The payments industry is experiencing one of its most explosive periods of change, with American Express Co. and Discover Financial Services entering the bankcard market with both barrels blazing. AmEx seized the day, forging partnerships with two major credit card issuers, while Discover moved to break into the burgeoning debit space with the acquisition of a leading electronic funds transfer network.
It is too early to judge the ramifications of these deals, but the addition of two new brands to the bankcard market promises some lively activity in the months and years to come. Both firms bring to the competitive battle huge capital resources and proven histories as smart and creative marketers. Both also keep their eyes open to new technologies and payment opportunities.
"This is a turning point for the industry," says David W. Nelms, Discover's president and chief executive. "We have the opportunity to grow loans and customer relationships by leveraging a strong rewards program."
Both are stepping on the toes of Visa USA and MasterCard International as they seek to broaden partnerships with the associations' members. The efforts of AmEx and Discover promise to generate new products and possibly better prices for banks and merchants.
AmEx and Discover both issue their own cards and run transactions over their own, closed-loop networks. But they differ in their business models, the consumers they target and, until recently, the merchants with which they work.
"Both seek to leverage their network and gain incremental revenue streams," says John Grund, a partner at First Annapolis Consulting in Linthicum, Md. "But how they go about it is different." Blue-chip AmEx goes after top-drawer issuers, while Discover looks for high-volume merchants, he says.
The two firms got a strong boost from two court cases that shattered the card industry status quo. The U.S. Supreme Court last October let stand lower court rulings that Visa and MasterCard policies barring members from aligning with AmEx and Discover violated antitrust rules. And in spring 2003, merchants won a huge victory when Visa and MasterCard agreed to pay a combined $3 billion to settle a retailer class-action suit led by Wal-Mart Stores Inc.
In a nutshell, the settlements gave merchants, at least the largest ones, greater negotiating power over the rates they pay to accept cards issued by Visa and MasterCard members. They gained that leverage because the card associations dropped their "honor-all-cards" rules that required merchants to accept all of their branded card products if they accepted any one of them.
The Supreme Court's antitrust ruling led AmEx and Discover to separately sue Visa and MasterCard seeking unspecified compensation for damages incurred due to their inability to partner with association members. However, AmEx also included eight major card issuers in its suit.
AmEx already had prepared for the Supreme Court's decision, announcing in January 2004 an issuing deal with MBNA Corp., the second-largest U.S. credit card issuer. In December, AmEx announced that Citibank would issue its card over the AmEx network by year-end 2005. (Neither MBNA nor Citi were included in AmEx's suit.)
"We are leveraging our existing infrastructure, investing in improvements and creating a viable alternative to Visa and MasterCard," says Peter Godfrey, president of AmEx's Global Network Services, the division that oversees issuing partnerships. "We want to create an industry where everyone benefits."
AmEx upped the ante considerably this February when it announced it planned to spin off its Financial Advisors unit to focus on payments and processing.
Discover's announcements have not been quite as dramatic, yet. But the company's dealings indicate it is jockeying to move beyond its current rank as the fourth-largest card brand. Discover in January bought the Houston-based Pulse EFT network, and it also signed a deal to provide its brand name and network services for a new card with Wal-Mart and GE Consumer Finance-Americas.
Discover created its niche through aggressive marketing, a fresh approach to cardholder rewards, and by offering merchants an inexpensive discount rate.
The Dean Witter investment subsidiary of Sears, Roebuck and Co. introduced Discover in 1986 when the giant retailer was attempting to offer financial products in its stores next to shirts and refrigerators. Sears in 1993 spun off Dean Witter Discover & Co., which in 1997 merged with Morgan Stanley. Nelms joined Discover in 1998, after serving as vice chairman at MBNA America Bank.
Discover gained consumer favor with its cash-back program that rewards cardholders for spending. Cash-back now is an industry staple, offered by all major credit card issuers.
Discover opened its doors to merchant customers by offering them a generally cheaper discount rate than that of Visa and MasterCard. Merchants pay their acquiring banks a per-transaction fee, or discount rate, for card acceptance. Interchange, the bulk of the discount rate, goes to the card issuer.
Experts have estimated Discover's rate is between 1% to 1.5% of a sale, depending on the merchant, while Visa and MasterCard interchange ranges from 1.5% to 2%. The cost difference helped Discover build its number of acceptance locations to about 4 million. That is a worthy total, but well shy of the 5.7 million locations that accept Visa and MasterCard.
As both the issuer and acquirer for their transactions, Discover and AmEx have greater flexibility when negotiating discount rates with merchants.
Some industry observers believe the court decisions giving merchants greater power over interchange rates provide an especially big boost to Discover because of its merchant-friendly approach. Grund is not so sure.
"Merchants are more unified and certainly carry a bigger stick in 2005 than in 1995," Grund says. But, he says, merchants still must offer customer convenience, and that includes providing payment choices at the point of sale.
Indeed, any merchant that only accepts one brand, such as Discover, runs the risk of turning away customers. "You will look stupid if you save $2 million (on interchange) while losing $10 million in sales," says Grund.
