American Express (AXP, Financial) provides charge and credit payment card products, and travel-related services to consumers and businesses around the world. It connects merchant and consumer through the “close-loop” network.
American Express generates its revenue mostly from fees charged to merchants when card members use its cards. It also receives revenues from annual card membership fees, commission and management fees charged to customers and suppliers for travel-related transaction, and interest earned on outstanding balance (refer below for the specific breakdown of American Express’s revenues).
The table below comes from American Express’ 2014 Annual Report.
American Express is a “Spend-Centric” business, meaning the more its card members use its cards to buy products or services, the more income the company earns. In this case, for every additional dollar its card member spends, American Express makes about half of a cent. In 2004, its card members spent about $1 trillion on products and services, purchased through American Express’ network (including cards issued by third parties).
In the U.S., merchants and consumers have four major credit card service providers to choose from: Visa (V, Financial), MasterCard (MA, Financial), American Express and Discover (DFS, Financial). According to nerdwallet.com, American Express charges about 1% higher discount rate from merchants than Visa or MasterCard.
The table below comes from cardfellow.com.
American Express' pricing power comes from its affluent card members. According to Forbes Magazine, the average payment volume per transaction for American Express cards is around $150, while Visa is around $50. In a merchant’s perspective, American Express brings in a customer that will be more likely to spend more than other card members, and higher spending by the customer leads to more revenue for the merchant. By charging a higher discount rate from the merchants, American Express can provide more benefits to its card members, which in turn will bring more cardmembers. The more consumers use its card, the more merchants are leaning towards accepting its cards. But the recent loss of the Costco (COST) contract has shown its declining pricing power.
American Express’ total purchase volume consists of 30% from co-brand partnerships, and Costco is one of the co-brand partnerships. Costco has about $260 billion revenue in the year 2014, assuming all of its revenue has been charged through American Express cards. The loss of the Costco contract will cost American Express about $1.5 billion of earnings annually. That’s assuming American Express doesn’t seek other co-brand partnerships after Costco, and also assuming all customers of Costco used American Express card to pay for their products or services. In the short term, the opportunity cost for American Express to lose Costco’s contract is most likely less than $1.5 billion.
American Express and Discover operate under the “close-loop” network, while Visa and MasterCard operate under the “open-loop” network. One of the key differences, between “open-loop” network versus “close-loop” network, is in a “open-loop” network, credit card companies generate revenue from the number of transactions performed by its card members; versus in a “close-loop” network, companies earn their revenue from the amount of each transactions used by its card members. For example, Visa processes about 60 billion transaction per year, and American Express processes about 6 billion transaction per year. However, Visa generates about $14 billion in revenue, versus American Express makes about $30 billion revenue.
Worldwide, American Express has about 100 million of its cards in use, while Visa has about 2 billion of its cards in use. From the number of credit cards being used, consumers will more likely use a Visa card than an American Express card, therefore merchants will more likely to accept Visa cards than American Express cards.
One of the ways American Express is fending off competition from Visa and MasterCard is through its information collecting from its “close-loop” networks. The network that connects millions of consumers and merchants is a great source of data about the purchasing preferences of cardholders. American Express is able to leverage this data to personalize specific products and services offers by the merchants. Facebook (FB) and Google (GOOGL) also holds similar data about preference of consumers, when their users clicks on “like” button or search for specific products or services.
For a long time, the affluent cardholders of American Express have attracted merchants to accept American Express cards, and the great benefits that come from holding American Express cards have attracted consumers to sign up. Technological changes, from Google and Facebook, have decreased the value of the information collecting from “close-loop” network. However, they haven’t changed the way American Express connects merchants and consumers. In the future, Paypal, Foursquare, or other technological innovations will change the ways consumers pay for their products of services. In my opinion, technological advances might change the way from using a plastic cards, to using a phone, or using your fingerprint. But merchants will still need to use credit card service providers’ networks to check its customers' credit balance.
American Express can ride the wave that comes from consumers moving from traditional store shopping to online shopping. And credit cards are more convenient and secure way to do online transactions than paper money. How will American Express benefit from the tide? For each additional dollar of revenue, American Express needs about 3 cents capital expenditure. The low capital needs to generate future earnings, and helps shareholders to pocket more profit. For the last five years, the average return of equity amounts to 27%. This performance has translated into a total five-year shareholder return of 145%.
American Express faces a couple of headwinds from the lost partnership with Costco and JetBlue, and the lawsuit from Department of Justice. American Express cites cost as the main reason not to renew its contract with Costco. American Express is exploring other new partnerships from different regions and newer businesses.Ă‚
