Home Technology American Express The Best Credit Card Company

American Express The Best Credit Card Company

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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.

American Express The Best Credit Card Company

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.

Unique advantages

“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 credit risk. However I believe it’s business model is superior to that of its competitors.. Companies like Visa and MasterCard only charge fees for processing the transactions and are not in the lending business and therefore it seems that they do not carry any credit risk. However it doesn’t make them immune to the financial crisis because the financial institutions which issue cards on their network do carry significant credit risk and which would definitely affect the revenues of companies like Visa and MasterCard. Also there is a legislative and regulatory pressure on interchange rates and the banks might be forced to lower it and that would mean that a major source of revenue in the form of interchange fees for the banks will be reduced and a decrease in the interchange fees would make these cards a much lower-profit business for the issuing financial institutions and to compensate for that the banks might increase the interest rate charges on the cards issued. Raising interest rates would make their cards a less appealing option to the customers and as a result would affect the revenues of Visa and MasterCard.

On June 22,2005, a purported class action lawsuit was filed by a group of merchants in the U.S. District Court of Connecticut against MasterCard and Visa and a number of banks alleging, among other things, that MasterCard’s and Visa’s purported setting of interchange fees violates Section 1 of the Sherman Act. In addition, the complaint alleges MasterCard’s and Visa’s purported tying and bundling of transaction fees also constitutes a violation of Section 1 of the Sherman Act.

“Certain of our competitors, including American Express, Discover, private-label card networks and certain alternative payments systems, operate closed-loop payments systems with direct connections to both merchants and consumers, without involving intermediaries. These competitors seek to derive competitive advantages from their business models. In addition, these competitors have not attracted the same level of legal or regulatory scrutiny of their pricing and business practices as have operators of open-loop multi-party payments systems such as ours. Operators of three-party systems, such as American Express and Diners Club, were unaffected by the interchange fee regulation” – VISA Inc.

” In recent years, regulators in several countries have focused on the fees involved in the operation of card networks, including the fees merchants are charged to accept cards. Regulators in the United Kingdom, Poland, Germany, Spain, the European Union, Australia, Mexico and Switzerland, among others, have conducted, and are continuing to conduct, investigations into the way bankcard network members collectively set the “interchange,” which is the fee paid by the bankcard merchant acquirer to the card issuing bank. The interchange fee is generally the largest component of the merchant discount rate charged to merchants by the merchant acquirer for bankcard debit and credit charges. Although the regulators’ focus has primarily been on VISA and MasterCard as the dominant card networks, antitrust actions and government regulation of the bankcard associations’ pricing could ultimately affect all networks.”

* American Express

However a card issued by American Express represents a greater value to merchants because of its high spending members and also the marketing services provided by the company to attract customers and build business for the merchants. The affluent card membership base enables it to charge premium discount rates to the merchants and therefore it is unaffected by interchange fee or discount rate regulation. Presently assuming a 5% normalized default rate Amex stock seems to be fairly valued.

Disclosure: I own shares of American Express

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