How Much Credit Is Too Much? Where AmEx Went Wrong 22 comments
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The Wall Street Journal and other media outlets have talked about the demise of the credit card industry for decades now. Yet credit card businesses are truly one of the best businesses I have ever seen. I can't find a single person in the news media positive about the credit card industry. And those people who are bearish on the credit card business simply never understand the economics of the business.
The credit card industry is one of the most profitable industries in the United States with annual earnings in the $30 billion range. Many people might be surprised to learn that a single credit card issuer -- MBNA -- earned 1.5 times more profit than McDonald's (MCD) in 2004. Citibank (C), another major credit card issuer, earns more profit than both Microsoft (MSFT) and Wal-Mart (WMT).
How did the credit card industry become so profitable? With Americans charging 3 trillion dollars per year on their credit cards, one can begin to understand. Each time a credit card is used, a merchant pays a small fee (2-2.6%). In addition, about half of all Americans habitually carry a balance on their high interest rate credit cards which is a nice cash cow for the credit card issuers.
Here's some historical data on the credit card industry. It seems card issuers did even better in recession years than non-recession years.
Historical Profitability
(Visa, MasterCard and Discover)
YEAR ROA
1989 - 4.1%
1990 - 3.7%
1991 - 3.4%
1992 - 3.1%
1993 - 3.3%
1994 - 3.9%
1995 - 3.6%
1996 - 3.3%
1997 - 2.6%
1998 - 2.5%
1999 - 3.1%
2000 - 3.6%
2001 - 4.0%
2002 - 4.2%
2003 - 4.4%
ROA-net pre-tax return-on-assets
Source: R.K. Hammer Investment Bankers
(Can you tell which year is in recession from the above data?)
Barriers to entry in this business are quite high. The top 10 issuers enjoy almost 90% of the market share. Warren Buffett understands this business very well. He invests his money in American Express (AXP), Wells Fargo (WFC), B of A (BAC) and US Bancorp (USB). They all 'happen' to be large card issuers. Jamie Dimond described that JP Morgan Chase (JPM) has a fortress balance. He forgot to mention it is because JP Morgan Chase is the second largest credit card issuer in the US.
American Express has been having some trouble lately, and I think it's an Amex company-specific problem. Barron's had an article titled "Rich Deadbeat" to describe the sour state of the American economy. As they put it, Riches are having financial problems too. I have to say, not so fast. Let's look at some facts here.
From American Express Credit Card Master Trust, I have some interesting stats [SEC]:
click to enlarge
As you can see, American Express has the lowest percentage of card-members defaulting on loans in the last 5 years. Amex also had less people defaulting on loans than in the previous 5 years.
The question then is why American Express missed its second quarter estimates so badly? Why are charge-offs going up when Amex has less people defaulting?
The likely answer is a decision the management made in the last few years to hand out larger credit limits to its card-holders. By doing so, American Express juiced up spending growth in the last few years, and made Ken Chenault look like a managerial genius.
It's ironic now that we have a recession on hand that this practice seems to have backfired. Just like Amex's largest shareholder Warren Buffet said famously, "you only find out who is swimming naked when the tide goes out." And it looks like Ken Chenault has been swimming naked.
Here's some credit limits on some issuers, Discover (DFS) has been most conservative.
So what's the right credit limit? The credit limit should be large enough so the average card-holder can not pay off their balance in full every month, yet small enough so they would not declare bankruptcy.
Disclosure: Long Discover; no positions in American Express, Visa or MasterCard.
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This article has 22 comments:
1. Without checking your numbers, I'll grant that the MBNA > McDonald's comment is okay, as MBNA was a pure-play issuer. But comparing Citi to Wal-Mart and Microsoft is dumb. Citi's card issuing business is a tiny part of its whole operation.
