Did App Tracking Transparency Really Ruin Small Businesses?

Patrick McGee from Financial Times penned an article named “Small businesses count cost of Apple’s privacy changes“. The piece, as the title may already suggest, focuses on the premise that privacy changes from Apple, namely App Tracking Transparency (ATT), increase marketing expenses for small businesses. To make his case, the author cited a few companies that had to scale back, fire staff or even close shops due to rising marketing costs.

The alleged impact on SMBs’ customer acquisition expense has been one of the primary talking points of ATT critics. Make no mistakes here, I do think that ATT did make acquisitions more expensive, but it’s not right to say that Apple wrecks the advertising world or every company regardless of size. First of all, privacy and personal data belong to users. Facebook’s business model hinges on selling access to such data even though there was never explicit consent. There is no prohibitive policy on what Facebook does to user data captured on Facebook platforms. What Apple did is to simply give users an ability to allow or disallow Facebook to track them off-platforms. If it were wrong to let the end users have a voice in the use of their own data, then we would have a bigger problem at hands, wouldn’t we? In a world where personal freedom is considered sacred, why can’t we have a say in how our own data should be used or in whether we should be tracked on our own phone?

Facebook and other ads platforms were quick to use ATT as an excuse for their disappointing financial performance. However, as Nick Heer deftly pointed out, the timing of ATT and the reported numbers in the subsequent quarters indicate that there are other forces at play.

The actual figures tell a much murkier story. I do not think it is fair to suggest ATT does nothing, but its effect does not seem as pronounced as either its biggest supporters or its biggest naysayers suggest. Snap, for example, is a company that has no major revenue stream outside of ad placements in its smartphone apps. But in Q3 2021, a full quarter after ATT’s public debut, Snap posted year-over-year revenue growth of 57% overall. In North America, it reported 60% growth — higher than in any other region.

The following quarters all show overall revenue gains in North America just one percentage point below the company’s total growth. It is a pattern that more closely mimics the number of daily active users. Snap has only posted modest, single-digit year-over-year gains in North American users, but decent double-digit growth elsewhere. Meanwhile, its growth in the average revenue per user has been stronger in North America since ATT’s debut than anywhere else.

Meta’s business is the one everyone appears to be watching because two quarters this year have been rough. In its most recent, it reported its first ever year-over-year revenue decline, which dropped by about a billion dollars in Europe and about $600 million in the U.S. and Canada. That is alarming for the company, to be sure, but it still does not track with ATT causality for two reasons:

  • iOS is far more popular in the U.S. and Canada than it is in Europe, but Meta incurred a greater revenue decline — in absolute terms and, especially, in percentage terms — in Europe.
  • Meta was still posting year-over-year gains in both those regions until this most recent quarter, even though ATT rolled out over a year ago.

In the case of Facebook, this is a tough environment for their business. TikTok is insanely popular among younger users and shows no signs of abating. A few days ago, Pew Research reported that only 32% of teenagers aged 13 to 17 in the US used Facebook, a massive drop from 71% reported in 2015. Additionally, supply chain, inflation and the threat of an economic downturn are red-hot concerns for every business and they all prompt businesses to take a hard look at expenses, among which advertising is the easiest and most obvious choice. When there are such headwinds, it’s a little bit dishonest and misleading to say that ATT is the primary reason for financial mishaps.

Think about it this way. If regulators cracked down on the sales of dubious cryptocurrency or increased the scrutiny on this business, the issuers would say: well, your actions would affect companies that sold accessories like cold storage. How do you think about that argument? For me, it’s pretty similar to what we have regarding ATT. Businesses that directly or indirectly benefit from shady practices should know that eventually there will come a time when somebody refuses to look the other way.

I’ll let the CEO of one of the companies cited in the article reflect on how ATT impacted his business

Shelly Cove’s Schroeder has cut his digital ads budget to one-third what it was a month ago, hoping that returning customers will keep the business afloat. “It’s irresponsible to say ‘Apple killed my business’,” he said. “I’m self reflecting — I realised I was way too reliant on Facebook.”

I don’t believe that as a society, we need surveillance tracking which Facebook is engaged into, in order for small businesses to survive. As the owner of the biggest social media apps in the world with millions of daily active users, Facebook has enough at their disposal to compete. They can afford expensive PR campaigns to repair their image and generate goodwill. These will lead to more trust from users and ultimately permission to track the them across apps. Moreover, the executives already thought about changing their business models. They just decided not to, out of concern that it would hurt the bottom line. Well, perhaps the recent onslaught on the stock may change their minds.

In this debate, I support Apple, but I am under no illusion that the company is an angel. The company is driven by the top and bottom line too. Though Apple has their own reasons why they do certain things and I believe them in many cases, I also believe that if they could curtail their greed a bit and do things a little bit differently, there wouldn’t be as many criticisms leveled at them as what we see now. Examples are:

  • Invest more in app reviews. Some developers complain about the time-consuming aspect of the review process and how it can be used to coerce developers into paying the company more
  • Be more discreet about the ads business. The launch of ATT and the ads business were pitifully close to each other. It’s no surprise that folks lament that Apple cares more about its financials, than users
  • Stop pushing their own services at every chance. Even I am annoyed that Apple advertises their own services on the Settings or Profile page on my iPhone. As the most followed brand in the world, with the financial resources at disposal, I am sure Apple won’t have to worry too much about consumers not knowing their services

In short, I am in favor of ATT and giving consumers more say in how they are tracked. Having said that, I do understand why some folks are frustrated with Apple and doubt their motive. I am sorry that some small businesses got caught up in this whole situation. But I have no empathy for Facebook, even the slightest.

PayPal Q2 FY2022 Results

Last week, PayPal announced its Q2 FY2022 results, its forecasts and some important personnel changes. Here are the headlines:

  • Net revenue hit $6.8 billion, a 9% YoY growth
  • International revenue declined by 1.7%, to $2.9 billion, while US revenue was $3.8 billion, a 19% growth YoY
  • Operating cash flow and free cash flow grew to $1.5 billion and $1.3 billion respectively, meaning that FCF margin is 19%
  • Total Payment Volume increased by 9% to $340 billion
  • Total payment transactions of 5.5 billion
  • US TPV grew 16%, to $219 billion, while International TPV and Cross Border TPV decreased by 1.6% and 11.8% respectively
  • Venmo recorded $61 billion in TPV, an increase of 5.2%, and 90 million active accounts
  • Total active accounts went flat sequentially at 429 million with 35 million active merchants
  • While the company welcomed a new CFO, it’s now looking for a replacement for their CPO, who is retiring at the end of the year
  • Cost-saving initiatives are expected to save the company $900 million by the end of 2022 and $1.3 billion next year
  • $15 billion in share buybacks was authorized, $4 billion of which will be realized by the end of 2022
  • PayPal expects operating margin expansion in FY2023

Despite the tough macro challenges and fierce competition, PayPal’s TPV increased by 9%, on top of the 30% and 40% YoY growth in the last two years. That’s pretty solid because Visa grew payment volume in the same quarter by 12%, even with its duopoly market power. The divorce from eBay is entering the final stages as the famed marketplace now makes up only 3% of PayPal’s TPV and is projected to have negligible impact in the future. Losing a household name like eBay isn’t great, but because the partnership was exclusive, PayPal couldn’t work with any other retailers or marketplaces. Hence, the separation paved the way for deals like the one with Shopify or Amazon, and would benefit PayPal more in the long term.

