The following report aims to provide a primer on what is probably Amex’s most remarkable business, the Global Commercial Services (GCS) segment. GCS’s Profitability and ROE are broken down by the numbers to simply show the extent of the business’s profitability in comparison to other Amex segments. The most fundamental value propositions that the business possess are analysed to determine how well positioned Amex is to defend its current market position. The findings are that Amex is most probably better positioned to defend the higher levels of profitability that its GCS business produces than that of its less profitable segments. GCS’s runway for growth is also examined with a comparison of GCS’s current composition of clients by size against the respective weightings of companies in the US and Global Economies.
Why Do Amex’s Commercial Services Exist?
Amex's GCS segment is a working capital solution that delays cash outflows and accelerates cash inflows, whilst also providing non-taxable rewards. I have yet to find a business that is in a rush to pay its suppliers, and conversely, is indifferent to whether their customers pay invoices on time.
Why Do Businesses Use Amex for B2B Payments?
There are two equally important fundamental value propositions of the Amex card for B2B users. There is also a third value proposition which is not fundamental but serves as a significant differentiator, which is the multiple ancilarry services.
The two main value propositions are the earning of points and the extension of short-term credit. Due to Amex's closed loop business model, detailed in my previous report, the company can offer significantly higher membership rewards earn rates on its commercial cards whilst not being dependent on interest income. This is the differentiating feature.
Since Amex capture the total Merchant Service Fee (MSF) they are not dependent on driving revenue from lending. Lending is a profitable and material portion of their consumer business, but it is miniscule within the commercial billings business. This is due to SME's having small average balances in proportion to their spending on Amex cards.
Reward points act as a subsidy to businesses paying via their Amex card, with the owner often benefitting directly from the points themselves. With any surcharge being tax deductible and all rewards points being non-taxable, the earning of points can be economical for business owners, encouraging further spending. This attracts businesses who do not need the cash flow benefits of a charge card.
Secondly, the value of accepting Amex for businesses servicing SME's is prompt payment, however, this is secondary to SMEs wishing to delay the time that they must incur cash outflows to suppliers.
This is highlighted by the existence of both Amex partners and subsidiaries that allow SMEs to pay invoices using their Amex card to companies that do not accept Amex. These services are prominent and widely used by Amex SME clients.
Businesses consistently offer discounts for the early payment of invoices, there is room for these same businesses to absorb the Amex MSF instead of offering early payment discounst. The Biller and the Payee both achieve their desired working capital outcomes in regard to payment.
Thirdly, Amex provide a variety of basic tools as ancillary services to GCS customers. These tools are easy to use and designed with business owner/operators in mind.
These ancillary services include the ability to track expenses, manage employee cards, reduce reliance on petty cash and make travel related purchases, all without having to call the bookkeeper or travel management company. This is an imitable feature, and not as important as the others mentioned above, though the competition to date have yet to invest in similar easy to use applications, with the travel services being a key differentiator for Amex.
The provision of these services is an example of the attention to detail Amex apply to their GCS services that their competitors do not.
Profitability and ROE
Revenue and drivers
Revenue and net income are generated predominantly from discount revenue. This is defined by Amex as:
Being "generally deducted from the payment to the merchant and recorded as discount revenue at the time the Card Member transaction occurs."
Discount revenue is also allocated to different company segments based on whether the segment represents an issuing or an acquiring function. This is defined by Amex as: “We allocate discount revenue and certain other revenues among segments using a transfer pricing methodology. Within the GCSG and GCS segments, discount revenue generally reflects the issuer component of the overall discount revenue generated by each segment’s Card Members; within the GMNS segment, discount revenue generally reflects the network and acquirer component of the overall discount revenue.”
When looking into the profitability of the GCS segment it will help to compare it to the GCSG segment of the Amex business. Whilst the GSCG segment is itself an impressively profitable business, contrasting the GCS business against it will allow us to easily comprehend the effect of billings to receivables turnover on driving the levels of return earned within the GCS segment.
Having always focused primarily on FCFE I must say I have found the comparison of the GCS and GCSG segment to be a great real-world example of DuPont analysis. As with most theories, the real world application is where you really learn the most, and this has been the case for myself during this research note.
The numbers below are quite self-explanatory, but what they depict is a higher billings to loans and receivables turnover ratio. This is how we can see that both SMEs and larger businesses are using Amex cards for short-term credit / working capital cash flow needs.
This is slightly different to consumers who carry outstanding balances longer than commercial users. Consumers would more likely use Amex credit as a source of medium-term financing of large ticket items, for example the family's annual holiday to Waikiki paid off over a few months.
As is evident, the turnover of the GCS segment is nearly twice that of the GCSG segment. What this translates into is that for every dollar of income that the GCSG segment generates, the GCS segment can also generate with only half the required capital investment in loans and receivables.
If we examine the revenue, income, and net profit margins of GCS, GCSG and Amex, which are compared against each other in the below tables, we can see the current mix of Amex’s operations.