2. It's Jamie Dimon, not Dimond. What's next? Warren Buffet?
3. You're missing some important decimal points in your charge-off table.
4. Your big point, that AXP has handed out larger credit limits to its card holders is conjecture not based on fact. It's possible, given the scenario, but you've provided no proof.
5. Discover's credit limits are low because they are targeting the low FICO, high risk sorts of people.
6. How can anyone trust advice from someone who is long DFS? LOL
2. Discover's credit limits are low because they are targeting the low FICO, high risk sorts of people? Discover has been the best underwriter in the last few years. Discover Card is the hardest one to get.
3. Amex is a still great business, it's a business even an idiot can run it.
In a sense, this made sense, as they had basically all of the rich market, so expansion necessitated that they broaden to grow. And while the economy boomed from the housing bubble, it looked like a brilliant move. In the current economy, they are paying the price for their decision. By the way, I'm not saying that this negates your point about raising limits. They weren't alone in this, as all card issuers were raising limits during the housing boom.
This was purely a Chenault decision, so while he took the kudos for brilliance during the boom years, he has to take the brickbats now. Like all CEOs, his performance is dependent on general economic trends. They, and analysts, tend to forget that 85% of a CEOs performance is due to general economic trends. How could they demand exorbitant compensation if they remembered? ;-)
1. The fact that Citi is a large card issuer is a far cry from saying that cards are its core business. Listen to one conference call, and you'll know what I mean. The amount of time that management, and the analysts, spend discussing cards is dwarfed by the focus on the banking operation. Back to my point: The author would do better to compare pure-plays (MBNA (pre BAC), Cap One, Advanta, DFS even), than Citi. Whether or not C is a large US player (forget about the rest of the world), the type of comparison he's making calls for like to like. What % of C employees do you think are actively focused on the card business? 5% maybe?
2. You're mistaken again. This is simple logic, man. Look at the charts and think: If you have a young, low income, thin credit file type of card applicant, do you grant him/her a large line? Of course not. And what if you have a high FICO, 6 figure applicant -- doesn't he/she merit a higher line? Sure thing! That, very generally speaking, is why Discover has lower lines. Seriously, Discover could (and should!) be very tight with lines if it's granting credit to low income/thin credit file consumers. In a sense, I'm almost agreeing with you and the author, actually. For any given cardmember, the limit should be "right," however you define that to be. But best underwriter? What does that even mean? If you give miniscule lines, no one defaults, or the default loss is minimized. But being "hardest to get" does not make DFS the best underwriter.
By the way, you make me laugh. It seems like you're implying that's there's something desirable about the hard-to-get Discover card. So ... the ultra-rich are tossing their Amex Black cards for Discover cash back? LOL. Even among us normal folk, who wants to pull out a Discover card at a nice restaurant? Might as well pay with food stamps.
Good points. The only thing I'd add is that, beyond the need to grow the business by expanding the target, there's another strong rationale: merchant acceptance. Expanding Amex's footprint gives the company a stronger argument (network effect) when it is negotiating with retailers to take the card.
BTW, Cards is a business within WFC and C. And not a very large part as well. Don't confuse Citi's card standing relative to other issues with the size internally.
Finally, I am not sure you can summarize AMEX's line size this way since they issue both charge cards with no "credit line" (though they do have a guideline) and credit cards with hard limits.
I recently signed up for a Discover card to get the signup bonus- there is also 5% back on gas purchases and a minimum of 1% back across the board. So far I have found it has been accepted almost everywhere.
Maybe I'm missing something, but I have never noticed any stigma attached to using Discover, not that I would care anyway. I do not live in a trailer, I have all my teeth, my wife does not have big hair, I DO take the kids to McDonald's occasionally...the fact that self-important snobs need a "higher class" card to validate their self-worth only makes me feel better about the card I choose to carry...
When we started spending more than we made, leveraging our credit to afford a lifestyle beyond our means, and borrowing knowing that we didn't have money to cover all the debt that was being charged up- WE- (the country- and our people went wrong).
