Starbucks Mobile Deal Chops Its Card Costs

In the Square deal Starbucks announced on Wednesday (Aug. 8), the coffee company sharply cut its payment processing costs by turning over all of its U.S. credit- and debit-card processing to the Visa-backed Square. Although Starbucks wouldn't comment on how deep the savings would be, some are suggesting that the processing savings—not the interchange fees—could be almost complete. Hey, a $25 million investment should be worth a little discount, no?

Also, despite what various media reports implied, when Starbucks starts accepting Square payments right before the holiday sales rush it will not be the mobile phone stays in the pocket customer identified by first name and a POS-displayed photograph approach that Square has done with a handful of smaller merchants. No, the Starbucks approach will mirror the exact method it's been using for its own mobile payments for years: Customers will display a 2D barcode on their mobile phone, the Starbucks associate will scan that code, and then the store's existing POS system will handle it normally.

This will not involve a Square sled, either on the customer's mobile device or on a Starbucks mobile device, said Lisa Passé, director of global brand PR at Starbucks. The customer will have to download the Square app and that will be used to pay, with the displayed barcode being scanned by the Starbucks associate. "We will then be able to seamlessly integrate the Square app into our current point of sale system," she said.

When asked if Starbucks might eventually adopt some of the more cutting-edge Square functionality, Passé said: "We haven't talked about exactly what that experience would be."

The program will also be limited to just the 7,706 U.S. company-operated stores (about 61 percent of all domestic locations) and not the 4,947 licensed stores, such as those in Target and various supermarkets. And Starbucks' stored-value card—whether used through the plastic version or using Starbucks' mobile app—is also exempt from this deal.

The deal also gives Starbucks a seat on the board of directors of Square, along with an unspecified equity stake. Whatever that stake was worth before, though, it's likely worth a lot more now that Starbucks will accept this alternative payment in so many of its stores.

Todd Michaud, formerly VP of IT for Focus Brands (Carvel, Cinnabon, Auntie Annie's, Seattle's Best Coffee, etc.) and Director of Retail Technology for Dunkin' Brands (Dunkin' Donuts and Baskin-Robbins), knows the restaurant space well and he argues that this is an impressive endorsement of Square.

"So Square gets the absolute biggest merchant in the restaurant space (their core market), they get $25 million (more than a typical contract would have gotten them), a board member with tons of influence in their core market and free advertising at all Starbucks locations?" Michaud asked. "What's not to love?"Michaud argues that it's likely Square's processing fee for Starbucks is either zero or close it. Indeed, zero is probably cheaper for both Starbucks and Square.

Here's Michaud's rationale: "It's not uncommon for the processing partner (like Square) to offer a 'signing bonus' to the merchant in exchange for switching from a previous provider. For someone like Starbucks, I would not be surprised if a processor offered a multi-million dollar signing bonus. In reality, this is just another way to discount the processing fees. But rather than give up a fraction of a penny on the billions of transactions, they simply give them a cut up front. Typical processing agreements are interchange plus processing fee. I would find it hard to believe that as progressive as Starbucks has been in the payment space in the last decade, that they would be paying more than a penny in processing fees and it's likely as low as half a penny. Since the card brands set the interchange, the only place Square can really play is in the processing fee."

Michaud adds that given that Starbucks has about $8 billion in annual revenue with a roughly—Michaud estimates—$6 average ticket, that suggests about 1.3 billion transactions. "If I then assume a 50 percent rate of credit cards vs. cash, that is $650 million in cash transactions. If they saved Starbucks half a penny on each transaction, that is only about $3.2 million. They are likely offering this deal to Starbucks for free processing in exchange for the $25 million investment. By my estimates, above a five-year contract at half a penny per transaction would only get them about $16 million. In effect, Starbucks is buying their processing down and getting the benefit of company ownership."

In theory, this deal could have substantial impact in both Starbucks' retail world and Square's payment world. On the retail side, Starbucks' endorsement of Square might make this alternative payment move seem less frightening to other chains. It's also easier to sell to senior management being the third or fourth early adopter, rather than the first.

As for the payment world, payment consultant Todd Ablowitz, president of the Double Diamond Group, argues that it has some major potential.

"There will be an inflection point in the near future, where Square will have to decide whether to keep the experience solely on payment cards or whether to offer direct bank account access through ACH (like PayPal, for example) or Dwolla. This could be influenced by their interactions with major retailers, especially the Durbin enthusiasts," he said. "I would imagine the pressure could be substantial and could include interactions with the much talked-about retailer consortium on mobile payments. If Square were to do this, it could put real pressure on the card brands over time, much as PayPal has done in the online business. That said, I'm not sure that the card brands are out of bullets, either."