A collection of articles that I read recently on the major credit card companies – Visa (V), MasterCard (MA), and American Express (AXP) – is perfect evidence of the strength of American Express’ moat, and gives reason to be cautious after the extremely successful IPOs of both Mastercard and Visa.
This recent article from Bill West attempts to paint the pure credit card processors (Visa and MasterCard) in the best light possible on all angles. I’m not surprised that Bill is long both stocks, and while I’m not short either of them, I do feel that he glossed over several potential negatives to allow for an overly bullish argument.
The most glaring dismissal is over the current legislation that could potentially result in the renegotiation of fees that merchants pay issuing banks, known as the interchange fee. While I’d be far out of line to assess the odds that the bill passes, it’s a worthwhile example to illustrate why American Express is the much better company and – as we’ll see later when looking at valuation – investment.
West likens the Congressional review of interchange fees to the on-and-off threats against the integrated oil majors for their “excess profits” – typically attributed in Congress to the oil companies having a monopoly over the commodity. Trouble is, the oil companies don’t have any real, actual control over the price of oil - in fact, even the largest publicly traded oil companies pale in comparison to the size of state-run oil companies. Deep down, I believe most everyone in Congress would acknowledge this, as long as it never came back to some of their constituents angry after a $4/gallon fill-up at the pump. Visa and MasterCard, however, are very much a duopoly in the credit card market, with roughly 80% of the cards in force being one of those two brands. While there are lawsuits by merchants alleging antitrust violations, none have gone to trial as of yet, although a successful verdict against Visa wouldn’t be the first time that company has been hit for anti-competitive practices – Visa was forced to settle a multibillion dollar lawsuit brought by American Express alleging Visa had a long history of preventing banks from issuing rival cards.
The big question, though, is whether the leverage Visa and MasterCard have over merchants is enough to entail government arbitration to the point of setting fee schedules lower. Again, whether or not that happens, or to what extent it does happen, is beyond my knowledge. But there are two adverse possibilities, one being that interchange fees are lowered, and the other being that the fees Visa or MasterCard can charge are lowered. While the latter’s impact is quite obvious, the former’s isn’t so much – Visa and MasterCard, after all, don’t collect the interchange fee; it goes to the bank issuing the card. But a decrease in the interchange fees would make these cards a much lower-profit enterprise for the issuing financial institutions, and that would incentivize them toward making money on the interest rate side. Raising credit card interest rates would make using credit cards a much less-appealing option for consumers, and this could put a clamp down on the revenues Visa and MasterCard receive. In a way, the celebration of Visa and MasterCard for being non-credit exposed financials is highly ironic, because they are dependent on the highly credit-exposed financial institutions to put the cards in force that drive their earnings growth.
Some rudimentary calculations show that the processing fees Visa itself collects are quite low as a percentage of transactions. For the two quarters ending March 31, 2008, Visa processed 17.9 billion transactions, from which it earned data processing revenues of $986 million, or roughly 5.5 cents per transaction. Those transactions amounted to roughly $1.3 trillion in payment volume, from which Visa earned $1.52 billion in service fees – or slightly under 0.12% of transaction dollar volumes. When adding in interchange fees (again, which do not go to Visa or MasterCard), the net remittance from the merchant is around 1.8%. This is the amount that the credit card payment processors are being dragged before Congress over. The real kicker in that equation? As noted at the end of the AP article, “Visa executives have also complained that the bill, which applies only to companies with ‘substantial market power,’ wouldn’t affect American Express Co or Discover Financial Services (DFS).”
Like I noted in my recent American Express stock report (see my PDF valuation), that company’s highly affluent cardmember base allows for them to charge a premium discount rate, and their closed loop payment network means they retain the fees charged to merchants. Last year, American Express’ realized discount rate averaged more than 2.5% - even though they obviously occupy a relative niche in the market share scheme of things. This is the benefit of having one of the best customer bases of any large-cap company on the planet, which creates a moat that Warren Buffett noted consistently expands year after year.
But wait, you might be saying – doesn’t American Express have scary credit exposure, whereas (to go back to Bill West) “MA and V are simply toll-takers in the credit economy?” Yes. But part of taking on that credit exposure means American Express is much better compensated from merchants, and looking at profitability over time shows that credit exposure has hardly been detrimental to American Express’ bottom line.
None of this is to say that Visa or MasterCard are bad companies – far from it; their model has very positive operating leverage, they should benefit greatly from marginal shifts from cash to plastic, and the lack of huge capital commitments puts most other industries to shame. But are these companies worth fairly high multiples given their existing size and scale? I think it’s going to be a real contest for earnings growth to outpace multiple compression over the intermediate-term, and given how hot Visa and MasterCard have been of late, the prudent thing to do is be cautious… or even look at the unloved stock with the best underlying economics in the space – American Express.
An additional note: Oppenheimer’s Meredith Whitney has said that she expects roughly $2 trillion in credit card lines to be removed between now and 2010, effectively halving outstanding credit to consumers.