The Centurion’s Dented Helmet

In less than one grim month, American Express lost two cobranded partnerships and a major court case involving its merchant-acceptance rules. But the 165-year-old payments company is far from finished.

As cold as this winter was in most of the country, it was considerably chillier at American Express Co.

The company on Feb. 12 said its contracts with Costco Wholesale Corp. for cobranded card issuance and exclusive credit card acceptance would end March 31, 2016. The news caused a 6% drop in AmEx’s stock price and put $82 billion in charge volume at risk.

A week later, AmEx lost a hard-fought, four-year court battle with the U.S. Department of Justice. The DoJ had challenged AmEx’s rules banning its merchants from steering AmEx cardholders to cheaper forms of payment as violations of U.S. antitrust laws.

The news also broke that AmEx would lose a smaller cobranded card program with JetBlue Airways Corp., which reportedly was bolting to a cobranded MasterCard issued by Barclaycard.

And all of that came just a few weeks after AmEx said it would lay off 4,000 employees, about 6% of its workforce, in a restructuring.

Network Price War?

A powerhouse in the payments business for decades, AmEx uses the image of a centurion on many of its cards. But in the wake of this winter’s setbacks, AmEx seemed more like the hapless Iraqi army than Rome’s once-invincible legions.

AmEx’s chief executive, Kenneth I. Chenault, set the stage for the gloom last summer when he testified during the DoJ trial that if the company’s so-called merchant non-discrimination provisions (NDPs) “are eliminated [AmEx] will not survive as a company.” And, “if the NDPs go away, [AmEx] will go away.”

But it looks like the NDPs are indeed going away, so what’s ahead for AmEx? Almost no one believes the company is going away.

Instead, look for a renewed focus on more profitable cobranded deals and ways to get customers to charge more.  In mid-March, AmEx unveiled a “coalition” rewards program called “Plenti” with seven other companies. Also, expect exploitation of new markets in which AmEx already has a toehold, such as prepaid cards.

Some armchair quarterbacks predict the removal of the NDPs will trigger a network price war the likes of which has not been seen in more than 20 years and in which AmEx supposedly would have the most to lose. But others downplay that possibility.

“It’s hard to say; we don’t know what the longer-term impact would be,” says Brendan Sheehy, a director at New York City-based securities-rating agency Fitch Ratings, which rates AmEx’s bonds.

Judge Nicholas G. Garaufis of the U.S. District Court in Brooklyn, N.Y., who presided at the trial, didn’t buy Chenault’s apocalyptic prediction in his 150-page ruling.

“Defendants [American Express] are not, as they might have the court believe, powerless in a world in which merchants and customers are able to jointly determine which payment product is used at the point of sale,” he wrote.

“American Express is the single largest issuer of credit and charge cards in the United States by purchase volume, maintains a worldwide acceptance network with millions of accepting merchants, possesses one of the most valuable brands in the world … is a highly profitable enterprise that earned over $5 billion in post-tax profit in 2013, and is operated by a tremendously qualified and resourceful set of employees and executives, many of whom testified at trial.”

He added: “American Express has a proven track record of transforming itself and adapting its business model to suit changing competitive landscapes and market conditions.”

‘A Lot of Value’

Indeed, this is a company that was founded in 1850 as a transporter of goods between New York City and the hinterlands. Over the years, AmEx got out of the transport business and into the business of travel services for consumers and businesses, including travelers checks and charge cards for the carriage trade.

Its first effort at revolving credit cards in the early 1990s blew up, but AmEx recovered to become a major credit card issuer as banks’ no-annual-fee credit cards started nipping at the market for its expensive charge cards.

More recently, AmEx has moved far beyond its travel-and-entertainment base with its Serve platform, which offers prepaid cards for underbanked or “unhappily banked” consumers. And it has greatly expanded its merchant network to include everyday retailers, not just hotels, airlines, white-tablecloth restaurants, and Fifth Avenue and Beverly Hills boutiques.

Some Wall Street analysts agreed with the judge. Deutsche Bank Securities vice president and analyst David Ho on Feb. 26 upgraded his recommendation for AmEx’s stock from hold to buy. AmEx could mitigate up to 47 cents of the estimated 75-cents-per-share earnings hit from the Costco loss, Ho said.

Further, AmEx’s stock price, when compared with the share prices of Visa Inc. and MasterCard Inc., doesn’t fully reflect the value of its merchant network, he wrote.

