So far, 2015 hasn't been kind to American Express (NYSE:AXP). Last month, the company was unceremoniously dropped as both the exclusive credit card accepted at Costco Wholesale stores and the retailer's only co-branded card partner. Soon after that, the company suffered a loss in federal court against the Department of Justice, which had accused it of engaging in anti-competitive practices.
As a result, AmEx's stock has been the laggard in its peer group so far this year, losing over 11% of its value. Meanwhile, both of its big rivals, Visa and MasterCard, are in positive territory. Yet these unpleasant developments obscure an important, positive fact -- the company has an unbeatable advantage in its segment.
American Express is not only the operator of the payments network for its cards; for the great majority of them it's also the issuer. In other words, it's the company extending the credit to the cardholder (or "member," in AmEx-speak). This double-dip model is formally known as a "closed loop" system.
That's in contrast to Visa/MasterCard's "open loop" regimes. The two companies are exclusively payment network operators. In such a system, the issuer (typically a bank) is a separate entity lending its own money to cardholders.
Being involved directly in credit issuance means a bigger piece of the action for AmEx. Any credit card purchase generates a merchant discount fee, a small percentage of the total that typically ranges from 2% to 3%. (It's called a "discount" fee because it's deducted from the purchase price; the remainder is what the merchant receives).
AmEx pockets this fee. With Visa and MasterCard, the issuer gets the bulk of it; the networks get a much smaller piece for their participation in the transaction.
This is why AmEx generates much higher revenue than its two monster rivals, despite having far fewer cards. In fiscal 2014, the company's top line was just under $36 billion, on a global card tally of 112 million (although this total includes branded cards issued by third parties, a relatively new business line for the company).
Visa and MasterCard's revenue totals, meanwhile, were $12.7 billion and $9.5 billion, respectively. Visa's cards outstanding figure last year was 2.2 billion, and MasterCard's was nearly 1.3 billion.
Know your borrower
Discount revenues are the bedrock of AmEx's business. They constitute far and away the company's single largest top-line category, coming in at $19.5 billion in fiscal 2014.
As an issuer, the company can also draw from another strong revenue stream that Visa and MasterCard cannot -- interest on loans to cardholders. This amounted to over $6.9 billion last year.
Being an active and busy lender has a significant knock-on advantage. The company has a wealth of detailed information on its cardholders, allowing it to tailor and customize the rewards it's famous for offering. These bonuses encourage product loyalty and help boost spending.
It also makes the company a good judge of creditworthiness. What helps is that by now it's had decades of experience evaluating many thousands of potential borrowers.
This is a big reason its cardholders tend not to be deadbeats. The company's write-off rate has been notably -- and consistently -- lower than that of the nation's banking incumbents. In Q3 2014, for example, this figure was 1.5% for AmEx, compared to 2.9% for Wells Fargo, Bank of America's 2.8%, and 2.5% for JPMorgan Chase. Those rates were a respective 2.3%, 4.4%, 5.5%, and 4.3% in Q1 2012.
Down but far from out
Make no mistake: American Express' divorce from Costco is a setback for the credit card giant. That arrangement brought in a lot of business it's now scrambling to replace. But this doesn't change the fact that AmEx has managed to encircle a lucrative and durable business within its closed-loop model.
A fine writer and smart investor once advised us to "neither a lender nor borrower be." If we twist that around some, we might say that "a processor and lender be" can be a potent combination for success. Exhibit A: AmEx.