Don't Leave Home Without It
Don't Leave Home Without It
An in-depth analysis on American Express.
Good afternoon investors 👋,
Do you know anything underappreciated?
Maybe your job… maybe even your wife? But what if I said American Express? A company that rakes in $60 billion a year from charging fees and collecting interest. A company with a stock up 30% in the past year, yet somehow still trading at a price that could make you 15% a year for the next half-decade.
Amex is one piece of the pie in my new little mini-saga of analyzing the card networks. Next week, I’ll send out an issue covering Visa and Mastercard, called “A Processing Duopoly,” to finish off this saga. So without further ado, it’s time to meet American Express.
(I was originally including all three stocks in one analysis, but Substack kept giving me email length warnings. I didn’t want to risk it, so I scheduled two seperate posts. As a little side note: For some reason, these companies all have amazing slogans.)
Let’s get into it. (21 min read)
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Today at a glance:
What’s a Card Network?
American Express Analysis
Fundamentals, Moat, Growth, Valuation
What’s a Card Network?
You swipe your card, insert it, tap it, and buy stuff online — simple acts of spending your money. Most likely on stuff you don’t need. Sometimes, it’s with your debit card; other times, with your credit card (if you have one). Regardless, someone is making money off you. Usually it’s the company you’re buying the stuff from that profits. But the cards you use? They’re making bank. Quite literally for some. Here’s how it works:
Picture this: You’re headed to your local Loblaws to buy some Bick’s pickles. Why a specific brand? I have no idea, but that’s besides the point.
You walk into Loblaws, grab your pickles, and you know what? That gum at the register looks good too, so you decide to buy it.
“That’ll be $53.24,” says the cashier.
Why are the pickles and gum so expensive? Again, I have no idea, but let’s imagine it’s 2080 and inflation has gone haywire.
“Uh, credit please… American Express Platinum,” you politely and seemingly smirkingly respond.
You take out your hunk of metal, tap it on the screen…and it declines.
“Sorry, we don’t accept Amex,” says the cashier.
Feeling the embarrassment from the line of people watching, you take out your Visa Infinite, swipe the card, it approves, and you leave the store, happily ever after with your overpriced pickles and some gum.
Loblaws is the merchant selling the products to you in this transaction. Visa, as the card network, manages the transaction for Loblaws and takes a fee for doing so. You, as the consumer, don’t pay the fee; Loblaws does. This fee is typically around 1-2% of the total transaction for Visa (which is split with banks and other institutions). The reason Amex isn’t accepted at as many locations as Visa, is because Amex charges 2-3%, but more on that below. That, in an oversimplified way, explains what a card network is.
TL;DR: When a cardholder makes a purchase using a credit or debit card, what a card network does is processes the transaction, verifies the card details, checks the available funds of the cardholder, and if funds are available, transfers the money between the merchant’s bank and the cardholder’s bank. The card network makes money by taking a small percentage of the overall transaction they process (more on that below).
Up first, American Express.
American Express Analysis
American Express, operating mainly as a card network, makes money by charging fees in the same way as described above. That’s their core business. In fact, as of their most recent full-year earnings report, roughly 60% of total revenue comes from merchant fees (discount revenue).
But American Express is different from Visa and Mastercard even though the company is often compared to them.
The main difference is that Visa and Mastercard operate in an open-loop system. Visa and Mastercard process transactions as a card network and make money from every transaction — that’s it. In this open system, Visa and Mastercard partner with banks and institutions to issue their cards. Transactions are processed through the Visa and Mastercard networks, but are managed by the issuing bank. Annual card fees and interest earned on outstanding balances from those cards are revenue for those banks, not Visa and Mastercard.
Visa and Mastercard are purely card networks, and all they do is process transactions and take a very small cut of said transactions.
American Express operates a closed-loop system. Amex issues its cards acting as the issuing bank, pocketing revenue from not only processing transactions but also the annual card fees and interest on outstanding card balances.
This closed-loop system allows Amex to have a direct relationship with their millions of cardholders and the merchants, therefore giving Amex access to a massive array of data on its customer base. I’m talking about access to detailed consumer data like spending habits, preferences, and credit history. All of which come together and help Amex directly target their cardholders with incentives and rewards to keep spending and make more from card fees. This strategy works so well, in fact, that Amex cardholders spend on average double what those using a Visa or Mastercard credit card spend.