We can also see how each of the segments have similar margins, with GCSG being slightly higher, and how over the last 4 years the GCS segment has become an increasingly larger part of Amex’s operations. This has been the trend over the last decade, it is just easier to display 4 years of data:.
Whilst using a return on assets is a purer form of determining how good a company is at generating returns with “what they have got” I don't think it is as useful when evaluating a financial services firm. My line of thinking on this has been influenced not by the fact it makes Amex look more profitable, I hope, but through readings of Investment Valuation by Aswath Damodaran. More specifically Damodaran states that:
“With a financial services firm, debt takes on a different connotation. Rather than view debt as a source of capital, most financial service firms view it as a raw material. In other words, debt is to a bank is akin to steel for an automobile company, something that can be moulded into other financial products that can be sold at a higher price and yield a profit”
One could argue that debt is still an input for the automobile company, as it was used to buy the steel, but I don’t think that this argument is valid. The argument is based on the raw materials used in creating a product, in the case of the automobile company the debt is used to buy the raw material, with steel itself having its own value and risk of ownership, whereas debt raised by financial companies, particularly in the business of lending, is the raw material.
Given the above it would be valuable to compare the return on equity of the GCS segment against the GCSG segment, and also against Amex as a whole. To do this the return on assets has been calculated for each of the segments, and Amex as a whole, with the return on equity being calculated by simply applying the financial leverage ratio of Amex as a company to each category for each respective reporting period.
The financial leverage of each segment may be possible to determine from Amex’s financial reports, though for the sake of this report the simpler method of applying the company’s financial leverage ratio to each segment has been used. The results are below:
As the above results show, there is a considerably higher ROA and ROE produced by the GCS segment compared to the GCSG segment. The higher ROE of GCS can also be solely put down to the segment’s smaller investment requirement driving higher overall returns on assets, given that as we can see above, the slight difference between net profit margins is that GCS’s is slightly lower.
Competition Within the GCS Segment
With levels of profitability as high as they are for the GCS segment the only certainty is that other companies will aim to replicate Amex’s offering in an effort to earn similar returns. This raises the question of whether Amex’s corporate and SME card offerings can be replicated by other firms, or in more simpler words, can Amex defend its position?
Given that the two primary value propositions are the provision of credit and points, it would appear that offering this combo is quite straight forward. To a certain extent it is, with multiple competitors providing credit cards for commercial use. Credit cards are much a like to charge cards in the fact that they provide interest free cash flow days, so for the sake of this analysis credit cards with interest free days and the cash flow days provided by charge cards will be considered an equivalent credit offering.
We have seen that the interest incurred by Amex’s business customers is miniscule, hence it would be reasonable to assume that the borrowing behaviours of commercial customers of other issuers are similar, leading to equivalently low levels of interest income.
The only other significant revenue source derived from billings other than interest income are transaction fees, which are earned in the form of interchange fees. As broken down and explained in my prior report, Amex is able to capture the entirety of merchant service fees (MSFs).
This allows the company to generate a greater proportion of income from the spending function of charge and credit cards, whilst also reducing the cyclicality of the business’ performance. It is also due to Amex’s somewhat unique closed loop network that the company can stave off competition in the long run.
An issuer would require its own card network, whilst Visa and Mastercard would be required to become issuers, if they were to offer products that were to compete with Amex’s corporate offerings over the long run. As previously explained the chances of either of these events occurring currently appears to be remote.
This is all very similar to what is insulating Amex’s consumer business from competition in the high-income earner segment. Though, in this case the company’s competitive advantages are being applied to a less asset intensive, and hence more profitable, business segment. This application of core strengths to other verticals is what I have been trying to find for quite some time after reading both The Innovators Dilemma and Common Stocks and Uncommon Profits.
DFS and their subsidiary Diners Club pose what I think is a possibly significant threat to Amex in the GCS B2B space. Their competition comes partly in the form of their partnership with SAP Ariba in providing a built-in payments solution within SAP Ariba’s procurement and supply chain software suite.
The payments solution is named AribaPay and allows business to easily pay invoices using their SAP Ariba software, whilst Discover settle the payment through their settlements network. A Discover card is not required to use the feature.
The service enables buyers to pay suppliers from their bank accounts, whilst the partnership with DFS offers some of the benefits associated with card payments, such as the tracking of payments and optimisation of payments to improve working capital, though no credit is provided.
Whilst not being a direct form of competition to Amex’s GCS segment I have included it to show how Amex cards can be squeezed out of the B2B payments market from other less direct sources. Pondering the possibility that other business software companies, such as Xero (XRO:ASX) could partner with either Visa or Mastercard to issue a card that offers the same value as Amex's commercial cards has been a valuable exercise.
With accounting software providers being a stickier service than payments by far, it could make sense for a company such as Xero to issue a business rewards card as a tool to aid the acquisition of new clients. If a company such as Xero were to issue a truly competitive card offering it would only be detrimental to Amex.
Given the short-term nature of the finance sought and provided with commercial credit and charge cards, the interest income would be similarly miniscule for any card issued by any competitor.
