AXP/PYPL: The Case for Strategic Partnership

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Howard Mason

203.901.1635

hmason@ssrllc.com

March 6th, 2016

AXP/PYPL: The Case for Strategic Partnership

With tokenized solutions being in the marketplace, we are constantly looking at what makes sense … and if it makes sense at some point to do something different with interchange rates” V CEO Charlie Scharf Jan 2015

  • The primary mechanism (accounting for ~two-thirds of revenue) by which AXP monetizes the brand loyalty of its cardholders is through the fees paid by Amex-accepting merchants; these fees are, in turn, set by reference to the Visa interchange rate. It is therefore important that, at its investor day on March 10th, AXP is clear about how it will respond to the shift in the payments industry from zero-sum interchange and towards issuer-merchant partnerships aimed at increasing respective wallet-share at common customers, and what this means for its long-run target of 8% revenue growth. The notion that the AXP’s growth-shortfall is due to cyclical economic conditions, independently of changes in industry structure, is not supportable.
  • As a price-taker, AXP has benefited from increases in the Visa interchange rate over the last decade and will be challenged as these increases reverse in the next. Specifically, Visa credit interchange in the US increased from ~1.6% in 2003 to 2.5% for some cards today. This enabled AXP to raise its merchant fee (after adjusting for mix-effects) by ~9bps from 2005-2010; thereafter, the firm shifted strategy more to brand-relevance and allowed its premium pricing to decay[1] as Visa raised interchange so as to broaden merchant acceptance[2]. Either way, as Visa interchange flattens and then declines, the tailwind to AXP economics becomes a headwind.
  • The pressure on Visa interchange arises as merchants gain more flexibility to route credit transactions to alternative processing “rails” given evolving technology (and particularly the adoption of tokenized solutions for mobile payments) and changes in the legal and regulatory landscape (and particularly the likely removal of anti-steering constraints preventing merchants from influencing consumer choice of network-branded card tender at point-of-sale).
  • To maintain economics as Visa interchange rates decline, AXP will need to revert to premium pricing; this is challenging given the firm’s own surveys indicate merchants see “perceived value is significantly higher for Visa than for Amex.” AXP’s traditional arguments that it brings to merchants more affluent customers who write bigger tickets and supports merchants with data-analytics are apparently not enough. This can be addressed by introducing segmented pricing[3] (so that, for example, merchants pay more on a corporate travel card where use is mandated by an employer than Amex Blue where the cardholder has more ability to choose alternative card tender) and by improving data-analytics (including through initiatives such as the Plenti loyalty coalition which generates visibility into transactions independently of use of Amex-branded tender).
  • However, bolder action may be required including a strategic partnership with PayPal (echoing that between Visa and Stripe). Stripe and PayPal’s Braintree are transforming the payments value-chain by leveraging their merchant relationships, particularly with developers of merchant apps seeking to embed payments capability, to distribute the payment “token” solutions that securely represent the funding-account credentials of consumers. This breaks the traditional model where networks have leveraged their bank-issuer relationships to distribute tokens (such as the 16-digit number on the front of your Visa card). PayPal’s tokens, in contrast to Visa-issued tokens which are tightly-bound to the Visa brand, can be used to process any electronic payment tender including, in addition to network-branded transactions, private-label card and direct-to-account (e.g. ACH) debit transactions. These tender-neutral tokens, unlike network-issued tokens, increase the network-routing choices, and hence bargaining power, of merchants.
  • PayPal offers merchants a broad-spectrum of white-label services (as distinct from the eponymously-branded buy button) including token, gateway, analytics, and app-development support that align well with AXP’s pricing objectives. PayPal also differentiates from competing buy buttons (such as Visa Checkout), from the integration of payments into mobile operating systems (as with Apple Pay and Android Pay), and from competing white-label service providers (such as Stripe) through the potential for sales-lift from its loyal wallet-holders including users of the PayPal, Venmo, and Xoom brands. This brand-loyal consumer model is, of course, foundational to AXP’s approach to merchants and the combined buying power of AXP’s ~120mm cards-in-force and PYPL’s ~180mm active wallet-holders is compelling.
  • An outright AXP/PYPL combination would compromise the tender-neutral positioning of PYPL’s white-label services and, in any event, the financials are challenging (market caps of $56bn and $48bn respectively and 2017 earnings-multiples of 10x and 22x respectively). However, a commercial agreement in which AXP and PYPL work jointly on token and product innovation (in a similar way that Visa does with Stripe) and where PYPL optimizes its services for integration with the Amex brand, as it is currently doing for the Venmo and Xoom brands, would increase the alignment and incentives for the companies to share expertise and customers on both consumer and merchant sides.