Another bright spot is the US market. PayPal’s home soil saw a 16% increase in TPV and a 19% expansion in revenue. Considering that the US is home to other payment alternatives, including some fierce direct competitors, those US numbers showed resilience and a formidable market presence of PayPal. Because the company barely added new active accounts, given the lack of full disclosures, my guess is that PayPal managed to increase usage among existing users.

Venmo TPV
Figure 1 – Venmo TPV

Among the factors that contribute to the domestic success, I want to call out Venmo. Popular among young consumers, Venmo boasts 90 million active users, double from what it had three years ago. In the same time frame (from Q2 2019 to Q2 2022), Venmo TPV grew by 150% from $24 billion to $61 billion. Despite this growth, Venmo still has a lot of grow to monetize. The three main levers are debit card, credit card and the partnership with Amazon. While I suspect that PayPal will have to make some financial concessions to be on Amazon’s marketplace, this will undoubtedly help grow both revenue and margin. Meanwhile, the management team has high hopes for what the Venmo debit and credit card can bring onto the table. If PayPal can monetize Venmo more, the company will become so much more secure and attractive in the eyes of investors. In case you forgot, despite the massive scale of adoption, Venmo is still only available in the US.

Gabrielle Rabinovitch

I’d also point out the card strategies for Venmo are important, as well. The debit and credit cards continue to grow their volumes and those are really important for habituation. They reinforce all the in-wallet spend with offline spend, as well.

Dan Schulman

Yes, I totally agree with that. If you look at Cash App, their big growth is off of their debit card. We have a lot of room in our debit card and credit card to grow too.

Source: PayPal’s Sell-Side Analyst Conference

Moreover, I am very pleased with the switch of focus onto increasing efficiency. I used to receive a bunch of promotional offers from PayPal. $5 here, $10 there for low-impact activities. Now, the company is willing to let go low-engagement customers and focus marketing dollars on driving usage from active users. Efficiency is also apparent in the product development side as well. Although stock trading was on the plan last year, PayPal decided to put a halt on its development. The push for in-store QR code is now replaced by efforts to promote card usage. These decisions obviously led to surplus in headcount and dismissals, where necessary. Due to its enormous scale, PayPal managed to negotiate more favorable contract terms with suppliers. The management team believes that these efforts will drive ROI and yield higher results for the organization. Concretely, they are estimated to bring $900 million in cost savings for the rest of FY2022 and $1.3 billion next year.

These cost savings are likely the main reason why the management forecasts operating margin expansion next year. Low-margin businesses such as BNPL, Venmo and Braintree are expected to grow in the near future. It’s unclear to me, reading their reports, where the margin will come from the revenue side of things. Hence, the gains must come from being a leaner organization with reduced expenses.

On the other hand, it’s not all smooth and rosy with PayPal. I am concerned about the uncertainty that changes at the top level will bring. They have a brand new CFO, who was chosen among at least 14 candidates. By next year, they will have a new Chief Product Officer. These changes may bring about new ideas and positive results, but they may also delay the progress as new hires need time to acclimate themselves to the new work settings.

PayPal's Revenue Growth
Figure 2 – PayPal’s Revenue Growth

While it’s good that a business wants to be laser-focused and mindful of expenses, it remains to be seen whether PayPal is doing too much. After riding to new heights amidst Covid, PayPal’s stock got clobbered, down from more than $300 to $90, due to abandoned forecasts and slowed growth. Then, the narrative switched to higher efficiency and more focus. I get it. The leadership wanted to present a nice story to investors to stop the bleeding. They may even genuinely want to set the company on a better course for the future. But they also have a history of botched plans and forecasts. Who is to say that they are not being too aggressive at the moment? What if the cost cuts hurt the business in the process? We already have three consecutive quarters of decline in International. PayPal competes on multiple fronts and their competitors are fierce. Can they right-size their capital allocation to avoid disasters?

Overall, this is not a disastrous quarter. There are some bright spots, including Venmo, solid growth overall, the US market, the cost-cutting initiatives (at least for now) and the buybacks. However, there are also things that give me pause for concern. As bullish as I want to be on the company’s outlook, I’ll wait for another quarter or two so that by then some of my concerns will be hopefully eased.

Appendix

PayPal's Active Accounts & Active Merchant Accounts
Figure 3 – PayPal’s Active Accounts & Active Merchant Accounts
PayPal's Transactions Per Active Account
Figure 4 – PayPal’s Transactions Per Active Account
PayPal's P2P TPV
Figure 5 – PayPal’s P2P TPV

Even with a loss of $2.6 billion, Uber had a great quarter

Uber lost $2.6 billion in the last 90 days!

However, that headline-grabbing figure doesn’t fully tell the whole picture. The fact that Uber stocks went up by more than 10% after hours indicates investors were pleased with what they saw and heard from management. There are reasons to that.

Total Gross Bookings (GB) grew by 33% amidst a challenging environment when inflation was the highest in decades. Revenue went up by 105%, although that included contribution from the acquisition of Transplace. Without the acquisition, my estimate is that Revenue would still be up by at least 30-40%. The number of monthly active platform users hit an all-time high record of 122 million while the number of trips increased by 24% to 1.87 billion, just a tad shy of the all-time record of 1.9 billion set in Q4 FY2019, right before Covid.

More importantly, Uber became a free cash flow generator for the first time in history. All three main businesses, including Mobility, Delivery and Freight, were all profitable on an adjusted-EBITDA basis. I understand that some folks have a bone to pick with the adjusted-EBITDA numbers, but Free Cash Flow doesn’t lie and it indicates Uber is on the right track. The giant net loss quoted above included $1.7 billion of unrealized losses related to Uber investments in Zomato, Aurora and Grab, as well as $470 million in stock-based compensation expense.

Back in my review of Uber Q3 FY2021 earnings, I wrote that Covid created a golden opportunity to transform itself. The latest results were further proof of that. Before Covid, Uber was all about Mobility, both in terms of gross bookings and revenue. The pandemic hit Mobility hard, but gave Delivery a great momentum that has not been relinquished since. In the last quarter, both segments notched the second-highest gross bookings in history in Q2 FY2022 while each recorded the highest revenue ever, albeit with some benefits from the model changes in some markets. Without Covid, I doubt that Uber could turbocharge its Delivery business that quickly. Now, instead of relying on Mobility, Uber has two weapons that complement each other well.

Uber Mobility and Delivery's Gross Bookings and Revenue
Figure 1 – Mobility and Delivery’s Gross Bookings and Revenue
Uber Delivery Gross Bookings and Basket Size
Figure 2 – Uber Delivery Gross Bookings and Basket Size

In A look at Uber after it acquired Postmates and Drizly, I wrote:

The way I think about Uber as a business is that it connects end users, partners and drivers altogether. The more end users Uber can present to its partners, the more partners it is likely going to sign. In turn, that means Uber’s end users can have a bigger selection at their finger tips, raising Uber’s value proposition. On the other hand, a bigger end-user pool helps the company sign up drivers. Drivers have limited resources in their vehicles and time, as even the most dedicated drivers can’t drive for more than 24 hours a day. Nobody wants to drive around needlessly all day without getting paid while having to pay for vehicle expenses and gas. As a result, the more business opportunity Uber can bring to drivers, helping them better leverage their time and resources, the more drivers will sign up.

