I am happy to announce that Sandesh Trivedi of sandeshtrivedi2.blogspot.com a brilliant value investor will be a regular guest columnist on Value Walk. Sandesh can be contacted at [email protected] Sandesh’s most recent article discusses the great business model of American Express. Sandesh is not alone in his thoughts regarding American Express. American Express is one of Warren Buffett’s largest holdings. Buffett’s Berkshire Hathway currently holds over $6 billion of American Express stock. This figure represents 11% of Berkshire Hathaway’s equity holdings.
Below is the article:
Credit and Charge Card Industry
Over the past few decades the payment cards industry- debit, credit and charge cards have truly revolutionized the way we shop and pay for goods and services. They provide a flexible line of credit with which the consumers can finance their purchases. And for the internet transactions payment cards are the main currency and almost everything can be bought from internet with a payment card. However because of the recent financial crisis there is a lot of noise about the economics of the payment card business and as a result the stock price of the companies operating in the payment card business suffered. Even though for some time the market looked like it was on an inevitable path to disaster. But if we look closer and ignore the noise we can find a business with good economics and predictable business model. On the surface the payment card business might seem to be dominated by Visa and master card and it is true to some extent however I feel even though Visa and Mastercard might be the largest network of payment card transaction but American Express is way superior to these companies in terms of the economics and the profitability of the business.
Overview of Economics of Payment Card Transactions
The credit and charge card companies can be distinguished by the nature of their network. Some like American Express and Discover Financial services are go-alone charge card issuers and have a closed loop network where they act as both the card issuers and the merchant acquirers whereas companies like Visa and Mastercard have an open network and through their network banks issue cards and acquire merchants. Companies like Visa and Mastercard do the job of processing the transactions and charging certain fees on it. An open network provides a platform for banks to participate in their vast network by allowing them to issue cards which can be processed on their network and also provide a brand , authorization and settlement of payments and a set of rules that enables them to issue cards and acquire merchants. Your browser may not support display of this image.
A typical transaction in an open network looks like this where the a cardholder (A) purchases goods or services from a merchant (B) using a card.After the transaction is authorized by the issuer (D) using the network, the acquirer (C) pays the amount of the purchase, net of a discount, to the merchant. This discount, which is referred to as the merchant discount, takes into
consideration the amount of the interchange fee. Interchange fees represent a sharing of a portion of payment system costs among the financial institutions
participating in the network and are generally the largest component of the costs
that acquirers charge merchants in connection with the acceptance of payment cards. Generally interchange fees are collected from acquirers and passed to issuers to reimburse the issuers for a portion of the costs incurred by them in providing services that benefit all participants in the system, including acquirers and merchants. The issuer pays the acquirer an amount equal to the value of the transaction minus any interchange fee and posts the transaction to the cardholder’s account.
American Express: A closed loop network
American Express has a closed loop network in which it is both the card issuer and the merchant acquirer and as a result keeps the entire merchant discount fee.
The company has a “spend centric” business model which focuses on generating revenues primarily by driving spending on cards and secondarily by finance charges. Average card-member spending is 4-5 times higher than the competitors like Visa and Mastercard, which represents greater value to merchants in the form of loyal customers and higher sales and higher revenues generated from higher spending enables the company to offer attractive rewards and incentives to cardmembers which in turn creates an incentive to spend more on their cards. It high spending customers bring more business to the merchants and therefore it represents more value to merchants. Also because of the closed loop network and direct relationships with the merchants and cardmembers the company has an informational advantage over its competitors. Its network provides the data that indicates how, when and where the customers spend. This information is read and interpreted to benefit both the cardmembers and merchants. It provides value to both cardmembers and merchants. Through its closed loop network and information management and marketing expertise it is able to match the right offers and experiences with the right customers at the right time which benefits both the cardmembers and build business for merchants.
“American Express has a circular spiral, reinforcing sort of economic system in its credit card business. Upward spiral: If more businesses accept charges on The Card, the convenience and ease of use of The Card increases, and more people will want to use The Card, and will charge more often, and more habitually. Greater card usage, in turn, leads to increased acceptance of The Card by a wider array of businesses who want sales from holders of The Card”
* Tweedy Browne
“The strategic advantages of a closed loop are quite clear to our competitors, quite notably Visa, who is currently trying to replicate our capabilities in a test they are running on the West coast. Their test is limited to a select number of issuers and merchants, but the real test will come in making this a scale pay. The difficulty of creating technology connections between millions of cardmembers and merchants cannot be underestimated. These connections and importantly, these relationships have been built into our model since the beginning, so we know that building them from scratch will be no easy task. Now, having these strategic advantages is one thing, but capitalizing on them is another.” – Kenneth Chenault, CEO, American Express
* It is the only company with scale in all key areas of payments—as a card issuer, network, transaction processor and merchant acquirer and is the largest global card issuer by spend volume and the fourth-largest card lender in the United States. And, unlike the vast majority of issuers and networks, it has direct relationships with cardmembers and our merchant partners.
* Unlike its competitors amex has a spend-centric business model and doesn’t rely on interest spread. It generates majority of revenue from recurring fees and around 75% of the revenues is in the form of fees and is therefore more resistant to the credit crisis.
American Express is considered to be more risky than its competitors because it is in the lending business too and therefore carries