The Strategic Challenge to AXP of Falling Interchange Rates

AXP faces a strategic challenge that goes beyond the loss of its partnership with Costco and, more generally, increasing competition in the co-brand space.

This challenge is that Visa interchange rates, which have risen over the last decade, are now declining or flattening because of regulation in some markets, such as Europe and US debit, and gains in merchant bargaining power in other markets such as US credit. This matters because the primary way (accounting for near two-thirds of revenue) that AXP monetizes the brand loyalty of its customers is through the fees paid by Amex-accepting merchants and these fees are, in turn, set in reference to the Visa interchange rate.

Merchants are gaining leverage in interchange negotiations with Visa (and banks in its ecosystem) because of increasing ability to use alternative “rails” to the branded networks for clearing and settling card transactions. This increasing ability arises in part because of regulation (with Durbin, for example, allowing merchants to use any rails for debit[4] transactions rather than, as before, being required to use Visa rails for transactions originated on a Visa-branded card), in part because of legal rulings (with the Courts likely to afford merchants more flexibility to influence consumer choice of card brand at point-of-sale through the removal of “anti-steering” restrictions), and in part because of technology and, specifically, the breaking of the network oligopoly around token-distribution as consumers adopt mobile payments.

Regardless of whether it arises from regulation, legal opinion, or technology, the consequence of a shift in the balance of power in the payments industry to merchants from networks and issuers is that the trajectory of interchange rates will change. For context, interchange is the amount paid by the acquiring bank representing a merchant in a card transaction to the issuing bank representing the cardholder and has increased meaningfully over the decade to the point that on some premium rewards cards it amounts to $2.50 for each $1 of transaction value (versus $1.60 in 2003 – see Chart 1).

Chart 1: 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.

The increase has been driven by a simple flywheel effect. Visa has pricing power with large merchants who cannot refuse to accept Visa cards (because of the cost of lost sales) and cannot encourage customers to use less expense payment tenders (because of “anti-steering” restrictions[5]). Visa leverages this pricing power by raising merchant fees and then passes the benefit, through interchange, to issuers who in turn pass the benefit to cardholders in the form of rewards. Rewards increase cardholder insistence on using the Visa brand thereby increasing the cost of lost sales for merchants of refusing Visa and hence increasing Visa’s pricing power.

This flywheel effect is interrupted by the increased leverage of merchants in the payments value-chain so that hikes in merchant fees will increase the risk to the offending network that volumes are routed away. As a District Court ruled in February last year “the challenge [anti-steering] restraints interrupt the ordinary price-setting mechanism in this market by taking away a network’s reward for competing on the basis of [merchant] price”. In practice, as merchants have more flexibility over how to process card transactions, the branded networks will need to compete for merchant share of wallet on price (through lowering interchange) just as traditionally they have competed for issuer share of wallet on price (through raising interchange). The result is that the equilibrium rate for credit interchange will not increase as in the past and is likely to reset lower.

Flattening or declining Visa credit interchange is of economic significance for American Express which is a price-taker. We know how AXP sets its merchant fee which is referred to as a “discount rate” since, in effect, AXP performs a factoring function in providing cash to a merchant sooner than a customer pays and taking a spread or “discount” of ~2.6% of the transaction value for doing so: AXP estimates the average rate paid by the merchant for Visa transactions and adds an “insistence” premium based on its assessment of how much incremental business the merchant will gain by accepting the Amex brand. As CEO Ken Chenault used to say “an insistent cardholder is a profitable cardholder”.

As a price-taker, AXP benefits from the increases in Visa’s interchange rate so that Court documents note AXP was able “to impose significant price increases during its Value Recapture initiatives between 2005 and 2010 without any meaningful merchant attrition”. In support of this view, the Court referenced economic analysis suggesting that, after adjusting for mix effects (which tend to reduce the discount rate reported by AXP as the acceptance footprint broadens from T&E establishments, which tend to pay high average rates, to “everyday spend” establishments which tend to pay relatively lower rates), the Value Recapture initiative raised AXP’s discount rate by 9bps.

AXP abandoned Value Recapture in 2010 as the strategy shifted from premium pricing to broadening the acceptance footprint. Regardless, rising interchange rates generate a tailwind for the business whether AXP chooses to raise its own rates in sympathy or leave its rates unchanged and improve the value proposition for Amex-accepting merchants and hence, through a broader footprint, its share of card spending. This tailwind abates as interchange flattens and the positive dynamics of a rising interchange environment reverse to create a headwind in a falling interchange environment.

