In reviewing the company’s competitive advantages, we should start with the obvious observation that using charge cards and credit cards is vastly superior to using cash and checks in terms of convenience, safety and record keeping and thus cards should continue to gain market share from cash and checks for years to come. As noted above, American Express is not the only option within the card industry. However, in comparison to Visa and MasterCard, the company has a number of key competitive advantages. Chief among these are the American Express brand and the higher spending patterns of its wealthy consumer, corporate and small business cardholders. Because American Express customers spend more, merchants are willing to pay the company a higher fee. Furthermore, because American Express is primarily a charge card, rather than a credit card, it is far less reliant on consumer lending for revenue and profits than typical card issuers. For example, the company generates almost four times as much revenue through transaction or interchange fees from merchants ($18 billion) as it does from lending to cardholders ($4.6 billion of net interest income before $2 billion in charge-offs). Cardholder rewards are a key enticement for customers, and with $6.3 billion allocated to rewards in 2012 American Express has the largest program in the industry.
In terms of growth, if the company maintains its appeal and usefulness for consumers over time, per-card spending and transaction fees should increase with disposable income as should market share gains from cash and checks. Because the Internet does not accept cash, the high growth of Internet commerce provides an additional tailwind. The total amount spent by American Express cardholders, or “billed business,” has increased from $124 billion in 1993 to $888 billion in 2012, an increase of seven times in 19 years, or almost 12% per year. International billed business has almost doubled since 2006 and now accounts for $313 billion or 35% of the total, up from 30% then.
Finally, because its payment network is wholly owned, American Express largely avoids sharing its transaction fees with others. This closed loop allows the company to generate significantly greater revenue per transaction dollar than the networks of its competitors Visa and MasterCard, whose interchange fees are shared with issuing banks and other payment processors. Full control over the payment network should also lead to better customer insight over time, perhaps enhancing targeted customer offers and driving higher spending per card.
Turning to people, Ken Chenault (age 62) has been CEO for 12 years, having joined the company in 1981, and we give him high marks. Working closely with his predecessor Harvey Golub, Mr. Chenault helped refocus the company on the core charge/credit card business while spinning off the financial advisors business (Ameriprise) in 2005 and other unrelated businesses before that. Since becoming CEO he has repeatedly lowered the cost structure of the business, including cutting costs in the corporate and retail travel business in late 2012 with a goal of reinvesting at least half the savings in the card business. President Ed Gilligan (age 53), Mr. Chenault’s likely successor, also has had a long and distinguished career at the company, having joined in 1980 and previously run the travel, international and corporate services divisions. In addition to the fact this team has done a good job managing their business, they also deserve praise for avoiding both large acquisitions and, to use another excellent term coined by Peter Lynch, “diworsification.” Finally, we commend this team for maintaining generally sensible compensation practices and exercising unusual restraint in the granting of large amounts of dilutive equity compensation.
Turning now to price, American Express trades at approximately 14 times our 2013 estimate of owner earnings, what an owner of the entire business could distribute or choose to reinvest on a discretionary basis. Put differently, purchased at today’s price, the company generates about a 7% earnings yield. The dividend yield is 1.2%. The company’s return on equity has consistently been above 20%, and the company generates substantial discretionary free cash flow that can be returned to shareholders, often in the form of share repurchases and dividends. The number of shares outstanding has declined 24% since 1993, a decrease of about 1.5% per year. More recently, shares outstanding at year-end 2012 were down 4.2% from year-end 2011, and we expect the trend of higher share repurchases to continue in 2013. At the same time, the dividend has increased from $0.33 per share a year in 1993 to $0.80 per share a year, an increase of 2.4 times or 5% per year. The potential capital returns are enabled by a very strong capital position, with a Tier 1 capital ratio of 11.9%.
Finally, and most important, we should discuss our view of the major risks facing this wonderful business. Chief among these is the possibility of the company losing its consumer relevancy in terms of convenience, brand, service, or the value proposition (rewards). Although such a decline can happen slowly or quickly, we are reassured that management continues to plough money into marketing and cardholder rewards rather than “milk” the business for short-term earnings. A second critical risk lies in the possibility of a dramatic upheaval in the payments industry, likely enabled by Internet technology. In considering this possibility, we note that a number of small and larger companies have attempted to break into the electronic payments industry, but so far PayPal is the only clear success story. Others, such as Square, actually have expanded the reach of the industry by allowing smaller merchants to accept cards. In addressing this risk, the company has also made a number of small acquisitions of new technologies, which might be viewed as a type of R&D expense. A third major risk is that the economics of American Express’s existing business could be slowly eroded as other card issuers pursue the same transaction-based (rather than lending-based) customers. JPMorgan Chase has been a particularly determined competitor in the affluent customer segment, with aggressive marketing and rewards programs. For example in its most recent financial statements, JPMorgan indicates that its total payment volume and customer spending per card are almost as large as American Express’s U.S. retail card business. While this trend must be watched closely, we feel management is doing a good job meeting these competitive challenges. For example, since 1999 American Express has grown its share of U.S. credit card purchases from 20% to 26%, a meaningful increase in market share in 13 years. Next, we must always consider the actions of regulators. Retailers are not forced to accept credit or charge cards, but they often complain to regulators and legislators about the fees they pay. Although this is a more modest risk for American Express than Visa or MasterCard and also less likely today than a few years ago, it could become an issue again at some point. Finally, we must consider the possibility of American Express making a large, dilutive acquisition, a risk we also noted above in our discussion of Bank of New York Mellon. Fortunately, as with Bank of New York Mellon, we consider this risk a remote one under American Express’s current management.
From Chris Davis' Davis Funds fall 2013 manager commentary.