The rise of Delivery does wonders for Uber as it can bring more businesses to drivers. At times, when there is no rider to transport, couriers can deliver food or other items to better utilize the one resource that we can’t get back: time! Now that consumers are back on the road to office and travel, drivers have more opportunity to earn. On the call, the executives bragged that drivers in the US earned $30 per hour on average. That’s pretty competitive. Thanks to its scale, Uber believes it is best positioned to attract and retain drivers. The company has consistently talked about being more efficient with their operations and relying less on incentives. Such self-sustained growth is reflected by the fact that Delivery has had positive adjusted EBITDA for three quarters in a row.

Uber Delivery Net Revenue and Adjusted EBITDA
Figure 3 – Uber Delivery Net Revenue and Adjusted EBITDA

Uber is a multi-sided network, dealing with consumers, drivers and merchants. They co-exist together and each cannot without the other two. Retaining drivers is crucial to retaining merchants and riders. In addition to the $30+ per hour income, Uber recently introduced some new features to support drivers. Soon, for the first time ever, drivers will be able to see in advance where the trip will end and how much they will earn for that trip. Drivers can compare multiple trips at once and decide what works best for them. Then, Uber will offer drivers a chance to earn 2-6% cash back at gas stations with Uber Pro Card. Gas is arguably one of the biggest expenses for drivers. The cash back is a nice gesture that will go a long way to retain this important class of stakeholders.

When delivery companies such as Getir or GoPuff are forced to shrink operations, the scale that Uber is operating on provides a great deal of advantages. If they can maintain that scale, other competitors will find it highly challenging to take share from Uber without near-term damage to profitability. And in case you haven’t noticed, profitability and sustainable growth is the tune that Wall Street wants companies to sing, not growth at all cost.

Sustainable growth is one area where Uber has been much better since Dara became CEO. Back in 2020, in Uber’s latest chess moves, I wrote about the downside of Uber operating in many markets and praised Uber’s effort to withdraw from countries where it was not competitive. Yesterday, in a conversation with Bloomberg, Dara reiterated that stance by saying that Uber is still operating Mobility in India, but will shut down Delivery because they don’t think they can be the market leader. This type of strategic thinking and discipline can only benefit a company like Uber in the eyes of investors.

Moving forward, there are several levers that Uber can pull to stimulate growth and profitability. The first is Uber One. As of Q2 FY2022, Uber One has 10 million paid subscribers. That’s a respectable figure, compared to the 6 million reported in Q3 FY2021. However, considering that the company has 122 million monthly active platform customers, Uber One’s penetration is less than 10%. Once that number increases, it will boost the company’s top and bottom line meaningfully.

The second lever is advertising. Every company wants those high-margin ads dollars and Uber is no exception. Since its launch in Q3 2020, advertising on Uber has been used by 27% of all active Delivery merchants. Though Uber should be mindful of how a litany of ads can adversely affect customer experience, I don’t see any reason why the share of active advertising merchants cannot reach 40%.

Uber Active Delivery Merchants and Share of Active Advertising Merchants
Figure 4 – Uber Active Delivery Merchants and Share of Active Advertising Merchants

Then, there are New Verticals in Delivery (groceries and non-food items) and Uber 4 Business. Combined, these two levers make up less than 10% of Uber’s Gross Bookings, indicating that there is room to grow in the future. The management team mentioned that they are still hiring for Uber 4 Business, a strong signal that they consider it important to the company’s future. New Verticals, like the partnership with Albertsons, plays a key role in increasing the utility of the Uber apps to consumers. Here is what Uber had to say:

As far as new verticals go, we’re quite satisfied in terms of the growth of that team. It’s at about a $4.5 billion run rate in terms of gross bookings. We are investing in this business. And despite investing in this business and it’s in the hundreds of millions of dollars, you can see the profitability that we’ve been able to drive with the delivery business overall. It’s really because of the scale and efficiency that we’re bringing to bear.

What we’re seeing with new verticals customers is that Uber Eats customers who also order from new verticals tend to stay with us, tend to have higher frequency. And it’s really a part of the power of the platform that we’re having. If you ride with us, if you eat with us, if you drink with us, if you order groceries with us, we just become an everyday part of your life. You top that off with the membership program. And we think we have a relationship with customers that really can’t be duplicated in industry on a global basis. That’s what the strategy is all about and we’re quite optimistic about our progress to-date

Source: Alphastreet

Overall, I am pleased with what Uber reported this quarter. Even though the stock is still down significantly, the business is in a stronger position now than it was before and during Covid. That is not to say that the company can afford to take its foot off the gas pedal and to lose discipline. What is gained today will be easily lost in 90 days. The macro economic situations remain chaotic and unpredictable. Consumers may have to cut back on non-essential spending and Uber, whether they like it or not, often falls into that category. Regulatory threats are always there. Formidable rivals such as DoorDash and Instacart are still competing hard. Hence, they need to stay focused and relentlessly execute. But with this result, I think at least they gained some investors’ confidence, including mine.

AWS – What a business!

AWS, AWS, AWS

The importance of AWS to Amazon cannot be overstated.

Covid-19 was a blessing to Amazon between Q2 FY2020 and Q2 FY2021, boosting its top line significantly. As the economies opened up, folks got back to the stores and the YoY comparisons were clearly tough, growth became so much harder to find. North America’s 10% YoY growth this quarter is the lowest I have seen in the last five years. International took a 12% plunge after growing 38% and 36% in the same period in 2020 and 2021 respectively. Both segments reported negative operating margin, the third quarter in a row.

Amazon's Business Segment YoY Growth
Figure 1 – Amazon’s Business Segment YoY Growth

Meanwhile, this quarter saw AWS take home $19.7 billion in revenue, brining the turnover in the last twelve months to a tad more than $72 billion. Despite a rapid increase in scale, AWS still clocked in 30% YoY consistently in the last year and a half! Although the business only made up 16% of the parent company’s revenue, AWS was responsible for all of Amazon’s operating margin when North America and International were in the red. Traditionally, AWS has been the engine powering Amazon’s profitability. Now, it carries the company’s revenue growth as well.

For good measure, AWS’s potential is as good as its current numbers. While quarterly revenue is now almost at $20 billion, AWS has long-term commitments (from contracts of at least one year in length) of more than $100 billion. These commitments have never grown less than 48% YoY since they were first reported back in 2018. If we compare this unearned revenue to the rolling last twelve month sales of AWS, the ratio grew from 75% in Q4 FY2018 to 139% currently. It means that AWS has the last twelve month sales and 39% on top of that in unearned revenue!