“They continue to attract a higher-spend customer,” Ho tells Digital Transactions. “There’s a lot of value in that side of the business.”

AmEx for years has used the argument that it delivers higher-spending customers to merchants as one justification for its discount rates, which generally are the highest among the four major U.S. general-purpose card networks. Its worldwide average discount rate last year was 2.48% of the sale, down slightly from 2.51% in 2013.

‘It Will Survive’

In addition to AmEx, the DoJ in 2010 sued Visa and MasterCard over similar merchant rules, but the bank card networks immediately settled and either repealed or modified the challenged regulations. AmEx refused to settle, leading to last summer’s trial. (AmEx settled two separate merchant class-action lawsuits over acceptance rules in late 2013.)

Garaufis gave AmEx and the DoJ a month to propose a so-called remedy, or agreement, that would lift the anti-steering rules with the least amount of damage to AmEx’s business model. Initial proposals were scheduled to be filed March 23. If the warring parties can’t find common ground, Garaufis will impose his own remedy.

“I don’t think that they need to restrain competition in order to compete,” says attorney Jeffrey I. Shinder, managing partner at New York City-based Constantine Cannon LLP, which represented several retailers—Sears, Ikea, and Crate and Barrel— whose executives testified at the trial.

“When this remedy goes into effect, American Express will compete, and if it has value to offer to cardholders and merchants, both sides, it will survive,” Shinder continues.

But AmEx has already signaled that an appeal is a real possibility, meaning the fight over network rules could continue for years. In the near term, AmEx’s profits could come under pressure when the U.S. Costco relationships expire next spring.

Warehouse Woes

AmEx chief financial officer Jeffrey C. Campbell said at a Feb. 12 investor call that the cobranded card for Costco, which has 474 U.S. stores, accounted for 8% of AmEx’s worldwide card-billed business in 2014. That’s $81.8 billion out of a total of $1.02 trillion in charge volume.

Another 1% of AmEx’s billings come from spending by other AmEx cardholders at Costco. AmEx’s Costco cardholders do 70% of their spending outside of Costco stores.

Costco customers also accounted for 10% of AmEx’s worldwide cards in force, or 11.2 million of the 112.2 million total at the end of 2014, and 10% of AmEx’s $70.4 billion in loans, according to Campbell. The warehouse chain has 76.4 million holders of its membership cards, which means about 15% of its customer base carries the AmEx cobranded card.

The loss of Costco had been rumored for months, especially after news broke in September that the AmEx-Costco cobranded card in Canada would be replaced by a cobranded MasterCard from Capital One Financial Corp.

At recent investor conferences, Chenault and Campbell put the best face they could on the Costco relationship, saying that while it generated considerable volume (about $35 billion annually within Costco, based on the AmEx-provided numbers), it wasn’t as profitable as other merchant relationships.

At a March 10 conference in New York sponsored by Keefe, Bruyette & Woods Inc., Campbell said that in contract-renewal talks with Issaquah, Wash.-based Costco, “it became clear to us that we would not be able to reach an agreement on terms that we thought made sense for our shareholders over the moderate to long term.”

Deutsche Bank estimates Costco paid a 2.25% discount rate on its AmEx card, which would be nearly 0.25% lower than the worldwide average (AmEx doesn’t break out the U.S. average). In addition to generating lower-than-average discount revenue from Costco, AmEx’s TrueEarnings cobranded card had no annual fee and offered generous rewards—3% cash back on groceries and 2% on restaurants and travel.

Costco picked Citigroup Inc. and Visa as its new payments partners, with Citi the cobranded card issuer and Visa the new exclusive general-purpose network brand accepted. AmEx and Citi are negotiating over the sale of the AmEx portfolio to Citi.

Retention Game

Now AmEx is playing the cardholder-retention game, though Citi undoubtedly will pick up many of the current AmEx-Costco cardholders.

“Generally speaking, the revenue and profits on the spending inside Costco U.S. are much lower than on spending outside of Costco,” Campbell said at the Feb. 12 call. “Therefore, we will focus on customers who frequently use their card at non-Costco merchants.”

One problem AmEx may face with the Costco cardholders is that while the company has many card products, it doesn’t have one that closely matches the Costco card’s particular rewards mix, according to Deutsche Bank. Still, Campbell is optimistic that AmEx can keep a good many cardholders.

