AXP: Brand Strategy and Industry De-Pricing
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
January 24, 2016
AXP: Brand Strategy and Industry De-Pricing
“I would say our merchant rates really do reflect the value that we provide” AXP CEO Ken Chenault, Jan 2016
“American Express’s merchant restraints sever the essential link between the price and sales of network services by denying merchants the opportunity to influence their customers’ payment decisions and thereby shift spending to less expensive cards” US District Court, Feb 2015
- AXP has an unusual brand strategy: the brand-message is directed at the consumers and businesses who use the card while ~two-thirds of revenues are generated from the merchants who accept the card. This works because, as CEO Ken Chenault used to say, “an insistent cardholder is a profitable cardholder” by which he means that merchants are willing to pay high fees to Amex (in the form of a “discount rate” that is currently ~2.5% of the transaction value) because the alternative of not accepting Amex cards risks loss of business from brand-loyal customers who insist on using them.
- The rational response of merchants is to remain attractive to these brand-loyal customers by accepting Amex while offering inducements to less insistent customers to use other card brands, such as Visa and MasterCard, with lower merchant acceptance costs. To forestall this approach, Amex presents merchants with an all-or-nothing choice: merchants who choose to accept the Amex brand must contractually commit not to preference competing cards.
- These merchant restraints have long caused friction with Amex-accepting merchants: for example, when United Airlines looked for some leeway, an internal Amex memo commented that United “insists on the right to preference Amex competitors that have lower discount rates and this, of course, is unacceptable to us”.
- In enforcing its “anti-steering” rules, AXP is protecting industry pricing not just its premium fees relative to Visa and MasterCard. This is because the rules apply not only to the Amex brand but also to these competing brands: as a result, it is banks and network-brands that influence consumer choice of card tender (through rewards, for example) rather than merchants who are hobbled. This is very extraordinary: it is as if PG were to say to KR that it could not carry Tide unless it agreed not to offer coupons on competing brands of soap powder. Following a District Court decision last February, it has also been ruled unlawful and, while the merchant restraints remain in place pending appeal, we expect them to be removed later this year.
- The consequence of removal of the anti-steering rules will be downward pressure on the fees paid by merchants to accept payment cards of all brands; the reason is that merchants will be able to influence consumer choice of card at point-of-sale so that banks and networks, just like other vendors, will need to compete for poll position in the merchant storefront. We call this the “Bentonville effect” and it is already in evidence: DFS has said it will “aggressively pursue a strategy of lower [merchant] prices” in return for merchant-preferencing at point-of-sale and Visa has explored with Hilton Hotels arrangements where Hilton will pay lower fees in return for directing a greater share of its volumes to the Visa brand.
- Given AXP is a price-taker, declining Visa fees will adversely affect the discount rate. It is important to distinguish this loss of pricing power from the benign reductions in the reported discount rate (~10bps over the last decade) to which the market is acclimatized. These reductions are driven by a growth-supporting shift in the merchant-mix to everyday spend categories, such as groceries and drug stores which pay lower fees, from the travel and entertainment category and the related use of third-party acquiring companies in the OptBlue program. Adjusting for this mix-shift, however, the discount rate the Amex discount rate increased by ~8bps from 2006-2010 as Visa increased its rates by ~15bps.
- We expect gains in mix-adjusted discount rate to reverse from 2016-2020 once the anti-steering rules are removed and Visa begins to lower its rates. The trend in the mix-adjusted discount rate will then reinforce, rather than offset, the downward pressure on the reported discount rate arising from a shift in the merchant mix, and this likely contributes to guidance in Thursday’s earnings call that the “discount rate will decline by a greater amount during 2016”.
- AXP has a number of strategic responses to industry de-pricing including moving from a one-size-fits-all discount rate (so that a merchant will pay a higher rate on, say, an Amex corporate card than on Amex Blue) and using its closed-loop advantage, involving a direct relationship with both cardholder and merchant, to deliver value-added information services and marketing insight to merchant clients. However, these strategic responses to industry de-pricing carry more execution risk than simply applying an insistence premium over a rising Visa rate and we would avoid the stock notwithstanding current valuation.
- The average premium of the Amex discount rate over the equivalent Visa rate has fallen over time, so that it now averages 3-8bps versus nearer 30bps in 2007, but will need to widen if AXP is to offset the impact on its mix-adjusted discount rate from declines in the Visa rate.
The challenges at AXP run deeper than the loss of the Costco portfolio and the cyclical effects of a strong dollar and lower gas prices. Specifically, the company guided to greater declines in the discount rate (i.e. the fee charged to Amex-accepting merchants that, in 2015, averaged 2.46% of dollar volumes). Unlike prior declines which have been driven by a healthy shift in the merchant mix towards everyday spend categories, such as groceries and drug stores, go-forward declines will be impacted by a loss of pricing power within merchant verticals.