AWS Quarterly Revenue & Unearned Revenue Commitments
Figure 2 – AWS Quarterly Revenue & Unearned Revenue Commitments

Amazon management knows that they have a gem in possession and they are spending money to keep that gem. Let’s look at it this way. AWS sales in the last twelve months totaled $72 billion. The company is trading at $1.25 trillion today. The market capitalization is about 17.4 LTM sales. If we project the next twelve months’ sales is about $83 billion, the multiple is 15. Some argue that means we get the Retail business for free and like it or not, they may have a point!

In 2021, the company splashed $24 billion on technology infrastructure which includes support for AWS. They planned to increase total capital investments in 2022 and more than half would go to infrastructure. It’s not certain that more CAPEX would mean more growth or revenue. But it’s a positive sign that a company is willing to open its checkbook to deepen the moat of its star business.

Andy Jassy, the current CEO of Amazon and the man credited with the success of AWS, said previously that Amazon actually stumbled upon this amazing business. At the beginning of the 2000s, after working diligently to improve the internal tools that supported the eCommerce site, Amazon realized that they were really good at running infrastructure services. It took three more years of planning and preparation after such realization before the company launched what is now a highly important and lucrative business in AWS. What a serendipitous discovery!

Apple Q3 FY2022 Earnings

A well-managed company

Let’s go over the headline numbers first. Apple had a record Q3 result with almost $83 billion in revenue, a 2% YoY increase on the back of a 36% growth last year. The 1% decline in product revenue was more than offset by the 12% growth in Services, which hit almost $20 billion in sales. The company’s gross margin profile this quarter stayed relatively similar to the historical trends: 36% for Products, 71% for Services and 43% for the whole company. Operating margin was 28%, down 200 basis points YoY, while net margin dropped to 23% from 27% in Q3 last year.

Figure 1 – Apple’s revenue and YoY growth

Make no mistakes: this was a tough quarter. All companies had to deal with significant challenges such as the new variant of Covid-19, unfavorable foreign exchange headwind, supply chain constraints, the war in Ukraine and macroeconomic concerns across the globe. Big retailers like Walmart or Target reported higher expenses and lower profit guidance. Meta had the first revenue decline in history while incurring more operational expenses. Even the great Amazon saw a 4% decline in revenue from their famous eCommerce segment.

Figure 2 – Product, Service & Overall Gross Margin

Yet, we see Apple increase their top line, albeit modestly. Unfavorable foreign exchange rates were estimated to have a 300 basis point impact. Otherwise, the revenue growth would have been higher. On the other side of the equation, Apple stayed disciplined with their costs. Gross margin was relatively intact while the operating expenses (R&D and SG&A) were under controlled and rose only modestly. We all know how hard it is personally to stay disciplined with living expenses when disposable income grows. Hence, given the balance sheet that Apple has, they deserve praise for not wasting shareholders’ money on unnecessary acquisitions or ludicrous ventures.

For the next quarter, the company expected a 600 basis point impact from foreign exchange, better-than-this-quarter supply chain status and an acceleration in revenue growth. The positive note on revenue forecast is dire contrast with a somber tone from other companies, especially when we take into the size of Apple and the breadth of its operations across the world. Apple used to be a design firm known for the willingness to spend on products and services regardless of the cost. Tim Cook took over and steered the company towards a financially and operationally disciplined entity. It pays off handsomely.

iPhone and the resilient brand

Commentary from the management detailed how strong customer loyalty was towards the Apple brand. iPhone customer satisfaction stood at 98% and there were record switchers from other operating systems to iOS. Installed base for Mac, iPad and Wearables all reached a new all-time high. Over half of the new customers in the quarter were new to these products.

Apple products don’t exactly fall into the necessity category due to their high prices. As inflation hits consumers hard every country and supply chain issues still wreck multiple industries, it’s nothing short of impressive to see a 3% YoY increase in iPhone sales. That is robust proof of how dominant and what a great brand iPhone is. And we all know that once a consumer enters the Apple ecosystem, they are likely to buy more products and services. Therefore, investors can be more confident in the strength of Apple’s business amidst economic downturns, but there is NO guarantee that will happen.

Figure 3 – Apple Business Segments’ YoY Growth

Greater China

China still made up 18% of the total company, pretty much in line with the historical figures for Q3. According to Apple, China’s Services revenue grew faster than the company average of 24% and hit an all-time June quarter record. The growth in Services revenue was offset by the lower demand of products in China, due to the lockdown, albeit a push late in June. China’s operating margin dropped from 43% to 38%. Because Services, which has a higher margin, grew this quarter, the drop in operating margin is likely attributed to higher SG&A. Traditionally, Q4 is the weakest quarter for China, both in revenue and operating margin. I expect the revenue share and operating margin to drop to 17% and 34% respectively. It’d be great to have an analyst ask the management for more color on China in Q4.

Figure 4 – Apple’s Revenue broken down by geographic areas
Figure 5 – Geographic areas’ operating margin

Services

Per Apple:

Our Services set a June quarter revenue record of $19.6 billion, up 12% over a year ago, with all-time revenue records in the Americas and the rest of Asia Pacific and June quarter records in Europe and Greater China. We also achieved June quarter revenue records in each major Services category, including all-time revenue records for Music, Cloud Services, Apple Care, and Payment Services.

Source: Fool.com

Where are the critics of Apple’s growing Services? The pivot to Services a few years ago raised eyebrows, but eventually proved extremely fruitful and important to Apple. Not only does Services make customer experience on Apple’s devices better, but it also aids the company’s profitability with 70% gross margin. Since 2019, Services is the only part of the business that has had no down quarter and as of this quarter, made up 24% of the company’s top line. For reference, in terms of 4-quarter rolling average revenue, Apple’s Services is already bigger than Amazon’s AWS.

The number of paid subscriptions rose steadily every quarter over the past 4 years and hit the 860-million mark. At this rate, we’ll cross the 1-billion mark in the next 12 months. As the paid subscription population is highly correlated with Services revenue, the more subscriptions there are, the higher Services revenue grows.

Figure 6 – Apple’s paid subscription and Services revenue

Additionally, Apple’s commentary on the drivers of Services is very interesting. Apparently, the major contributors are Cloud, Apple Care, Payment Services and Music. The first three have high margin and are like to grow since they are sticky and central to user experience with Apple devices. How many use an iPhone without iCloud and Apple Pay? When, not if, this trend continues, it will do wonders to the gross margin of Services and the company.

One notable absence is ads. It’s understandable that this quarter saw some softness when the likes of Snap, Facebook or Google all reported slower growth than expected. But once this current economic environment subsides, ads will be a great lever to pull. Formerly limited to the Search tab on the App Store, Apple Ads was recently expanded ads to Today’s tab. More ads slots mean more revenue for Apple. These dollars also have high margin and don’t

Take-aways from Netflix Q2 FY2022 Earnings

Overall

Netflix recorded a tad below $8 billion in revenue, a 9% growth in revenue compared to the same period a year ago. It’s scarcely believable that a company formerly selling DVDs pivoted to online streaming and is now generating $32 billion in annual income. Because of some one-time expenses and the adverse impact from unfavorable exchange rates, Netflix’s operating margin was about 20%, down from 25.2% in Q2 FY2021. The company lost 1 million subscribers globally, an improvement over the loss of 2 million subscribers as forecast 90 days ago. Free Cash flow (FC) in the quarter tallied up to $13 million, significantly higher than -$175 million in FCA recorded in Q2 FY2021. These results were received well by investors as the stock has been up since the announcement.