He noted that in addition to its numerous non-cobranded charge and credit cards, AmEx has 50 other cobranded card programs. The company recently renewed its cobranded relationships with Delta Air Lines and Starwood hotels.

“We believe there is an opportunity to offer [Costco cardholders] attractive products from our suite of proprietary offerings,” Campbell said. “We will also be making investments in other growth initiatives across the company.” He added that “cobrand will continue to be a growth area for us as well.”

Some of the growth opportunities Campbell mentioned include more offerings for small and mid-sized businesses, where AmEx already is a major issuer and lender. Another one is a greater emphasis on payment services for large foreign corporations, a comparatively underdeveloped segment compared with AmEx’s high penetration among U.S. corporations.

Another potential growth area is the Serve platform, on which run AmEx’s prepaid card products, including the Bluebird card sold at Wal-Mart Stores Inc.

“We have one of the broader and most expansive product sets of any one of our competitors,” Campbell said at the KBW conference. He called Serve “a good long-term extension of the brand.”

Serve, however, “is still in its very early stages” and won’t be a big profit contributor in the next year or two, he cautioned.

Still Trailing

Still, AmEx will welcome anything that drives revenue-generating transactions to its merchant network. The Visa/MasterCard networks have about 10 million U.S. merchant locations. After nearly 30 years of trying, Discover has brought its network to near parity with Visa and MasterCard.

AmEx’s network, while growing, still trails. AmEx doesn’t disclose its size, but by some estimates it has about 7 million locations.

Like Discover, AmEx has recruited bank card merchant acquirers to close its biggest gap—acceptance at small merchants. The most recent iteration of this expansion effort, launched last year, is called OptBlue.

In contrast to an earlier program, OptBlue lets the acquirer that signs the merchant set pricing and own the relationship until it reaches $1 million in annual AmEx charge volume. When that happens, AmEx takes over the relationship.

The acquirer handles customer service and sends a single statement to the merchant every month with information about all of the merchant’s card sales. That removes a major obstacle in that the merchant no longer needs separate procedures to accept AmEx.

“OptBlue has been able to streamline that to reduce that friction,” says Deutsche Bank’s Ho.

An AmEx executive said at a January acquirer conference that the OptBlue program had bagged 400,000 merchants since it was unveiled early last year.

“We’re very excited about the program,” Campbell said at the KBW conference. “It’s going tremendously, it’s a very important effort for the company.”

No Slouch

Meanwhile, analysts downplay the possibility of a network price war, though it could suddenly become more possible if the DoJ prevails on AmEx’s expected appeal.

Such hostilities have broken out before. In early-1990s advertisements, Visa hammered AmEx for its high discount rates. And there was the so-called Boston Fee Party, in which some disgruntled Beantown restaurants loudly voiced their displeasure with AmEx’s acceptance costs. In one memorable incident, a restaurateur was pictured as he neatly bisected an AmEx card with a meat cleaver.

Those incidents were probably the last overt examples of payment card network price competition—the disappearance of which Judge Garaufis blamed on AmEx’s and the bank card networks’ restrictions on merchant steering.

At the trial, executives from Discover, which for years portrayed itself as the low-cost alternative for merchants, told how they tried to attract merchants on price, but the effort proved futile. Discover gradually raised its prices to levels close to those of bank cards.

Due to rewards funding, the acquirer-set pricing for OptBlue merchants, and other factors, Deutsche Bank’s Ho says there no longer is a substantial net cost difference for accepting AmEx and the other card brands, which is why he doesn’t think a price war is at hand.

“Taking into account all those factors, the difference in fact is very small,” he says.

Sheehy of Fitch Ratings adds that small merchants are less price-sensitive than large ones. The biggest merchants, the Wal-Marts, Targets, and others, are more cognizant of the savings that could be had from even a few basis points’ cut in their discount rates, but they have other things to consider. These include the potential for slowing down lines and angering customers if a clerk asks for another card.

“These merchants are all about throughput,” Sheehy says. “[They] are going to have to manage the trade-off between getting a slightly better [acceptance cost] and customer satisfaction.”

He adds: “I don’t think this decision will lead to a sort of price war. The competition will be centered around rewards, customer service, [annual percentage rate], rather than interchange.”

In those areas, no one would consider AmEx a slouch.

“We believe AmEx has a strong franchise, and has a history of being an innovator,” says Sheehy.