Apple Pay: Friend (and Potential Foe) to the Payments Industry Status Quo

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SEE LAST PAGE OF THIS REPORT Paul Sagawa /Artur Pylak

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September 15, 2014

Apple Pay: Friend (and Potential Foe) to the Payments Industry Status Quo

Apple Pay combines NFC, TouchID, and hardware secured “tokens” on its iPhone 6 to execute transactions at retail POS terminals, satisfying the security requirements of the major card nets (V, MC, AMEX) and issuing banks (JPM, COF, BAC, WFC, C) who will support it. AAPL gains rate parity with “card present” transactions, and a ~15bp fee for providing ID&V assurance and assuming some fraud risk. Alternative integrated mobile payment options will NOT be allowed on iOS and Apple Pay will obscure the branding by both card nets and banks, factors that loom as threats to the ambitions of many retailers, card nets and issuers. Adoption will be slow – an iPhone6/Watch is required, just 17% of US stores support it, and the use case is NOT yet compelling. Competitive alternatives will strengthen – the MCX consortium will fight Apple Pay, investment will narrow AAPL’s technical advantage, and open Android provides far more brand flexibility to banks, card nets and merchants, whose agreements with AAPL are not exclusive. The initial benefit to AAPL will be small –a 15bp fee would bring less than $300M in new revenue. The real benefit to AAPL is in strengthening its proprietary device-centered architecture against hardware commoditization and future cloud-based threats. For now, AAPL is content to leave interchange and network fees in place, preserving the status quo for incumbents, and deny interest in transaction data, assuaging merchants. However, with critical mass, AAPL could choose to monetize Pay more aggressively.

  • Apple Pay supports the status quo at POS. Apple Pay uses a fingerprint reader and card network issued “tokens” stored in a secure chip on an iPhone 6 to authenticate identity and specify a funding account, linking with secure POS terminals via NFC to execute transactions. This satisfies both the card networks and banks, relieving issuers of a bit of fraud risk and lowering AAPL’s mobile transaction fees to parity with chip-enabled cards. By abdicating financial disintermediation, AAPL gained the support of the major card nets and issuing banks, and by passing the fee savings to merchants and denying interest in consumer data, it hopes to build a critical mass of retail partners.
  • Adoption faces significant obstacles. Apple Pay will require an iPhone 6/6+ or an Apple Watch, excluding the current installed base of iOS devices and limiting it to an estimated ~40M US buyers over the next 12 months. It will be available at 222K stores that support NFC payments, including many big name chains, but more than 80% of US retail locations cannot yet support it, and the 70+ merchants of the MCX consortium are pledged to oppose it. Moreover, merchants have little incentive to push Apple Pay – AAPL has no path to lower credit card fees nor does it offer help in developing loyalty programs. Given that swiping a phone is not really easier than swiping a card and there is no $ incentive, it may be hard to convince consumers to change behavior – note that only 7% of iOS7 users use the SIRI app.
  • Merchants will need customer access. As Apple Pay offers no relief from 2-3% card fees, the primary benefit to merchants is access to the well heeled AAPL customer base. Retailers are not now able to push messages through Apple Pay, but such a channel would be intriguing IF a sufficient percentage of users opted in. AAPL has disavowed interest in transaction data, a plus for many merchants who see it as proprietary info, but does not provide any help to retailers looking to exploit that data for their own use. Merchants will be able to easily add Apple Pay to their apps to conveniently complete sales, albeit without available alternatives. The MCX retailers, with >$1T in combined annual purchase volume, are notably opposed to AAPL’s approach, which perpetuates fees.
  • Near-term benefit to AAPL is likely minor. The potential annual revenues from ~15bp credit scoring fees are tiny by AAPL standards, and are likely only a temporary advantage. Apple Pay may spur a few more iPhone 6 or Apple Watch sales, but the consumer benefits seem too ill defined to have much impact in the next year or two. The biggest immediate benefits to AAPL appear to be in a revamp of its retail operations, where mobile payments and iBeacon can be integrated with the on-line iTunes to offer an even more delightful customer experience that bridges online and in-store shopping. This could also serve as a model to draw in further merchant support.
  • Pay perpetuates the existing fee model but obscures card branding. Apple Pay emulates a card as an app, keeping issuing banks and card nets in place and supporting their fee structures. It reinforces a shift toward higher fee credit cards, benefitting banks and hurting merchants. However, it also buries the card net and bank brands, and blocks alternative wireless payments apps from iOS devices, dashing ambitions for using mobile to strengthen those brands and to offer innovative payments solutions of their own. Longer term, gaining a critical mass of transactions could give AAPL leverage to bypass credit cards, but we see this as unlikely, given the company’s strategic focus on devices and its institutional skill set. Instead, as it has with carrier subsidies, media purchases and app advertising, we expect AAPL to leverage higher fees from banks and merchants for access to iOS, happy to collect a toll rather than to disintermediate.
  • Pay supports Apple’s proprietary device driven strategy. AAPL has isolated the secure elements of its solution on the device itself. Even online transactions are authenticated with credentials stored in the phone, not in the cloud. Because Apple tightly controls both hardware and software on the iPhone, this yields much greater identity security than is currently possible from the cloud or from traditional cards. However, we do not believe that this edge is permanent, and, longer term, see considerable benefit from a more flexible cloud-based authentication solution that includes biometrics but is not inextricably tied to a specific device. AAPL hopes that it can establish its device managed approach as the de facto standard for payments and secure documents, forcing smartphone platform rivals, which do not control hardware and are years behind in biometric authentication, to play serious catch up.
  • Too soon and too proprietary to dominate. Apple Pay is the most complete mobile payments solution to date, offering superior fraud security and wide industry support. Still, only new iPhone 6 and Apple Watch buyers can use it, merchant support will be slow to build and consumer fears, confusion and inertia will make it difficult to drive more than modest usage over the next few years, giving time for alternative solutions to gain ground. Most consumers do not see credit cards as a “problem” to be solved, and ultimately, we believe mobile payments will gain real success only as a part of broader initiatives to modernize the retail experience. The existing stake holders appreciate AAPL’s “hands off” approach to fees and data, but they also recognize the dangers in granting AAPL unchecked dominance. In the long run, we expect Apple Pay will be but one of several mobile payment alternatives to survive.