Figure 1 – Regional breakdown. Source: Netflix

Subscriber loss in US and Canada

Netflix losing 1 million subscribers globally deserves some headlines, but I think it’s more telling that they lost 1.3 million in the most lucrative market UCAN (US and Canada). Such a decline is biggest in the last 5 years, if not ever. Even though the loss in UCAN was offset by the growth in APAC, Netflix is trading some of the most profitable members for some of the least. This happened despite the resounding success of Stranger Things Season 4. Needless to say, it is not what either the management or investors want to see.

Figure 2 – Netflix Subscriber Add and Average Revenue Per Membership in UCAN

The loss of subscribers in UCAN seems to coincide with the growth in subscription fees. Regular price hikes, coupled with inconsistency in content delivery, definitely impacts churn. I don’t think Netflix will lower their prices, especially when they are going to launch an ads-supported tier next year. While the company forecasts a net add of 1 million subscribers for Q3, who is to say that the losing streak in UCAN will abate? Are we going to see another slide in 3 months’ time?

The missing Net Add chart and the use of dubious data

Netflix used to have a chart (Figure 3) showing net adds by year. 2020 was really impressive due to the stay-at-home orders across the country. 2021 was lower than 2018 and 2019 due to the pull-forward effect. This chart was seen last in Q4 2021 earnings. Since then, it has been missing. The company doesn’t want investors to look at the net adds in the first two quarters of 2022.

Figure 3 – This Net Add chart has not been seen in two quarters’ earnings. Source: Netflix

I get that. Any company wants to put their best foot forward in earnings as long as the information is accurate. Withholding some unfavorable data is a common practice. What is funny; however, is that Netflix uses cumulative engagement on Twitter as a metric to show how dominant Stranger Things 4 was, against Obi-Wan Kenobi and Top Gun. I don’t know about you, but I’d take Top Gun’s $1.3 billion in box office any day of the week and twice on weekend, over some ambiguous engagement metrics. This is NOT the first time Netflix uses some misleading data in their letters. Back in January 2020, they turned to Google Trends data to demonstrate that their Witcher series was more popular than Mandalorian, Jack Ryan or the Morning Show. The key here is that Witcher is a popular game as well. Without isolating the category that keyword is in, it’s not fair to compare Witcher to the unique name of other shows. I explained here in more details.

Figure 4 – Netflix used Google Trends data misleadingly to appear more popular than others. Source: Netflix

Occurrences like these lost some of my confidence in the company

Ads-supported tier and the binge model

I have to give credit to Netflix’s management. They stuck their guns with the binge model (releasing all episodes at once instead of dripping one per week) despite what many claim contributes to the lack of engagement around their content. Their stock has been hammered hard in the last few months. I am sure that spurred a lot of meetings at the highest level. Still, they chose to be who they are and what they are known for. I can only give them props for that.

However, this binge model puts a lot of pressure on Netflix to deliver quality content consistently and regularly to reduce churn. Series like Sex Education, Stranger Things or Ozark released all at once certainly will draw subscribers, But to keep them on the platform, given Netflix being the most expensive streamer out there, is another matter. They will need great content every month. I watched The Gray Man, which is Netflix’s most expensive film ever and has arguably the most advertising from the company. The flick stars some of the most famous actors such as Chris Evans, Ryan Gosling and Ana de Armas, and the directors of Avengers: End Game. The action is definitely entertaining, but the plot leaves so much to be desired. That’s the pattern with Netflix. I don’t think that they are as good as Apple or HBO in producing original content. That’d be fine if their price point was not the highest or if they didn’t follow the binge model. But because it is and they do, it makes me quite bearish on the company.

An ads-supported tier will help Netflix expand the clientele and appeal to those low-income households that consider Netflix a luxury. Folks that are on the fence about leaving the streamer can instead choose the new tier so that they can preserve access while paying less. The benefits of this plan are straightforward, but how Netflix will execute it is a totally different matter. Key questions are:

  • What will the ads look like? How will they affect the customer experience?
  • How will Netflix enhance the targeting while protecting customers’ privacy?
  • How long will it take for the company to fine-tune all the workflow details and become well-versed in the world of advertising?
  • Are the ads going to help brands drive awareness only? If there is a call to action and such action leads to a website outside of Netflix’s domains, will Netflix be able to report reliable attribution?

Originally, I was concerned about Netflix and its ability to delivery content consistently. Not just any content. Great content that can get viewers hooked. Then, I was drawn into taking a very small position on the company because I mistakenly followed some on Twitter and didn’t believe my own intuition. Till now, I am still concerned about Netflix’s outlook as an exclusive SVOD company. Their venture into the advertising world is exciting, but it poses a lot of questions and frankly uncertainty. Until such questions and certainty are squared away, I will stay away from this stock.

Business Unlimited Ultimate+ for iPhone

Small business owners, you may want to pay attention to the new subscription that T-Mobile and Apple just announced today. Called Business Unlimited Ultimate+ for iPhone at $50/month/line, new customers with 6 lines will receive:

  • Unlimited text, call and smartphone data domestically
  • 200 GB of hotspot data per month
  • Unlimited Wi-Fi on select flights from American, Delta, and Alaska Airlines
  • Unlimited text and data while overseas, including 5GB of free high-speed data per month
  • Each employee on a new line gets a new iPhone 13. All the lines get Apple Business Essentials, which includes device management, 24/7 Apple support, and iCloud backup and storage into a single subscription, and Apple Care+. The two Apple services in total cost around $13 per device per month.

T-Mobile business customers can add Apple Business Essentials and/or Apple Care+ separately without a group plan and pay the standard subscription fees set by Apple.

In addition to the new Ultimate+ package, T-Mobile already has 3 existing small business plans. Compared to Ultimate+, Business Unlimited Ultimate (BUU), the highest among the existing plans, offers 100GB less in hotspot data per month, no iPhone 13, no Apple Care+ and no Apple Business Essentials. On the flip side, it does have Microsoft 365 Business 1 Basic and 1 Standard license ($25/month value) and usually costs $40/month/line ($30 now as a limited-time offer). Since each iPhone 13 costs at least $700, small businesses likely find net benefits from Ultimate+, even though they will have to pay more every month for each line.

What I really don’t like so far about this deal is that there are plenty of terms & conditions that can catch customers off guard. T-Mobile makes it clear that $50/line/month doesn’t include taxes and fees, but stops short of explaining in details and an easy manner what those fees are and when they are applied. I get it. It’s hard to make any website appealing while displaying page after page after page of terms and conditions. However, companies usually obscure the important details and “force” customers to accept the terms and conditions before making a deal. I am afraid this won’t be an exception to the rules, based on the reputation of these companies.

What’s in it for T-Mobile?

