It takes a lot of work to understand how a company such as American Express (NYSE: AXP) operates, makes money, and grows.
With all the effort that goes into studying a company, it's easy to ignore that company's competitors. This is true no matter what kind of company you're looking at. The tendency is to get too focused on what you've got under the microscope and forget about the rest of the lab. It's a big mistake, however, to give competitors cursory attention. One of the best ways to understand an industry -- and the company you've chosen to research within that industry -- is studying all the players. After all, you don't know how fast a sprinter runs until you see him against the field.
I picked Morgan Stanley's (NYSE: MWD) Discover Card business to try and get a better feel for the strength of American Express' charge and credit card business, which falls under its Travel and Related Services (TRS) division. American Express certainly has bigger competitors -- Citigroup (NYSE: C) offers a full range of financial services and operates an enormous card network globally, same as American Express. Much could be learned from setting the companies side-by-side. That's a topic for another day.
I picked Discover because the brand, originally started by Sears (NYSE: S) and picked up by Morgan Stanley in an aquisition, is growing fast and rapidly increasing its brand recognition through rewards programs, courtesy services (e.g., you can sign up for a service on Discover's website that notifies you when you're about to miss a payment), and smart advertising. Think of the "Danger Kitty" commercials, the mock rock band that overspent and ended up playing Bar Mitzvahs. It's a funny commercial, and it connects the brand to a message of depth and weight. It's not everyday a credit card company tells you to watch your spending.
But credit card companies don't benefit when consumers go hog-wild on their cards. This leads to charge-offs and asset quality problems. What card companies want is people who spend within reason and revolve those balances -- a really lousy idea from a personal finance perspective, but very profitable for card companies. It's a little like a casino, which wants its customers to win enough so they come back, and doesn't want them to lose so much they can't pay or need to change their lifestyle.
For starters, there's a big difference between the way American Express and Discover cards are issued, and how Visa and MasterCards are issued. Visa and MasterCard are associations that basically franchise the name to member banks, which seek customers by offering cards with various interest rates and incentives. American Express and Discover issue their own cards. They don't go through banks or institutions, at least not domestically, which means there isn't competition at the bank level. (Discover actually is issued by Discover Bank, owned by Morgan Stanley.)
In terms of the economics of the business, this means two important things: American Express and Discover collect the full merchant fees charged to businesses during transactions. This gives American Express a double leg-up since the discount rate (the fee it charges merchants) is roughly 1.2% higher per transaction on average than the merchant fee for Visa/MasterCard. In the Visa/MasterCard network, the discount fee gets split between the card-issuing banks and Visa/MasterCard.
This distribution system, in a sense, eliminates a layer of competition for American Express and Discover. See, banks issuing MasterCards or Visa cards must compete against one another for card members, whereas if you want an American Express card or a Discover card there's only one place to go. This centralized relationship with the merchants also gives American Express and Discover an advantage with retaining merchants, who -- just like card members -- want to do business with banks that offer the best rates and service, so there is a tendency to jump around.
Since companies break out financial results differently, it's hard to make an apples-to-apples comparison. Over time, however, you get a feel for what to look for. This is one of the benefits of buying a stock you plan to hold for a long time. You get plenty of opportunities to understand and evaluate the business relative to its competitors. The basic measures of the credit card business are: growth in cards, average portfolio yield (which has been falling for both American Express and Discover as they offer lower rates to lure new card members), growth in merchant base, growth in average spending per card, growth in receivables, and changes in discount fees. There are many other useful metrics, but those are a few that top the list.
Here are some year-over-year growth numbers for 2000:
- Discover grew its credit card accounts 10.6% to 42.6 million accounts.
- Credit services net revenues grew 11.3% to $3.9 billion.
- Credit services net income increased 9.7% to $726 million.
- Credit card receivables grew 24% to $47 billion.
- The number of merchant locations grew 20% to a total of 4 million.
- American Express grew its cards in force 12.4% to 51.7 million.
- Travel Related Services net revenue grew 14.5% to $17.4 billion.
- TRS grew net income 14.1% to $1,929 million.
- Average spending per card member is up 6.1% to $8,229.
Both businesses are performing well by these metrics, with American Express leading as far as growth in net income and revenues. As you can see from the data points, Discover doesn't break out average member spending per card and American Express didn't break out growth in its merchant base or receivables. Both companies also report different measures of card growth.
Nevertheless, these metrics tell us something important about the companies and the industry. First, American Express' ability to increase average spending per card member while it grows cards in force is notable given that it's hard to increase both at the same time. Typically, newer members don't spend as much as members with longer tenures.
For Discover, its receivables growth is noteworthy since this is one of the most important metrics in the credit card industry. It represents balances owed by customers, and since the company is earning interest on these assets, these balances drive profits. Before the late 1990s, credit card receivables often grew at the same rate as transaction volume, according to market research firm SMR, but the trend reversed itself toward the end of the decade as new customers started paying off balances every month. Provided Discover has been smart about its credit portfolio, this fast-growing balance is a good sign.
We'll look further at Discover and another American Express competitor on Monday.
Have a great weekend.
Richard McCaffery lives in Laurel, Maryland with his wife Linda and their two credit cards. He doesn't own any of the stocks mentioned in this article. The Motley Fool is investors writing for investors.