Apple Pay – A Solution Looking For a Problem

The development of mobile payments has been stymied by the competing interests of the industries that are converging on this opportunity. Card issuing banks want to preserve interchange fees and to better capture and capitalize on user transaction data. Credit card networks want to keep control over merchant acceptance and thwart new consumer credit brands. Merchants want to reduce the 2-3% fees that they pay for credit transactions and to hold proprietary any data about their customers for use in digital marketing and customer loyalty programs. Tech companies want to use mobile payments as a core service of their competing operating platforms, building customer lock in and, perhaps, disintermediating the financial players and capturing more user data for their own purposes. The conflicting interests of all of these stake holders have blocked progress in mobile payments and the swirl of half-baked solutions has confused consumers, who don’t see that there is any problem with credit cards that mobile needs to solve.

Apple Pay looks to break the log jam. AAPL has signed on the 5 biggest card issuers, expressing no interest in lowering interchange fees and agreeing to the NFC communications standard preferred by the banks. V, MC and AMEX are on board, with an approach that lets them issue the digital token installed onto the iPhone to approve transactions and thus, maintain the control over merchant acceptance that protects their fees. A number of retailers are on board, because they don’t have to invest to support it on their existing NFC POS gear and because AAPL has disavowed any interest in customer data. Still, other merchants, many affiliated with the MCX payments consortium, will be hold outs, aiming to be aggressive in combating transaction fees, protecting their user data and controlling their own customer relationships.

With this ecosystem and with its famously loyal user base Apple Pay has a real chance to succeed where others have failed, but there are big challenges. The solution requires biometric authentication, a “Secure Element” chip, and NFC communications, limiting it to buyers of an iPhone 6/6+ or an Apple Watch. Even with the expected very strong demand for those models, that is likely to be less than 40M users a year from now. It is also likely that many of those buyers will not adopt Apple Pay – only 7% of iOS 7 users use SIRI. At launch, fewer than 20% of US retail stores will support NFC – users will have to carry their wallets anyway. Even though Apple Pay is a significant improvement in security, the service will battle negative perceptions that have been influenced by the recent iCloud hacking scandal. There is no real incentive for merchants to push Apple Pay, so AAPL will be on its own in convincing its users that waving the phone and registering a fingerprint is more convenient than swiping a card and entering a PIN.