The distinction between mix- and pricing-effects on the AXP discount rate is important. While the reported discount rate has been declining gradually over time (from 2.57% in 2006, for example), the mix-adjusted discount rate actually increased by 8bps from 2006 to 2010. This increase was less than the 15bps increase on Visa products so that AXP was able to improve its economics at the same time as its relative pricing. The enabling factor was rate-hikes by Visa as it sought to increase its attractiveness to issuers by raising the interchange rate (an amount which is paid by the acquiring bank representing the merchant to the issuing bank representing the cardholder and is the largest component of the merchant fee).
The Visa rate is important as the industry benchmark with AXP, like other network brands, being a price-taker; the natural question is why merchants put up with Visa, and hence industry-wide, rate increases. In February, a District Court provided an explanation by opining that anti-steering rules, which prevent a merchant from encouraging their customers from using an alternative form of tender, “sever the essential link between the price and sales of network services by denying merchants the opportunity to influence their customers’ payment decisions and thereby shift spending to less expensive cards”. The Court ordered the anti-steering rules removed although they remain in place for now pending appeal.
We expect the District Court ruling to be upheld and interchange rates in the US to reset lower as Visa competes for merchant share of volumes by lowering interchange just as it has traditionally competed for issuer share of volumes by raising interchange. DFS has already said it will “aggressively pursue a strategy of lower [merchant] prices” in return for merchant-preferencing at point-of-sale and Visa has explored with Hilton Hotels an arrangement where Hilton will pay lower fees if it directs a greater share of volume to Visa. As a price-taker, AXP will then experience downward pressure on the mix-adjusted discount rate in the US just as it has in Europe where interchange rates have fallen (albeit because of regulation rather than competitive forces). As discussed in our note of February 2015, titled “AXP – The Strategic Impact of Removing the Anti-Steering Rules in the US”, AXP has a number of strategic responses including pricing by product (so that a merchant will pay a higher rate on, say, an Amex corporate card than on Amex Blue rather than a one-size-fits-all discount rate as at present) and using its closed-loop advantage (involving a direct relationship with both cardholder and merchant) to deliver value-added information services and marketing insight to merchant clients.
However, these shifts in strategy and pricing carry more execution risk than simply applying an “insistence premium” over the Visa rate based an assessment of the likelihood that a merchant will lose business by refusing to accept Amex cards. This premium has fallen over time, so that it now averages 3-8bps versus nearer 30bps in 2007, but will need to widen if AXP is to offset the impact on its mix-adjusted discount rate from declines in the Visa interchange rate. Until we have a clearer view on whether this can be accomplished, we would avoid the stock notwithstanding current valuation.
AXP is now guiding to 2016 EPS of $5.40-5.70 after reporting $5.05 for FY2015; the 2016 number includes an estimated $1bn gain from the sale of the Costco portfolio, corresponding to ~65 cents/share, leaving a “core” midpoint EPS result for 2016 of $4.90. This is 3% below the 2015 result and contrasts with prior guidance, reiterated as recently as October, for a return to positive growth in 2016. Beyond a target for operating expenses to be 3% below the 2015 base, there is no guidance for 2017 versus prior guidance that EPS growth would return to the target range of 12-15%
Even allowing for the likelihood that the majority of the gain on the sale of the Costco portfolio will be used for growth-oriented spending, management characterizes its revised guidance as “more cautious” given that volume and revenue growth has not accelerated in 2015 as expected, in part because of a stronger dollar and lower gas prices, and that “the competitive, economic, and regulatory environment has become more challenging”. It is the more structural issues that are of interest to us and specifically management’s remarks that the “discount rate [i.e. the transaction fees charged to Amex-accepting merchants that averaged 2.46% of card-billed volume in 2015 down 2bps from 2014] will decline by a greater amount during 2016”.
The AXP Discount Rate
Given that merchant transaction fees account for ~two-thirds of AXP’s revenue, the trajectory of the discount rate is important. The discount rate has declined over time, at 1-2bps per year (so that it was 2.57% in 2007, for example), as Amex has continued to extend its brand into everyday spending from travel and entertainment (T&E) spending which now represents approximately one-third of total billings. Everyday spend merchants, such as groceries and drug stores, pay a lower discount rate than T&E merchants in part because T&E merchants must accept Amex cards, and so have limited negotiating power, if they want to access business travelers carrying an Amex corporate card with an employer mandate to use it for company expenses; in addition, under its OptBlue program, Amex increases its merchant-reach through third-party acquirers and shares the merchant fees with them so that the net discount rate to AXP itself is lower.
We distinguish between the impact on the discount rate of these shifts in the merchant-mix and the outright pricing power of the Amex brand as reflected in the trajectory of the discount rate when adjusted for mix-shifts. Indeed, the Department of Justice estimates that AXP increased this mix-adjusted discount rate by 9bps through its “Value Recapture” initiative which was launched in response to increases in the merchant fees of Visa and MasterCard amounting, over the same period, to ~15bps. In other words, AXP was able to increase its discount rate in absolute terms while lowering it in competitively relative terms because, as CEO Ken Chenault commented on the earnings call, “Visa has consistently increased their prices”.
