In recent weeks, American Express has announced that the Costco processing and co-brand partnership will end in 2016. The implication is that either MasterCard (MA-NYSE, $87.14) via its issuing partners, or Visa, through its issuing partners, will assume the contract with Costco. This represents a major blow to Amex and comes on top of the loss of the Costco Canada contract that was reported in late 2014. A pre-announced loss of the JetBlue Airlines contract has not yet been modeled into American Express forecasts on the street. It is clear that for American Express, the competitive pressures that it faces with a closed loop business model are becoming increasingly challenging and may require a structural change.
The problems that Amex face are fourfold. First and foremost, its interchange system is US-centric. Companies such as Costco, which are steadily expanding into markets outside of the United States, may have simply outgrown American Express’ ability to process transactions, cost effectively, on a global basis. Secondly, the American Express fee schedule seems far too high, in relation to competitors, to convince new merchants to accept the card as a method of payment. Thirdly, MasterCard, Visa and Unionpay enjoy significant economies of scale in comparison to American Express. This enables the three larger processing firms to generate high EBITDA margins, at much lower per transaction processing charges, than does Amex. As existing contracts come up for renewal, the big three firms, in collaboration with the global card issuers, appear able to aggressively bid for new contracts at pricing tables that AMEX will consider unprofitable or only marginally so. Finally, the closed loop system employed by Amex, (issuer, processor and securitizer of receivables) is clearly under attack by multiple partner bids, government agencies that require some control, either regulatory or otherwise, over various parts of the system and/or by technological advances that permit competitors to leap-frog the entire Amex business model cost-effectively.
In short, American Express may be a business whose model has effectively peaked and that will soon commence a structural decline. As existing contracts come up for renewal, the implication is that margins may suffer, in a best case, for any renewals. It appears almost inconceivable that Amex will be able to wrest contracts away from the larger competitors to make up for defections. In a worst case, wholesale defections to competitors in the years ahead may be a trend. Frankly, I believe that the growth model of American Express, for lack of a better term, may be broken.
The beneficiaries of a wounded competitor are legion. MasterCard and Visa, which are investments owned by the model portfolio, appear to clearly be the winners. Card issuers that compete against American Express also may have appeal, to those who are willing to add a cyclical growth layer over and above the secular investment trend.
A third investment opportunity may shortly exist. EBAY (EBAY-NASDAQ, $56.47) will be spinning off the Paypal subsidiary as a publicly traded division. An increasing desperate American Express may attempt to eventually reinvent itself with a takeover of this rapidly growing business. I see few other options for Amex to compete in global markets, given the almost insurmountable edge that MasterCard, Visa, Unionpay and their card issuing partners, look to enjoy.
The model portfolio has, until recently, owned a modest position in Ebay. On February 13th, the account significantly increased its holding in Ebay, in anticipation of the spinoff.