant support, places of business that accept the card.
One of these three elements without the other equals failure for a company trying to penetrate this space - it requires all three. For example, a company like Bank of America (NYSE:BAC) could theoretically issue its own cards (No.1).
If for some reason BofA was to pursue the payment processing space it would have no problem with the card issuing part of this equation. In fact, BofA has millions of consumers for usage (No. 2). However, it is just one of many banks, thereby not having enough users to attract the widespread merchant support needed (No. 3) to be successful and ultimately compete against Visa or MasterCard. Thus, if merchants are not accepting BofA's (hypothetical) self-issued card, then consumers won't use it. Consumers will use Visa or MasterCard that are accepted everywhere.
Apple can make it work where very few can
Meanwhile, Apple is one of the very few companies that could make this transition work, almost in a seamless manner. It has an enormous ecosystem, with about 100 million iPhone users in the U.S. alone. While Apple Pay has not been a great success story, it has still gotten many iOS users familiar with making payments with Apple. The big problem is that Apple Pay offers no real advantage over credit cards, as far as convenience, and that's essentially Schiffer's complaint.
Apple Pay also has the support of merchants, and the reason is because of how many consumers use Apple products. Apple Pay is accepted in over two million retail locations. Therefore, with two million retail locations and 100 million U.S. users, banks would have an incentive to issue "Apple credit/debit cards." That incentive is a likelihood of success.
What makes this even more likely is that Apple already has a partnership with just about all major banks in the U.S., thereby establishing that connection if it chooses to make the leap to payment processor. While it is hard to see a large bank like Chase or Wells Fargo (NYSE:WFC) getting rid of Visa/MasterCard plastic in exchange for an Apple service, it is possible that banks would offer their customers an option between Apple or Visa/MasterCard. As it is now, banks choose one or the other, Visa or MasterCard. However, if a third payment processor is added to the mix, it creates an opportunity to give banks and consumers more options, which in the end, benefits everyone.
That said, MasterCard and Visa's partnership with Apple has allowed the company to build this ecosystem of necessary parts to become a legitimate threat. It's quite ironic.
For example, Apple's partnership with these payment processors gave it a front door to the lobby of just about every major U.S. bank that issues Visa or MasterCard. The partnership also opened that door to all the retail locations that accept Visa, MasterCard, or even AmEx. This is what separates Apple from the likes of Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Samsung (OTC:SSNLF) PayPal (NASDAQ:PYPL), or Amazon.com (NASDAQ:AMZN).
Apple's opportunity is unique
With a little time and effort, Alphabet could pursue the same opportunity as Apple in payment processing. However, Alphabet is not quite on the same level right now. It would take a lot of work, and there are no guarantees.
Sure, Android has more total users than iOS worldwide. But, Android Pay, which is Alphabet's equivalent to Apple Pay, is accepted in half as many retail locations, Apple has countless more participating banks, and Google does not have partnerships with Visa or MasterCard, where either processor pays Alphabet a percentage of the total transaction.
Furthermore, Alphabet's potential pursuit of this business could be stopped by the fact that it relies on hardware companies to adopt all of its software and services. Alphabet cannot very well launch a service like Visa or MasterCard exclusively to mobile phones and force all Android supporting hardware to embrace it. For example, Samsung's hardware is all Android. Yet instead of pushing Android Pay on its phones/tablets, Samsung has its own mobile payment service called Samsung Pay. This illustrates one big issue that Alphabet would have to manage before entering the payment processing space, competing with Visa or MasterCard.
Apple does not have this problem. Apple owns all of its software and hardware.
What will Apple do?
While I can't imagine that Apple would want to enter the banking space as a traditional payment processor, issuing credit and debit cards like MasterCard and Visa, I would not rule out Apple's attempt to innovate the space like it did with phones, tablets, iPods, etc.
The big question is can it do so without Steve Jobs, enter a new product category and make it successful? More than likely, Apple would try to make Apple Pay work, no longer being just another way to use your existing credit card, but an entirely new, Apple issued credit/debit card that is more secure and mostly mobile.
Nevertheless, it is all speculative. There is no way to know how AAPL will enter the space and compete with MA or Visa. In fact, there is no certainty that AAPL will pursue this market. It most certainly should, because at the very least AAPL could offer consumers an option between Visa and MasterCard - adding a third service provider could shake the industry a little bit.
While it is also impossible to predict Apple's fee structure or market share if it does go this route, let's just assume it does and reaches $1 trillion in payment volume. Keep in mind that Visa achieved $1.3 trillion in payment volume during its last quarter, so Apple's performance represents far less market share than what MA or Visa own. With this scenario, AAPL would dominate the majority of mobile payments, a market that is expected to surpass $600 billion this year and a slight share of the more traditional payment and credit card market.
If AAPL adopted a similar fee structure as Visa or MA, then it would create an additional $3 billion in annual revenue, where at least half could would be profit. Therefore, AAPL could add another $0.25 to its EPS long-term using this model, and if some way it could disrupt the entire industry and replicate Visa's business, then it could add upwards of $1.20 per share in EPS.
All things considered, AAPL has everything it needs to pursue the payment processing industry. It just has to take the right steps.
With AAPL stock down 22% over the last year, investors are desperately seeking the next big thing from Apple. Investors want to see innovation, something new, and they really want to see a major product in the software and services side of Apple's business. In retrospect, that's why this market is so attractive for AAPL - a big market where it could create real profits.
Therefore, it makes no sense for AAPL not to pursue this market near term, not only for the sake of shareholder sentiment but also to help drive its EPS higher. Historically, AAPL has been very opportunistic, realizing such opportunities when presented. The big question now is whether or not it will realize this opportunity, one that is there for the taking, a market where it could be actual competitor, if not leader. For the sake of AAPL stock price, I sure hope so.
Disclosure: I am/we are long AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.