In any case, Apple Pay is unlikely to be a money maker for AAPL. An estimated 15bp fee for fingerprint credit scoring and accepting a piece of risk is de minimus for the company given likely transaction volumes and future competitive response. By obscuring card net and bank brands underneath Apple Pay, AAPL could eventually squeeze its financial partners, using its own clout to drive acceptance and pushing for lower cost funding instruments. However, AAPL’s history suggests that it will be cautious in its approach to taking on an unfamiliar business. We are skeptical that payments is a sufficient use case to drive incremental Apple Watch sales. iPhone 6 will sell very well, but Apple Pay will have little to do with it. Apple Pay is a technical breakthrough and a real head start against rival solutions. However, the finish line is still far enough away for others to catch up and the rest of the industry ecosystem will work to assure that multiple solutions survive. By then, secure mobile payments will be a necessity but not a differentiator for devices.

How it Works

From the start, card issuing banks, responsible for fraud, have been hesitant to support mobile payments on their cards, demanding that credit and debit card numbers be kept on a “secure element” separate from the mobile device’s general file system and that the transactions be communicated directly with point of sale (POS) terminals at checkout, using the near field communications (NFC) wireless standard which limits connections to less than 12 inches. If solutions did not comply with these requirements, mobile transactions would be completed at fees that were higher than traditional card transactions and merchants would be responsible for fraudulent transactions (Exhibit 1).

Exh 1: Key Upcoming Dates for Merchant Adoption of EMV Compliant Terminals

These requirements left little room for differentiation and little room to give either users or merchants incentive to support mobile payments. For most mobile devices, the option for a secure element was the SIM card, which gave the wireless carrier that provided it enormous leverage to demand transaction fees for itself. The NFC standard required participating merchants to invest in new POS terminals, largely a non-starter until Visa announced that it would require all retailers accepting its cards to upgrade to new technology for PIN entry at POS or accept fraud risk for themselves. Since the incremental further investment for NFC is minor, this policy has accelerated investment in NFC-enabled POS, but the total penetration of the technology remains below 20% of total US retail locations. Moreover, the extremely short range of NFC requires that the user to bring the mobile device with a foot of the receiver, tethering the transaction to the POS terminal and keeping the user convenience of mobile payments no better than on par with that of a traditional card swipe. Thus, mobile payments featured higher transaction fees, were supported at a small minority of American stores and offered no improvement to the consumer experience. Little wonder the technology has been unsuccessful thus far.

Apple Pay offers an improvement. The iPhone 6, iPhone 6 Plus, and Apple Watch all contain a separate chip that has operates as a “secure element” holding authentication credentials behind very strong cryptographic security. This takes the wireless carrier out of the equation. These credentials are tied to biometric sensors – the TouchID fingerprint sensor on the iPhone or the heartbeat monitor on the Apple Watch – which match to the secure credentials stored in the secure element to authenticate identity (Exhibit 2). This match then enables the transaction, which is completed not with a credit card number, but with a device-specific number, called a token, loaded into the secure element by the credit card network. This number is useful ONLY in conjunction with the device and the biometric authentication. The device communicates the token to the POS terminal via NFC and the charge is authorized. Not only is this more secure than previous mobile payments solutions, it is also more secure than current credit card swipes, where user account numbers are shared in an open environment and stored by merchants. If a hacker were try to break into a retailer’s system to steal credit card information, the Apple Pay transactions would be represented by those tokens, unusable by the hacker without both the phone and the biometric authentication.

Exh 2: Apple Pay Payment Flow

Apple is able to implement this highly secure solution because it controls both the hardware and the software within its mobile device platforms. For Android to offer a similar payment product, Google would have to coordinate its OS development with its OEM partners, ensuring that the manufacturers had employed approved “secure element” chips and biometric sensors to support authentication and secure token management. It would also have to assure that the OEMs were not altering the security features of the OS for their own purposes, no guarantee in the Android ecosystem. Because Apple is early to market, and because its archrival must work with a range of partners to catch up, the Apple Pay functionality likely has a 2-3 year lead in the market to exploit.