Increases in the merchant fees associated with Visa cards create a tailwind from the Amex discount fee because, for any given merchant, AXP looks as the average rate paid on Visa products and applies a premium based on its assessment of cardholder insistence on the Amex brand at that merchant. On average, this premium has declined over time, particularly since 2010 when AXP terminated the Value Recapture initiative on the grounds that “the pain it was causing to many of our relationships with merchants was not worth the gain”, and now stands at 3-8bps compared to nearer 30bps in 2007. The risk to AXP is not further degradation in the premium but in its position as a price-taker given that the Visa fee sets the benchmark.
The largest component of the Visa fee paid by a merchant is the interchange fee which is set by Visa and paid by the acquiring bank representing the merchant accepting a Visa card to the issuing bank representing the cardholder. The Visa interchange has increased over the last decade (see Chart) creating a rising price-floor for AXP and hence lift in the AXP discount fee by merchant category that has helped offset the downward pressure on the reported discount rate, which is averaged across all merchant categories, arising from a shift in the merchant-mix to everyday spend. The challenge for AXP is that pricing dynamics in the card industry are changing as merchants improve their negotiating position so that the Visa interchange rate is unlikely to continue increasing and will likely decline.
Chart: Changes in US Credit Interchange Fee on $40 Transaction at Average Merchant
Source: GAO: The “premium” rates are for high-rewards cards, such as travel cards, directed at high-spending consumers while the “basic” rates are for cards directed more at consumers who are more focused on credit-availability than rewards.
This is obviously the case in Europe where credit interchange rates are now subject to regulatory maximum of 30 cents and, while AXP is not subject to these caps, there is an impact on AXP because of “downward pressure on our discount rate as we renegotiate with merchants”. This downward pressure was a factor in 2015 and will continue in 2016 before being lapped in 2016 and, to the extent billings growth in Europe exceeds that in the unregulated US market may have longer-run mix-related effects. The broader risk, however, is of a decline in the Visa interchange rate in the US and this is intimately connected to the anti-steering rules at AXP.
The Anti-Steering Rules
As a condition of accepting Amex-branded cards, merchants must agree not to encourage customers who present an Amex card to use alternative tender even if that would be lower cost to the merchant. These anti-steering rules were put in place following Visa’s campaign asking merchants to post “we prefer Visa” signage in the early 1990s that had the effect of moving volume from the Amex brand to the Visa brand. AXP monitors compliance with the anti-steering rules and insists on them as indicated by an internal e-mail commenting that United Airlines “insists on the right to preference Amex competitors that have lower discount rates and this, of course, is unacceptable to us”.
In February, a District Court found the anti-steering rules unlawful and demanded that they be removed. An Appeals Court has allowed AXP to continue to enforce them pending its own ruling but we believe they will be upheld and lead to declines in Visa interchange. The reason is that at Amex-accepting merchants the rules apply to all card brands and not just the Amex brand, and their removal will cause the card-brands to compete for merchant share of volumes, by lowering interchange, just as they have traditionally competed for issuer share of volumes by raising interchange. For example, DFS has said that it will “aggressively pursue a strategy of lower [merchant] prices” in return for merchant-preferencing at point-of-sale, Hilton Hotels has explored arrangements where it will receive higher interchange rebates in return for directing a greater share of charge volume to Visa, and we believe MasterCard offered interchange concessions to Sam’s Club to win the co-brand mandate from DFS in 2014. As discussed in our note of February 2015, titled “AXP – The Strategic Impact of Removing the Anti-Steering Rules in the US”, AXP has a number of strategic responses including shifting to product pricing, rather than a one-size fits all discount fee, so that a merchant will pay a different (higher) fee on an Amex corporate or black card, say, than on Amex Blue. On the earnings call, CEO Ken Chenault referenced the difference in pricing strategies, albeit without providing support for our thesis, when he commented that “I want to avoid an apples-to-oranges comparison between the Visa and MasterCard rate structure which is enormously complicated and varies by product”. Rather, he preferred to emphasize the information-value of a “closed-loop” network where AXP has a direct relationship with both cardholder and merchant and hence ability to support merchants with marketing insights that will be “even more valuable as the convergence of online and offline commerce continues”.
While these data strategies, including the data generated from consumer activity on AXP’s Plenti loyalty coalition, may support a rising premium over the Visa interchange rate, there is uncertainty over whether they will be sufficient to offset declines in this key reference rate. Regardless, the shift in strategy and pricing carries more execution risk than simply applying an “insistence premium” over the Visa rate based an assessment of the likelihood that a merchant will lose business by refusing to accept Amex cards, and until we have a clearer view we would avoid the stock notwithstanding current valuation
©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, BAC, WFC, and GS.
- In effect, Amex is a factoring business paying its merchants $97.50 for a $100 customer receivable ↑