PYPL as a Strategic Solution

Adapting the business model at AXP to a falling interchange rate environment is easier said than done. AXP executives have testified that the network no longer maintains any premium over Visa on a mix-adjusted basis as the firm has chosen to allow the historical premium to decay in order to improve is pricing proposition to merchants. This can be reversed by introducing segmented pricing[6] (so that, for example, merchants pay more on a corporate travel card where use is mandated by an employer than Amex Blue where the cardholder has more ability to choose alternative card tender) and by improving data analytics (including through initiatives such as the Plenti loyalty coalition which generates visibility into transactions independently of use of Amex-branded tender).

However, as interchange rates decline, AXP will have to need to move more boldly to increase its premium in order to avoid declines in its own mix-adjusted discount rate. AXP’s traditional arguments for premium pricing are: (i) that its cardholders are relatively affluent and write larger tickets than average; and (ii) that it supports merchants with data analytics and targeted marketing solutions. However, Court documents indicate that AXP’s own survey data suggest merchants see “perceived value is significantly higher for Visa than for Amex”. The attempt to bolster premium pricing, as an offset to declining interchange rates, will likely necessitate changing this value perception by upgrading value-added services to merchants. PYPL provides a possible road-map as no payments firm has been more successful at generating and monetizing a value proposition for merchants around incremental digital sales.

The initial impetus for the PayPal-branded buy button was to reduce cart abandonment costs for fixed-internet transactions by relieving consumers of the need to enter card credentials into each merchant web-site where they shopped. Under new leadership, with CEO Dan Schulman joining in September 2014, PYPL has looked to extend its franchise from fixed- to mobile-internet, and respond to competing buy buttons such as Visa Checkout, by increasing the emphasis on white-label merchant offerings, including its gateway service and tokenization solutions, so as to capture 100% of merchant-sales rather than only those transactions where consumers choose to use the PayPal buy button. This effort has been supported by the acquisition of Braintree (providing payments-integration services for merchant apps) in September 2013, Paydiant (providing the white-label services supporting the Subway mobile app) in March 2015, and Modest (which helps merchants create mobile apps for their stores) in September 2015.

The significance of capturing 100% of merchant checkout is that it provides the transaction fodder for data analytics to support merchants in fraud risk management and targeted marketing. Of course, PayPal faces competition in providing these merchant services particularly from Stripe which competes head-to-head with PayPal’s Braintree in supporting payments-integration into merchant apps. However, PayPal has an important differentiation from Stripe: unlike Stripe, it also has a consumer franchise and so can offer merchants technology support along with the opportunity to access its customers some of whom, particularly those using the Venmo and Xoom apps, are quite loyal.

While an outright AXP/PYPL combination would compromise the tender-neutral positioning of PYPL’s white-label services and, in any event, the financials are challenging (market caps of $56bn and $48bn respectively and 2017 earnings-multiples of 10x and 22x respectively). However, a commercial agreement in which AXP and PYPL work closely on token and product innovation (in a similar way that Visa does with Stripe) and where PYPL optimizes its services for integration with the Amex brand, as it is currently doing for the Venmo and Xoom brands, would increase the alignment and incentives for the companies to share expertise and pursue joint initiatives.

©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.

  1. AXP executives have testified, albeit to a skeptical Court, that its average premium over Visa is currently zero on a mix-adjusted basis
  2. AXP estimates that its US merchant coverage now satisfies 94% of the spending needs of its customers.
  3. Unlike Visa which has bewilderingly complex interchange rate schedules that vary by product, Amex-accepting merchants pay the same fee regardless of the particular Amex-branded card presented by a consumer.
  4. Durbin does not provide this same routing flexibility on credit transactions but merchants can leverage their improved negotiating position in debit into credit discussions just as, in the past, Visa leveraged its pricing power in credit into debit discussions. Furthermore, in the case of ChaseNet, JPM has negotiated Durbin-like routing flexibility on Visa-branded transactions for both credit and debit.
  5. Technically, anti-steering constraints are imposed by American Express, and so apply only to Amex-accepting merchants, but they restrict steering in general across all card brands and not just where the Amex brand is involved.
  6. Unlike Visa which has bewilderingly complex interchange rate schedules that vary by product, Amex-accepting merchants pay the same fee regardless of the particular Amex-branded card presented by a consumer.
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