Exh 4: Quarterly iPhone Sales, Launch to June 2014

The Apple User Base

Apple’s tight control of its ecosystem also plays to its advantage in implementation. There are 69+ million iPhone users in the US, and a further 150+ million outside the country (Exhibit 3). Apple approves every bit of software that makes it onto those devices, either integrated into its iOS upgrades or downloaded through the rigidly managed App Store. In this case, Apple Pay is integrated into iOS 8, and every iPhone user that installs the upgrade will get it, although only an iPhone 6, iPhone 6 Plus, or an iPhone 5 or later in combination with an Apple Watch will be able to use it for mobile payments because of the need for biometric authentication and NFC communications. Given previous patterns of iPhone upgrades, and allowing for the euphoria of the first modern sized smartphone displays, we expect as many as 40M iPhone 6 and iPhone 6 Plus units to be sold in the US during the first year of availability, with considerably less robust penetration in the rest of the world (Exhibit 4). We believe that the Apple Watch, which will go on sale sometime in 1H15, will be a luxury item and that, at least initially, will find its market with the high-end consumers most likely to be upgrading to the new iPhone models anyway. As such, we don’t see support on the Apple Watch as a meaningful driver of addressable users for Apple Pay.

While Apple cannot make those customers use Apple Pay, it can keep them from using anything else, at least for POS retail. Apple has banned all competing mobile payment solutions that use a wireless radio connection like NFC – the SoftCard solution from VZ/T, Google’s Checkout, Visa’s PayWave, PayPal, Square, etc. are NOT welcome on iOS except as they are willing to process payments through a “Pay with Apple” button in the app, defeating much of the purpose for a mobile payments app. Note that the MCX consortium’s CurrentC mobile wallet generates a QR code image on the phone display to transact payment rather than an NFC connection, and thus far, is exempt from the iPhone ban.

Exh 4: SSR iPhone Sales Forecast (US), 2014-18

Apple is also extending the program to online retail. Merchants can a “Pay with Apple” button to their apps to give users an easy and consistent in-store and online payment methodology. For online purchases, Apple will not demand exclusivity – the market is far too developed for that – but for merchants looking to conduct both online and on premises merchandising through a single app, it is probably the only reasonable default choice.

Exh 5: US Non-cash Payments by Transaction VOLUME, 2003-12

The Apple Pay Ecosystem

Access to Apple’s demographically attractive user base, along with the company’s unique ability to marry hardware and software for an integrated solution, and its leverage to restrict its users’ choices, are a strong argument to the financial players and merchants that currently make up the payments market. The past two decades have seen a massive shift away from cash and check payments at retail, as credit and debit cards have become the primary instruments for consumer purchases (Exhibit 5-6). These transactions, now worth more than $4T annually in the US, are a closely coordinated series of actions by banks and intermediaries that generate fees at nearly every step, that are subtracted from the eventual payment that the merchant receives to its bank account. These fees, which typically total to 2-3% of the purchase price add up to a $50B market for payments (Exhibit 7).

Exh 6: US card payments by aggregate transaction VALUE, 2003-12

Exh 7: Sample U.S. Credit Interchange Fees

Exh 8: Funds flow from Consumer to Merchant across most commonly accepted payment forms

Merchant Acquirers are the banks that represent the retailer’s end of a transaction, requesting payment and receiving funds. Typically, these banks are represented by 3rd party acquirers, which recruit new merchants, help the merchants implement the systems necessary to process payments and maintain the regular relationship with the merchant. Issuing Banks represent the consumer side of the transaction, providing consumers with cards, assuring their credit-worthiness to the merchants, protecting their own customers from fraud, and providing payment to merchant acquirers for their customers’ purchases. Finally, Card Networks (Visa, MasterCard, American Express, and Discover) act as intermediaries between acquirers and issuers, routing requests for payment to issuers and returning payment back to acquirers. The card networks also set the terms for operating within the card brand, establishing the specific fees that each party can take from each transaction. Roughly, a bit more than 76% of credit card fees are taken by issuing banks, just over 6% by the card network, and about 17.5% by the merchant acquirers (Exhibit 8).

