Why Wealthy Americans Love AmEx

52.9 billion dollars. That's the total income net of interest expense that Amex earned in 2022. But despite its impressive earnings, Amex is far from dominating the credit card industry. Its domestic payments volume lags far behind Visa and MasterCard, and it trails Discover based on the number of cards in circulation. It's a tough business for American Express, given the threats posed by Visa and MasterCard. They have relied on people who use the card a lot, spend a lot of money and pay it off, and they are willing to cater to that crowd by offering them premium benefits, whether at the airport or on things that can be used every day.

Whether it's a Walmart plus membership or Uber cash or things that allow you to use that card, keep it at the top of your wallet. Armed with impressive rewards and a loyal customer base, Amex has achieved impressive growth. The company's revenue has increased more than 32% since 2017, and the company's stock has shown resilience and growth in a tumultuous market. Amex, I would consider them a little more of what we call a quality compound, a very stable and stable business. Growing revenue, single digits to 10% and then they get a little bit of operating leverage on top of that.

They increase their profits by low double digits. They have learned a lot through COVID. They have diversified their business model. They have sharpened their pencils on what matters to their customers. And it is really showing and they are coming back strong. So what is the secret to Amex's success and where is it headed next? American Express began as a freight transportation company in 1850, transporting various products across a rapidly expanding nation. It was not until the end of the 19th century that it began its transformation into a payments company. It began to introduce financial products and travel services.

Then in the 1950s, following the huge success of traveler's checks, it introduced its first credit card to offer customers a more convenient way to pay. Where the brand as we know it today really begins, in my opinion. You know, they've launched several products, the gold card, the platinum card, and they really focus on the consumer and the corporate card business. What sets Amex apart from the rest of the industry is the way it operates its network. Most credit cards from companies like Visa and MasterCard operate on what is called an open-loop system. When a cardholder uses the card on their network to make a purchase from a merchant, they generate revenue by transmitting that information from the issuers, typically the banks that issued the cards to the acquirers, or the merchant's bank.

Amex, on the other hand, operates in a closed-loop system where it functions as a combined issuer, acquirer, and network. Amex differs from Visa and MasterCard because Amex is a lender. Visa and MasterCard are simply card networks, so they process transactions but don't actually issue credit. American Express is both. They are a credit lender and also a card network, a transaction processor. That really allows them to see exactly what their customers are spending on the item and have all that additional data where they can then advertise or target different reward tiers throughout that. That will be very different from what Visa and MasterCard can see, which would actually be total dollar amounts.

It allows them to tailor some of those offerings, especially on the business side. If there is a reason they want a specific merchant's business, they can change their normal terms to fit that situation. They don't have to worry about a bank getting upset about what those terms are, whereas Visa and MasterCard would. This closed-loop system also allows Amex to make money with interest, unlike Visa and MasterCard. The company generated around $9.9 billion in net interest income in 2022. It is advantageous to be diversified. So they get paid every time a transaction is processed and then there are other levers as well, like people paying annual fees or having debt or other things that incur fees.

But interest income is just the tip of the iceberg when it comes to Amex's total income. Discount revenue, or fees charged to merchants who accept its cards, generated more than $30 billion in 2022, contributing to more than 58% of Amex's total revenue net of interest expense for that year. They charge their merchants a premium to accept their cards, and merchants are willing to pay that premium because American Express serves the richest and highest spenders. They earn swipe discount revenue and therefore charge merchants a certain discount rate, two and a half or so, it depends. This can actually vary depending on the size of the merchant, but a lot of their income, unlike their competitors, comes from this slippage fee versus net interest income.

Because of its reliance on discount rates, high spenders are Amex's most important asset. Recent reports claim that Amex card members spend, on average, three times more annually than non-members. Amex targets these

wealthy

cardholders through a spend-centric model that focuses on generating revenue primarily by driving spending on their cards. That's where the rewards come in. In 2022 alone, Amex spent nearly $17 billion providing services and rewards to its cardholders. When they talk about a model focused on spending. They're really talking about being your access card. And I think a very good example of this is the Amex Platinum card, one of their flagship premium products.

