Tuesday, October 11, 2005

"MasterCard Facing Extraordinary Pressure" (Green Sheet)

With increasing concern over cardholder data security, lawsuits filed by merchants over interchange, and competition among card brands, MasterCard Inc. is facing extraordinary pressure as a card Association. At the end of August, MasterCard announced some significant changes for the company that might assuage some of the heat.

MasterCard plans to restructure company ownership through an initial public offering of common stock; it also plans to restructure corporate governance.

The word on the street is that MasterCard hopes the IPO will not only raise capital, but also increase transparency in its operations (thereby buffering itself from public criticism) and help cushion the blow should any of the 20 or so lawsuits pending against it result in financial liabilities.
"We believe that the proposed changes will give us a more stable base on which to implement our customer-focused strategy and bring value to our customers' businesses," MasterCard wrote in an Aug. 31 letter to shareholders.
"The company is building a war chest for investments and expasion," said John Gould, Partner at research firm PrepaidAdvisory LLC. "Their goal is a fast increase in revenue."

In announcing the IPO, MasterCard said it would put a 49% stake in the organization on the block in the form of Class A common stock; these stockholders, combined, will share 83% of shareholder voting rights.

The banks that now make up MasterCard's Board of Directors will retain a 41% share in the new company, represented by nonvoting Class B common stock with unspecified voting privileges. A newly formed charitable foundation will own the remaining 10% of MasterCard. MasterCard said it will use monies from the IPO to purchase a portion of the collective ownership now held by banks. The organization's new governance structure includes eight independent Directors, three bank Directors, a nonvoting Director from the current Board and the Chief Executive Officer.

Transformation in Progress

MasterCard has been a privately held corporation for the last several years; more than 1,400 member banks hold shares of the organization. In its letter to shareholders, MasterCard explained it would "retain $650 million of the IPO proceeds to fund a capital increase."

For the second quarter 2005, MasterCard reported $772 million in revenue, a 19% increase over the same period last year.

Gould said "MasterCard is trying to transform [itself] into a global payments company instead of just a credit card," and that the company is deemphasizing its reliance on credit and debit cards to generate revenues from other elements of the value chain, such as processing services.
"If I were MasterCard, I would become an acquirer," he said.

Litigation Looming

MasterCard's new governance structure and ownership diversity should also lessen the impact of pending litigation. At least 20 different lawsuits against MasterCard (filed by merchants, rival card brands and the like) are now pending; adding Visa and individual member banks brings the tally to more than two dozen cases.

Many of the lawsuits filed by merchants take issue with interchange. In 2003, MasterCard agreed to an out-of-court settlement of a lawsuit brought by a large class of merchants (led by Wal-Mart Stores Inc.) that put it on the hook for a little more than $1 billion in restitution payments to merchants. Many believe that settlement opened the courts to the current pending lawsuits over interchange.

The big gripe merchants have with interchange is that a group of independently operated banks set its price structure, and thus would seem to be tantamount to price fixing and in violation of federal antitrust law. "We believe a majority independent Board, and broader diversity in our share ownership, will address perceived conflicts of interest," MasterCard wrote in its letter to shareholders.

"MasterCard is hoping now to be viewed as not just a consortium of banks fixing prices," said Dan Schatt, a Senior Analyst at banking and securities research firm Celent LLC. Nonbank entities will bring other interests into the decision-making process, he said.

Nonbank public owners conceivably would have the same access to the network as the banks, which could dramatically change the dynamics of competition. "Nonbank entities on the Board could change Association rules pertaining to who is allowed to issue and acquire credit," Schatt said. "Outside institutions not normally thought of as payment providers could now enter this [market]."

In 2002, MasterCard converted from a not-for-profit association to a for-profit, privately held incorporated company with member banks as shareholders.

This designation allowed it the "authority to issue shares of common stock" as a publicly traded company contingent upon approval by the Securities Exchange Commission (SEC) under federal securities law. It also established MasterCard as a pass-through entity, in which all monies over and above operating expenses pass through to the member, or owner, banks.

Discussions about a publicly traded MasterCard have occurred, on and off, for about 10 years.
"Based on [the] actions in 2002, this proposal [for the IPO] is not a surprise," said Attorney Adam Atlas. "MasterCard is responsible to their members for two things. The first is to maintain the network [in which] transactions are processed. The second is to support the brand." The latter includes regulation, marketing and everything in between.

The real industry shake-up would come in the form of the institutional investors. Schatt offered many investor possibilities including Wal-Mart, Google or a major telecom provider such as Cingular Wireless. "The structure will move away from bank-only members," he said. "Other stakeholders will fit the table."

Currently, only financial institutions may own a stake in the card Associations; therefore, they are the only entities allowed to issue bankcards.

However, if Wal-Mart, for example, purchased a substantial share of MasterCard, would Wal-Mart
gain card-issuing privileges?

For ISOs and sales agents wondering how the MasterCard reorganization will affect them, if anything, it might make their lives a little easier, Atlas said. "Not much will change [concerning] the ISO-bank relationship; [however] it may be easier for ISOs to deal with Association rules and possible violations. As a publicly traded company, [MasterCard] will be subject to SEC regulators who have more duty to the public than financial institutions," he said.

While the SEC might not go as far as requiring mandatory disclosure of all Association rules, it "may persuade MasterCard to be fairer in the implementation of the rules," Atlas said.

If MasterCard goes public, will Visa follow? Some say Visa is too big, and with deeper pockets, it simply won't follow MasterCard to the IPO table. Gould doesn't agree. "The pressure will be on Visa to follow suit. [It] will transform itself in the not too distant future," he said.

MasterCard's SEC filings are now being reviewed in Washington. MasterCard expects to complete the entire corporate transformation process by the first quarter 2006. MasterCard is in a quiet period and not able to comment for this story.

(source: Green Sheet)