Apple has not proposed significant changes to this payment system. It has offered its Apple Pay solution to merchant acquirers to add to the set of payment options on POS terminals equipped with NFC communications. There is little reason for acquirers not to add Apple Pay – the fees are the same and the update to the POS equipment is trivial – it is generally believed that all 222,000 stores that currently accept NFC payments will add support for the new service. The card networks will still act as intermediaries – this time administering the secure “token” that represents the card account on the Apple device as well as facilitating the transfer of payments – and will still draw their same fees. The issuing banks have offloaded some of the responsibility for fraud to Apple and its biometric identification solution, and have reportedly agreed to give around 15bp of each transaction, roughly 8.5% of their interchange fee, to Apple, which also agreed to take some of the responsibility for fraud. Given the broad accolades for the security of Apple Pay, this 15bp may be a net benefit to both Apple and the issuing banks.

By keeping the basic payments process intact, without scary pronouncements about driving “usurious” fees down, and without apparent interest in taking more for itself, Apple was able to pull together an impressive coalition around its Apple Pay launch. The top five credit card issuers (JPM, COF, BAC, C, and WFC) are on board, representing more than 85% of US credit cards (Exhibit 9). The top three card networks (V, MC and AMEX) are in, with Discover expected to join shortly (Exhibit 10). A long list of merchants – essentially all of those that already accept NFC payments – are also participating, with some likely to make Apple Pay a visible element of their consumer marketing (Exhibit 11). This is a very good start.

Exh 9: Top 10 US Card Issuers by Volume, 2012

Exh 10: Global Payment Volumes, V/MA/AXP 2011-2013

Exh 11: Apple Pay Partners

What’s in it For Merchants?

Credit card fraud has become big business and a big problem, as evidenced by the recent widely reported security breaches at Target and Home Depot. To combat this, Visa will require all of its US merchants to implement upgraded POS terminals that can read computer chips physically embedded into cards and require the input of a PIN to complete a transaction by year end or face managing the fraud risk on their own. This is a considerable motivating factor, and if a retailer is to upgrade its POS equipment anyway, the further addition of NFC capability is just an additional $40/terminal. Since the incremental cost of supporting NFC, and thus, Apple Pay, is low, many have projected that the acceptance could spread very quickly (Exhibit 12).

Exh 12: Global installed base of NFC enabled POS terminals

Not so fast. For many merchants, and particularly the largest retail chains, the 2-3% fees that they must pay for credit card processing are a serious pain point. Adding to this pain, the mass of more than 500M cards on file that Apple hopes to lever into Pay are believed to skew heavily toward credit rather than debit, which generates significantly lower transaction fees. Many merchants fear, (and many banks hope,) that Apple Pay will be a strong force driving a larger proportion of purchases to those high fee credit cards. A group of more than 70 major retailers, led by WalMart and representing more than $1T in annual purchase volume at more than 110,000 locations, have joined together to form the MCX consortium, dedicated to using its own mobile payments solution to drive those fees down (Exhibit 13). Thus far, the MCX merchants have resisted Apple’s offer, instituting an agreement that none of its members will support alternative mobile payments solutions to the forthcoming MCX CurrentC mobile wallet. Because CurrentC uses QR codes downloaded to the mobile device and optically scanned at POS, rather than communicated by radio waves, it has not been banned from iOS, although Apple’s restriction against competitive payment services is likely to become a serious hurdle in future iterations.

Exh 13: Merchant Customer Exchange Participating Merchants

Beyond squelching payment competition on its iPhones and perpetuating fees, Apple Pay has further downsides for merchants. While there is a provision for private label credit cards and a tool to make them pop to the front of the line when the phone determines that the user is geographically present in the store that issued it, there is a limit of 10 private cards in the wallet and an added step for users to choose it if that tool has not been implemented or it cannot determine location. Furthermore, iPhones represent just 42% of US smartphone users. Merchants will have to have completely different mobile payment solutions for their non-iPhone shoppers, creating confusion and adding development costs.

One way in which Apple Pay could be a boon to retailers hasn’t been implemented. Apple is not allowing merchants a channel back to communicate with their customers through the payment application. Interestingly, even though Apple has introduced the iBeacon architecture for low power Bluetooth (BLE) hubs in public spaces to establish communications directly with iPhones in the vicinity, Apple Pay includes no provisions for using them (Exhibit 14). We can only imagine that this will be added at a later date, but given Apple’s propensity for jealously guarding access to its users, it may not extend this “push notification” type advertising beyond the reach of a store’s iBeacon. While the issuing banks have insisted on the very short range NFC, which tethers transactions to a traditional POS terminal, Apple may eventually enable transactions processed via an iBeacon’s BLE signal, which could enable very different and engaging shopping experiences. This could be a future carrot for merchants.

