In Part I, we looked at Nicholas Financial, a microcap subprime auto lender. We saw evidence of a moat based on nothing more than temperament, restraint and a rational approach to credit risk. Today, we look at a much larger company, The American Express Company (Amex). This business also looks rather commodity-like, at least on the surface. Could they too have a moat?
In 1958, a venerable old company named American Express decided to enter the charge card business. It would have to compete with the incumbent, Diners Club. The need was urgent because the Diners Club charge card was stealing business from Amex’s travelers check business. It would therefore have to get to scale quickly. To do so, Amex would have to solve a classic chicken-and-egg dilemma. Amex needed cardholders to get merchants to sign up. Simultaneously, consumers wouldn’t sign up unless a lot of merchants accepted it.
The company entered the charge card industry on October 15, 1958 with 17,500 merchant locations and 250,000 cardholders. It achieved this scale quickly by buying Gourmet Magazine’s card business and the Universal Travel card.
From the beginning, Amex pitched itself to the more affluent, higher spending segment.
What Business is Amex in?
Amex is a unique amalgam of a bank and a payment processing company.
- Global Payment Network Operator: This is Amex’s toll booth business. Every time you use your Amex card, Amex charges the merchant a fee, o r a toll. Millions of little tolls charged on each transaction add up. These merchant fees or “discounts” in the parlance of the industry, act almost like a toll on global commerce. Also, this credit card toll bridge requires little in the way of capex. As Warren Buffett said, ““In an inflationary world, a toll bridge would be a great thing to own because you’ve laid out the capital costs. You built it in old dollars, and you don’t have to keep replacing it.” Somewhat surprisingly, Amex earns the majority of its income from these discounts – 52% in 2012. This percentage has increased rapidly over the past 10 years, growing from 34% in 2003 as Amex has achieved scale.
- Lending: Amex also lends funds to its cardmembers. Interest income represented just 20% of revenue in 2012. At different points in time, Amex’s relative lack of interest income has been seen as a handicap (see this 1995 Fortune article for one example). But, following the 2008 financial crisis, it certainly looks wise.
- Fees: The next biggest piece of revenue is net card member fees. Cardmember fees are another low risk activity. Fees have been flat at 7% of revenues for the last decade.
- The remaining 20% of revenues is made up of travel related services and commissions and fees, including foreign currency conversion fees, delinquency fees, service fees and other card related assessments.
Overview of the Payments Industry
The major players in the payments industry are as follows:
- The Card Network Operators – The networks impose rules for issuing cards, clear and settle transactions, advertise and promote the brand, authorize transactions, assess fees and allocate revenue among the transaction participants. The card network operators also bear the costs necessary to maintain the network.
The major card network operators are Visa and Mastercard. The Visa and MasterCard are open –loop networks, meaning that they allow third party banks to issue cards and process payments on their networks. The other major card networks are Amex and Discover who for the most part operate “closed-loop” networks. Amex manages both the acquiring relationship with merchants and issues cards to consumers.
- Issuing Banks – As of 2011, over 5,000 depository institutions including commercial banks, credit unions and saving institutions, issue VISA and MasterCard credit cards and independently set the terms and conditions on their plans. In addition to the firms issuing cards through the VISA and MasterCard networks, two other large firms, American Express Co. and Discover Financial Services, issue independent general purpose credit cards to the public. Issuing banks collect payments from cardholders, extend credit to cardholders, distribute cards, finance receivables and authorize transactions. Their principal revenue streams are interest payment from cardholders and interchange fees from merchants.
- Acquiring Banks – Banks that service merchants and process their credit card transactions.
- Cardholders – Purchases goods and services using the card. For purposes of this discussion, a “card” can mean a credit card, a charge card or a debit card but will usually mean a credit card unless otherwise stated. The chief benefits to the cardholders are: convenience of making purchases without carrying cash, ability to time payments to match cash flows, access to credit and rewards programs.
- Merchants – Sell goods and services and accept payment via cards. Access to large number of consumers, ability to sell to consumers needing credit without carrying credit risk and guaranty of payment.
A typical credit card transaction on an open loop network works as follows:
- A good or service goes from a merchant to a consumer.
- The consumer is billed for that product by the issuing bank.
- The price the consumer pays is transferred to the acquiring bank and then to the merchant.
- The merchant pays a merchant discount to the acquiring bank and the acquiring bank pays an interchange fee to the issuing bank.
- MasterCard and Visa serve as clearinghouses for each of these transactions and extract a small transaction fee from both sides
The interchange fees are set by Visa and MasterCard. Interchange fees are the largest fee merchants pay for the privilege of accepting credit cards.
