American Express’s Revamped Business Model Has Long-Term Potential, Could See Near-Term Pressure

Last month, American Express‘s new CEO Stephen Squeri announced a fundamental change to the company’s business model. Moving away from a business model that relies almost completely on merchant fees, the cards and payments giant is looking to slash merchant fees so that it can increase card usage. The increased card usage should lead to a faster increase in card loans as well as transaction volumes over the coming years – mitigating the impact of lower merchant fees on the bottom line.

American Express’s new business model is sound, with its success already visible in the card lending operations of the country’s largest banks. While Amex shareholders will benefit from this strategic shift in the long run, we believe that they will have to contend with lower returns over 2018-2020. Our conclusion is based on our interactive model for American Express, which captures the changes in key operating metrics as well as expected share price for the company over coming years.

Overview Of Forecasts

Our estimates for American Express’s performance over 2018-2020 are based on our forecasts for four key input metrics for the company under the original business model (represented in the graphs below by grey lines/bars) as well as under the new business model (blue lines/bars) :

• Fees as a % of Total Transaction Volume: American Express’s new strategy involves reducing this metric going forward by lowering merchant charges on transactions. The company has historically charged much higher merchant fees compared to competitors Visa and MasterCard – something that helped it earn more revenues per transaction, but also weighed on the size of its merchant base. By lowering merchant charges, Amex can get more merchants to accept its cards – something that will help total transaction volumes grow at a faster rate. At the same time, more transactions by Amex cardholders should also have a positive impact on the rate at which card balances grow – leading to higher interest incomes in the future. As we show in the chart below, we expect this metric to decline at a much faster rate over coming years to reach 2% by 2020 under the new business model (as opposed to 2.1% under the original business model)
• Total Transaction Volume: As we described above, lower merchant charges should boost transaction volumes. We forecast transaction volumes to cross $1.5 trillion for 2020 due to the new strategy (well above the figure of $1.4 trillion for the original strategy). However, as evidenced by the revenue growth in the chart below, transaction volumes are unlikely to grow rapidly enough to offset the loss in revenue over 2018-2020, which stem from the fee reduction.

• Average Card Balances: American Express’s outstanding card balance had a setback in 2016 as it transferred its portfolio of Costco card loans to Citigroup. But the company has done well to grow card balances over 2017 by refocusing on the affluent cardholder segment. With its decision to reduce merchant fees, American Express stands to gain more ground across all cardholder segments, as increased acceptance among merchants should boost the number of people applying for Amex cards. Additionally, as a larger number of cardholders use their cards for making payments, there should be a proportional increase in total card balances over coming years. The proposed change should not have an impact on net interest yields on card balances, because of which the net interest income could increase to $8.7 billion by 2020 (as opposed to $8 billion under the old business model), as card balances increase ~10% from $79 billion for the old strategy to $86 billion for the new one.

• Net Margin: American Express’s proposed changes should have the most impact on its net margin over the coming years. This is because profit margins for payment services are much higher than those for card lending. As payment revenues are likely to be subdued over 2018-2020, this could erode the company’s margins over this period. Additionally, as American Express will likely increase spending to attract more merchants into its fold, elevated marketing costs may also drag down margins in the short term. However, we expect margins to increase at a rapid pace over the coming years, as detailed in the chart below.

As seen in the chart above, we forecast American Express’s EPS for 2018 to be $6.55 under the new model, as opposed to a higher figure of $7.25 for its older strategy. Using a P/E ratio of 14.5 for the company, this represents a downside of about 10% to our price estimate for the company from $105 to $95. However, our estimates for American Express’s EPS and price estimate under the new plan converge with our estimates for our old plan in 2021 – beyond which the new plan should yield better results for the company.

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