Even with the potential advent of central bank digital currencies, credit cards, debit cards and other cashless forms of payment will continue to be the predominant method of payment used. I think American Express Co. (AXP, Financial) has a huge advantage over the two other credit card issuers, especially in recessionary times.
American Express operates under a closed-loop network model, meaning it acts as both the card issuer and the network provider. This means the company controls the entire transaction, from the customer to the merchant. This model allows it to gather more data on transactions and to have a direct relationship with both cardholders and merchants. This vertical integration is a durable competitive advantage.
American Express versus Visa and Mastercard
On the other hand, Visa Inc. (V, Financial) and Mastercard Inc. (MA, Financial) operate under an open-loop network model, acting primarily as network providers. They work with issuing banks (like JPMorgan Chase (JPM, Financial) and Bank of America (BAC, Financial)) that issue the cards to consumers and acquiring banks that work with merchants.
Due to its model, a significant part of American Express' revenue comes from merchant fees (discount revenue), which are typically higher than those of Visa and Mastercard. Visa and Mastercard mainly earn revenue from transaction and service fees paid by the issuing and acquiring banks in their network.
American Express traditionally targets affluent customers with excellent credit histories, offering premium services, exclusive benefits, best-in-class customer service and robust rewards programs. The company's cardholders, on average, tend to be wealthier and spend more than users of most other cards. This allows the company to charge merchants higher fees for transactions (the "discount rate") on the basis that they are giving them access to high-spending customers.
In contrast, Visa and Mastercard cater to a broader customer base, with a sizable portion of cards issued to individuals building credit or with fair to good credit. Considering the average balance on credit cards is approaching $1 trillion, Visa and Mastercard issuers will be at greater risk of significant financial downturn at some point in the future.
It may be true that Visa and Mastercard are more widely accepted and also earn revenue from service fees paid by the issuing and acquiring banks in their network. However, just because American Express is not as widely accepted does not mean the company’s financials lag behind. In fact, on many fronts, it does far better.
As the only entity involved in credit card transactions, the company is able to fully profit from each payment. This leads to a situation where the bulk of its revenue is derived from discount revenue and card fees, contributing to roughly 80% of its total income. Other credit card issuers tend to rely heavily on net interest income, which becomes dangerous with rising interest rates, cardholders' ability to repay credit used and economic cycles.
Financial comparison
On an apples-to-apples comparison, either Visa and Mastercard are overvalued or American Express is underpriced.
Visa’s market capitalization is $509 billion and the company generates $15 billion in net income on $30 billion in revenue on 98% gross margins. Mastercard’s market capitalization is $381 billion and it generates nearly $10 billion in net income on $22 billion in revenue on 100% gross margins.
American Express is priced just under $130 billion, while producing more than $7 billion in net income and $57 billion in revenue. It also pays a higher dividend yield than either Mastercard or Visa, and generates comparable operating cash flow of $16.8 billion. Visa and Mastercard have generated cash flow of $19 billion and $11.3 billion, respectively, in the last 12 months.
These numbers leave me scratching my head because, by seemingly all accounts, American Express is a steal, but do not forget the price you pay matters. Both Visa and Mastercard are trading at multiples that are extremely high with Mastercard’s forward GAAP price multiple at 34 times earnings and Visa’s around 30. American Express is trading at just 15 times forward earnings, below its historical average.
Take nothing away from Visa or Mastercard. Both have incredible financial strength and all of these companies have a history of growth across the board. It just looks like Visa and Mastercard have been mispriced, whereas American Express is actually the undervalued stock.
Thoughts on valuation
American Express has seen its market capitalization grow $5.6 for every $1 in retained earnings over the last decade. Visa had similar growth in retained earnings to American Express and almost identical numbers on the balance sheet; however, the $9.6 billion added retained earnings translated into $400 billion in market value, a $44 to $1 increase. At Mastercard, a $45 billion increase in retained earnings put an additional $310 billion onto its market capitalization, a $7 to $1 rate.
I do not imagine it will take long for sellers in other stocks to realize that American Express is a bargain. The company’s greatest strength remains its base of high-spending individuals and small businesses. Higher income cardholders and spenders are not as likely to cut back in bad economic downturns. Again, it seems like investors are mispricing American Express' stock right now.