A typical credit card transaction on a closed loop network involves just 3 parties:
- A good or service goes from a merchant to a consumer.
- The consumer is billed for that product by Amex.
- The price the consumer pays is transferred to Amex and then to the merchant.
- The merchant pays a merchant discount to Amex. The merchant discount, or discount rate, is a fee charged to the merchant for accepting Amex cards and is generally expressed as a percentage of the charge amount. Amex does not share the discounts with other parties.
Competition in the Payments Industry
Due to AMEX’s hybrid business model, it faces competition from both network operators and card issuers.
Competition Among Networks
The goals of competition among the network operators is (1) expansion of the network and (2) wider usage of the network. The primary means for competition are the merchant discount, advertising and innovation. The network operators will promote the expansion of the network into new retail sectors by dropping interchange fees. In the early 1990s, for example, all 4 networks encourage the use of cards in the grocery business by dropping the fees.
Market share among the competitors varies based upon the unit of measure. Analysts typically use dollar volume, number of transactions or cards-in-force. By any measure, AMEX trails Visa and MasterCard dramatically globally with a slight edge over MasterCard when looking at the US market exclusively.
Competition Among Issuers
The goals of competition among card issuers are to sign up and retain card holders. The primary method is solicitations, usually by direct mail, offering more advantageous terms (e.g., lower APRs, annual fees, rewards and rebates) and introducing new products such as affinity cards. Prior to the early 1990s, credit card companies competed largely on the basis of rewards programs. Amex still does but interest rate competition plays a more prominent role for Amex’s competitors. They routinely use 0% balance transfers to attract customers and gain market share. For Amex, 0% balance transfers represented just 5% of offers. For its top 5 competitors, it ranged anywhere from 90% to 50% of offers. Such offers are unlikely to attract the affluent customers that merchants want to reach and the segment where Amex is so strong. Further, these offers do not expand the market for credit cards but instead represent a short-sighted bid for market share at a 0% yield. See Chart 1.
Chart 1 (click to expand)
AMEX is the clear leader in the US market. See Chart 2.
Chart 2 (Click to expand)
Differentiated Business Model
How does American Express effectively compete when it seems to have so much working against it? After all, it has fewer cardholders, fewer merchants, higher merchant fees, and higher cardholder annual fees than its competitors.
The key to Amex’s success is its “spend-centric” business model. The spend-centric business model focuses on generating revenues primarily by driving spending on the cards and secondarily by finance charges and fees. The average Amex customer spends 2-4 times as much as customers using competing cards. See Chart 3. American Express sells its network to merchants by playing up their relatively wealthy customer base. Merchants are willing to pay the higher discount rates in order to get access to Amex’s affluent cardholders.
Chart 3 (click to expand)
By charging higher discount rates, Amex knowingly avoids the lower end of the market and is not accepted at many smaller merchants. While there are a lot more small and medium-sized business than large businesses in terms of raw numbers, in terms of credit card purchase volume, we find it likely that there is an 80/20 effect whereby 20% of the merchants are doing 80% of the volume. There’s a good chance that the bigger merchants in the 20% accept Amex, which offers plenty of volume from which Amex can profit despite a small network.
On the cardholder side, competing cards simply do not offer the same benefits and level of service. Rewards, benefits and service is what lures consumers to the brand. The Starwood Preferred Guest (SPG) card is a good example. No other card allows you to accumulate SPG points at a rate of one per dollar spent. Even in Amex’s on point network, these SPG points go for ~3 Amex points to 1 SPG point, so it’s a great deal at 1 per dollar of spend.
With Amex’s higher level cards (Platinum and Centurian), they often have special early access to certain blocks of premium seats at major events and concert.
The premium pricing also augments Amex’s brand image of prestige and exclusivity (more on this below).
In contrast to its competitors, for Amex lending is merely “a planned and profitable outcome of our spend-centric strategy as we offer cardmembers the flexibility to revolve payments, but it is not our primary focus.” This business model creates much less risk than the “lend-centric” model of its peers. The majority of the Amex business is in charge cards, which people have to pay off, in full, within 30 days, so there is no danger of running up debt as there is on credit cards.
A Virtuous Circle
Perhaps most importantly, the spend-centric model also drives both customer and merchant loyalty through a self-reinforcing process:
- Spending on Amex cards is higher on average on a per-card basis versus its competitors
- Merchants want to accept the Amex card to attract these high-paying customers
- This affluent customer pool enables Amex to charge higher discount rates
- Because of the revenues generated from higher-spending Cardmembers, Amex has the cash to invest in more attractive rewards and other benefits to Cardmembers
- The rewards program in turn creates incentives for Cardmembers to spend more on their Cards.
