Visa and Mastercard are distinctly different from other credit card companies like American Express and Discover Card. When you swipe something on your Visa or Mastercard, you are not actually using cards issued by Visa or Mastercard. The card itself is issued by a bank or financial institution somewhere, and the Visa and Mastercard brands represent networks that the issuing card joins. Anytime you make a purchase, the merchant has to pay a fee to the issuing bank by the end of the day, and the financial institutions have to share this fee with Visa and Mastercard.
Visa was created by Bank of America back in the 1966 to act as a way for banks to collect more from non-check purchases than the rising Mastercard which was an open-loop system created to electronically transfer funds. The important takeaway is that the Visa and Mastercard networks were created to make transactions more convenient than the relatively burdensome act of writing a check, and it wasn’t about assuming risk. Bank of America created Visa to collect fees in a toll-booth manner from each transaction while the banks assumed the risk associated with the fund transfer.
American Express does not possess such a limited role. It issues cards, authorizes purchases, and then settles fees thereafter. It assumes fund transfer risks that Visa and Mastercard do not because it is the issuer rather than merely a network participant charging customers for using an electronic highway.
Because American Express assumes additional risk, it charges customers more per swipe. The typical fee for an American Express transaction is 3.25% of the purchase amount. For a Visa and Mastercard credit card, the typical fee is 2.60%. And for debit cards that are part of the Visa or Mastercard network, small-scale retailers like coffee shops and gas stations are charged a flat fee for transaction.
This creates a disincentive for retailers to accept Discover Card. It is not merely extra management initiative that explains why Visa and Mastercard acceptance signs show up everywhere you shop, while American Express cards are comparatively rarer. When you buy $100 worth of stuff and swipe your Visa, the retailer gets to collect $97.40. When you swipe your American Express card instead, the retailer gets to collect $96.75. Compounded across hundreds of transactions daily, and measured over the full course of the calendar year, this small fee difference between American Express and Visa/Mastercard starts to matter. Yes, each American Express purchase is more profitable, but the higher fees have created a merchant resistance that makes it hard for American Express to gain market share and grow volumes.
The credit card industry is something that grows, grows, grows, but American Express hasn’t quite been able to match its peers in the market. Putting aside profits for a second, look at how much the sales figures are different for American Express compared to Visa and Mastercard. Over the past five years, the amount of interchange fees that Visa has been able to collect has grown by 15.5% annually. For Mastercard, the growth rate is 14.5% annually. As for American Express? 2.5% annualized.
The hard part for American Express is that the bank is exposed to risk in a way that Visa and Mastercard is not. During the worst of the financial crisis, American Express saw its profits decline from $4 billion to $2 billion. Even though American Express card users have a stronger card profile than a typical bank, it still has to worry about defaults and fewer American Express swipes during a recession. It took a few years to rebuild its base, and that is American Express has lagged Visa and Mastercard.
During The Great Recession, Mastercard grew its profits from $1.1 billion to $1.8 billion and Visa grew its profits from $1.7 billion to $2.9 billion. They didn’t have to worry about the credit quality of its users—you could be a complete deadbeat, but Visa and Mastercard shareholders got to collect a share of the $6 swipe at Burger King. This immunity to the users themselves explains why Visa and Mastercard have become dream lifelong holdings: they only have to use retained profits growing at their network and investing in advertisements that bolster credibility, and the rest of the money goes to share buybacks and dividends. American Express has to worry about loan loss provisions and the quality of the specific clientele.
This raises the question: Why doesn’t American Express just lower its merchant fees below those charged by Visa and Mastercard, or at least achieve parity with them? The answer is that it would be too painful of a bandaid to pull off. Any executive trying it would probably lose his job in the short term because the shareholders would be miffed, even if it would be best for the company’s competitive position in the long run.
American Express makes $5.8 billion in annual profits. It works out to $5.56 per share in earnings. If it achieved interchange fee parity with Visa and Mastercard, it would see its annual profits come down to $3.88 billion, or $3.72 per share. It would be very difficult for American Express to reinvest itself without harming its cash cow, and that is why the status quo continues.
You can’t call American Express stupid for staying the course, either. It made $3.39 in profits per share in 2007, right before the financial crisis hit. That figure, which now sits at $5.56 per share, amounts to 64% cumulative growth over eight years. The cumulative earnings per share growth of the S&P 500 has been 37% over the same time period. So even though American Express has been a better stock to own than a typical S&P 500 component, it has also been a worse company to own than its peers.
American Express is playing a different game. They do things like issue the American Express Platinum Card for $450 per year, and over 87% of the owners of this card pay the monthly balance on time. The primary benefit of the card is access to airport lounges and other travelling perks. To earn a profit, American Express has to consolidate the purchasing power of its customer base and negotiate these parks at a discount so that the profits come from doling out $200 to $300 in annual benefits to a customer that is paying out $450 per year. Visa and Mastercard take the swipe, don’t even have to say thank you, collect the fee, and then build out the network, grow dividends, and buy back the stock.
What makes life interesting is that valuations are not equal. If someone had to choose between owning American Express or Visa for ten years, and an ownership stake was available for the same price, the clear choice would be Visa. But in the real world, we have to answer that question with valuation in mind. Visa currently trades at 30x earnings, and American Express currently trades at 14x earnings.
For every $100 you invest in Visa, your ownership position represents $3.33 in profits plus the future growth of the company. For every $100 you invest in American Express, your ownership position represents $7.14 in current profits plus the future growth of the company. This valuation differential makes life interesting because American Express is selling for half the starting valuation of Visa. If you have a holding period of ten years or so, the question you have to ask is this: Even if I think Visa is better, do I think its future is twice as bright as American Express?
American Express has a long history of trading at 17x or 18x profits in ordinary times. The loss of Costco exclusivity plus the recent death of Chenault’s heir apparent have made the stock a bit cheaper than usual as earnings per share growth has stalled in response to the Costco losses. Visa, meanwhile, is delivering excellent quarterly results and the stock is now trading at the highest valuation in the company’s history. Visa had its IPO at a valuation of 32x earnings, currently trades at 30x earnings, and has a trading history in the 20-23x earnings range. To figure out which stock is a better deal, you have to combine American Express’ expected growth rate with the likelihood the P/E ratio will expand to 17.5x earnings while comparing it to Visa’s growth rate mixed with the likelihood that the valuation will eventually drift towards 20x profits.
If I ran a portfolio that only planned on owning 20 stocks for 25+ years, I would choose Visa over American Express and I would refuse to initiate a position in Visa over 25x earnings. There’s just other fish in the sea once a company hits 30x profits. If I were running a 50 stock portfolio that diversification amongst high-quality businesses, I would find a place for American Express and I would have no issue paying today’s price of $79. If you want to be like a young Charlie Munger, your attitude would be: I’ll buy Visa, and I’ll buy Visa at a discount. Just you wait and see. If you want to be like a mid-career Walter Schloss, you would buy American Express now and keep a little something on the side for when Visa comes down a bit. Some people like focus and excellence, and others prefer diversification and value.
Originally posted 2015-05-30 18:02:07.
