Don’t Grow Your Business With Bad Customers
The CEO of one of our clients, a public company that provides credit card processing services to merchants, had a problem: The company had consistently delivered revenue growth rates better than most of its competitors, but its price-earnings multiple was lower than those companies.
The CEO had a valid question: “Why is the market being irrational and undervaluing my company, and how do I fix it?”
Steeped in the wisdom of efficient markets, our ingoing hypothesis was that the CEO was likely overvaluing his own company. To validate this hypothesis, we set out to understand the true economics of his business.
Credit Card Processing Economics
The mechanics of processing a credit card transaction are fairly straightforward. The merchant’s point-of-sale terminals forward the transaction details to the merchant’s bank, who forwards to the credit card holder’s bank for approval. Once approval is received from the credit card holder’s bank, the merchant’s bank sends an approval code to the merchant, and the process is complete.
This round-trip process incurs roughly $0.05 in costs at the merchant’s bank. The total fees to the merchant for executing this transaction are typically 1.5 to 2.0 percent of the purchase amount (i.e., for a $100 purchase, the merchant might pay $1.50 in transaction fees, and thus only receive $98.50). The merchant’s bank typically receives 0.1 percent of the purchase (i.e., $0.10 on a $100 purchase).
It is critical to note that the merchant’s bank fee is a per-fee-dollar rate, whereas the bank’s costs are per-purchase. Thus the bank receives a much higher fee for a $500 purchase than for a $50 purchase, yet the cost to approve each purchase is identical. This has an enormous impact on the profits our client earned from each merchant. An airline that averages $500 per transaction might be 10-20 times as profitable per-transaction for our client bank as a restaurant.
Customer Activity and Longevity
We also found that customer activity (the number of transactions per year) and longevity (the number of years we could expect the company to remain a customer) were key drivers of value for our client. For example, a supermarket might process thousands of credit card transactions per day, whereas a local restaurant might only process 50 per day. A supermarket might remain a customer for 10 to 20 years, whereas a restaurant might only survive for two to three years.
As a result, the cost for our client to acquire a customer (e.g., salesperson salary and bonus, upfront equipment costs, new customer processing costs) could be spread across a much higher number of lifetime transactions for the supermarket rather than the restaurant. Our client would gladly pay $10,000 in customer acquisition costs to add a supermarket customer, yet resent paying $500 to acquire a restaurant customer, simply based on lifetime activity levels.
As a result of these drivers, we found enormous differences in customer value. For example, supermarkets were highly valuable customers: they had high volumes (thousands of transactions per day) of large purchases ($100+ on average) over a long lifetime as the bank’s customer (10 to 20 years). By contrast, restaurants had low volumes (10 to 50 transactions per day) of small purchases ($20 to 50 for most restaurants) over a short lifetime (two to three years).
Thus, a supermarket might have a lifetime value of $1 million to 2 million, whereas after acquisition costs a restaurant might actually destroy value for the bank (i.e., the costs to acquire the restaurant as customers were higher than their lifetime profits).
The CEO was very surprised to see the stark differences in customer value by industry. He of course knew that high-volume, large-purchase, longstanding customers were more valuable, but had no idea that the many low-volume, small-purchase, short-term customers in his portfolio were creating little value, or worse, destroying value.
We also were able to show that much of the company’s recent growth came from such value-destroying customers. As a result, the market was correctly recognizing that his revenue growth was value-neutral or value-destroying, and giving him no credit for it (hence his low and shrinking P/E multiple).
The moral of the story: As a business owner, it is vital for you to understand the value of your customers. You cannot make good business decisions without knowing customer value intimately.
KARL STARK AND BILL STEWART | Columnist | Co-founders, Avondale
Karl Stark and Bill Stewart are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree.