In E-Commerce, Small is the New Big

By CIOinsight  |  Posted 01-06-2006

In E-Commerce, Small is the New Big

In January 2003, Jim Cantalupo, then the CEO of McDonald's Corp., found himself in unfamiliar territory. For the first time in 47 years, the $19 billion burger company had posted a quarterly loss. Consumers were fed up with the long lines and lousy service, and Cantalupo admitted in his annual letter to shareholders that "McDonald's has lost what it takes to make customers feel special."

As part of a new strategy, dubbed "Plan to Win," Cantalupo quickly outlined the Oak Brook, Ill.-based company's comeback, with technology taking a lead role. Within a year, in addition to introducing new salads and breakfast sandwiches, the company had rolled out a new payment option that allowed consumers to buy everything from Big Macs to French fries with credit and debit cards—even if the purchase was just $1. "It was a natural move for us," says Gina Pfeifer, vice president of business integration for McDonald's USA. And it was a successful one, too: The cashless system shaved an estimated seven seconds off each transaction, speeding up the line, and aiding McDonald's in serving 1.6 million more customers per day in 2004 compared with 2003. Analysts say the company's average sale rose from $5 to $7. In 2004, McDonald's enjoyed its highest sales increase in 17 years, and earned $2.3 billion.

That McDonald's was even able to offer credit-based transactions for such small amounts signals a fundamental shift in the evolution of microcommerce, a loosely defined term that generally refers to any sale totaling less than $5. Historically, cash has been king of these small sales, largely because credit card companies charge merchants too much in fees to make the transactions profitable (due to its size, McDonald's was able to negotiate smaller fees with its credit card networks). But cash doesn't work over the Internet, and all prior attempts to disintermediate cash and credit cards for online transactions resulted in miserable failures: Anyone remember Flooz? Beanz? DigiCash?

Meanwhile, microcommerce continues unabated: Americans spent $1.3 trillion last year on purchases that cost less than $5, and 99 percent of that was paid for with cash, according to the TowerGroup. Now, the credit card companies, the most dominant payment method on earth, want a piece of the action. So a variety of new technologies that work with credit cards, not against them, and a new willingness on the part of the credit card companies to reconsider their fee structures, are combining to enable new business models and profit centers based on very small transactions.

All of which means that some of the irrationally exuberant business models conceived during the 1990s may finally come to pass. Goodbye subscriptions, hello pay-per-page-view. Buying stamps online? No problem. In fact, Gartner Inc. predicts that by 2015 the average American will make more than 20 micropurchases on a credit or debit card each month. That means big money off small payments for businesses of all sizes—if they can figure out how to make it work.

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Paper or Plastic?

The eye-popping growth in the use of credit and debit cards over the last decade means that credit card companies will play a critical role in the effort to facilitate microcommerce. Enticing consumers with countless rewards and loyalty programs—everything from cash back to air miles—the credit card companies were able to persuade U.S. consumers to use their credit and debit cards for 34.6 billion transactions in 2003, according to a study by the Federal Reserve. That's a 45 percent increase over 2000. During that same period, the number of debit card transactions nearly doubled, from 8.3 billion to 15.6 billion.

Why the sharp increase in plastic? One reason: According to Visa USA, more than 80 percent of American households are enrolled in some kind of credit card rewards program. "Consumers look to be rewarded in everyday life," says Niki Manby, vice president of product innovation at Visa USA. "You have a relationship with your bank, and an opportunity for the bank to reward you for being a customer, and that doesn't happen with cash or checks."

Meanwhile, as consumers have grown more comfortable buying on credit, they are increasingly willing to make smaller purchases using the same means—a pack of gum, a cup of coffee, a digital song. In 2004, Visa saw roughly $40 billion in what it considers small-ticket transactions—charges of less than $25. And according to consumer research group Ipsos Insight, consumers' willingness to use cards for purchases of less than $5 has grown 24 percent in the past year. More than half of those surveyed said they're willing to use credit or debit cards to pay for convenience-store items. And the percentage of Americans that have made online purchases of $2 or less has increased 28 percent since September 2004, from 15 million to 19 million.

