Dilemma of Commodity

The price of commodity is dropping against dollar. I have been shorting oil by going long on airlines. I decided to review my position after US government officially took over Fannie and Freddie. The dilemma of commodity lies between worsening supply/demand and high inflation pressure.

There are many forces that will drive commodity price down, at least over the near term. Demand destruction is obvious. In the US, total petroleum and other liquids consumption is projected to decline by 610,000 bbl/d. The sale of gas-guzzler is plummeting. The change of consumer behavior will likely to effect long term demand. Internationally, Asian equity markets are among the worst performers this year. Chinese market is down more than 60%. The weak equity market reflects a gloomy outlook of the region's economy. I also use the chart of Euro-Yen exchange as an indicator for oil supply/demand picture. As Europe is a big oil producer and Asia is a big consumer, when oil demand decreases, Yen will appreciate against Euro. (see the chart)

On the supply side, oil producing countries are increasingly addictive to high oil price.Their expansive fiscal policy depends on exporting oil. Iran's nuclear power project and Chavez's nationalization plan come to mind. If oil price drops further, they might be forced to increase their output to maintain the capital inflow. Thus the downward move is reinforced.

However we can not ignore dollar when analyzing commodity-dollar relationship. After taking over Fannie and Freddie, US government is officially on the hook with the 5.2 trillion mortgage debt. According to some reports, it will likely to cost US government 200 Billion or more. The question is how this bill is going to be paid. With the dismal economy, tax revenue will be down. I doubt that US government will be able to fund this 200+ billion entirely by issuing treasury. Mostly likely big Ben's money printer is running at full speed. Hence I think the recent strength in dollar might be short lived. The inflation pressure will remain high, which will support commodity price.

Wage might become the unexpected force to further drive inflation up. Labor unions are been gaining strength recently. Boeing, GM, Ford just to name a few. In the last 20 years of low inflation and high growth economy, workers do not need to defend their share of cake. During last high inflation era (early 80s), 20% of private sector workers are union members. Today this number is 7%. It will be naive to believe the real way will keep falling. When the real wage is falling at record pace (article), workers will more rely on union to negotiate higher wage. Higher labor cost will further push the inflation higher.

How do I trade this? I have kept my long position in airlines expecting further drop in oil price. The price increase implemented during the days of 150 dollar oil will not go away. Airlines will be the major beneficiary of falling oil. I went long with a small position in Peabody Energy (BTU)yesterday to hedge my oil bear bet. Coal demand is more stable, as the majority of production goes to electricity production.

My gloomy view of the economy

I am not an economist. The market is telling me that US might have dodged a severe recession. According to my humble common sense, I can not believe it.

The 3.3% GDP growth of US in the first half of 2008 was supported by two factors: stimulate checks and strong exporting. The former helped retailers to meet their lowered sales target. But it is gone. We will have a clearer picture of US consumers in the 2nd half of this year, especially the Christmas season, when the shock of high heating bill hits people. The strong export made up most of the "surprise" of the GDP number.What's the picture outside US? Japan just checked in the "Hotel of R" and many Europe countries,such German and UK, have booked their room on priceline.com. As a significant portion of US export are technology, I can not convince myself how it will hold its head above water, when Japan and Europe are drowning. The growth in emerging market might provide some cushion for US export, but slowing US consumer might eventually hit the emerging countries.

So, here is my gloomy outlook. There might the first time in the recent history that all three major economies (US, Europe and Japan)are in the recession at the same time. The slowing global economy will eventually drag on emerging markets. However, as my emerging markets, China and oil producing countries, have sufficient foreign reserve and healthy trade surplus, they might get back to the growth earlier by trading between themselves.

Let me know what do you think!

Brief analysis of Retail Payment Processing Industry

I recently came across ACI worldwide (ACIW), when I was researching Fidelity National (FIS). Since I have been studying Michael Porter’s “Competitive Advantage”, I will try to lay out a detailed business analysis first. ACIW takes cost focus strategy. It dominates in the transaction processing software market serving the large banks. ACIW has built the scale of economy to have cost advantage against its competitors. The high switching cost nature of such products further fortify ACIW’s wide moat.