(Amex cards, most of the time, also have annual fees. These amazing personalized rewards work to help cardholders justify those annual fees, giving American Express pricing power on said annual fees that are sometimes over $500/year. (According to American Express’s CFO, these rewards Amex gives to its cardholders (ballpark) are double the cost of the annual fee.)
And so, because Amex cardholders will on average spend more than competitors, Amex can charge much higher fees to merchants per transaction. Amex typically negotiates individually with merchants when it comes to fees. But like we’ve seen before and recently, sometimes these negotiations don’t work out, and merchants resort to not accepting Amex as a payment option. That’s why Walmart and Amazon accept Amex, but Loblaws and eBay don’t.
Here are the differences in fees that scare off some merchants from accepting American Express:
Amex’s fees: 1.60% + $0.10 to 2.85% + $0.10 per transaction.
Visa and Mastercard’s fees: 1.15% + $0.10 to 2.50% + $0.10 per transaction.
(So on average, Amex’s fees are ~30% more than that of Visa and Mastercard.)
Now back onto the subject: Amex’s whole setup here is what’s called a spend-centric business model:
TL;DR: When a cardholder spends money with an Amex card, Amex takes a cut of the transaction. (These fees make up almost 60% of Amex’s revenue.) When this cardholder spends money, Amex operates in a system that tracks what the cardholder is spending, enabling them to incentivize that same cardholder with amazing personalized offers and rewards to entice them to spend even more, therefore making Amex more money. Because of this setup, Amex cardholders spend 2x the average credit card consumer, and Amex can justify charging merchants higher transaction fees.
Here’s American Express’s revenue breakdown:
Discount Revenue (58.0% of sales)
Fees charged to merchants for accepting Amex, and proccessing fees from the Amex card network. Typically 2-3% of the transaction amount. (This percentage fee is negotiated with every merchant that accepts Amex.)
Net Interest Income (21.7% of sales)
Revenue earned from the interest on loans, (e.g., outstanding credit card balances) minus the interest expenses paid on borrowings (34% of total interest income).
Card Fees (11.9% of sales)
Mostly annual fees charged for the privilege of owning an Amex card. Includes late payment fees, foreign transaction fees, and other fees (cash advance fees, balance transfer fees etc.)
Service Fees & Other Revenue (8.3% of sales)
Fees charged for services to cardholders like membership fees and fees for expedited card delivery. Also includes revenue from co-branded card partnerships and data analytics services to merchants.
Fundamentals, Moat, Growth, Valuation
Pristine fundamentals
Over the past five years, Amex’s stock price has seen great growth, with a 17.18% CAGR1, beating the S&P 500’s return by 0.6% at the time of writing.
A stock price doesn’t just go up by fluke. Over the long term, a stock price always follows the underlying business fundamentals. As an investor, you want a business that is growing earnings, free cash flow (FCF)2, and revenue to sustain the growth rate you want. My personal growth rate target is 12-15%. Let’s take a look at Amex’s key metrics from the past five years:
Revenue growth: 8.40%
Earnings growth: 6.82%
FCF growth: 17.40% (21.04% on a per-share basis)
Dividend increased: 79.48%
Shares outstanding decreased: 31.23% (in the past 10 years)
Your typical way of looking at a business’s growth should be FCF. American Express has grown earnings and revenue at a decent pace these past years, but looking at FCF, it trumps every metric. A key aspect to keep in mind is that you can’t buy anything with earnings, but you can with cash. That’s why when you analyze or value a company like American Express, looking at free cash flow is much more important than looking at other metrics. Amex has not only had amazing FCF growth but has nearly doubled its dividend and bought back a third of its shares outstanding in the past decade, which is a sign of not only great fundamental success but a management of a company that cares about its investors. These are some pristine fundamentals.
Amex’s competitive advantage
When looking at companies or businesses to invest in, aside from the obvious —which is understanding the business — making sure the company you invest in has a proper moat or competitive advantage matters. Why does it matter? Because, just like in medieval times when castles had moats of water to protect against incoming enemies, companies need moats to protect against competitors. A company with a good competitive advantage means an investment with a low chance of losing money long-term.