The exploding popularity of credit card networks has made them indispensable in enabling the coming wave of microcommerce. But ironically, high credit card processing fees have traditionally made the prospect of accepting plastic for small purchases pointless for merchants. Credit card companies, and the banks they work with, charge merchants a host of confusing fees, including a one-time application charge (up to $500), monthly processing and statement fees (up to $60), a flat per-transaction fee (usually $.30) and, finally, a "discount rate," which is essentially a slice of the actual sale, usually around 2 percent. Taking all other costs into account—the cost to purchase goods, ship them, store them, market them and so on—it's likely that a merchant will end up losing money on a small sale.

But given the growing popularity of business models based on small payments—think iTunes and Starbucks—the credit card companies are finally coming around, says David Robertson, publisher of the Nilson Report, a newsletter that covers the payments industry. "Debit cards have already surpassed checks at the point of sale, so now we're down to cash. The last bastion of paper-based payments are these small transactions."

Some credit card companies are starting to lower fees to make small credit and debit card payments look more attractive to merchants. Visa announced in November 2005 that, come April 2006, it would extend its small-ticket program—previously available only to fast-food restaurants, video-rental companies, movie theaters and parking lots—to bus lines, tolls and bridges, news dealers and newsstands, laundries and dry cleaners, copy services and car washes. Visa's new rate for credit charges under $15 is 1.65 percent plus a $.04 per-transaction charge, while MasterCard International charges 1.9 percent with no per-transaction fee. American Express Co. has no plans to lower fees for small payments.

It's a step in the right direction, but even the lowered fees aren't enough for some merchants. That's where the third-party micropayment processors such as eBay Inc.'s PayPal, BitPass Inc. and Peppercoin Inc. fit in. These firms have come up with several creative work-arounds that make small payments profitable. First is the aggregation model, whereby small charges are accumulated over a set period of time—say a month—and then sent to be processed by the credit card company as one large transaction. The aggregation model is particularly well suited for merchants that have frequently returning customers who buy small-ticket items, such as Apple Computer Inc.'s iTunes Music Store. MasterCard announced a marketing partnership with Peppercoin in December to accelerate the use of aggregation among merchants.

Micropayment Models
MODEL EXAMPLES
Aggregation Payments are batched together and processed only after a temporal (20 days) or monetary ($20) threshold is reached. iTunes Music Store
Direct Payment Micropayments are added to a monthly invoice for existing services such as a cable or telephone bill. Time Warner Cable, cell phone carriers
Stored Value Upfront payments stored in a debit account are deducted as purchases are made. Starbucks, 7-Eleven, EZPass
Subscription Upfront, buffet-style payments cover access over a defined period of time. Wall Street Journal, New York Times
À la Carte Merchants process customer transactions as they occur using economies of scale to negotiate lower credit card processing fees. McDonald's, Golden Tee Golf
Sources: Mercator Advisory Group, CIO Insight

The stored value model allows customers to pre-fund a debit account with a specific merchant or payment service (such as Starbucks Corp.'s Duetto card, which combines a traditional Visa card with a reloadable debit account), and the small payments are automatically deducted as they're spent. Another option, called direct payment, adds the small charges to bills that customers already receive on a regular basis (such as ringtones on your cell-phone tab, or pay-per-view charges on your cable bill).

"We are very cognizant of the fact that consumers want to use their cards more and more for all payments, because they are more convenient," says Art Kranzley, MasterCard's executive vice president of advanced payments. "We want to make it clear to merchants that MasterCard is endorsing smaller payments."

All these models save merchants money because they lower the number of actual credit transactions. Still, they may not be enough, because they don't work together. An account set up with BitPass, for example, can't be funneled into a PayPal account. Ultimately, consumers will want a seamless way to pay for things online and off, using whichever payment method they choose. Since the credit card lenders already have the worldwide systems in place, they are the best positioned to create the much-needed standard that would make micropayments seamless. But the fees will have to come down even more. "The credit card companies have to make this happen," says Jeff Reed, CTO of Logicalis, which helps companies set up microcommerce systems. "They are vital because they have the infrastructure. And they are driven by market forces to do it."

