Article

Acquisitions feeding ISO growth

Perhaps the hottest job title in the ISO world is vice president of acquisitions. With organic growth on the decline, more ISOs are employing a person whose full-time responsibilities consist of ferreting out profitable ATM portfolios and negotiating deals to purchase them.

August 25, 2003

Perhaps the hottest job title in the ISO world is vice president of acquisitions (or something to that effect.)

With organic growth on the decline, more ISOs -- particularly those who manage 1,000 or more machines -- are employing a person whose full-time responsibilities consist of ferreting out profitable ATM portfolios and negotiating deals to purchase them.

According to an annual survey of ISOs conducted by ATM&Debit News in June, the country's top 10 ISOs -- identified by the trade publication as eFunds, E*Trade, Cardtronics, American Express, Innovus, FTI, First Bankcard, International Merchant Services, Money Marketing Inc. and Nationwide Money Services -- now operate some 68,400 ATMs, a 15 percent increase from 59,500 ATMs in 2002.

Several of those on the list -- most notably eFunds, Cardtronics, E*Trade and Innovus -- have grown their networks through acquisitions in recent years.

Most industry watchers agree that the rapidly maturing retail ATM business is in the midst of a strong consolidation phase.

At a crossroads

Many ISOs "have come to a crossroads over the last two years," said Sam M. Ditzion, president and chief executive of Tremont Capital Group, a firm that specializes in advising ISOs on mergers and acquisitions. Ditzion recently helped broker a deal between Access to Money and Automatic Bankcard Services.

"ISOs constantly struggle with the question of whether to continue growing their businesses -- either organically on their own or through acquisition -- or whether it may be the right time to consider selling their portfolio of ATMs," Ditzion said.

Ditzion believes that some companies, especially those with roots in the payphone or vending businesses, may have entered the ATM industry with the intent of building up portfolios and selling them. Concerned by the upgrade costs that may be required to comply with Triple DES and other impending regulatory mandates, he said, they see now as a logical time to cash out.

"In its infancy, I think this looked like an easy entry business," said J. Michael Brown, chief executive of Innovus, which earlier this year purchased Momentum Cash Systems. "Some folks are starting to realize that this business is more capital intensive than they thought it was, and that it will continue to be more so going forward."

While the past few years have seen an uptick in acquisitions, such activity has long been a fixture of the ISO world, said Rick Holt, president of Aptus Financial. Holt and several other Aptus executives formerly headed Card Capture Services (CCS), a Portland, Ore. ISO that triggered a flurry of buying and selling with its 2000 sale to E*Trade Financial.

"Acquisitions are not new for us or for the industry," said Holt, who noted that CCS acquired a number of ATM portfolios before its own sale.

Doug Deitel, executive vice president of corporate services for Cardtronics, one of the industry's most active consolidators over the past two years, believes acquisition activity has intensified due to a number of factors, including a dwindling number of good new ATM locations, shrinking margins and small players' difficulty in competing for large retail contracts.

The economies of scale achieved by larger ISOs -- whether through acquisitions or organic growth -- make it tough for smaller companies to compete against them, Deitel said. "The bigger players drive their expenses down through scale, and then they can pass that along to the customer."

Whose market is it, anyway?

So is it a buyers' or a sellers' market?

"I think it's an even-steven market right now," opined Brown. "I don't think there are any real steals out there, but there are some real opportunities out there."

"While price expectations must be realistic, the M&A market for ATM portfolios has been, and will remain, a sellers' market for the strongest portfolios whose owners are smart about the way they approach the sale," Ditzion said.

Market expectations have been "unrealistic" when it comes to valuing ATM portfolios, said Neil Randel, chief executive of First American Payment Systems. "I think people have way overpaid."

Randel, whose company purchased two portfolios from American Express in 2000 and the ATM business of FirstCard Financial last October, believes that buyers often overlook key details when evaluating portfolios.

"They're assuming that all of those contracts are going to be there five or 10 years from now. They're not applying proper attrition rates," he said.

Another common mistake is not allowing for drops in transaction volumes, Randel believes.

"Debit is cutting into the market, and you're seeing fewer and fewer cash withdrawal transactions at the ATM," he said. "People are paying multiples based on a certain number of transactions, and some of those transactions are going to go away."

Ditzion said that many buyers now assign each individual location a specific value -- rather than assigning a multiple to a metric such as monthly profitability or the number of terminals, as has been done in the past.

"Accurate valuations are dependent on a multitude of factors, which include historical profitability, risk-adjusted projected profitability, contract length, contract quality, expected attrition rates, vendor agreement flexibility and literally dozens of other factors," he said.