Exh 14: Wireless Technology Specifications

Finally, as Eddy Cue, Apple Senior Vice President, put it during the introduction of Apple Pay – “Apple doesn’t know what you bought, where you bought it, or how much you paid for it. The transaction is between you, the merchant and your bank.” For a certain subset of merchants, growing paranoid about the use of transaction data to market to consumers, this is an important reassurance. Of course, the Apple Pay API specifies a payment sheet to be passed to Apple in order to process the transaction that includes the name of the buyer and the details of his or her purchase, so the data flow would exist for Apple to begin capturing transaction data at some later date. Furthermore, Apple’s stated disinterest in analyzing this data speaks to a general institutional weakness in the sort of big-data analytics and cloud data processing that is the lingua franca of its biggest rivals. Merchants ought not to expect Apple to be much help at setting up and administering customer loyalty programs or cross-platform digital marketing.

What’s in it For Banks?

The well publicized 15bp fee for identification and verification (ID&V) from the iPhone’s TouchID fingerprint system is likely well worth it for the banks, which bear the costs of card fraud, particularly if Apple has agreed to accept a portion of that risk along with the fee. The banks also get solid support for the current, lucrative fee structure and for promoting the ongoing shift from cash and lower fee debit toward high fee credit transactions (Exhibit 15). Longer term, banks could negotiate with Apple to manage their own card tokens as Apple works directly with Merchant acquirers, cutting out the card networks and their 8% of overall fees out of the equation. These are clear near term positives for bank revenues.

Exh 15: Share of US retail purchases by form of payment, 1999-2017

There are also negatives. First, Apple Pay will bury bank branding on credit cards. Once the card tokens are activated, consumers will see the Apple Pay app, not a credit card app, and a wave of the phone and a fingerprint scan will charge the purchase to the primary card on file. Changing cards from transaction to transaction will require a step or two more for consumers, adding friction for banks looking to pick up volume from customers who often hold multiple cards. It also means that the banks can’t enable mobile payments directly from their own personal banking apps without going through the generalized Apple Pay experience. Some banks were counting on that regular interaction as an opportunity to push customer loyalty messages on behalf of merchant partners – well, not on iPhones.

Second, as Apple gains critical mass and can measure the impact of its security technologies on card fraud, it could press the banks for an ever higher share of interchange fees. Once those iPhone users are hooked on Apple Pay, the company could threaten to drop support for issuing banks that weren’t willing to play ball. Eventually, Apple could even reverse field and push for debit funding or direct ACH withdrawals if it weren’t able to wrest a better stream of fee payments for itself. This would be a departure for Apple, which has profited from its general strategy of siphoning value from incumbent revenue streams. This is Apple’s strategy in media distribution, in carrier subsidies and in apps, where 3rd parties fork over 30% of their revenues for a place in the App Store.

Exh 16: Sample U.S. Card Network Assessment Fees

What’s in it For Card Networks?

Like the banks, the card nets are keeping their fees intact under Apple Pay (Exhibit 16). The fees are made more secure by a new role in administering the tokens stored on the device to represent each credit and debit account. However, also like the banks, the card net brand is subsumed under the generalized Apple Pay brand – you pay at the register with “Apple Pay” not with Visa, MasterCard or American Express. Similarly, any ambitions the card nets may have had to operate their own mobile payments electronic wallet is dashed by the announcement, at least, for Apple devices. Not a lot of reason to maintain the PayWave app on an iPhone, when any payments would be automatically shunted over to Apple Pay anyway. Apple could also turn on the card networks, working with merchant acquirers to apply its own acceptance brand at POS and turning directly to the issuing banks to manage tokens and processing.

What’s in it For Consumers?

The benefits to consumers are subtle. Apple Pay offers superior security relative to traditional credit cards, but this may not be immediately accepted by consumers who have seen the massive breaches of retail payments data at Target and Home Depot, and the hacking of individual iCloud accounts to access troves of private celebrity photographs. It is possible that the greatest benefit of Apple Pay will be perceived, at least initially, as a weakness.