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Microcommerce 2.0

In the physical world, microcommerce can boost the speed, size and frequency of sales, as in the case of McDonald's. But in the online world, entirely new business models become feasible. Book publishers can offer services where consumers can "rent" pages or chapters instead of buying entire books. Researchers can create buy-an-answer services where customers pay to have their complex queries answered by experts. Television networks can sell their newscasts, soap operas and other shows online, and charge by the episode.

Many companies are already forging ahead with their cashless initiatives. Incredible Technologies Inc., the $60 million Arlington Heights, Ill.-based maker of the popular Golden Tee Golf video game, has more than 100,000 Golden Tee video units in hotels, bars and airports around the world, with millions of devoted users. According to Andy Kniaz, the company's executive director, more than 400,000 people carry the game's loyalty card, which offers express game check-in and advanced online stat tracking. Kniaz has a hunch those players will be willing to pay for games with their credit cards, too. Incredible Technologies plans to go live in the U.S. early this year with a new system that will allow just that. Kniaz says that the sheer volume of transactions—he estimates that Golden Tee players spend as much as $5 per game, to the tune of $400 million annually—enabled the company to negotiate its own rates with credit card vendors.

Kniaz hopes that a predicted 20 percent increase in game play will translate to a similar lift in sales of individual game units, which go for $6,000 each. "The way to increase sales is to prove that our machines earn a lot of money," Kniaz says. "The amount of business we will gain is absolutely huge."

Random House Inc., the world's No. 1 trade-book publisher, based in New York City, announced in early November that it would launch its own pay-per-view digital-content system in 2006. Keith Titan, vice president of New Media, says the idea is to offer Web surfers the ability to search through digitized books and buy pages online—for roughly $.04 per page, though pricing models vary. "We believe this model has great potential," Titan says. "Digital content for publishers could certainly become a very big part of the business."

Random House is still working out how users will pay for the service, whether through a stored-value card or through a direct-payment service model where the per-page charges might be added to, say, your monthly America Online bill, or other Internet service or mobile provider. "We are in talks now with a number of partners to build this business," he says. "We have a lot of people who are spending their time evaluating all these opportunities."

Even for physical retailers, microcommerce can facilitate new business models. McDonald's was so thrilled with the success of its cashless payment system that, in late November, it launched its new Arch card—a prepaid debit card that customers can buy in denominations of $5, $10, $25 and $50. "Our cashless and debit options have become the foundation for the launching point of many other initiatives that will let us do more for our customers, like the Arch card and WiFi access," says Frank Liberio, vice president of information services at McDonald's.

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The Once and Future King

Are we on the cusp of a cashless society? Not by a long shot, though the use of cash is declining, accounting for 15 percent of consumer spending in 2004, compared with 18.6 percent a decade earlier. "I don't think it will ever go away completely," says Mike Friedman, director of the emerging technologies practice for Mercator Advisory Group, a Waltham, Mass., research firm that covers the payments industry. "There is a certain cachet to cash, it feels good to have a big wad of it in your wallet, and it's anonymous." Still, he says, "things are really pointing toward the microcommerce market taking off. In the next year or two we'll see substantial growth in the number of places that accept credit and debit cards."

Resources
Web Sites
Mercator Advisory Group

The Nilson Report

www.paymentsnews.com Online daily news site on the payments industry


Book
Presenting Digital Cash
By Seth Godin
Sams, 1995

And credit cards themselves are due for a makeover. New contactless cards, such as Chase Bank U.S.A.'s Blink program and MasterCard's PayPass, have radio-frequency chips that let customers wave their cards before readers instead of swiping them. Before long, consumers could be using chips embedded in their cell phones, wallets—even their watches—to make micropayments quick and painless at the point of sale. "We are exploring a whole host of new vehicles, including the deviation from cards entirely," says Visa USA's Manby.

Cash will always have its uses, of course. It will always be the best way to conduct private, anonymous transactions. And concerns over how credit card companies use the avalanche of personal information they collect everyday are unlikely to abate anytime soon. But if you're the trusting type, it will be hard to beat the convenience of credit, whether you're buying a new car, or just a cup of coffee.