Card Issuers: Facts and Fictions

Most people religiously believe that Visa (V) and MasterCard (MA) are much better investment than Discover (DFS) and American Express (AXP). The consensus views are here:

1. Visa and MasterCard don’t have credit exposures to American consumers.
2.  Visa and MasterCard hold very large market share. In fact, Visa and MasterCard enjoyed over 80% of credit and debit card transactions
3. The economy is in a toilet, and more and more consumers fall behind mortgage and credit card payments. Why touch Discover and Amex?
4. Card payment transactions have increased double digits year after year, even during the economic slump.

All these arguments are true, except one small issue that most people overlooked: just how exactly each company makes its dough.

Visa and MasterCard are in exactly the same business, and Discover and Amex are in a very similar business (let’s say 95% similar).

Let's use Steve Murray's point as an example: let’s say you go out and purchase a watch for $100 by using your Visa card. Out of that $100 purchase, the merchant would usually pay 2%, or $2, of that fee for the use of the card. Out of that $2 fee, only about $0.20 go to Visa the rest would be paid to the issuer of the card (ex: Chase, Citi, etc.) and the bank it corresponded the transaction with. Large banks have huge clouds over Visa and MasterCard. In order to keep them happy, Visa and MasterCard typically rebate back 15 cents out of that 20 cents back to the large issuers. To smaller banks, well Visa and MasterCard just says "no, no rebates, sorry, you are too small".

Put into perspective just how powerful large banks are: Citi (C), Chase (JPM) and BofA (BAC) account for about 70% of Visa and MasterCard total credit card transaction volume.

Before Visa and MasterCard became public companies, they were jointly owned by the banks. Visa and MasterCard’s annual profits were equally distributed back to card-issuers based on how much business they did for Visa and MasterCard. There was no competition between Visa and MasterCard.

Since they became public, they are now fighting each other, and Amex and  Discover, over card-issuing deals with potential card-issuers. As competition heats up, I see Visa and MasterCard losing pricing power completely. In the future, issuers will likely only issue one brand to get the most rebates. In other word, Visa and MasterCard will constantly see their revenue per transaction drop, even though more and more electronic transactions are going to take place. Visa and MasterCard will get smaller and smaller portions of their pie as time goes on.

Discover and Amex would be much better investments; these two companies have a large consumer base that will not defect overnight. Yes, the economy is in a crapper; yes, charge-offs will go up; and yes, everyone is bearish on these two businesses; but one fact remains: these two businesses have pricing power. Charge-offs are irrelevant. They can simply hike the interest rates that cardholders are paying to offset the rise in charge-off expenses. It’s called risk-based pricing.

As seen in the chart below (click to enlarge), in the credit card industry, profits mostly go to card-issuers.

Discover has many great things going for it nowadays; by early next year, I expect it will reach acceptance parity with Visa, which should help its business. And in the last 4 years, Discover has improved credit quality in its loan portfolio. In fact, Discover has the lowest charge-offs rate among the largest card-issuers.

Disclosure: none

Comments

[mrbill for V:]

Frank Rong you will not live long enough to ever see the day that Visa
"Completely Loses pricing power" if i was you i would invest in Bonds.

2008 Jul 31 07:21 AM

[Jake Blues:]

What an appropriate last name.

2008 Jul 31 07:23 AM

[tilut:]

Thank you Frank,finally a person talking with his head and objectivity.So far the brainless analysts,except MS analyst, have constantly tried to demolished DFS with their stupid recommendations and ridiculous price targets.I am a believer in DFS business and prospects like the third-party payment segment , their recent acquisition of Dinners Club and the fact they got rid of their money losing business in U.K.DFS is extremely well capitalised ,may the best in the industry , and remained very profitable even in this though environment.It is presently selling at its book value ,so the market gives almost no value to its healthy credit card business,its fast growing third-party segment and the billions they will probably receive from V and MA as settlements.DFS represents a great investment for long term investors. I have got nothing against V or MA but it is true that they are only intermediaries created by banks and their only real assets are their goodwill.

2008 Jul 31 08:00 AM

[Hoser:]

This guy is FULL of it. As a former business owner, we didn't take AMEX or DISC because their fees are too high! Much higher than Visa/MA. Rarely did we have someone ask if we accepted anything other than Visa or MA. Also, most people don't carry AMEX or DISC but if you have a debit card, chances are it's Visa or MA.

Since most credit issuers are tightening standards as to who gets a cc and for how big a credit line, does he REALLY expect AMEX or DISC to grow in the next 2-3 years while the economy continues to slump? Gimme a break. The only thing he said that makes sense is that business MAY slow down for VISA/MA because of a tightening in the issuing of credit. I kind of doubt it as people will switch to their debit card (especially for online purchases) and that is likely to be VISA/MA. They will continue to beat the Street's targets in the next few years.

2008 Jul 31 10:55 AM

[jcole:]

Discover is actually accepted at over 4.5 million locations in America and is currently adding thousands of merchants a day with recent partnerships with 3rd party payment systems. I agree that Discover is a great long-term investment. Their only issue has been overseas acceptance and that wont be an issue in the years to come. They are the most accepted U.S. card in China and recently bought Diner's Club.

