iPayment Satisfies Its Appetite

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iPayment (Nasdaq: IPMT) and First Data (NYSE: FDC), a Motley Fool Inside Value recommendation, enjoy getting together over the holidays. Yesterday, iPayment announced that it would be purchasing 25,000 electronic payment processing contracts from First Data Merchant Services (FDMS) for $130 million in cash. On December 22, 2003, iPayment purchased 18,000 contracts from FDMS for $55 million. News of the second agreement sent shares of iPayment up 15% to $50.29.

According to the press releases and the company website, iPayment's target market is small merchants, defined as those businesses that have up to $250,000 of yearly transaction charges. These customers tend to get lost in the shuffle at large processors like First Data and Total System Services (NYSE: TSS), the two largest players in the industry, because they would need a huge sales force to serve those businesses effectively. Hence, iPayment set itself up as a business that manages an independent sales office (ISO) and outsources receiving and settling fund transactions. First Data handles that part of the job because it already has the infrastructure to do so. So iPayment is paying for the contracts and then paying First Data a piece of the future profits? But I digress...

I have to admit that iPayment seems to have carved out a very nice niche. Its customers need the service to help their businesses grow. iPayment does not seem to be competing directly with the big boys. Instead, it has an alliance with them to process the transactions. And with small business being an important part of the U.S. economy, it seems as though there are good growth opportunities. So why do I feel worried?

For starters, First Data would only sell contracts that did not meet its requirements. I am guessing that small merchants do not generate the returns that big merchants do. Companies like Starbucks (Nasdaq: SBUX) and Home Depot (NYSE: HD) generate lots more transactions (think economies of scale), can use a variety of services (think cross-sell), and are less likely to go out of business. Thus, I think the risks are inherently greater in the iPayment model.

The other thing that worries me is buying customer contracts. In November, iPayment exceeded third-quarter expectations only to warn that it was likely to miss fourth-quarter expectations. This is especially troubling when growth has been via acquisition. The likely culprits are higher-than-expected costs and revenues that failed to materialize because merchants didn't renew their contracts. And these problems can get larger and larger as the business tries to swallow more than it may be able to chew. Fools would be advised to dig into the financial statements and assess just how well the previous acquisition worked.

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Fool contributor David Meier does not own shares in any of the companies mentioned.