Does Amex Have a Moat?
Quantitative Evidence of a Moat
- High ROE: Amex has been able to maintain high returns on equity, averaging 26% over the past 10 years. Amex also compares favorably to its big banking peers. MasterCard and Visa have slightly higher 10 year averages but their results are less meaningful. See Chart 4.
- Free Cash Flow: FCF has grown at a fast clip and is regularly far greater than reported earnings. It dipped at the height of the financial crisis in 2009 but otherwise has been very reliable. In fact, FCF has compounded at an annual growth rate of 17% over the past 10 years. This CAGR compares favorably with every wide moat company we have looked at thus far, including Moody’s.
- Stability of Market Share: One of the hallmarks of a great business is very little competition. As discussed above, Amex, MasterCard and Visa have controlled the US market for decades and have strong presence overseas as well. Amex is the fourth largest general-purpose card network on a global basis based on purchase volume, behind Visa, MasterCard and China UnionPay. Among card issuers, it has been the leader in the US market on purchase volume for years.
Chart 4 (click to expand)
Qualitative Evidence of a Moat
Amex has customer captivity in the form of network effects and brand loyalty complemented by economies of scale.
Network Effects- Higher Spending Customers, More Merchants, Better Rewards
How could a new card network possibly compete against the big 4? Think about it. You are trying to start a new card network to compete in the US with AMEX, V, MA and Discover. Unlike 1958, it would find it very difficult to sign up new merchants. The top 4 – Visa, MC, Amex and Discover – account for ~85% of all credit card spending in the US and have already signed up the vast majority of merchants and consumers. How do you bring together large numbers of cardholders with large numbers of merchants who accept the cards as payment? How do you get to scale? The huge network of merchants gives Amex, as well as V, MA and Discover, a competitive advantage over any other company that may want to start up a new card network.
The four network operators represent an oligopoly and illustrate a fundamental reason why the network effect can be an extremely powerful competitive advantage: Network-based businesses tend to create natural monopolies and oligopolies.
A key part of Amex’s moat is its brand. The Amex brand stands for service, success and prestige. The Company has been building its brand since 1886. A brand is a promise, and a fulfilled promise, such as Amex delivers, creates substantial value. See Chart 5.
Chart 5 (click to expand)
To build a brand, businesses must continually strengthen the brand in the minds of consumers. Once a business stops investing in its brand, it is likely the value of the brand will decline. You can start to see this when management begins to cut development, marketing, and promotion to save expenses. This causes the brand’s long- term identity to suffer at the expense of these short- term savings. Amex is just the opposite. In 2012, Amex spent $3.6 billion on marketing and promotion and they are committed to spending 9% of revenue per year on this area. Capital One spent $1.3 billion in 2012 on marketing, about 6% of revenue. Even if they could push it up to 9% of revenue, it would still be substantially below Amex.
How would you create a brand that competes with Amex? JPM is trying. It introduced the Chase Sapphire and Sapphire Preferred cards take on Amex’s Gold Card. JPM also introduced the JP Morgan Palladium Visa card, made of palladium and 23-carat gold to compete with the Amex Platinum card and the Centurion card (a.k.a, the “Black Card”).
But, JP Morgan seems to be battling for market share at the expense of profitability. It has to offer expensive rewards and services to lure away Amex customers while charging a much lower interchange fee, close to 1% per Barron’s.
Amex reinforces the competitive advantages from its brand and network with best in class service and its leading rewards program.
Amex’s huge economies of scale in rewards make it difficult to compete. Amex takes its pricing power from the merchant side of the business and plows the cash into rewards to compete against the other issuers. Amex spent $.3 billion on rewards in 2012, the most in the industry. Capital One spent just $1.3 billion on rewards and Discover spent even less, $1 billion. If you are a new issuer trying to compete with Amex, how do you get to scale in rewards?
The rewards program also creates switching costs. If you have accumulated significant points at Amex how can you switch to a competitor?
