American Express (NYSE:AXP) has announced an agreement with Wells Fargo (NYSE:WFC) whereby the latter will launch credit cards that will be accepted on the Amex network.  American Express is well known for its closed loop network, wherein the company issues its own propriety cards through its bank subsidiaries, American Express Centurion Bank and American Express Bank, FSB (AEBFSB). However, in recent years, the company has taken to third-party agreements for expansion, particularly in foreign markets where American Express invites financial institutions to issue cards carrying the signature American Express logo and also to act as merchant acquirers on the Amex network by leveraging its infrastructure and brand image.
Transaction fees earned through third party issuers have increased by a compound annual growth rate of 15%, higher than the CAGR of 9% for propriety cards in the U.S. Revenues earned through third party issuers accounted for 15% of the company’s gross revenues in 2012, indicating the importance of this business. Amex branded third party issued cards have grown from 26.3 million in 2009 to 37.6 million at the end of 2012.
Our $75 price estimate for American Express’ stock is in-line with the current market price. We will keep a close eye on the performance on the new card and update our model accordingly.
The expansion strategy has hitherto been restricted to foreign markets. In 2012, almost 80% of the American Express branded cards issued outside the U.S. were issued through third party financial institutions in agreement with the company’s global network services (GNS) division. At the end of 2012, American Express had 67 independent operator agreements across the world in countries including Brazil, Russia, Indonesia, Turkey and Ecuador. It also had 77 network card license agreements including those with Lloyds TSB Bank in the United Kingdom and Westpac Banking Corporation in Australia.
Under the network card license agreements, the third party institution can issue Amex branded cards and is responsible for design of product features, customer service, billing and credit and authorization of transactions. American Express is responsible for the merchant network, processing transactions from point of sale to settlement with card issuers. The company charges fees based on transaction volume and also earns royalties and currency conversion fees. This type of agreement is implemented in countries where American Express has a propriety card business.
Wells Fargo is the largest bank in the U.S. in terms of market capitalization and the fourth largest in terms of assets. The bank currently issues Visa (NYSE:V) branded credit cards with a total credit card loan portfolio of $24.8 billion representing 3% of its total loans. Wells Fargo serves more than 70 million customers who will be able to apply for the new cards through mail, online, phone and retail stores. The company will launch a pilot program in the third quarter of 2013 with a full scale launch next year.
How Does The Deal Affect American Express?
American Express’ closed-loop network is critical for its spend-centric business model. The company primarily issues cards to affluent customers who are likely to spend high amounts and are less likely to default on a credit loan. The average American Express household earns about $97,000 per year.  The average cardmember spend per Amex card in the U.S. is around $15,000 while for Visa this figure is close to $1,000. High spending customers allow Amex to charge higher discount fees from its merchants. The average discount rate for American Express is around 2.5% of the transaction amount involved. Banks issuing Visa and MasterCard generally charge less than 2%.
Last year, American Express took a step away from its traditional business model by entering a partnership with Wal-Mart (NYSE:WMT) to offer a prepaid debit card called Bluebird. More than 5o% of Wal-Mart’s customers make less than $50,000 per year and are not what are normally considered American Express customers.  We believe that Amex might be looking to expand its target demographic beyond the affluent class. According to the 2010 U.S. census, around half of the U.S. population earns less than $50,000 per year. 
However, since it is no longer promising to bring high spending customers, this strategy will mean that the company might well have to reduce the discount fees it charges from merchants. Amex currently charges an average commission of 3.66% of the transaction volume of transactions on third party issued cards. To illustrate this impact, there is a 10% downside to our price estimate should the average commission fall to around 2% by 2015. While we don’t currently expect this drop, you can modify the interactive chart below to gauge the effect a change in forecast would have on our price estimate for American Express’ stock.
Targeting affluent customers has also helped American Express lower the risk of consumers defaulting on loans. Amex’s delinquency rate or the percentage of total loans that are past the due date on credit card loans is 0.36% for loans 30-59 days past due date, 0.27% for loans that are 60-89 days past due date and 0.59% for loans that are more than 90 days past due date. This is well ahead of the industry average, the delinquency rate for all commercial banks in the U.S. was around 2.73% in the fourth quarter of 2012. 
The company’s charge-off rate or the percentage of loans that are considered nonredeemable is around 2%, lower than the industry average of around 4%.  Wells Fargo’s quarterly net charge-off rate (annualized) for credit card loans was 3.90% for second quarter 2013, and 3.93% for the six months ending June 30. Depending on the terms of the collaboration, American Express could see an increase in the charge-off rates in the coming years, which could mean an increase in losses in receivables on third party issued cards. Losses have been around 0.07% of the transaction volume on third party cards for the last four years.Notes:
- American Express Company : Wells Fargo and American Express Announce Credit Card Issuing Partnership, Press Release [↩]
- Spending by affluent helps Amex to strong quarter, Yahoo News, April 18th, 2012 [↩]
- The Demographics of Retail, AdAge, 19th March, 2012 [↩]
- Annual Social and Economic (ASEC) Supplement, United States Census Bureau [↩]
- Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System [↩]
- Charge-Off Rate On Credit Card Loans, Top 100 Banks Ranked By Assets, Board of Governors of the Federal Reserve System [↩]