The largest business for ACI worldwide (60% or Rev) is electronic retail payment processing market. From company 07 annual report:
“The electronic payments market is comprised of financial institutions, retailers, third-party electronic payment processors, payment associations, switch interchanges and a wide range of transactiongenerating endpoints, including automated teller machines (‘‘ATM’’), retail merchant locations, bank branches, mobile phones, corporations and Internet commerce sites. The authentication, authorization, switching, settlement and reconciliation of electronic payments is a complex activity due to the large number of locations and variety of sources from which transactions can be generated, the large number of participants in the market, high transaction volumes, geographically dispersed networks, differing types of authorization, and varied reporting requirements. These activities are typically performed online and are often conducted 24 hours a day, seven days a week.”
ACIW is the leader in retail payments software that facilitates all of the underlying steps involved in processing credit and debit card payments, including (but not limited to):
Channel Management & Enterprise Access: Routing the information along the relevant networks based on the various originations of transaction (ATM, credit, or debit) and geographic locations.
Authentication: Verify the authenticity of POS terminal, network, card, cardholder, and bank.
Authorization: Matching PIN to the account, fraud prevention and etc
The secular growth of Payment processing


Plastic is replacing the paper. Global electronic payment transaction is expected to grow at double-digit pace. Processing capacity and security of the data are major concerns of financial institutions. The old generation mono-line products built for processing single type transaction (e-banking, debit card, ATM service and etc) need to be integrated onto a single platform.

Competitive landscape of the industry (Threat of substitution):
There two other products competing against retail payments software in this segment. Small financial institutions generally outsource to third party for transaction processing service, such as First Data or Fidelity National Information Services. Due to the lack of scale of economy, small banks can not justify the cost of housing the processing capacity in house (maintaining IT hardware and licensing software). It typically cost the bank 0.02-0.05 cents per transaction, if using third party service. The second is the in house developed transaction processing software by large banks. Some banks even license their program to smaller banks. ACIW believes that such systems represent at least 34% of the market among large banks.

Retail payments software does not directly competing against the third party service provider, because their customers are typically large banks who have comprehensive in-house IT infrastructure. Using software like ACIW’s, this cost falls to $0.0001 to $0.001 per transaction, significantly less than the third party service.

In-house developed software is the real head-to-head competitor. Theses homegrown software are quite “stone age”, with the newest being 15 years old. The main sources of stress on these systems are from rising payment volumes and new regulatory mandates from bodies such as Visa, MasterCard, and the Office of the Comptroller of Currency. These mandates usually change how transactions have to be processed or encrypted and thus require updating the software. The software update requires much more cash outlay than licensing software from ACIW. ACIW’s software is like an expandable platform where various functional modules can be installed (will discuss later in detail). For big banks, it is much more efficient to have all the functional program built on a single platform. Besides the secular trend of increasing electronic transaction volume, it is critical to watch whether ACIW can take shares from the homegrown program during this update cycle.

High switch cost:
Installing this type of software is like a major organ transplant. You do not want to do it unless the one inside you is failing. It usually takes 9-12 month and can be as much as 24 month to fully install the program. The IT engineers need to be re-trained as well. The switching costs are evident in the fact ACIW’s renewal rates are 98% (5 year term). Winning a new customer almost guarantees a stable cash flow for 100 years.

Rivalry between competitors
The rivalry among the software vendors has been moderate. There two companies competing on the global basis: Mosaic and eFunds. Because the cost of licensing and maintaining software is a small portion of cost of ruining the transaction processing infrastructure, ACIW and its competitors are competing on performance of its product and maintenance service.

Mosaic acquired by S1 in late 2004 sells Windows based products that competed with ACIW in mid-sized banks. S1 has attempted to sell Mosaic’s mid-sized software to large banks, but this strategy proved unsuccessful. ACIW dominates the competition in large banks, because Windows wasn’t perceived as robust enough for datacenters. It confirms that customers are more concerned with the performance and less price sensitive.

eFunds has a division that competed with ACIW for decades, but this division eventually morphed towards a processor type business model. Before it was acquired by Fidelity National, that unit has 50MM of revenue (vs. 370M for ACIW) and installations at 30 of the world’s top 500 global banks (vs. 120 for ACIW). Due to its lack of scale, its profitability is inferior to the rest of Fidelity National’s businesses. As Fidelity National (FIS) focuses on a processor type business model, it is likely that capex will be reduced in this software development division (Management at FIS has mentioned cost cutting at eFunds, but did not breakdown). I think eFunds will not compete aggressively for market share.

Internationally, ACIW competes with various regional players, but a global support infrastructure is proving increasingly important in serving global banks. In addition, ACIW has the scale of economy to offer the most comprehensive solution in the industry. Its competitors, by contrast, only provide pieces of the overall solution.

Bargaining Power of the customers
ACIW’s customers have relatively strong bargaining power mainly due to their ability of backward integration. Historically, they were able to get as much as 40% discount on the renewal license. However ACIW has been able to achieve EBITA margin in the high teens range, comparable to other third party processing companies. Their customers are less price sensitive, which allow ACIW to maintain a desirable margin.