The press release from the communications giant is that Ultimate+ is the first and only wireless plan in the country as of now that offers Apple Business Essentials and Apple Care+. I looked at the websites of Verizon and AT&T and indeed no plan can match the latest offering from T-Mobile. What Apple brings to the table will help their partner stand out from competition and attract small business customers. However, I remain skeptical of how much T-Mobile can benefit from Apple Business Essentials. Here is why.

To have at least 6 employees who actually NEED 6 new iPhones and data to do their job, a small business has to reach a certain scale. A team of two or three entrepreneurs likely won’t be the target audience of this wireless plan. Even if a small business meets the scale requirement, the expense won’t stop there. A phone is NOT the primary technology tool to work. You need a laptop or a PC. Apple Business Essentials only offers the maximum value when all the devices are in the Apple ecosystem. Hence, it will cost a small business more to cover Apple Business Essentials for the additional hardware, let alone the Apple Care+. In that case, a business owner will wonder if it is really necessary to shell out at least $300/month for Ultimate+. Or will it be better to just cover Apple Business Essentials for the laptops? Those who can justify the expense will even have to have a bigger operations scale. The higher the required scale, the less I think the impact that this new service will have on T-Mobile.

What’s in it for Apple?

This partnership with T-Mobile provides Apple with another channel to grow Apple Business Essentials. It’s logical to combine a device management subscription with a wireless plan. Instead of spending money and growing the workforce to market the subscription, through this collaboration, Apple can leverage T-Mobile salesforce and marketing efforts. After all, T-Mobile is the second biggest carrier in the country and has the scale as well as resources that Apple requires.

Then, why not Verizon or AT&T? I don’t know how Apple executives made this decision, but one possible reason is the advantage in 5G that T-Mobile has over its rivals. Contrary to AT&T and Verizon , which prioritize download speeds at the expense of coverage, T-Mobile is willing to lower the top speed in order to widen their availability. This approach leads to the highest customer satisfaction with T-Mobile 5G connection.

Source: Speedcheck
Source: PCMag

Know for its obsession with user experience, Apple doesn’t want spotty 5G services to ruin their device users’ experience. From the user experience and marketing channel perspective, I can see why Apple chose T-Mobile. But there could be plenty of other reasons, namely T-Mobile being the only carrier willing to bend to Apple’s will. Nonetheless, as an Apple shareholder, I am happy to see Apple’s push into the SMB world. This won’t be their last move.

How Does Direct Mail Credit Card Process Work?

Have you ever wondered how banks or credit unions can mail credit cards offers to you at your current address? How does the process work behind the scene? What impacts a campaign? Why do you receive the same offers from the same issuers but in different envelops? If you have such questions, I am here to pull back the curtain a bit by talking about the Direct Mail (DM) process in general, what impacts the success of a DM campaign and some less known details.

Direct Mail Process

Let’s go backwards from the moment you tear up a mail from an issuer. Whenever an issuer, whether it’s a bank or a credit union, sends you an offer, it must contain information on the offer as well as credit terms and conditions, as mandated by regulations. Inside a mail piece, some issuers include a postage-free envelop that customers can use to send back a filled paper application. Since each piece of paper is an expense, some elect not to send a paper application to save costs, especially during the times of supply chain constraints and inflation. In that case, customers can go directly to the issuer’s website, either by inputing the address manually on a browser or by scanning a QR code. They can also call customer care and apply on the phone.

Each mail piece carries an access code and a reservation code. These codes will be used to identify which offer is attached to an application. Normally, an issuer assigns a unique identifier to an offer for easy and transparent tracking. More on this later.

How do issuers know who you are and where you live? The answer is by working with credit bureaus. Credit bureaus like Experian, Equifax or Trans Union collect a lot of data on Americans. They have your latest address, your social security number, how many trades (mortgage, loans, credit cards…) that you have, how many with a balance that you own, so on and so forth. Issuers can work with these bureaus to pull the names of prospects for DM campaigns. The caveat is that in addition to a fee per name, issuers need to commit that they will send an offer to the names that they pull. Said another way, issuers can’t just call bureaus out of a blue and say: hey, I want to pull sensitive information of these people, but I don’t send them any offer.

Because of this requirement and the fact that each credit card is an unsecured loan that carries risks of losses, issuers must have a plan as to whom they want to send what. To answer these questions, issuers rely on their Credit Risk department, Marketing team and historical data. Credit Risk determines the risk parameters in which new acquisitions must fall. For instance, some banks are more comfortable with people who have little credit history than other banks. Some want to acquire folks with FICO less than 660 than others.

After Credit Risk defines the broad risk parameters, Marketing will work on the specific criteria and offers for a campaign. Each year, Marketing will conjure a campaign calendar that details how many pieces will be sent, when a campaign starts, which offers will be sent, how many applications and accounts can be expected. These details are determined with the help of historical data. Hence, the longer an issuer has been around, the more data it has to make informed decisions regarding DM campaigns.

What Impacts A Direct Mail Campaign?

The biggest factor is whether an issuer sends the right offer to the right audience. People have different preferences. Some don’t like complex rewards structures while others love to maximize rewards points. Some want to transfer balance to a card with a much lower interest rate while others just want to get a cash bonus for their activity. Issuers need to figure out who likes what and sends an appropriate offer. There is a big caveat. Credit cards are highly regulated in the US. Issuers can’t be caught being discriminatory towards any portion of the population. They can use certain behavioral traits as targeting attributes. What they can’t do is to use demographic elements. For instance, income, age, marital status, occupation or place of residence, just to name a few, are strictly forbidden.

Indicators from the bureaus such as how many trades a person has, the age of the oldest/latest trade, the total balance or how many delinquencies a person has can be used in a campaign. Issuers and bureaus themselves also try to use machine learning to build predictive models based on these legal attributes to gain an edge. The better the models are, the more efficient DM campaigns become.

Of course, offers with numerous benefits will excite prospects. As credit card is a fragmented business with a lot of competition, issuers cannot afford to come to prospects with bare bone offers. However, they must also think about their bottom line as rich products tend to be money-losers. Would you apply for a credit card with zero interest on balance transfer and purchase for 20 months, 2% cash back on everything and $400 bonus offer after spending $1,000 in the first 3 months? You likely would, but I can almost guarantee that the issuer of that card would not make a cent of profit. Hence, it’s all about finding that sweet spot between profitability and acquisition efficiency.

Additionally, mail design, paper quality, paper color and copywriting can contribute to the success of a campaign. I am sure you can recall seeing the same offer from the same company, but in different mail designs with different types of paper. Issuers conduct a lot of tests to see which paper or design can generate an extra basis point or two. Furthermore, the use of QR code can also help. USPS currently has a deal in which they will lower the postage expense if issuers use their Informed Delivery service. This is a numbers game. It’s all about finding those extra basis points in response rates.

Behind-The-Scene Details

Let’s start with promo/campaign codes. These codes are usually invisible to credit applicants. They are what issuers use internally to identify offers. In fact, each offer can have two promo codes: the parent code and the child code. The child promo code represents applicants that are upgraded or downgraded, depending on the setup of each campaign. For instance, anybody who applies for a Visa credit card and is awarded a credit line of more than $5,000 will receive a Signature card, instead of a Classic card. Signature cards carry more benefits and give more interchange revenue to issuers. The child promo codes for Visa campaigns are usually assigned to these “upgrades”. For Mastercard, the parent promo codes are given to the higher tier and the child codes are given to the “downgrades”.

