American Express (NYSE:AXP) executives have a big decision to ponder: Should the company completely sever ties with its Costco customers, or retain them as customers on a new, AmEx-branded card?
The company could sell its Costco card book at a gain, which could fund marketing efforts to attract customers. Alternatively, it could simply keep the loan book from Costco, and hope to retain their spending in other retailers. It's a big decision to make, and it effectively boils down to just how good the AmEx marketing machine really is.
Reading the tea leaves
On its second-quarter conference call, American Express executives declined to give direction on whether they would sell or retain the portfolio, but they cited some statistics from their experience in Canada, where the company lost its exclusivity agreement with Costco in 2014.
When it lost its deal with Costco in Canada, it didn't sell its credit card book. Instead, it moved customers over to a different card, but kept many things the same. Most importantly, card numbers were not changed, which helped retain customers who had routine expenses billed to their cards. As a result, the company reported that it retained roughly 50% of its customers' previous spending volume outside of Costco.
If AmEx could retain 50% of its non-Costco spending on its U.S. cards, the company would retain about 35% of its total billings from Costco card members in the U.S., or roughly 2.8% of the 8% of its total worldwide billed business generated from Costco cards in 2014. Notably, these are some of its most profitable billings, given that its non-Costco volume is processed at its standard rate, not the discounted rate it had to offer the retailer to win the exclusivity agreement.
Which way will AmEx go?
AmEx CFO Jeff Campbell made the point that the United States isn't like Canada, referring to the fact that AmEx may sell its U.S. Costco business. Based solely on the conference call commentary, I get the sense that American Express is leaning toward selling the credit card business, booking the gain, and using the proceeds to try to win customers with rewards and incentives on new cards. That's just my hunch based on the back-and-forth from the Q&A session with analysts.
My suspicion is predicated on the fact that Canada is, in fact, very different from the United States. Visa and MasterCard are a true duopoly in Canada, controlling the vast majority of the processing market. The two control roughly 92% of transaction volume in Canada. American Express was the also-ran competitor, securing just 8% of transaction volume.
In the United States, American Express sits on much better footing. It processed roughly 25% of all credit card transaction volume in 2014. Where it seems to needs every customer it can get in Canada, it is in much better competitive shape in the U.S.
The ups and downs
On the company's first-quarter conference call, one analyst suggested that if American Express sells the portfolio, it could generate a premium of 15% on the sale. Later, a Deutsche Bank analyst opined in a note that a 15% premium wouldn't be out of reach, suggesting the company could net a $2.2 billion gain on the sale of the $15 billion credit card book. Citi would obviously be the buyer in such a scenario, given it is in line to take over as Costco's card issuer when the AmEx deal ends on March 31, 2016.
The ultimate question is how much it will cost AmEx to replace its customers. The Deutsche Bank analyst suggests that every $1 billion in spending should result in $25 billion of billed business, and $3 billion of loans, resulting in $0.27 in annual earnings per share. Of course, these are built on what amounts to guesswork -- it's impossible to know how much AmEx will spend to attract card members, or how effectively it can bring card members back to its network.
But it seems, at least to me, that American Express is favoring the decision to take the gain and invest heavily in marketing to add new card members. The simple fact is that credit card users, particularly on the high-end where AmEx competes, are largely bought with sign-up bonuses and other rewards. Costco card members make up about 11 million, or 10%, of its cards-in-force. Assuming a post-tax gain on the sale of $1.43 billion, AmEx needs to replace or retain these card members at a cost of $130 each. For reference, American Express spent about $3.3 billion on marketing in 2014.
Whether or not it can replace the customers it sells remains to be seen. But one thing is certain: if AmEx dumps its Costco customers, we'll get a very good look at just how strong the AmEx moat really is. Just how much, exactly, do its card members really love their credit card?
Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends American Express, Costco Wholesale, MasterCard, and Visa. The Motley Fool owns shares of MasterCard and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.