The company was then organized as an express mail and banking company, but would later expand into money orders and traveler’s cheques. Today the business derives most of its revenue from discount fees it charges merchants in addition to cardholder fees. The companies’ moat is secured by the network effects it has built over the past 50 years. American Express describes their international credit charging network as a “closed loop” in their financials.
Like Visa, MasterCard and Discover, these credit card companies control much of the plumbing of consumer credit and debit transactions. American Express differs from Visa and MasterCard in one key feature: They do not assess interchange fees. Nonetheless, American Express and its peers share in a tight oligopoly that lends itself to exceptional profits. Recently these profits have drawn the ire of numerous governments.
Regulators from the United Kingdom, Canada, Switzerland and Venezuela to name a few, have all recently conducted investigations into interchange fees and price-fixing within the credit card industry. The United States enacted its own regulation of the industry in the new Frank-Dodd legislation, though it does not affect American Express nearly as much as their rivals in Visa and MasterCard. The main provision in the bill related to card companies is the cap on debit surcharges. American Express does not issue debit cards, but they do issue pre-paid cards which are affected in the legislation.
There is a separate provision that will likely affect revenues for American Express. Previously merchants were forbidden from offering discounts to customers that use payments such as cash or check. The new Frank-Dodd law opens up that option for merchants.
American Express currently has some of the highest discount rates charged to merchants. Their rationale for the higher rate is that their cardholder brings more purchasing power. Average spending on a per-card basis is higher for American Express than any of their competitors. However, there has been erosion of the discount rate over the years and 2010’s average discount rate stood at 2.55%.
Overall satisfaction of cardholders has been a cornerstone for American Express and has been built into their brand. American Express was ranked by JD Power & Associates as the highest in overall satisfaction for credit card issuers in the US for the fourth year in a row. The company is organized like a bank, but it acquires most of its funding through brokered deposits or deposits obtained via third parties. The deposits allow it to finance the credit lines of its cardholders and it also gives the company significant leverage. This leverage combined with high profit margins produce exceptionally high returns on equity as shown below. Return on equity is one of Warren Buffett’s preferred metrics, and most of his holdings share the common thread in being exceptionally high.
In my next article I’ll describe the risks and further examine the financials of American Express.