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Founded in 1850, American Express (NYSE: AXP) has become synonymous with luxury and prestige. Over decades, American Express has established itself as a leader in the premium credit cards market, one of the most lucrative operations within the industry, through acquiring a high-spending, wealthy clientele.
The ‘Spend-Centric’ Model
American Express, or Amex, has over 114 million members, industry-leading client retention and card usage. The credit card industry remains a growing industry, with strong economics and low entry barriers. While everyone in the industry is a competitor, American Express has done well to differentiate itself. Targeting the rich and wealthy as their primary clientele, enabled them to build strong, profitable roots in this industry niche.
Many, mistake the American Express business model as being similar to other credit card companies, overlooking just how distinct it is. Major competitors include Discover Financial, Capital One, Barclays, JP Morgan Chase, Citi and Bank of America. All of whom rely on revolving credit to generate interest income as their primary source of revenue for their credit card businesses. American Express couldn’t be more different.
Operating under a ‘Spend-Centric’ business model, they rely on discount fees as their primary source of revenue. These fees are charged on transactions occurring at merchants, who have entered into a card-acceptance agreement with Amex. Unlike, other major card-issuers, revenues are generated by driving billed-business and not from revolving credit and regular interest payments.
In FY19, American Express generated revenues of $43.5 billion. Non-interest streams accounted for 80% (or $35 billion) of the total revenues, with the remaining 20% ($8.5 billion) derived from net interest income. Non-interest revenues comprised of discount revenue ($26 billion), net card fees ($4 billion) and other smaller streams ($5 billion). This revenue mix incentivises a greater focus on growing billed-business, thereby boosting the average spend-per-card, to generate greater earnings. The benefit here being, the revenues earned can be reinvested into creating more rewards & benefits for current and new members, driving further spending, almost creating a continuous loop of increased billed-business.
American Express is able to execute this with superior efficiency to the rest. Being both, a card-network provider and banking institution enables them to retain revenues earned from both, the merchants and the cardmembers. While other major banks, except for Discover Financial, are restricted to managing relationships solely with cardmembers and relying on Visa or Mastercard to process payment transactions. For use of their card-network, Visa and Mastercard charge processing fees on each transaction, leaving banks with interest income as their primary source of revenues.
We emphasise, in the practice of generating greater revenues & receivables, the banks relying on revolving credit and interest payments would eventually run into a problem. They would only be able to lend to current cardholders up to a predefined limit, and while raising credit limits is common practice, there comes a point beyond which defaults and default risk will make the activity unprofitable. Therefore, incentivising them to increase their customer base. This would enable them to lend more, build receivables and increase interest income. Sounds Good? Well with the industry being so saturated, many banks would need to ease their credit entry criteria, to widen their target pool. In essence, this means offering credit to customers with poorer credit ratings (lower FICO scores) and compensating with higher interest rates.
We acknowledge, major credit card companies have made huge profits from revolving credit and interest income-based models, and continue to do so, by mitigating risk through sophisticated risk-management strategies. We also do not identify any particular business model as being superior to another. However, from our analysis above, it becomes evident how American Express operates under a far more progressive and risk-averse approach, differentiating them greatly from competition.
The key reason why the analysis of business operating models should be of concern to the investor is to erase any misconceptions that may be prevalent beforehand. It is vital, the investor can distinguish between the different business models operated within the credit-card industry, before coming to any sensible investment decision.
Client & Cobrand Portfolios
Boasting one of the most valuable and revered client portfolios in the industry. American Express leverages their clientele, to charge premium discount rates and sign lucrative cobrand partnerships worldwide, especially in the travel and hospitality industries. Major partners include Delta Airlines, British Airways, Marriot International and Hilton Worldwide. Airlines and hotel chains have proven to be the most attractive partners, as they match well with the travel-oriented, high spending clientele which American Express attracts and retains.
American Express, in 2019, had approx. $1.24 trillion of billed-business worldwide, of which, 18% (or ~$223 billion ) was derived from their cobrand portfolio. Cards issued under the cobrand partnership with Delta Airlines alone accounted for 8% (or ~$99 billion) of the worldwide billed-business. Thereby, establishing Delta as their largest strategic partner, with whom they have signed an 11-year renewal in 2019. Delta is also a card-accepting merchant, corporate payments customer and active participant in their membership rewards program by providing travel-related benefits, including Delta SkyMiles, access to Sky Club Lounges (for certain Amex members).
These partnerships help retain and attract new members, increasing revenues from discount & membership fees. While also, enabling Amex to offer members innovative ways to earn and spend reward points (e.g. Avios points, Delta SkyMiles). The rewards program remains spend-driven, thereby incentivising increased spending, to unlock greater rewards, earning greater discount revenue for American Express and boosting sales for merchants. The mutual success of these partnerships has meant a growing cobrand portfolio for American Express, with new acquisitions including partnerships with Amazon and Hilton.
Integrated Platform – The ‘Closed-Loop’ Framework
A card network provider, merchant acquirer and card-issuing bank. American Express and Discover Financial, are the 2 major card issuers to provide an end-to-end platform. All other major banks are restricted to partnering with a card network provider (e.g. Visa or Mastercard), to issue their credit cards. A processing fee is charged by the network provider per transaction, reducing potential revenues for card-issuing banks. Providing an end-to-end platform enables American Express to maintain direct relationships with card members and merchants, creating a ‘closed-loop’ framework, being able to retain more revenue-per-transaction and harnessing key data to improve risk underwriting, marketing and fraud protection across its business.