Economies of scale notwithstanding, Cardtronics is looking for "quality versus quantity," Deitel said. "We're way past the stage of growth for growth's sake."

Deitel said that Cardtronics' acquisition strategies include expanding its presence in specific geographic areas, adding new types of locations to its network (the 22 shopping mall sites purchased from CenterCourt Cash in February, for example) and gaining more relationships with "brand names" like Rite Aid, Winn-Dixie and Barnes and Noble.

"We're not a household name, but because we serve household names, we gain credibility with possible future customers," he said.

Sellers are seeing "dampened enthusiasm" when it comes to prices buyers are willing to pay for portfolios, Brown said. Several well-publicized deals created an overheated market, but it chilled rapidly when some of those buyers seemingly struggled to realize gains.

Those missteps made potential buyers "more careful and sophisticated," Brown said. "People have realized they are going to be sorry if they overpay." Holt said that Aptus looks at four major criteria during its due diligence process: residual growth margins, contract length, contract strength and possibility of future partnerships.

Buyers often overlook the partnership factor, he said, noting that some sellers will accept less in up-front revenue for an opportunity to play a future role in the business. "A lot of folks aren't necessarily interested in taking their check, going to the beach and being done with ATMs."

It's the contracts, stupid

First American Payment's Randel said that his company tries to determine the quality of the sale by poring over contracts and, in some cases, interviewing merchants. One red flag is merchants who have been promised items that "just don't make economic sense" and may not appear in written contracts, such as free service or supplies. Those merchants will be more difficult to retain, he said.

The single most important thing is to "make absolutely sure of what you're getting," Deitel agreed, through transaction processing reports and other means. In some cases, he said, sellers have come to the table with contracts that have expired and allegedly been renewed via a handshake. "How can you buy a contract that doesn't really exist?" he said.

Such tenuous deals are not uncommon in the ISO world due to lax organization and record keeping at many smaller companies, said Brown of Innovus. He estimated that 10 percent to 15 percent of contracts in most portfolios have expired and not yet been officially renewed. While not an automatic deal breaker, those locations will obviously not command as high a price as ones with more solid agreements in place, Brown said.

Ditzion believes that most sellers benefit from consultations with companies like his, which can help them identify and resolve such weak spots before negotiations begin. He likened it to hiring a lawyer rather than opting to defend oneself in a legal dispute.

"There's a natural tendency for an entrepreneur to want to sell a business on his own, but selling a business calls on a very different set of skills than building a business," Ditzion said.

In addition, he said, a consultation with an outside company often demonstrates to buyers that a seller is serious rather than just shopping a portfolio out of curiosity.

Deitel agreed that outside counsel can help a seller get a fair price for a portfolio. It's important that both sides benefit from a deal, he noted. In some cases, a seller agrees to provide customer support or other services during a transition period. However, he rarely puts much effort into it if he is unhappy with the deal, Deitel said.

Holt, of Aptus, said that due diligence is perhaps even more important for sellers, who need to ensure that buyers can come up with the capital they promise. They should beware of "the guy who shows up in a fancy suit and a rented Jaguar" for negotiations. "When he finally opens his briefcase, there's no money in it," he said.

"What seems like the highest bid may actually end up being one of the worst deals for the seller and/or its merchant customers," Ditzion said. "Deal structure, tax implications, legal intricacies and a buyer's ability to properly integrate the portfolio while keeping merchants happy are just a few of the literally hundreds of other items that must be thoroughly evaluated before moving forward with a deal."

Not a panacea

Some in the industry, including Tom Mortimer, vice president of marketing for Kahuna Business Group, believe that the consolidation trend has helped create some worrisome business practices among ISOs both large and small.

"Some people are in love with the sheer volume. They're giving away all of their profits just so they can build a big book of business to sell," Mortimer said. "It scares me when some big companies in this industry are creating business models that are not sustainable."

Selling a portfolio is "not the right decision for everybody," Mortimer said. "I don't think that consolidation is going to be the panacea that some people seem to think it will be."

While some companies "sell out for the right reasons," Mortimer believes that "a fear mentality" is becoming pervasive and is leading many smaller ISOs to believe that they have few alternatives to selling their businesses.

Few believe that the small ISO will vanish from the retail ATM landscape, however.

"There will always room for the niche players who can serve the customers in their own communities that are flying below everybody else's radar," Deitel said.

"Just about every time a company is sold, another new little ATM company pops up," Brown said. "I don't think you'll ever see the smaller players go away -- but they will have to become more savvy about complying with regulations."