What happens between bureaus and issuers? After an issuer finalizes a campaign’s strategy using criteria from a chosen bureau, the issuer will send the bureau such criteria and get back at least three files. The first file will go to the printing house and have some necessary information such as name, address, promo code or a unique identifier tagged to a mail piece called Solicitation ID. The file will not have people’s social security numbers. Nor will it have all the attributes that the bureau has at its disposal because the printing house doesn’t need to have such information.

The second file will go to the issuer and it has fields such as Solicitation ID, promo code and all the targeting attributes that the issuer and the bureau already agreed upon beforehand. These attributes will enable the issuer to analyze campaigns and see what can be the most predictive of success. Almost every issuer usually tasks its Machine Learning team to use multiple bureau attributes to come up with a predictive model so that it can use to generate more applications in future campaigns. Like the first, this second file will not have Social Security Numbers as Marketing or Machine Learning team does not need that kind of data.

The third file will also go to the issuer and be integrated into its decisioning engine. This file will have Social Security Number as Credit Risk and Operations will use it to make underwriting decisions. Of course, these teams don’t need all the targeting attributes as they are less relevant to them than to Marketing.

How do issuers deploy custom models? The answer is that issuers don’t “deploy” the models themselves. Credit bureaus do. After finalizing a model, an issuer will send the “formula” to its chosen credit bureau and the bureau will calculate the score based on such “formula”. The score will be appended to the appropriate files mentioned above and sent back to the issuer every campaign. The issuer will use the real performance data to validate the model and adjust, if necessary.

Every issuer must make sure that all models are in compliance with all lending regulations. Annually, the Office of the Comptroller of the Currency (OCC) conducts an audit to see if financial institutions comply with the regulations. Hence, every model must get approval from an issuer’s Compliance before deployment.

That’s all I have for today’s entry. I hope you find it useful. Drop me a line if you do or if you have questions.

Apple and Major League Soccer

Yesterday, Apple and Major League Soccer (MLS) announced a deal that would make the Apple TV app the home of all MLS games globally in the next 10 years, starting in 2023. Fans will be able to stream all MLS games, with no blackout dates, through a subscription service only available on the Apple TV App. The League has not yet announced the details of said subscription, but are expected to do so in the coming months. Apple said the subscription would also feature highlights, replays, analyses and other original programming. Furthermore, the partnership will also seek to enhance coverage of MLS teams in Apple News and fans can watch highlights right from the News App.

Subscribers of Apple TV+, which is Apple’s own streaming service, can watch a few games at no additional cost. A limited number of games will be available for free, even to non-subscribers of Apple TV+. MLS season ticket holders will automatically receive a complimentary subscription to the MLS streaming service as an additional perk.

The two parties didn’t disclose the value of this deal, but folks familiar with the matter said that it’s worth at least $2.5 billion in its entirety, approximately $250 million a year. The current deal with ESPN+ is worth $90 million and will expire after this year. It was reported that MLS was hoping to make $300 million in annual revenue due to increasing viewership and popularity. Apart from this deal with Apple, MLS is also talking to a few cable companies over the rights to broadcast some games on linear TV.

Below is what each party had to say about this partnership:

For the first time in the history of sports, fans will be able to access everything from a major professional sports league in one place. It’s a dream come true for MLS fans, soccer fans, and anyone who loves sports. No fragmentation, no frustration — just the flexibility to sign up for one convenient service that gives you everything MLS, anywhere and anytime you want to watch. We can’t wait to make it easy for even more people to fall in love with MLS and root for their favorite club.”

Eddy Cue, Apple’s senior vice president of Services

Apple is the perfect partner to further accelerate the growth of MLS and deepen the connection between our clubs and their fans. Given Apple’s ability to create a best-in-class user experience and to reach fans everywhere, it’ll be incredibly easy to enjoy MLS matches anywhere, whether you’re a super fan or casual viewer.”

Don Garber, MLS’s commissioner

Why MLS picked Apple?

In my opinion, it’s about reach and accessibility. A unique part of this deal is that Apple secured the streaming rights globally, not just within the US; which is very different from the usual practice of rights being given over select geographical areas. Apple is one of, if not, the most global and recognizable brands in the world. Its Apple TV app is available on many types of devices, not just those that run on Apple operating systems. By working with Apple, MLS has a partner that can bring the game to the global audience instantly. There is no need for MLS to set up its streaming service. It’s not an easy task, especially for a global audience. With this deal, MLS is responsible for generating content and Apple will take care of the distribution. Moreover, the Apple TV app is native on Apple devices and doesn’t require any more installation. Fans can just head to the app and subscribe to the MLS service; which the Commissioner already alluded to in his remark.

The second reason is reach. Everything Apple does is widely covered and followed. This blog entry is one example. Apple can use its massive following and Marketing expertise to increase the awareness of MLS and help the League become more global. I have no doubt that we’ll see more ads from Apple about this deal, more mentions during events & earning calls, as well as more articles from news outlets, fans and bloggers. From the League perspective, instead of running Marketing campaigns in each part of the world, either by itself or partnering with an agency, I imagine that leveraging Apple is easier and more effective.

Why Apple partnered with MLS?

I find this comment from Don Garber, the Commissioner of MLS, very interesting

This is a minimum guarantee. It’s not a rights fee,” Garber said of the non-traditional deal. “…So if we exceed the minimum guarantee, then we share in the upside in that guarantee. If we’re able to sell our linear rights for what we hope and expect to sell them for, then we would even exceed our expectations.

Source: Tennessean

The new MLS subscription service is only available through the Apple TV app. Hence, Apple will be the one collecting the subscription dollars upfront and grow its Services revenue, at least on the surface. Based on the comment from the Commissioner, I figure no matter how much revenue the MLS streaming service brings in, Apple will pay the League at least $250 million a year. Past that figure, the tech giant will be able to take a share of the upside. It’s clear that this arrangement will do two things: 1/ Apple has something exclusive to sell to its customers; 2/ MLS will have a partner incentivized to promote the League globally as much as possible. With a lot of cash and 73% in Services’ gross margin, I think Apple can afford the $250 million figure promised to MLS.

If an MLS subscription costs $100/year or less than $10/month, Apple will need at least 2.5 million subscribers around the world for it to actually make any money from selling the service itself. Given the current awareness of MLS, especially to countries outside the US, is 2.5 million subscribers an attainable threshold? Unlikely in my opinion, but over a long term, who knows? The financial success of this partnership for Apple hinges on the future popularity of MLS. There are a couple of factors that may come in handy:

The first is that the World Cup 2026 will be hosted by Canada, the US and Mexico. As the world’s biggest soccer event, the World Cup will undoubtedly raise the awareness of soccer as a sport and of MLS. Currently having 28 teams, the League will add one more next year and plan to eventually feature 32 teams in the near future. The more local teams there are, the more interest such teams will generate among communities.