Given the additional fact that the interchange fees earned by cards issued on the Visa and Mastercard network are also smaller in size by those earned by Amex on its proprietary network, any rewards offered that are to be competitive will be a larger portion of the revenue earned from interchange fees than it is for Amex.
The result is that for almost any new entrant such as Xero, or another business services company, the business of offering a competitive short-term financing and rewards credit or charge card will be significantly less profitable than it is for Amex whom have their own payments network.
More direct forms of competition include the Chase Ink Business Preferred card, as well as the Capital One Spark Cash for Business card. The two mentioned cards appeared to be the stand outs amongst the competition in terms of their rewards, annual fees and interest rates. A comparison of the competitor cards with two of Amex’s most popular cards are below:
Whilst it is evident that the two competitor cards provide a similar offering, with Chase currently having an aggressive bonus rewards offer, neither on a whole outshines the two selected Amex offerings in terms of credit or rewards.
Slim leads in the two core value offerings may appear to be insufficient to generate the levels of profitability already shown, and I believe in the short-run they are insufficient, when looked at alone. Though in the long-run Amex seem to be able to provide commercial payment offerings that provide marginally more in the area of points, and credit for working capital, but are also delivered with a large suite of valuable auxiliary services such as travel management and expense management software.
It is the level of precision and attention to detail in making the commercial payments offerings useable, in terms of points redemption and expense tracking, that cannot be easily included in comparison tables. It is these small details and extra attention applied by Amex within their GCS segment that gives the company its edge.
Whilst I believe maintaining a position of leadership in commercial payments within countries where the company has an existing presence is likely, I do not believe that the company will be able to maintain levels of profitability quite as high as it currently has.
The only certainty of a business that is as profitable as the GCS segment is that it will attract new entrants. Though given the competitive advantages that Amex has I believe the company will be able to maintain a level of profitability that produces considerable value for the company as the segment continues to grow in the long run.
Are Amex able to not just remain the largest single issuer for SME businesses, but to grow the company's presence within the growing SME electronic payments space?
To do this Amex will have to provide and offering to SMEs that leads in the area of credit and points, and to be able to do this significantly better than competitors who can potentially provide a similar offering. As outlined in the previous section I believe that there is a reasonably strong argument for Amex being able to provide such an offering over the longer-term.
In modelling growth, I think it is good to look at where Amex is at now with its GCS business and what a mature GCS business will eventually look like. Currently Amex’s commercial billings by client size is as below:
Global and Large Accounts ~25%
International SME ~10%
US Medium Business ~45%
US Small Business ~20%
As we can see above, Amex do not yet derive a large portion of commercial billings from small businesses, both within the US and globally. With most of the commercial billing being derived from medium to large US and global accounts.
This weighting is incredibly disproportionate to the real-world business landscape, with small businesses making up 44% of economic output in the US, and global developed economies having a median output of 55% derived from SMEs. The current billing distribution is significantly different from what one would expect it to look like once the commercial billings business has matured and has reached a high level of penetration within commercial payments.
The importance of merchant acceptance is also of less significance for the GCS segment than within GCSG. There exist service providers who act as remitters for Amex GCS clients who wish to pay suppliers who do not accept Amex.
Amex GCS cardholders pay the service provider, who charges a fee of around 2-2.5%, with the service provider then transferring the payment to the supplier on the Amex cardholder’s behalf. From my own lean scuttlebutt approach, I found 5 SME business owner/operators who made use of one of the two services. These two services were Amex’s own FX International Payments service and Australian based RewardPay. The RewardPay service is described as allowing cardholders to “earn more reward points by paying Superannuation and all other business spend with your American Express credit card – even if your suppliers don’t accept it".
A key reminder reminder, the surcharge provides a tax shield due to it being an expense, whilst rewards points are non-taxable.
All 5 business owners seemed thrilled with the service, which after tax costs less than 2%. Given that when rewards are used effectively, they provide around 2-2.1 cents on the dollar (2-2.1% in value). Hence, it isn’t surprising to see why businesses consistently use these services, as they provide access to both the working capital benefit Amex cards provide, as well as what can simply be described as the thrill of being rewarded when spending.
We have also seen that the GCS business has a significantly higher rate of billings to receivables turnover than the GCSG segment. Given that the capital required to grow GCS discount revenue is half that required for the GCSG segment, combined with the significant runway Amex has in the commercial payments market, it would seem reasonable to think continued periods of high growth are possible.
I don't like Amex's investor presentations. I think they are full of unnecessary fluff and that the data is framed in a misleadingly bullish and aggressive manner. Saying that, I believe that the following statement "In the commercial payments space, our goals are to be the leading payments and working capital provider for small and mid-sized enterprises globally", is one of the rarely realistic bullish claims made by Amex.
There will be considerable execution risk in achieving this goal, though from what I currently understand I think that Amex will be able to get within close enough range of achieving it. If successful over the next decade, Amex may become more known and associated as a commercial services company than as the provider of premium consumer rewards cards. If, or when, this were to occur the market is surely to be aware of the remarkable nature of Amex’s GCS business, as I am doubtful it is aware at present.
 Page 582, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition, Aswath Damodaran