Visa, MasterCard in Focus After Fed's Debit Card Proposal

A little more than a year ago, card processor Visa (NYSE:V) came out with a survey that ended up comparing its business to a utility. Analysts called it an eyebrow-raising move, considering how tightly regulated electric and gas companies tend to be.

Now, it seems the Federal Reserve might be calling Visa’s, and vicariously its competitor MasterCard’s (NYSE:MA), bluff.

On Thursday, the Fed issued a proposal to cap debit card interchange fees at $0.12 per transaction, a 70% decline from the current cap of $0.44 per transaction. Investors saw it as potential blow to bank's and card processor's revenue. The reaction was swift and vicious.

Visa’s stock plunged 13% Thursday while MasterCard shares dropped 10%. Trading on Friday was considerably quieter, with Visa shares rising 1% and MasterCard falling 0.8%.

Analysts said the proposal raises several questions on how the Fed, which was recently granted more power by the Dodd-Frank Act, views the multi-billion dollar card payment industry. Instead of seeing it as a value-added service as Visa and MasterCard market themselves, it now appears that Fed officials are starting to raise questions on whether the debit card industry is simply another type of utility company and should be regulated as such.

“This announcement was much more negative than we were expecting,” said Chris Brendler, an analyst with Stifel Nicolaus, who covers the industry. “It’s clear that the Fed is taking the merchant’s side in this issue, and I’m worried about the ramifications.”

Visa and MasterCard are primarily payment processing networks that collect a small fee every time a consumer swipes with his or her card. The fees range in price and percentage, and vary depending on whether a consumer uses a credit card, a debit card using a PIN or a debit card using a signature.

Merchants have long complained about interchange and card processing fees, saying they cut into profitability and make prices generally higher for consumers. Meanwhile the card networks have said that they provide a value-added service to merchants, and should be compensated as such.

Visa and MasterCard don’t collect the interchange fees at the center of the Fed’s proposal – the banks who issue the cards do. However, the proposal certainly sets the tone of how the Fed feels about transaction fees, analysts said.

“In trying to maximize returns for their customers and themselves, we think the networks may have lost sight of the need to balance the interests of merchants,” analysts at Bank of America Merrill Lynch said in a note to investors.

Facing this proposal, the banks could in turn put pressure on the card-payment networks. Because the interchange fees were collected by the banks, the 70% drop in revenue to force the big card issuers Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC) will have to seek financial concessions from Visa and MasterCard to make up for lost revenue, analysts said.

“We don't see how banks will incur upwards of a 75% reduction in their debit interchange revenue and not look for concessions from the networks,” Merrill Lynch said.

One troubling Fed proposal for the industry is the requirement that all debit cards carry at least two alternative signature payment networks and at least two PIN-based networks.

If imposed, each debit card would have multiple payment networks attached to it, making the well-known Visa's marketing claim,  "It’s everywhere you want to be” and MasterCard's “For everything else, there’s MasterCard” null and void.

“We would expect pure unbridled competition [in merchant fees and payment network],” Merrill Lynch analysts said in a note, most likely cutting into the 55% profit margin and 51% profit margin of Visa and MasterCard respectively.

Goldman Sachs analysts said that the fate of the two companies is “uncertain” but kept a "buy" rating on both. The investment bank cited that Visa and MasterCard only earn a relatively-small portion of their revenue from debit cards--16% to 20% respectively--compared to the more lucrative credit card market.

“Although the headlines on the proposed interchange reduction appear ominous, we continue to emphasize that interchange is not a source of revenue for MA and V and are not making any changes to our estimates as a result,” Goldman wrote.

Credit card transaction costs have not been addressed by the Fed, but are likely to be addressed after the central bank finishes its work on debit cards.