The second factor is the arrival of superstars who make their names in Europe and have massive global following. We already saw household names join the MLS in the past, including David Beckham, Thierry Henry, Zlatan Ibrahimovic, Wayne Rooney, Frank Lampard, Steven Gerrard and David Villa. Recently, Giorgio Chiellini, a popular Italian veteran, signed a deal with LAFC. But MLS would rise to a whole new level if it could acquire superstars such as Messi or Suarez. These players did it all in Europe and are already rumored to play in the US soon due to the media & business landscape as well as the Latino fanbase in the country. The arrival of legends such as Messi would be an instant boost to the MLS and its streaming service.

Apple wants to keep existing customers loyal and appeal to new ones. Sports are a great way to consumers’ heart and Apple seems to agree. Before the partnership with MLS, it struck a deal with Major League Baseball to broadcast games on Friday nights. There were reports that claimed Apple already secured rights to NFL games on Sunday nights. All this sports content will enrich the Apple digital ecosystem and help the company make more money. Two possibilities that I can think of:

  • Apple TV+ is natively available on Apple devices through the Apple TV app. Android users can also access the streaming service, but only through browsers. That’s inconvenient. Great sports content on Apple TV+ can give a nudge to on-the-fence Android users to switch to Apple devices. Whatever money the company lost on this front can be made up by higher margin services (Apple Care, Ads, iCloud, payments, etc..) and slightly more expensive devices
  • At $4.99/month, Apple TV+ is one of the cheapest options on the market. With more games in the library now, Apple can make a case to raise the subscription price. Even a $1 increase could lead to millions more in revenue

From my perspective, this is a good partnership for both parties, more so for MLS than Apple, given its current level of popularity globally. But Apple is known for its patience and long-term planning. The company must have a plan in mind and I am curious to learn more about it.

Interchange and the major factors that can influence it

Have you ever wondered why some merchants enforce an additional fee when customers pay with credit cards? Or why do some merchants politely request customers to pay by cash when a purchase is less than $5? Or why can some fintech startups offer debit cards with rewards when big banks don’t seem to bother?

The answer is Interchange. Cash has been the medium of transactions for centuries. When a shopper hands cash to a merchant in exchange for goods or services, the merchant takes 100% the amount of such exchange and deals with taxes when the time comes. The problem with cash is that 1/ storing a large amount of cash requires a lot of effort for merchants and 2/ not many customers find it convenient to carry cash around, especially for large transactions. Card transactions bring convenience. Merchants get paid in the form of increased balance in a bank account while consumers can spend without carrying a thick purse or wallet. With credit cards, consumers can transact on the credit line extended by a financial institution. But as the old saying “there is no free lunch” goes, such convenience comes at a cost and that cost is Interchange.

Interchange is a small fee that merchants have to pay on every card transaction. The recipient of interchange is financial institutions (FIs) that issue debit or credit cards to shoppers. These FIs use this revenue stream to either pay for their operational expenses or fund rewards that are promised to consumers. Since doing business nowadays always involves card payments, interchange is one of the expenses that merchants can’t avoid.

How much do merchants have to pay on every transaction? The amount of interchange is determined by interchange rates mandated by networks such as Visa, Mastercard, Discover or American Express. There are a lot of factors that can influence these rates and below is a list of factors that I know (by no means, it’s an exhaustive list):

Merchant Category Code

Merchant Category Code (MCC) is a 4-digit code that represents the type of business area in which a merchant operates. For instance, 5411 refers to grocery stores while 5300 represents wholesale clubs. Some companies such as Walmart or Amazon can span across multiple MCCs because of the breadth of their offerings while others like mom-and-pop restaurants have only one MCC. In some industries, including airlines or hotels, a merchant can have its own code. For instance, 3000 and 3001 are assigned to United Airlines and American Airlines respectively.

High frequency categories such as Gas and Grocery carry low interchange rates while others such as Dining or Travel fetch higher rates. Whenever there is a push to promote a specific area, networks raise the interchange rates as an incentive for card issuers. Take Electric Vehicle Charging 5552 as an example. Its rate for consumer cards is 3%+ which is much higher than the average 1.7% across other categories.

Sometimes, it’s easy for consumers to guess MCCs of their purchases. However, it’s much trickier when it comes to big merchants such as Walmart or Amazon. The only way to know is to wait for the transaction to be posted.

Merchant

Giant merchants such as Costco, Walmart or Amazon command great bargaining power and can negotiate a special low rate with the networks. Think about it this way. The rates that I have seen for these companies are around 0.7%. At $500 billion in annual revenue that the likes of Amazon or Walmart generate, interchange expense amounts to $35 million a year. If they had to pay 1.4% in interchange, the expense would double to $70 million. Their retail business margin is not big enough for them to ignore that difference.

Card-Present or Card-Not-Present

A transaction is considered as “card present” only if a card is swiped or tapped or if an EMV chip is processed. A transaction by fax, Internet, mail or over the phone is considered “card not present”. Since card-not-present transactions do not require a cardholder or a physical card to be present at the time of the transactions, the risk of fraud is higher. Hence, issuers receive higher interchange rates on CNP transactions for taking on additional risks.

Networks

There are a few major networks such as Visa, Mastercard, Discover, American Express and JCB. Each has its own pricing schemes and that can affect the rates that merchants have to pay.

Plastic Type

The type of your card also influences interchange rates significantly. On the Visa Consumer side, there are usually three types of cards: Visa Classic, Visa Signature and its highest tier, Visa Signature Preferred. Visa Signature Preferred comes with much higher rates than Classic or Signature. Normally, if your credit limit is above $5,000, your card is qualified for Signature. To qualify for Signature Preferred, a cardholder typically needs to meet a certain spend threshold. To my knowledge, an issuer sends a list of cardholders that meet certain criteria to Visa so that they can flagged as Signature Preferred. If successful, the issuer can earn a decent amount of additional interchange revenue. On the Mastercard, there are also similar schemes and tiers.

Consumer or Commercial

The rule of thumb is that commercial credit cards have higher interchange rates than consumer cards.

Credit or Debit

Credit cards command higher interchange rates than debit cards, simply because credit cards are much riskier as a product than debit cards.

Purchase Volume

Sometimes, the size of a transaction can affect how much merchants have to pay. For instance, American Express has different rates for different ticket size tiers across key categories. Typically, the bigger a transaction, the higher the interchange rates.

Point of Entry

If you shop in store, whether you use an EMV chip, swipe your card, tap your plastic on the card reader or pay with a mobile wallet can affect the interchange rate of that transaction. To make it more complex, the type of mobile wallet that consumers use is also a factor. For instance, staged wallets (PayPal, Cash App) which break down a transaction into funding and payment stages command slightly higher rates than pass-through wallets (Apple Pay, Samsung Pay) that pass payment details directly to merchants. The alleged reason why there is such a difference is that staged wallet providers do not provide as much information regarding payments as the networks would like and that could make the verification task a tad more challenging.

Regulations

To help smaller banks compete, the US government allows debit card issuers with less than $10 billion in assets to charge significantly higher interchange rates than bigger issuers. That’s usually known as the Durbin Amendment. Fintech companies use this loophole to partner with small less known banks to offer debit cards with rewards. In many countries, including the European Union, interchange rates are capped by laws and much lower than what we see here in the US.