Superior Credit Performance in the Cards for Amex

American Express is often seen as an adversary to merchants, and indeed its high discount fees and consumer-friendly practices have not endeared the company to this important set of customers over the years. However, its embrace of the consumer--in transaction disputes, for example--has created a valuable intangible asset in the company's brand. And while discount fees have been falling for years, American Express is now offering more to merchants, in addition to the superior benefits received by cardholders. Efforts such as Small Business Saturday, the new Plenti loyalty program, and the Amex Express Checkout online payment option all build on American Express' historical value proposition--increasing customer spending (and building loyalty) at the merchants that agree to accept its cards.

We think the market is underestimating the potential for superior credit performance at American Express and its issuer peers over the medium term. Underwriting standards have been quite conservative even as rewards competition intensified, and an improving economy and falling unemployment rate bode well for credit quality.

Overall, we think the company's strong brand, expanding network, and close relationships with merchants and cardholders--along with its ability to return essentially all of its income to shareholders--will drive healthy growth in earnings per share.

Customer Data a Valuable Edge American Express relies on powerful network effects and the valuable intangible asset associated with its brand in order to generate excess economic profits. Over the years, American Express has assembled a base of big-spending cardholders by offering exceptional rewards and services. These affluent customers are attractive to merchants, who willingly pay higher discount fees to American Express. In turn, high discount fees fund the company's rewards programs, making its offerings more appealing to cardholders and completing a virtuous circle.

American Express' closed-loop network both issues cards to consumers and acquires transactions from merchants. As such, American Express possesses a vast amount of valuable data about the spending habits of its prosperous cardholders. The company is still in the early stages of monetizing this data, but its unique knowledge of spending patterns is a clear source of opportunity. American Express' closed-loop network is also somewhat resistant to regulatory change compared with networks that set interchange fees for participants. However, American Express' reliance on superior rewards is also the biggest competitive threat to the company. Other issuers are aggressively targeting American Express customers with ever-increasing levels of rewards and services, and we expect this phenomenon to slowly take a toll on the firm's profitability.

We were initially skeptical of American Express' attempts to go downmarket, as previous efforts to expand the company's lending activities resulted in skyrocketing charge-offs. However, its newer efforts are relatively low-risk experiments in disruptive realms like prepaid cards and offer the prospect of running far more transaction volume through the company's network. We see these new customers as a double-edge sword--though they represent additional business for the company, the lower levels of customer service provided to them may eventually weaken the intangible assets associated with American Express' traditional business.

Big Spenders Dig a Moat American Express' closed-loop network and spend-centric model is the source of its wide economic moat. The network effect created by a large base of cardholders and merchants is strengthened by American Express' focus on the affluent--average annual spending on an American Express card is much larger than the amounts spent on competitors' cards. This makes the card more attractive to merchants, strengthening the American Express brand--a powerful intangible asset--as well as its pricing power and its ability to offer rewards to cardholders. Furthermore, as both issuer and merchant acquirer, American Express possesses vast amounts of data on spending patterns that few competitors can match. This data can only benefit the company as commerce becomes increasingly digitized and merchants seek to offer personalized shopping experiences.

Competition in the payment space is intense, but although other issuers are offering higher rewards in an attempt to win over Amex customers, the American Express brand remains quite powerful, and its cardholders still spend considerably more than peers. Although the move from plastic cards to mobile payment technologies is likely to intensify pricing pressure, we think a complete disruption of the virtuous circle that creates the company's moat is still far off in the future. Furthermore, American Express' closed-loop network will provide opportunities to exploit its proprietary data for custom promotions, advertising, and other solutions as technology advances.

Technology Could Make Traditional Networks Obsolete The biggest risk for American Express is the possibility that new types of technology will eventually bypass the traditional payment networks. It's also possible that digital wallets will shift some of the value now captured by the major network brands to cardholders, merchants, and wallet providers. American Express also faces competition in the rewards space and a consequent erosion of its pricing power. The company faces regulatory risk--restrictions on interchange fees could lead to reductions in the discount fees it earns. Finally, American Express faces credit risk in its lending business.

American Express is in good financial health, reflected in strong capital levels and low nonperforming loans. Capital remains solid, with a tangible common equity ratio of 12.6% as of the end of 2014. Based on the Dodd-Frank stress test results, Amex and other credit card companies score among the highest of the 31 bank holding companies. Nonperforming loans represent approximately 1% of assets, the lowest of the credit card companies we cover. With predominantly credit card loans, deposits constitute only 35% of total liabilities, with most of the remainder from long-term senior notes. Liquidity is not a near-term concern as the company has dramatically reduced its dependence on securitizations and unsecured term debt over the past five years.