Similarly, Amex has economies of scale in service. It routinely tops the JD Power lists for customer satisfaction. Here is a list of services Amex provides to cardholders per the 2012 annual report:
|• Business Platinum Office Program||• Event Ticket Protection Plan|
|• Global Assist® Hotline||• Automatic Flight Insurance|
|• Car Rental Loss and Damage Insurance||• Premium Baggage Protection|
|• Extended Warranty||• American Express® Travel Insurance|
|• Purchase Protection||• CreditSecure®|
|• Return Protection||• Roadside Assistance|
|• Emergency Card Replacement||• Advance Ticket Sales|
|• Manage Your Card Account Online||• Exclusive Access to Cardmember Events|
|• Online Year-End Summary|
One of the clearest indications of a moat is the ability to raise prices without fear. The card network oligopoly is able to raise prices without fear of losing business. The greater fear is that rapidly rising merchant fees will invite government intervention (more on this below). Numerous commentators and lawsuits have focused on the fact that the 3 network operators have too much pricing power. An indication of Amex’s pricing power can be seen in the steady level of its discount rates. There has been a slight erosion over the years that is thought to be the result of large merchants having the leverage to get volume discount rather than competitive pressure. Amex’s discount rates are thought to be substantially higher than Visa and MasterCard’s.
AMEX recently settled two lawsuits regarding the restrictions they place on merchants. The issue is whether merchants can tack on a surcharge when customers use their AMEX card. Under the agreement announced late Thursday, American Express will drop its ban on retailers charging a surcharge to cover transaction fees. The settlement is still needs court approval. The actual cash settlement is an immaterial amount, $79 million. Further, the Company believes that merchants will not actually use surcharges for fear alienating the big spending AMEX customers. The more likely outcome is that merchants will offer discounts for debit cards, cash or checks.
The Threat of Technological Disruption
Commentators are actually more concerned about a dramatic lack of competition and a concomitant stifling of innovation.
Felix Salmon, an economics blogger on Reuters, wrote: “. . . (I)f you look at the main players in the payments industry, whether they are incumbents or new innovators who aspire to disrupting the status quo, everybody seems almost unthinkingly resigned to working on and within the present architecture, where consumers pay with their credit or debit cards, and merchants require some kind of way of accepting those payments.
“Visa and Mastercard, of course (and American Express, too) are very happy with this. They can work on innovations themselves, or they can outsource innovation . . . either way, they get paid, because they’re the default payment architecture. But what we’re missing here is any kind of threat to their dominance. And that’s a great shame, because these dominant companies have an enormous amount of pricing power.” (Emphasis added.)
Of course, Mr. Salmon is writing from the perspective of a consumer advocate and not a shareholder. From a shareholder’s perspective, or course, the state of affairs he describes is highly beneficial. Shareholders, unlike consumers, benefit when competition is reduced and the “creative destruction” of capitalism is held off by a wide moat.
Can AXP Grow Faster Than GDP?
One concern with a company has large as AXP ($31 billion of revenue in 2012 net of interest expense) is whether it can continue to grow. To be sure, the US credit card market is quite mature. As of 2009, the latest year for which I could find data, 72.2% of consumers had a least one credit card. Credit cards are widely accepted by merchants, including nearly all retail establishments.
There are two aspects of any credit card growth strategy: (1) grow the pie or (2) grow your slice of the pie.
Growing the pie consists of expanding the volume of transaction processed on credit cards. One of the key long term trends driving growth at AXP is the shift away from cash and checks to cards and electronic payments. I typically don’t focus on macro trends but this seems pretty obvious and unlikely to reverse. Currency has no meaning online. As more transactions move online, the trend toward a cashless society intensifies. Although the trend away from checks is accelerating, check use is likely to continue through at least one more generation because they are viewed as the most convenient form of payment by many small and medium-sized businesses, charities, and older generations. See Chart 6.
Chart 6 (click to expand)
The other positive trend is the rapidly growing consumer markets of the developing world.
Growing your slice of the pie means increasing Amex’s market share. Since Amex already has a such a big piece of the affluent market, increasing market share means going down market. Amex must somehow appeal to down market customers while maintaining its brand image.
Why is Amex a great business? It requires no capital. It’s essentially a royalty on growth and consumption. It has great tailwinds: credit and charge cards are taking share from cash and checks. Amex is the type of business Buffett loves. The basis business model is so strong that is very difficult for management to screw it up. It’s not like a retailer where you have to get it right over and over again. Management’s sole job is to protect the brand and allocate capital accordingly.
 Professor Bakshi did a great job expanding upon the toll bridge metaphor here: http://fundooprofessor.wordpress.com/2012/10/21/toll-bridge-meaning/
 Board of Governors of the Federal Reserve System, “Report to the Congress on the Profitability of Credit Card Operations of Depository Institutions,” June 2012
 2007 letter to shareholders
 For non-finance companies, we use ROIC. We find the ROE works better for financial companies. ROE here is defined as net income / shareholders’ equity.
 After much googling, I gave up trying to find data on Visa and MasterCard’s weighted average interchange rates. If anyone has access to this data, please send it to me. Thanks.
 “The 2009 Survey of Consumer Payment Choice,” Federal Reserve Bank of Boston; published in 2011.