Costco Credit Decision Exposes Amex's Weaknesses

| About: American Express (AXP)
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American Express is having a difficult time adapting to new realities in the world of payment processing.

Costco’s decision to drop Amex in Canada shows how inflexible and old fashioned the credit card can be.

American Express’s inability to develop a mass market card may drive Costco to switch to Capital One.

American Express is now a niche player in the credit card industry, and that niche could shrink.

Costco could drop American Express because it needs the middle class customers Amex does not serve.

American Express (NYSE: AXP) is going to have a much tougher time maintaining its position in a changing credit card market than we previously believed. Costco Wholesale's (NASDAQ: COST) decision to drop Amex as its official credit card and payment processor in Canada and replace it with a Capital One (NYSE: COF) MasterCard exposes American Express's shortcomings as a payment solution.

Amex could take an even greater hit if media reports that Costco is considering dropping it as the official card at its U.S. stores are true. Currently, Costco is one of the few retailers that will only accept one credit card-American Express. You cannot use your Visa (NYSE: V), Discover (NYSE: DFS), or MasterCard (NYSE: MA) credit card at Costco, although you can use debit cards with those brands there.

American Express Needs Costco

The relationship with Costco has certainly been a profitable one for American Express. Amex's TTM revenue increased by $1.16 billion between September 2013 and September 2014; Amex reported a TTM revenue of $32.57 billion in September 2013 that grew to $33.74 billion in September 2014. How of much of that growth was driven by Costco is hard to determine.

It is safe to assume that Costco has a big impact on Amex's bottom line. Costco's TTM revenue grew by $7.48 billion between August 2013 and August 2014. Costco reported a TTM revenue of $105.16 billion in August 2013 and $112.64 billion in August 2014. The company's growth rate is phenomenal, and its impact on the greater retail market is growing.

Supermarket News reported that Costco is now the third largest grocer in the U.S. behind Kroger (NYSE: KR) and Wal-Mart Stores Inc. (NYSE: WMT). I noted elsewhere that Costco has around 10 million members in Canada alone and is now Canada's third largest grocer. Costco actually sells more groceries north of the border than Wal-Mart does.

Costco Does Not Need American Express

The important question investors need to ask here is, why is Costco thinking of dropping American Express? What is prompting the hard-headed retailer to stop taking one of the most respected credit cards around?

Well, first there are sheer numbers; Statistics Brain estimated that 27% of the credit cards in the U.S. were issued by MasterCard in July 2014. At the same time, only 6.5% of U.S. credit cards were American Express. Costco is seriously limiting its customer base by just taking Amex; lots of people don't have an American Express card in their wallet. It could even drive away some American Express card holders because most of the Amex card holders might want to use another card at Costco.

That could be a real problem with middle class families-Costco's main customers-increasingly strapped for cash and more dependent on credit cards. The median U.S. household income fell by 4% between 2009 and 2012, according to the U.S. Census Bureau. It rose slightly-by .3%-in 2013, by an increase of around $180 (the cost of one trip to Costco) to $51,939. The income for the average American family is still 8% lower than it was in 2007.

That's good news for Costco with its low prices and huge sizes, which are a perfect fit for penny pinching households. It is bad news for American Express, which caters to more affluent customers.

Why Ditching Amex Is a Smart Move for Costco

By switching to MasterCard, Costco could increase the range of payment options available to its customers and its potential revenue. It also makes Costco more attractive to middle and working class shoppers on limited budgets that don't have an Amex card in their wallets.

When it switches to Capital One in Canada on January 1, 2015, Costco will start taking all kinds of MasterCard credit cards in Canada. That means it'll be able to take bank cards linked to checking accounts, gas station cards, and the other cards middle class consumers are most likely to carry. It could also help Costco's gasoline business because the club store's filling stations will now be able to take many more gas credit cards.

People that are trying to accumulate cash back or other rewards on their MasterCard will be able to use those at Canadian Costco outlets as well. That's a powerful incentive for the growing number of average people who rely on credit card rewards to augment their limited incomes. This blog post shows just how important rewards are to such people.

Capital One Needs Costco

Ditching American Express seems like a smart move for Costco at this point. That move also shows some of Amex's shortcomings. It's a niche product aimed at a small segment of the market; that makes it a poor fit for a mass market retailer like Costco. Capital One, on the other hand, could be a very good fit for Costco.

In addition to MasterCard, it might be able to get Visa into Costco. That would be a very smart move because 36% of the 1.8 billion credit cards in the United States were issued by Visa, according to Statistics Brain.

Linking up with Costco would be a very smart move for Capital One, which, unlike Amex, has seen stagnant revenues for the past year. Capital One reported a TTM revenue figure of $22.46 billion in September 2013 that fell to $22.02 billion in September 2014.

Capital One was the only credit card processor that did not report revenue growth in the past year. In addition to Amex, Discover Financial reported that its TTM revenue rose from $8.093 billion in September 2013 to $8.568 billion in September 2014. Visa's TTM revenue rose from $11.78 billion in September 2013 to $12.7 billion in September 2014. MasterCard's TTM revenue grew from $8.115 billion to $9.183 billion in the same period.

The Costco situation shows just how limited American Express's traditional business model of issuing cards for affluent individuals is. It ensures cash flow at the expense of growths and limits options for payment processing customers. Costco is seeking a more flexible payment processing solution that Amex might not be able to provide.

Costco is showing us that the future of credit cards belongs to flexible, widely available payment solutions like eBay Inc.'s (NASDAQ: EBAY) PayPal, Visa, Apple Inc.'s (NASDAQ:AAPL) Apple Pay, and MasterCard rather than niche products like the traditional Amex card. American Express might have to change its business model to survive in today's retail and financial services environment, particularly with next generation payment solutions like PayPal and Apple Pay becoming widely available.

Disclosure: The author is long EBAY, KR.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author has investment and savings accounts at Capital One's bank.