Its like the lack of personal responsibility in education. If Jimmy is a retard and has trouble putting air in his tire- that is ... name the politician...etc...
AXP?? NO- my friend- the consumers that most likely lied to up their credit limit. The consumer that took out that 18th card- the consumer that charged beyond their limit. AMEX may have been the pusher- but the user- injected that credit- and the Amex didn't put a gun to their head.
Amex cardholders tend to like to show off. In fact I know many people really broke, wrote bounced checks and carry an Amex Card. Amex has 23 million active users in the US, and I don't think we have that many rich people in US.
Enjoy your weekend,
Frank
Was curious about the fact I had never heard of you- and suddenly you just popped up taking the V/MA- contra position with AXP/DFS.
Got a strange feeling when you were on the V boards- because I didn't sense conviction on your part-
Let me ask you a question; you wouldn't happen to be be friends with 'GC' would you??
I am a value investor, I am not a friend of "GC", I am long DFS since it's the cheapest stock, yet this a great business. I figure DFS can earn about $2.50 a year, so it sells for 6 times normalized earning. comparing to V and MA, they sell for 30 tmes earning.
In my estimation the absolute BEST thing DFS has going for it (and you haven't mentioned it) is the pending litigation DFS has against both V and MA. V and MA have entered into a joint settlement agreement and I predict a settlement will be reached prior to the trial date (in Sept). V and MA have the cash (well V has it in hand- but MA can make AXP like payments- and I don't think DFS wants to risk a trial because their case is week. People talk about 'treble' damages as its an anti-trust case- BUT- the case itself is week.
Basically DFS marketshare has pretty much flatlined since MA and V stopped the 'onerous' business practice (which was actually just capitalism at its finest)- whereas AXP's increased substantially. DFS is going to have a hard time proving that its ability to grow was constrained if they were not able to prove growth after-the-fact.
In fact, if this does go to trial- that is a sign that V/MA are so confident about their case that they didn't feel the need to settle.
I, for one, expect to see a pre-trial settlement this month. You could make the case for a quick pop. If, for example- V/MA are willing to each give DFS 1.5 to 2billion -that would help out the smaller - lesser equipped CC provider out quite a bit..
Look, I careless about the trial, What I like about DFS has nothing to so with the lawsuit. As you know, the Visa bylaws was put in place in 1992, specifically against DFS. The problem DFS had over the years is acceptance, It was accepted far less places than Visa, the reason is simple, like I told you, Visa banned acquiring banks from doing business with DFS. That damage is huge. Who signs up merchant for acceptance? Acquiring banks, there are thousands of places that you can sign up to accept credit cards, but these places will not let you sign up for Discover. Why? because Visa told them, look, if you let merchants to take Discover, we will not let you do business with US again.
Forget about the past, let us look into the future, the truth are self-evident, the question is steve, can you handle the truth?
Discover has 18 million active users, Amex has about 23 millions. Discover card is not used as often as Visa for one simple reason, i.e. too many places did not take Discover Card. That's about to change for good. by early next year, Discover should reach parity, and it can partner up with merchants encourage more usages of Discover card, which means more money for DFS.
Visa on the other hand, will be looking at renew contracts with banks, Banks want to keep more of Visa's share of revenue, or they will move, no royalty there. Imagin sit down with Jamies Dimon or Ken Lewis, they will get very large concessions from them. Ken lewis even threaten to start a new network to compete against Visa.
you to pay with Discover Card, your credibility is shot along with 90% of these bloggers, check their past comments.
That is why I have maintained that V was a better play all along. I have also maintained that V would decouple from MA in the second quarter of this year (which it did).
I now have the full support of most top analysts, institutional money, and the market itself (not to mention reported financials and actual results).
But why gloat- we are all here to support eachother.
Mr. Bill- you are sounding smarter all the time.
ALOHA!
In the meantime- we have a wide-variety of content on V:
visawinners.com