Discover is also a great company because they continue to win the Brand Keys Loyalty award and investing in a company who has the most loyal customers in their respective industry is usually smart. Add to that, they continue to win the award for best in Customer Service, 11 years I believe, in their industry. So add all that up, most loyal customers, best in customer service, HUGE acceptance gains in America, presently gaining acceptance overseas, the choice is clear that Discover Card is a great investment, especially long term.

2008 Jul 31 11:11 AM

[Payments Guru:]

Your analysis isn't bad but you have a fatal assumption regarding rebates. V/MC lifeblood revenue comes from assessments. If you would present the data in your posting, you could show this has grown in direct relation to scale.

2008 Jul 31 11:38 AM

[Panda63:]

Hey jcole--you couldn't be more wrong about Discover being the most widely used cc in China??!! I've news for you--VISA is the ONLY card worth carrying when traveling to the PRC! I know I've been there recently and traveled thousands of miles thru China. And even at that, it was advisable to only use a cc at a hotel establishment because of cc fraud.

If you ever go to China, leave your Discover card or whatever-card at home and bring a VISA card only!

2008 Jul 31 11:25 PM

[jcole:]

No Panda63, Discover IS the most accepted American Card in China because they are on the Union Pay Network, which is the largest network there. Please refer to the link and read "Where can I use my card in China?". Remember, I said most accepted, NOT most used. I was pointing out the acceptance fact because people earlier mentioned Discover's acceptance issues. Enjoy! www.discovercard.com/c...

2008 Aug 01 02:33 PM

[visaman:]

"...large consumer base that will not defect overnight..." "They can simply hike the interest rates that cardholders are paying to offset the rise in charge-off expenses. It’s called risk-based pricing."

I'm sorry. WHAT!!! They can simply hike the interest rates that cardholders are paying to offset the rise in charge-off expenses. "It's called risk-based pricing." WHAT???? You're saying that in order to offset charge-off expenses DSC/AMEX would raise the interest rates on my/their credit card(s)? If that's true, who would keep using they're DSC/AMEX card? I don't know about you, but if I ever had to carry a balance I would want it to be on a card that charged me a lower rate than a card with a higher rate. I think if this were to happen you would definitely see many of their loyal customers defect overnight.

2008 Aug 01 08:39 PM

[User 172125:]

Most of you know what a troll is (and for those that don't - a troll is a semi-human being that has no life- no sex- but a fast computer- who gets their kicks by molesting blogs and forums to get a rise out of people-combined with the fact that they are depraved anti-social nerds)......

Well-in this case - I think what we have is a case of a 'devil's advocate author'. This is not as negative as a troll- but it is a form of deception. Now I could very well be wrong- but I don't think so.

As far as the post- lets have a little fun here. The game is to figure out who else has been paying attention and can figure this one out...

As far as Frank Rong- I don't know if you guys think it strange- but does anyone else who has been on this site for a while think his writing style is very similar to another poster who took the contra position on V for a long time? Listen to the post- and the writing pattern and then look at the mojo7489 posts (that is Frank Rong's handle)- see if you can figure out who he is...

Now - I was arguing with this guy on a couple of the V posts- and I finally realized who I was arguing with- by the way he wrote-the questions he asked- and the tone he took. But what gave him away was when I realized he didn't have conviction in his position- sort of like a debater trying to argue a point he doesn't really believe in- the lack of conviction comes through eventually. THAT was when I realized he was just taking the contra MA AND V position- and we are all being sucked into an argument that is not even real (on his part).....

Now I am 90percent sure I know who Frank/Mojo ALSO is... Do you have anything to tell us Frank?

The only part I can't figure out is motive??

Does Seeking Alpha need the traffic? Does controversy drive more traffic?

Or, Is Frank/Mojo/? trying to get a job as an analyst and practicing on a live specimen?

A lot of you seem pretty bright- lets see if anyone else can figure this one out... I'll check this post again to see if anyone else got the right name........




Most of you know what a troll is (and for those that don't - a troll is a semi-human being that has no life- no sex- but a fast computer- who gets their kicks by molesting blogs and forums to get a rise out of people)......

Well-in this case - I think what we have is a case of a 'devil's advocate author'

2008 Aug 02 02:32 AM

[harold.roach:]

One thing I want to point out is that most direct processing companies charge the same rate for Discover as Visa and MasterCard. I know mine does. Amex has already started to be more negotiable with its rates and I'm confident they will negotiate the same way Visa, MC, and Disc. do in the near future or risk going the way of Diners. You can be as profitable as you want but having businesses actualy accept the cards you market is important too.

2008 Aug 04 04:21 PM

[User 172125:]

The bottom line-

Is that if Amex stands a chance against V/MA- it should merge with DFS- and go heavy into debit- and global markets.

DFS as a stand-alone play is weak and picking up Diners was a non-event.

All cos will have to negotiate- this will be a necessity going forward whether voluntarily or not. That is why the multiple revenue streams and modes that V is developing, in addition to its investor base and debit platform makes it the clear cut winner in the plasic revolution.

First mover advantage is so entrenched that DFS has already lost the battle and will never be a real player.

Frank/Mojo- Do you really believe your position or are you just offering a contra argument for some other strange reason?

2008 Aug 05 02:46 AM

[Frank Rong1:]

Steve,

Let's move on from this topic, and we can find out what happen to these four companies in two or three years.

I wrote two more articles I want to know how you think

2008 Aug 05 10:40 AM