Apple Pay also offers a consistent way to manage both online and in-store purchases through a single platform. Unfortunately, on day one, acceptance will be limited to the about 17% of US retail locations that already accept NFC-based payments from other e-wallet programs. Amongst the more than 80% of American stores that are not supporting it are the 70+ members of the MCX consortium, including stalwarts like WalMart, Target, BestBuy, ExxonMobile, Dunkin Donuts, Lowes, The Gap and CVS. These vendors seem unlikely to come to agreement with Apple quickly, given the looming launch of their own mobile payment initiative CurrentC and their strong focus on driving down transaction fees. Indeed, MCX has supposedly agreed to a moratorium by members on supporting all other mobile payments solutions. So, few consumers will really be empowered to leave their credit cards at home.

As long as you have your cards with you, it is not clear whether or not Apple Pay will really be any more convenient than a simple swipe at the register. By now, most consumers have learned how to quickly access their cards to make a swipe and sign. Pulling out your iPhone, waving it and then confirming with a fingerprint is not materially easier, and fights against a habit that will still be reinforced at more than 80% of the stores that a consumer could visit. Since there are no monetary incentives associated with Apple Pay, there are no merchant reward programs that are specific to it, and the shopping experience remains essentially unchanged, getting adoption, even by rabid Apple fanboys may be harder than it seems. Note that three years after the introduction of the Siri voice command app, and with endless hype around its awesome utility, just 7% of iPhone users with iOS7 actually use it.

Exh 17: SSR iPhone Sales Forecast (US) and Payments Revenue, 2014-18

We believe that about 40 million Americans will buy an iPhone 6, iPhone 6 Plus and/or an Apple Watch in the next year – this is about half of the current Apple installed base (Exhibit 17). Of these 40 million with access to Apple Pay, how many of them will become active users? If the percentage is not high, there is a good chance that momentum will be lost and that the mildly enthusiastic ecosystem of partners will look around for better deals.

What’s in it For Apple?

In the early years, Apple Pay will not move the needle for Apple. Assuming that half of American iPhone 6, iPhone 6+ and Apple Watch buyers go on to be active Apple Pay users, that those users execute 20% of their retail purchases using the solution, and that Apple is taking 15bp on all of those transactions. This adds up to a tidy $80 million revenue stream for Apple. Bulls could argue that these assumptions are overly pessimistic and that the penetration and use ought to grow with time, but the reality is that even an $800 million all profit revenue stream is small potatoes for Apple. Of course, if Apple could maneuver its way into a much bigger share of those fees, it could be more material, but competition and the incumbent payments players will fight it tooth and nail.

We are a bit skeptical that mobile payments, an orphaned application that has yet to find a loving home, could possibly be the driving use case for an upgrade to an iPhone 6 or a purchase of an Apple Watch. It will be the other way around, with the enthusiastic demand for a large screen phablet or the conspicuous consumption of wrist bling driving the possible adoption of Apple Pay. It does add another element of lock in for Apple customers to stay on the Apple platform, but Apple customers are already pretty locked in now, so it’s hard to see this as a primary driver of value for the company. Arguably, Apple Pay will also force the Android ecosystem to counter with integrated hardware/software security solutions of its own, leaving a key point of differentiation for 2-3 years as Google struggles to coordinate its device partners around a standard hardware implementation for biometrics and the secure element.

We do see real value for Apple in integrating Apple Pay into its own retail experience. Expect new Apple Stores head Angela Ahrendt to push a significant revamp of the in store, using mobile payments along with iBeacons to untether transactions from traditional check out, to offer customer service, and to bridge online and in store activity. This could build further sales volume for Apple’s retail channels, yielding profit and acting as a demonstration account to build enthusiasm amongst other merchants.

Ultimately, Apple could lever a successful Apple Pay into something much more – disintermediating credit card funding and going after other consumer finance businesses – but this would require building institutional skills that it currently lacks. Faced with similar opportunities to make incumbent industries obsolete in music publishing, media distribution, carrier phone distribution, and software publishing amongst others, Apple chose to keep the incumbents in place and simply collect a toll for access to its platform and its customers. We don’t expect anything different this time.

What’s in it For Competitors?