At first glance, this is a travel card and it has a lot of travel benefits with rewards, airport lounges, and all that fun stuff. But you can also get a free Walmart plus membership and you can get many other types of everyday credits. They're trying to make this an everyday option, not just something you do a few times a year when you travel. That high-spending model is why they can offer such strong rewards and why customers are willing to pay those higher annual fees than for other cards because they get the spending and rewards benefits. Because the people who spend are actually making up for it with their spending behavior.

Having a closed-loop system means that how much the cardholder spends is often more important than the number of transactions made. Amex also uses the immense information collected through its closed-loop system to create offers that attract and retain customers. A lot of the tricky part about big, more conventional card rewards programs is that the rewards are a little ad hoc, like they have cool, cool rewards, but maybe they're not things you can imagine. as value for the consumer. In the case of American Express, because of that closed-loop dynamic and because they know you and the merchant, they are able to create rewards that you feel as a consumer, like this program was custom designed for me.

Like they can go out and recruit all the best hotels and all the best restaurants and have specialized offers and specialized rewards and things to attract consumers, the

wealthy

consumers, to those hotels, to those restaurants. And everyone sees the benefits of their role in connecting those dots. Having a wealthy client base also provides the added advantage of lower credit risk. Amex's delinquency rates have remained substantially lower compared to other major issuing banks. Credit losses over the cycle will move closely with unemployment, as expected. If you think about changes in unemployment, they increase about 1.7 to 2.25 times in a recession, and the largest credit card issuer will see about the same type of increase in credit losses during that time period , while an American Express might actually see a little less than that.

So if it went up twice, it's possible that American Express would go up 1.8 times. And that makes a big difference in terms of the cyclicality of the business, the overall risk to earnings and profitability. It's really one of the reasons investors focus on this stock during a recession. It is considered a safety play and that is why we are outperforming the stock today. In recent years, Amex has begun to further diversify its customers, primarily targeting millennials and unbanked Americans. I really think Amex is also doing a good job attracting younger customers. They've talked about about 60% of their new card acquisitions being from Gen Z and Millennials, and I think they've done some creative things there with experiences, whether it's trips, dining, or exclusive concerts, like they did one with Jack Harlow. .

And, you know, they're just trying to reach a younger audience who will be the leaders and big spenders of tomorrow. Amex has also made significant investments to expand and improve its technology, allowing its offerings to be more competitive against the rise of alternative premium cards. They continue to progress abroad. In fact, they were the first U.S.-based credit card issuer to gain approval in China, and they're partnering with local brands there to tap into that increasingly affluent consumer audience. In Europe, such as in France and Germany, credit card adoption, both by wealthy consumers and small businesses, is much lower than, for example, in the United States, the United Kingdom and Australia, where it is quite high.

And so there is an enormous amount of opportunity for fair growth. I think increasingly they are also technology companies in some sense, whether it's the apps and web experiences they provide or all the data they collect. You know, some people say that a concept like buy now, pay later could be a big threat to the Amex model. In fact, they were the first traditional credit card issuer to reveal their version. A few years ago, they launched Amex Pay It Plan It, which I think again speaks to offering something for everyone. The biggest threat to Amex is competition within the credit card industry.

To me, the biggest weakness or danger for American Express is really the market power of Visa and MasterCard and what they may decide to do with it, which may or may not be something American Express can control. The value they can offer from the closed-loop model is distinctive and unique. But as things like data analytics and artificial intelligence improve and the entire process of card issuance and card program management becomes more digitized, as their technology advances, those open-loop card programs can replicate best what American Express is uniquely capable of doing. So they can run better analytics to understand their consumers' spending and better tailor their rewards.

But while provisions for credit losses have increased after a period of high inflation, experts believe Amex is more than prepared to weather a potential recession. They are by no means immune to a recession. But at the same time, with that high-spending, wealthy customer, those credit losses are probably significantly lower than some of their peers who focus more on the average consumer, even subprime borrowers. Therefore, there is no reason to think that American Express will not have a strong customer base after the next recession.