American Express and Costco: Who Divorced Who?

The announcement that Costco (COST -0.40%) and American Express (AXP -0.86%) will be parting ways, with Citigroup (C -1.34%) and Visa (V 0.08%) stepping in as of 2016, struck many casual observers as bad news for Amex. However, the Fool's senior banking specialist John Maxfield has a different interpretation.

With Costco cardholders accounting for some 10% of all Amex cards issued, there's no doubt that the change will have an impact. What kind of an impact this will have on the business and what it means to shareholders is a more complex question; tune in to find out what current or potential Amex investors need to know about the switch.

A full transcript follows the video.

Kristine Harjes: American Express and Costco's breakup. This is Industry Focus.

[INTRO]

Welcome to Industry Focus financials edition, everyone. Kristine Harjes here with John Maxfield, our senior banking specialist, on the line. Hi John!

John Maxfield: Hi Kristine! It's great to be with you this morning. I guess maybe it's afternoon for you already.

Harjes: Just slightly afternoon, but still morning for you, right?

Maxfield: It is. It is, a beautiful morning as well.

Harjes: It's great to have you on the show, as always.

Today we want to dig into the big news from Costco and American Express, who announced last month that their 16-year-long relationship will be coming to an end in March 2016. Previously, Amex was the only credit card brand accepted at Costco.

The partnership yielded Costco's only co-branded card, which doubled as a membership card and could be used both in Costco stores and elsewhere.

This relationship worked great for a time, but then negotiations came up again and both companies were pushing to get their own margins up and get the best deal, and apparently Costco was squeezing a little bit too hard.

In the words of Amex's CEO, Kenneth Chenault, the terms of the deal "didn't make economic sense" to the business and its shareholders, so Amex walked away.

We've since learned that Visa is to replace American Express as the only credit card accepted at Costco stores, while Citigroup will take its spot as the exclusive co-branding partner for the retailer's credit cards.

It's pretty apparent that Costco is getting a good deal here, but let's look at whether American Express did, as well. The popular reaction has been that Amex is losing pretty big, but John, it seems like you don't see it that same way. What's your argument?

Maxfield: Let's start with this. That exclusive agreement that they had with Costco was a huge deal for American Express. It accounted for something along the lines of 10% of all American Express cards that were issued.

Harjes: And 20% of their loan portfolio.

Maxfield: Exactly, 20% of their loan portfolio. In the context of this conversation, this is a huge deal for American Express on the revenue side. There's no question about that.

But the question is, given the fact that Costco appears to have changed the terms to make it a better deal for Costco customers -- which is why everybody loves Costco -- they seem to have upset that delicate balance between risk and reward for an actual credit card portfolio.

When you look at American Express, this is one of the premier lenders in the United States of America, and they have been for many decades.

When you upset that risk/reward balance, it is to be expected that your top-shelf lenders, who take a lot of pride in their credit risk management, you've got to expect that they're going to back out of the deal; and that is basically what American Express did.

Harjes: They said, "No thanks," because they want to keep those same standards that have served them so well in the past.

But that's such a huge chunk of their business. What are they going to do now? How can they see this, and their investors see this, in a positive light?

Maxfield: In a positive light, in my opinion -- this is something we've talked about on this show a lot in the past -- is that when you're a credit card lender, or any type of lender, the single most important priority of your organization has got to be the quality of the loans that you're adding to your portfolio, and the quality of the borrowers, and the terms of those deals.

And let me just add one more point about that: If you don't pay attention to those things and stay extremely disciplined about those things, because lenders -- banks, credit card lenders, etc. -- are so leveraged, it only takes a relatively small amount of drop in the value of their assets to completely wipe out their capital base.

When you have a company like American Express, that's been so good about lending over the past few decades, come in and say that, "despite the fact that this accounts for 10% of our outstanding credit cards, the terms of the deal do not match up with our credit risk standards," to me that just provides further evidence that this company is willing to do the hard things that are nevertheless the good things for the long-term value for their shareholders.

Harjes: Yes, and the thing is that it has worked for them in the past. We have seen, time and time again, that when American Express is faced with adverse situations they perform just fine.

We touched on this a little bit with the stress test episode. When the Federal Reserve put American Express through this annual stress test, forecasting for a potential hypothetical severely adverse economic downturn, American Express did fantastic in the results of these tests. John, can you touch on that with a little more detail for us?

Maxfield: Yes. The thing to keep in mind with this is that there are all these different types of loans a bank or a lender can make. There are various types of commercial loans, there's a variety of different types of consumer loans.

But of all of them, the riskiest are credit card loans because, number one, they're unsecured. If the borrower defaults there's not a piece of property, like with a mortgage, that the bank can just automatically foreclose on and then sell to help mitigate the loss.

