When considering a potential investment, it is important to think about whether the business has a durable competitive advantage. In fact, this is arguably the most important question to ask. The emphasis should be on the durability of the advantage. An investor should be looking for permanent, not temporary, advantages. American Express (AMEX) enjoys a number of such advantages.
The first, and perhaps most obvious, advantage that AMEX enjoys is that it is unlikely that there will be another major competitor in global payments. This advantage owes itself to the network effect whereby a network becomes exponentially more valuable in proportion to its number of users. No one wants to use a payment card that has limited acceptance. No merchant wants to accept a card that has few users. Overcoming this “chicken and egg” problem presents a large barrier to anyone contemplating creating a new payment card. Discover has been at it for years and still materially lags VISA, MasterCard and AMEX.
AMEX, VISA and MasterCard also enjoy formidable economies of scale. The fixed cost of building and maintaining a global payments network are enormous, yet the marginal costs of running additional transactions over the network are negligible. That helps explain why AMEX’s normalized return on equity in the payments business has been over 30% and they have been able to grow earnings at 12-15% while returning its business over 70% of capital to shareholders through repurchases and dividends.
Another advantage AMEX has, and arguably its most important, is that it is able to charge merchants a larger percentage of each sale than VISA or MasterCard. The reason is they can get away with charging more is that the average spending on American Express cards is over four times greater than that of VISA or MasterCard. Merchants may not like it, but they can’t say no to AMEX cardholders, especially when AMEX has a dominant position in corporate cards, the truly big spenders.
AMEX attributes this high spend to what it calls its “spend-centric” model. Here’s how it works. AMEX attracts high-spend individuals and corporations with a compelling value proposition. For individuals this includes the premium brand (would a high-net-worth individual rather pull out an AMEX Platinum Card or VISA when checking into a posh hotel or picking up the check at a 5-star restaurant?), outstanding rewards including access to unique experiences, and outstanding customer service including the worldwide travel office network. For corporations, this includes all of the above for their employees and advanced expense management tools. AMEX then creates insistence at the point of sale by giving corporations a reason to require employees to use the AMEX card (cash management) or providing such a strong value proposition to users – strong rewards and executing like crazy (great web site, pay all or in part with points, unique experiences) – that they insist on using the card.
AMEX’s powerful brand and position in the marketplace has allowed it to form premium lending partnerships with leading merchants such as Costco, the dominant U.S. wholesale club, and Delta, the largest airline in the world after the merger with Northwest, and many more: British Airways, AirFrance, Alitalia, Quantas, etc. Consider that if you want to use a credit card at Costco, it’s American Express or nothing.
The results show that the model is working. AMEX’s share of U.S. purchase volume has gone from 19.9% in 1999 to 24.0% in 2008.
AMEX’s has also made its corporate-card relationship “sticky” by giving corporate clients extensive cash management and expense management tools that integrate with corporate back offices. AMEX continually works at deepening and extending these tools to raise the switching cost to corporate clients.
Valuing a business is all about trying to figure out how much cash a business can generate going forward. A business with a durable competitive advantage makes that job a whole lot easier.
Disclosure: The author owns shares of American Express.