Apple Pay is unambiguously bad news for any company that had been looking to make money from payments delivered via iOS apps. 3rd party e-Wallets, like PayPal, Square Wallet, Google Wallet, and others will be bounced off of the platform with the requirement that all payments from their applications be processed with Apple Pay. With Apple controlling a high end skewed 42% of US smartphone users, a number that could rise a bit with the introduction of the larger screen 6 and 6 Plus models, this could eventually cut the consumer market opportunity in half for these players (Exhibit 18). For the time being, the iOS apps will continue to work for older iPhones, but the handwriting is on the wall. On the merchant side, Apple has yet to announce any analogous program to the credit card reading dongle popularized by Square and copied by Amazon, PayPal and others, and the economics may not be attractive enough for it to do so, but that remains a further significant threat.

Exh 18: U.S. Smartphone Market Share Trends – March 2009 – July 2014

For Google, Apple Pay is both a wake-up call and a proof of concept. It can rest assured that Apple Pay will NOT be ported to Android anytime soon, and as it comes up with its own payment concepts it can use the Apple Pay deals as a point of negotiation to get agreements of its own with card nets and issuing banks. Expect Google to be more focused on the integration of online and in store and to look to turn its data collection and analysis expertise into a benefit for merchants wanting to exploit data to develop more sophisticated merchandising strategies. Google may become firmer with its own licensees to drive adoption of a consistent hardware supported security solution in more expensive Android devices, but it will also look to prove in cloud-based authentication techniques that allow it to leverage payments fluidly across many devices. For Amazon, Apple Pay is a bit tangential. Amazon has only started to venture out into brick and mortar retail with a merchant-side payments processing solution – the closed door to the iOS eWallet market is largely unimportant.

Ebay’s PayPal, along with a raft of start-ups like Square, Lemon and Dwolla, is right in Apple’s crosshairs. We continue to see Ebay’s biggest opportunity on the merchant side, as it adds capabilities to upgrade and manage integrated online and in-store marketing, and innovates around the retail shopping experience. The window for making this strategy work is narrower with Apple’s announcement, which will rob PayPal of many loyal consumers (Exhibit 19).

Exh 19: PayPal Mobile Transaction Volume, 2006-2013

Winners and Losers

Apple is a clear winner this week, but not really because of Apple Pay. We believe that the iPhone 6 and 6 Plus will drive early upgrades from within the installed base and will win modest incremental market share, particularly in Asia. As usual, we believe market share gains will subside as the products gain shelf life and new models from Android licensees begin to hit the market in the spring. We are intrigued by Apple Watch as a luxury fashion statement, and despite limited value to the stated use cases, expect that object lust will drive demand, particularly at higher price points. Essentially, we expect total volumes to disappoint relative to most expectations, but for higher tier prices and margins to drive first year upside to revenue expectations. Still, we don’t believe that the market size will be big enough or the propensity to upgrade fast enough to allow Watch to be more than a small addition to the Apple family over time. As for Apple Pay itself, only time will tell if Apple can lever it into a meaningful revenue stream for the company. We suspect not, but see value in the solution as an integral part of the larger iPhone user experience.

Net-net, we see both banks and card networks as short term winners, but longer term losers in their dealings with Apple. In both cases, Apple is protecting their fee structures and helping to support an advantageous shift toward credit from cash and debit. Still, Apple will now wrap their brands on iOS devices, killing any dream of delivering autonomous payments capabilities under their own flags, along with any subsidiary opportunities that could be exploited along side. Moreover, the deals deliver enormous leverage to Apple, who will own the payments relationship with the consumer and could use that leverage to demand a bigger share of transaction fees or even to disintermediate parts of the payments chain entirely. We would expect Apple to stop short of taking on any of the roles themselves, but certainly believe that they will look for a bigger slice of pie.

Merchants, particularly those with hopes of freeing themselves from those 2-3% credit card fees, are losers. Apple is not a sympathetic ear on reducing fees, and has just slammed the iOS door on any alternative payments solutions that expects to use a radio interface to complete a transaction.

The biggest losers are Ebay and the flotilla of smaller payments start-ups that are chasing it. Roughly half of the US consumer market is now closed to them. For Google and Amazon, Apple’s payments play is a minor annoyance with some potential benefits if it is able to really move the needle on mobile payments usage.

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