Amex is not the largest card network and is not the largest credit card issuer. On face value, there is no moat whatsoever. But their ability to target and capture cardholders and successfully incentivize them to spend more, plus their pricing power on annual fees… it may seem simple, but that’s a position that neither the largest card network nor the largest credit card issuer could fill — that’s American Express’s moat. It’s a very unique combination of access to valuable consumer spending data, pricing power, and brand recognition, all of which come together to make American Express succeed time and time again.
Growth aspects & valuation
According to analysts, over the next five years, Amex is poised to grow revenue at 10%, earnings at 9%, and FCF in a range of 8-10%. Most of this growth will be attributed to Amex’s push on bringing the younger generation (Gen Z, younger Millennials) to their products. Here’s a little blip from a recent call with the CFO of Amex, Christophe Le Caillec, explaining this:
“And so we feel good about where we are from that standpoint. I'm very optimistic about -- there are always going to be young people, and we’re always going to have to win them. I’m pretty sure that a generation from now, we’re going to have to innovate around the products to win them again. But right now, the products that we put in front of them resonate extremely well with them. Remember that it’s a generation that is used to paying fees for many things, including how -- experiences, how they consume music through a membership or subscription fee, how they consume entertainment. And so we’re just playing in that space as well. And as you said, it’s resonating like very, very well with our younger card members. And to your point, like almost 60% of them enter the franchise and the first thing they do is pay us a fee.
But I need to say as well that the card members that we’re talking about for the Gen Zs and the younger Millennials are not the average Gen Z or younger Millennials that are impacted by this. We are very disciplined about who we bring to the franchise. As a matter of fact, our underwriting models do not have age as an input. So the people we’re talking about, the card members we’re talking about are typically young professionals who have jobs and who are starting in life. Like many of you, many of us, a long time ago for me. But these are typically the card members that we bring to franchise.”
There’s a lot of opportunity for the company to grow, and this is one of the biggest opportunities so far. However, then comes the question: Is Amex a good stock to buy after rising 30% in the past year?
Based on historical metrics, Amex has historically traded at a P/FCF multiple of 9. It’s currently trading at 7.6. Based on that alone, Amex is around 16% undervalued. When we use a DCF, assuming an 8% growth rate, an average future terminal (P/FCF) multiple of 9, a 15% discount rate, and a 30% margin of safety, we get a fair value of $189.36 billion or a 9% discount compared to the current market cap at the time of writing. This means that if you buy Amex today, you are potentially securing a 15% annual return over the next half-decade.
But this is assuming Amex grows FCF at just 8%, and the market only pays 9 times FCF for the company. Because according to the CFO, American Express is trading at a discount, and they deserve a higher multiple:
“We are at a time where we have a clear strategy and we are very focused as a management team on executing on that strategy. We do not need a new strategy. We have won, and we’ve been operating in that strategy for a while, and it’s delivering. And we laid out an ambition to grow revenue in excess of 10% and earnings per share in mid-teens. When you compound this, it’s a super attractive value proposition for investors. … for the most part, at American Express, when I was at a more junior level, we were trading at a premium to the S&P 500.
The recent history, you’re right, it’s history, but it’s the recent history, we are trading at a discount. [Although] the market will tell what’s the right multiple is, of course. But I hope that if you believe in the strategy, if you believe in their credit profile of this franchise, if you believe in our ability to execute and the strength of this leadership team, then if you compound that EPS growth over time, you can rationalize a higher multiple, which is where we were I would say, a few years ago. So I hope that, that’s what happens in the coming years and in the coming months [a higher stock price].”3
Thanks for reading today’s Deep Dive! I’ll be back in your inbox this Friday (tomorrow) for yet another Weekly Brief.
Happy investing, and again, thanks for reading!
☕️ - Jacob xx
Compound annual growth rate (CAGR): a metric to determine how much a stock’s price has returned every year over a certain period of time. (CAGR can also be used to determine revenue growth, profit growth, etc.)
Free cash flow (FCF): the money left over to shareholders after subtracting a business’s operating income by its capital expenditures.
Thank you. I have been waiting for this one. 👍