Credit Card Issuers and Processors - How They're Faring in the Crisis

In the credit card food chain, there are essentially two types of firms, issuers and processors.

The processors - and there are only two - Mastercard Incorporated (MA) and Visa, Inc. (V) – provide electronic payment services and act as promoters of the cards they process (they do the “Priceless” ads etc). Their business depends on consumers making purchases. They are the ‘house’ gaining a piece of every transaction.

The issuers are banks. They issue cards to businesses, consumers and government agencies. They also gain a piece of every transaction and many collect an annual fee, just for being available. They also take on credit risk when people use ‘credit” cards, and not charge cards. The difference is charge cards are paid upon receipt of the monthly bill. Credit cards are paid off over time, adding risk and reward to the issuer. The reward is in the form of interest. The rates can be high or competitive depending upon the issuer, the card holder and where interest rates are holding. The risks are late payment and default.

There are banks who issue a lot of cards, making credit cards a material part of its business such as Citigroup, Inc. (C) and Capital One Financial Corp. (COF). These are not pure plays in the credit card business as they have many other business lines.

There are however, two firms that have closed the loop and are both issuer and processor. American Express Company (AXP) and Discover Financial Services (DFS). These are pure plays and the two majors in this industry.

So how has the recession impacted consumer behavior and what should we expect to happen to the revenue and earnings results of these companies?

A recent Mintel study examines the credit card payment behavior of Mass Affluent (MA) Americans. The study defines “Mass Affluents” to be U.S. households earning between $100,000 and $2 million. These are the best and most sought after customers. The results of the study indicate that only 48% of MAs, who spend “significantly more” than the average consumer “currently feel financially secure.” That feeling has translated into over 55% of those surveyed, have cut down or deferred overall spending due to the recession.

Although 78% of the Mass Affluents did not change their credit card payment behavior, the remaining 22% “was split evenly between those who formerly paid balances in full but now don't, and those who didn't formerly pay in full, but are now making even smaller monthly payments.” Of the Mass Affluents, only 62% pay off their balance in full each month and 5% pay the minimum amount due. These numbers indicate that the Mass Affluent population is facing growing debt and even this group is experiencing growing unemployment. The accrued debt reflected on monthly credit card statements is a constant reminder of financial instability which continues to impact retailers adding to economic contraction.

The most frightening element of the study is that Mass Affluents only represent 10% of America. If people among the wealthiest, cushiest, decile of America are accumulating debt and unable or unwilling to pay off their bills, what does this mean for the majority of America? The increase in credit card debt is having detrimental effects on American businesses as well as consumers and their psyches.

Credit Card companies are suffering from changes in consumer behavior. Closed Loop companies such as Discover and American Express are involved in all aspects of the credit card business and are directly in the line of fire of credit risk. As debt piles up, closed loop companies need to fight to recoup accrued payments as evidenced by both AXP and DFS having already needing billions Federal TARP Funds. Open loop companies on the other hand have a lot less risk. Although decreased retail spending hurts both open and closed loop companies, open loop companies benefit from consumers’ need to buy more purchases on credit.

The impact of the different business model of open loop and closed loop companies can be seen in the chart below. In the past year, the open loop companies outperformed the S&P 500 Index and the closed loop companies underperformed the S&P 500 Index by a wide margin.

click to enlarge

What is not seen is the impact on issuer (read bank) balance sheets, loan loss provisions and how they are accounted. As we eased mark-to-market rules, a lack of transparency may grow. This is not investor friendly, but, admittedly may be the best road to recovery and for tax payers to have some relief as borrowers of last resort.

Shout out: This post was originally drafted by star analyst Emily Needell.

Disclosure: No current positions but I selectively short COF, AXP and DFS.

Comments

[BusinessMod...:]

Interesting - as credit quality ( higher delinquencies and losses) increases and utilization ( less purchasing) as well as payments decrease, and unemployment continues to increase ( some now expect 12% plus unemployment by year end) credit losses will soar as higher "affluent" balances" are charged-off. Not good for those institutions that are not diversified into other lines beyond consumer credit.

Apr 05 10:33 AM

[doublestrike:]

What makes V & Ma so much better is people are afraid to carry cash. Even if people cut their credit purchases the debit cards will become much more greatly used. As Ma & V get fees either way there outlook remains solid. Earnings may drop a little but overall they look like great buys at current levels.

Apr 05 12:08 PM

[1shilah:]

Ma's yield is .4% hardly worth the investment in a stock currently @ $173/share.

i have noticed in their Q4 report the GDV (gross dollar volume) has begun to decline in the US. this may begin to accelerate as more unemployment takes place, i.e. less transactions.

lastly, the WSJ reported the EU has made them cut their interchange fees, beginning in july, in half. the journal estimated this would cut MA's fees by over $200M. MA says effects only 5% of revenue. we'll see, this is not over. earnings are reported may 2.

Apr 05 04:10 PM

[ozcutty2:]

I've seen a lot of articles like this. Visa and Mastercard are wonderful, the rest are crap.....
Thats why Visa trades at 20xp/e and dfs trades at 3xp/e.
The question is not which is the better company but which is the better investment.
Considering dfs network volume has doubled since 2004, i'd say 3xearnings makes this a better investment

Apr 05 07:55 PM

[tom g:]

I believe the EU cuts on MA's interchange only pertains to cross border transactions, that's why the estimated 5% hit to revenues.

Apr 06 09:17 AM

[William Arm...:]

I beleive that the risks in credit card portfolios are being exaggerated. The dynamics of the credit card business are fundamentally different than the dynamics of, for instance, mortgage lending. Credit card portfolios on the books of Citi or JPM or pure plays Discover and Amex, are funded at a relatively low rate of interest and earn a very high rate of interest. The spread must be on the order of 10%. This is a heck of a cushion that can pay for a lot of loan losses. The same spread in mortgage lending is on the order of 1-3% leaving not much cushion at all.

Apr 06 10:38 AM

[maz:]

DFS & AXP access to TARP funds has less to do with debts piling up - managed loans outstanding at both companies has been roughly static over the last year & you can expect them to come down over the next year or so imo - certainly not "pile-up". The bigger problem for both companies has been liquidity as the ABS market for credit card loans virtually shut-down or became prohibitively expensive. DFS is doing a good job financing maturing ABS out of increased customer deposits but that has a big negative to earnings - first the IO strip associated with the ABS has to get written down and reserves have to be increased as the loans are now on the balance sheet. Combined with rising defaults we can see earnings depressed (negative) for the next year.

If FAS 140 eventually (2010) makes credit card companies take ABS on the balance sheet that will be a big event - $20 billion for DFS and $29b for AXP - the write-downs and additional reserving required will make both companies look poor and challenge Tier 1 capital adequacy - that's why you see lot's of cash on the books as both companies are in defensive mode & quite rightly so. If it doesn't happen then both companies will look really good on a Tier 1 capital basis - currently 17.1% for DFS. If the ABS were on the balance sheet that figure would be around 8.5 to 9%

Apr 06 11:44 AM