How American Express Gains A Competitive Advantage From Its Closed-Loop Network

In a recent article, we took a look at Visa’s (NYSE:V) business model, which is driven by transaction volumes. In this article, we will compare that model with the one employed by another credit card giant, American Express (NYSE:AXP), which focuses on spend rather than transaction volumes. This contrast is evident in the numbers; Visa has more than 2 billion cards in use worldwide and processes more than 60 billion transactions per year, while AmEx has just 107 million cards in force and processes just 6 billion transactions per year. Despite this disparity, American Express has annual gross revenues of $33 billion while Visa earns just $14 billion per year.

Our $79 price estimate for the company’s stock is at a discount of 10% to the current market price.

See our complete analysis of Amex’s stock here

What Is The Difference?

Visa’s clients are primarily banks and financial institutions, known as issuers, who issue cards bearing the Visa logo to their customers. When a cardholder uses a card to purchase goods or services from a merchant, information is sent via Visa’s network to the merchant’s bank, known as the acquirer. This is an open-loop system involving five parties. The issuer earns interest from the cardholder on the loan provided to the cardholder at the time of purchase, and charges a card fee for the use of its card. The issuer also earns an interchange reimbursement fee from the acquirer, who charges a merchant discount fee from the merchant. Visa charges data processing fees and service fees from its financial clients and is not involved in the lending process. Thus, it is not exposed to any credit risk and earns revenue on the volume of transactions carried out through its cards.

American Express, on the other hand, issues its own cards through its banking subsidiaries, American Express Centurion Bank and American Express Bank, FSB and employs a closed-loop network, acting as both the issuer and acquirer. The company’s primary source of revenues is the discount fee charged to merchants who accept its cards. These fees are charged as a percentage of the charge amount processed for the merchant and account for 65% of the company’s revenues. AmEx also earns interest on loans issued to cardholders, membership fees from its cardholders and other revenues based on travel services offered. However, its revenue model does not depend on the volume of transactions processed, but rather on the total amount spent by the customer.

Therefore, the company employs a spend-centric model, targeting affluent customers who are likely to spend more. This is indeed reflected in AmEx’s statistics; the average payment volume per transaction for American Express cards is around $150, while Visa’s is $50. Also, by directly earning discount fees from merchants, the company is able to bypass the issuers and acquirers, earning more revenue per transaction.

Why Would An Affluent Customer Go For American Express Over Any Other Card?

The answer to the question again lies in the closed-loop network. AmEx is able to analyze trends and information on cardholder spending and build algorithms to provide customized offers to attract and retain customers. The company is also able to leverage the information provided by its network to maintain relationships with merchants using targeted marketing to match merchants with the right customers, who are more likely to spend more and stay loyal. AmEx offers rewards to incentivize higher spending and also offers value added services such as merchant financing to select merchants, providing an attractively priced source of financing. American Express places a high priority on building relationships with customers, and has been ranked number one by J.D. Power and Associates in terms of overall customer satisfaction among card issuers in the U.S. for each of the last seven years. ^[1]

What About Credit Risk?

By focusing on affluent customers, American Express is also able to mitigate the credit risk associated with issuing loans to cardholders. High earning customers in the country are more likely to pay off their credit debt in time in order to avoid the interest they would otherwise have to pay. The delinquency rate – the percentage of total loans that are past due – on credit card loans for all commercial banks in the U.S. is around 2.39%, while only 1.07% of American Express’ loans in the U.S. are past due date.  ((Delinquency Rate On Credit Card Loans, All Commercial Banks, Board of Governors of the Federal Reserve System))

Our Forecast

The company’s growth prospects in the U.S. will depend on demographics. According to the 2010 U.S. census, around 22% of households in the country earn more than $95,000 per year. ^[2] These households form the primary customer base for American Express. American Express has 32.5 million propriety cards-in-use in the U.S., with a penetration of 45%. The number of cards has increased at a rate of around 4% for the last two years, but we expect a slightly slower growth rate in the coming years.

The average annual spend per card increased at a double-digit growth rate from 2009 to 2011, growing from $11,505 to $14,124 during the period. However, this growth rate has dropped in the last two years, with the figure increasing just 4.7% in 2013. We expect a moderate growth rate in the short term as the U.S. economy continues to recover, with a slight increase in the growth rate towards the end of the decade.

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1. 2013 U.S. Credit Card Satisfaction Study, J.D. Power Reports [↩]
2. Annual Social and Economic (ASEC) Supplement, United States Census Bureau [↩]