This platform enables American Express to retain full flexibility in its pricing and execute bespoke contracts more efficiently, with merchants & global brands, compared to a partnership of an issuing bank and card network provider.
Competition with Visa & Mastercard
Visa and Mastercard pose the greatest competition to American Express in the credit card network space, domestically and Internationally, generating pressure to lower merchant discount rates. Visa and Mastercard charges range from 1.4% to 2.5%, compared to American Express’s, 2% to 3.5% range and an average fee of 2.4%. The average rate charged by American Express is equivalent to the top band rate of its competitors.
So why is that? Well, American Express leverages its clientele to offer merchants superior value versus its competitors, in the form of larger transactions and loyal customers. The high-spending ability of American Express cardholders can be inferred from the table below, from which we note, the average yearly spend on an American Express issued card is nearly 5x that of Visa and Mastercard. Acquiring 1 Amex cardholder could be worth 5 Visa/Mastercard.
Accepting American Express is more viable in industries attracting larger single transactions, loyal customers and a wealthier clientele. Merchants in these industries, such as travel, hospitality and leisure, are best positioned to benefit from American Express, and not be deterred by the higher fees.
Discount fees remain the largest source of revenue for American Express and are very sensitive to changes in the discount rate. We do not anticipate the average merchant discount to increase in the future, instead, we would factor in a decline of 10-20 basis points, over the coming years, in our assessment of the company. This, however, should not be of significant concern to the investor. We expect any such declines to be fully offset from an increase in billed business and other growing revenue streams, which may arise as a result of the lower merchant discount rate.
While Visa and Mastercard may have undisputed acceptance for their cards globally, American Express is reducing the gap, through initiatives such as OptBlue, targeting SME's. Recently achieving 99% merchant acceptance in the US and becoming the world’s first foreign network to obtain approval from the Peoples Bank of China, to start building a card-network in China. Subsequently, Visa and Mastercard have also obtained similar approval. The approval came as part of the first phase of trade negotiations between the US and China in 2018 and remains at risk of being revoked upon future revisions or disagreements.
Competition with Major Banks
American Express’s dominance in the premium credit card space has, in recent years, come into question with the entry of rival banks, in particular, JP Morgan releasing their Chase Sapphire Reserve Card, as a direct competitor to the Amex Platinum. Despite the competition, American Express proceeded with raising annual membership fees on their platinum card by $100, from $450 to $550, and continued to enjoy a record increase in platinum account openings with most being millennials. While new competition will continue to enter and exit the market, American Express remains a fantastic brand with strong roots in the industry.
Cobrand arrangements have also received strong interest from rival banks, due to their ability to attract more members and boost spending. Many banks have entered into partnerships with Visa or Mastercard, to compete with American Express. Most notably, Citi Bank partnered with Visa, to replace American Express as the cobrand partner of Costco Wholesale Corporation, after a disagreement arose between the two companies. The co-branded cards with Costco accounted for 1 in 10 of the total American Express cards-in-circulation, making this a very significant partnership.
Despite having lost some partnerships to rivals, American Express has continued to increase its cobrand portfolio, with significant new additions including Amazon and Hilton. They have renewed their partnership with Delta for an additional 11 years and continue to expand their portfolio.
American Express continues to face intense competition from rival banks and technology companies, many of whom are significantly more resourceful. They have, however, over decades established a very lucrative business operation within the industry. Their brand and focus on the premium card category differentiates them from competitors and continues to attract a highly coveted clientele. Competitive threats may pose a risk to future earnings, however, American Express is best-positioned to overcome them and continue to dominate the premium cards market, for many years to come.
Interest Rate Sensitivity
Interest rates govern many important aspects of the financial markets, from asset valuations to consumer behaviour. However, it is the common investor seeking short term profits whom will concern himself greatly more so with the current market rates, than the conservative investor, seeking long term value. American Express, alike to other banking institutions, has significant exposure to the changes in the market interest rates. In FY19, American Express held avg. total interest-earning assets of $119 billion, with interest income of $12 billion, yielding an avg. rate of 10%. Total interest-bearing liabilities amounted to $133 billion, with interest expenses of $3.5 billion, yielding an avg. rate of 2.6%.
A hypothetical increase in the market interest rates of 50, 100 & 200 basis-points, would decrease net interest income by $70 million, $140 million and $280 million, respectively.
A hypothetical decrease in the market interest rates of 50, 100 & 200 basis-points, would increase net interest income by $70 million, $140 million and $280 million, respectively.
The decrease in net interest income, from an increase in market interest rates, arises largely from interest payables on customer deposits increasing, which make up most of the interest-bearing liabilities balance. We note, in the worst-case scenario of a 200 basis-point rise in interest rates, the decrease in net interest income of $280 million, is only 0.65% of the total revenues (of $43.5 billion) earned by American Express in 2019. This is largely attributable to the spend-centric business model the company operates, which shifts the focus of revenue generation towards non-interest revenue streams.
While this signals low exposure to market rates, other factors that arise from changes in interest rates should also be factored into any intelligent investment operation. This includes, but not limited to, impact on loan balances and payment requirements, changes in consumer behaviour and borrowing sentiment. Depending on the prevailing economic environment and market sentiment, different variables may arise and require consideration, before relying on any financial analysis model.
Disclaimer: The report above is strictly for information purposes only, and does not constitute professional advice or a recommendation to purchase or sell any securities. We do not endorse the use of the report above, for use as a basis for any investment decision.