Number two, credit cards are relatively easy to get. You've got to take into consideration that a company that can do a good job managing these, really knows what they're doing. When you look at the financial crisis, American Express, there was not a single quarter that it recorded a loss. It's just an unbelievable testament of their acumen when it comes to lending.

Then when you expand that out by looking at the stress tests, which we've talked about on the show a number of times; the Federal Reserve assumes basically another severely adverse economic scenario, akin to the financial crisis, and then projects out over a 9-quarter period what will happen to a variety of things with these banks.

One of the things they look at is whether or not these banks and lenders will earn money or lose money. There were 7 of the 31 stress test participants that were projected to earn money over the severely adverse economic scenario.

American Express was one of them. But not only was it one of them, it was projected to earn the most money of all the participants, and by something like two or threefold.

Look, Costco is an amazing company. I don't think there's any doubt about that. But American Express is equally in the same league.

Harjes: That is truly incredible performance, considering that those 31 participating firms in the stress test, they were banks. They weren't all credit card companies. For them to put up this kind of performance really speaks to their risk management and how prudent they are about being safe in that regard.

Another thing to keep in mind here is a similar rough patch that the company has gone through in the past, well before the most recent recession, back in the 1960s I believe it was, with the Salad Oil Scandal. Can you shed some light on what happened back then?

Maxfield: Sure. The Salad Oil Scandal was basically the Bernie Madoff scandal or the Enron scandal of the 1960s. You had a guy who was running a big business. I can't remember if he was producing or distributing, or had some arm in the salad oil business; random business that it is.

He had pledged a whole bunch of these large containers full of salad oil as collateral for some loans from American Express, but then when they went and looked at those actual containers, they were full of salt water or water, or something like that.

All that collateral was worthless and American Express took big losses on those loans, the share price tanked. Then, lo and behold, who came in and became a huge shareholder in American Express? None other than Warren Buffett.

When I look at what's going on with an American Express today, I think of the same exact thing. Look, this is one of the premier companies in the United States of America. It has been that way for many decades.

Nobody can predict the future, but based upon its past it seems to me like it is times like this that investors should want to get into a company like American Express. If you're going to get in on American Express when everything is going great, guess what? You're going to pay for that in terms of the share price.

I think you had said earlier today in the conversation we had, that American Express' stock is down something like 16%. That should be a glaring potential Buy opportunity for anybody who's looking at a stock like this.

Harjes: Especially if you have confidence in their management. If you look at it, it's the same exact management that led the company through the recession without posting a negative quarter, so you can really -- in my opinion at least -- trust that these guys are going to know how to navigate this difficult situation.

They have plenty of time to do it, too. They have until mid-2016 before this deal is going to come into effect, so I imagine that that is more than enough time for them to get their bearings, figure out the plan of action, find some way to market to these existing Costco customers, and get them to get a non-Costco branded version of an American Express card, to maintain them.

Even when you're looking at how big the Costco market is for American Express, they're not necessarily going to lose that entire 10% of their member base if they can effectively transition these same members and hold onto them, despite losing the Costco exclusivity.

Maxfield: That's exactly right. This relationship accounts for 10% of Costco's credit cards. But what I've read is that 70% of the purchases on those credit cards, those American Express/Costco credit cards, are made outside of a Costco store.

I think it is safe to assume that American Express will be able to do some things that will retain some of those customers.

Whether that's 50%, 80%, 20% is difficult to predict, but certainly investors shouldn't be looking at it and saying, "Oh well, this automatically means that American Express' credit card portfolio is going to decline by 10%." That's not what this means, by any stretch of the imagination.

Harjes: I guess to us, it seems like the market may have overreacted to this news a little bit, thus maybe presenting a good Buy opportunity for American Express.

Maxfield: Yes, and let me just add one point. That is that it would be naïve, of course, to assume that this is not going to impact American Express. It is going to impact American Express.

Harjes: Of course.

Maxfield: However, at the same time, in my opinion it would be short-sighted to assume, based upon American Express' history of incredible management -- through great times, difficult times, all different types of times -- it would be short-sighted to assume that they cannot navigate something like this.

Harjes: Right, definitely. Thanks so much for all that good insight, as always.

On a different note, something that we've got set up here is our very own email address for you guys listening in, to contact us with. Listeners, if you've got any questions for us or topics you'd like us to touch on in future episodes, send them our way! The address is [email protected].

Maxfield: I'm sorry, I know you're trying to wrap up, but any questions that any listeners have about banks or bank stocks, or the financial industry, feel free to send them in. We'll talk about them in our next episode or future episodes.

It's something that we -- Kristine and I, and other people at The Motley Fool -- we spend a lot of time thinking about these things, and we enjoy getting the opportunity to share some of the knowledge that we've gained over the years.

Harjes: Absolutely, and it's always good to know what's on our listeners' minds, too. It can help us shape the show and make sure that we're giving you guys the information that you want. Thanks for adding that, John.

Until next time, thanks everyone for tuning in, and Fool on!

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.