Discover's balance sheet indicates Nelms has spent the last few years cleaning up its portfolio. Discover's 30-day delinquency rate dropped to 4.55% of managed loans at the end of fiscal 2004 on Nov. 30, compared with 5.97% in fiscal 2003. The 2004 net chargeoff rate was 6%, down from 6.6% in 2003.
Trimming losses last year led to a 16% increase in Discover's pretax earnings, to $1.3 billion on net revenues of $3.6 billion.
But the portfolio has been spinning its wheels. Receivables totaled $48.3 billion, virtually unchanged from 2003, while the number of active accounts dropped 5% to 19.7 million at the end of the fiscal year.
Discover added about 1 million merchants to its acceptance base in 2004, signing deals with KinderCare Learning Centers, Dollar General Corp. and Sam's Club, the warehouse club unit of Wal-Mart. That strengthening of the company foundation now looks prescient, as it coincided with the court rulings.
Discover's big splash was the deal with Wal-Mart, the world's largest merchant, and GE, the largest provider of store card programs in the U.S. The potential of the cobranded card is huge because Wal-Mart's store card has 8 million active cardholders, and the retailer reported net sales of $285.2 billion for fiscal 2004.
"I expect them to issue millions of cards," says Nelms. "They are the biggest retailer in the world, and they generate a lot of volume." J.P. Morgan Chase & Co. was the previous issuer of the Wal-Mart cobranded card.
When consumers pay with the Wal-Mart Discover card at Wal-Mart stores, the transactions will be processed over the Discover network. That will undoubtedly add volume to the 99.6 billion transactions Discover reported in fiscal 2004.
However, GE will hold the card's receivables, while Discover will earn a discount rate that it probably cut to participate in the deal, according to a report from Guy Moszkowski, a Merrill Lynch first vice president that follows Morgan Stanley. That makes the deal a clear winner for GE because it will garner revenues from interest payments and other fees.
Discover is a winner too because it builds network volume and partners with the likes of Wal-Mart and GE, Moszkowski writes. But investors should not expect a giant, near-term jump in revenues because its per-transaction fee may be quite low.
Nelms declines to share revenue specifics on the GE deal, stressing that adding the largest merchant in the world will build both volume and Discover's credibility as a major network. Further, more Discover cards in circulation will entice more merchants to accept Discover, says Nelms.
"Merchants say to us, 'We love you but we don't see enough of your cards.' Now they'll see more cards," says Nelms.
Discover, GE and Wal-Mart ratcheted up their partnership in March, announcing the launch of two cards for Sam's Club. Both the business card and consumer card carry no annual fee and offer up to 2% cash back on purchases made anywhere.
The cards serve as Sam's Club membership cards so cardholders will have them out of their wallet after entering the store. Sam's Club's 46 million members pay a yearly fee to shop at the discount chain.
Cardholders may also choose the due date of their monthly payment, and receive no-fee cash access at the register at the 552 Sam's Club outlets.
This is the first business card to run on the Discover network. It includes a $1 million spending cap and an itemized billing statement for purchases made at Wal-Mart and Sam's Club stores.
Riverwoods, Ill.-based Discover's second important deal was the $311 million purchase of Pulse, the nation's third-largest PIN-debit network ("Discover Finds Its Debit Pulse," January). The Pulse network encompasses 3.3 million point-of-sale terminals and 250,000 ATMs.
Its 4,100 members, primarily smaller banks, credit unions, and savings institutions, voted to approve the deal in January. Discover is working with Pulse to convince its members to issue Discover-branded signature-debit and stored-value cards, broadening its product line, says Nelms. Visa and MasterCard each sponsor their own signature-debit program, the Visa check card and the debit MasterCard.
"Pulse gives Discover a strong beachhead in the higher-growth debit portion of the cards business," says Les Riedl, president of Speer & Associates, an Atlanta-based consultancy. U.S. cardholders initiated 8.35 billion signature-debit purchases through September 2004, a 17% rise from the same period in 2003.
First Data Corp.'s Star is the leading PIN-based point-of-sale debit network, followed by Visa's Interlink, Pulse and Metavante Corp.'s NYCE.
Discover's entry into the debit market is well timed because merchants have the acceptance infrastructure in place and consumers have embraced debit products, says Riedl. "Consumers expect to use a PIN pad," he says. "If you have a major brand on the card, then they (assume they) can use it pretty much anywhere."
Pulse President and Chief Executive Stan Paur will continue to lead the network from its Houston headquarters. Paur says the challenge is to blend the merchant-friendly approach of Discover with the card-issuing membership of Pulse. "We must reach a balance of what issuers receive and what merchants pay," he says. "That's not always an easy goal."
American Express takes a different approach, targeting the high-income, high-spending consumer, and then charging its merchants an industry-high discount rate. In 2004, AmEx's average discount rate was 2.56% of the sale, down from 2.59% in 2003, according to its financial filings.
Is it worth it to merchants? AmEx reported that its average annual charge per card last year was $10,686, up 11% from $9,608 in 2003. And its cardholders are the solid bill-paying type. In 2004 only 1.5% of its loans to cardholders were categorized as past due, or over 30 days late.
But convincing merchants to accept the card remains a challenge. AmEx trails other brands with an estimated 3.5 million merchant locations domestically, according to SourceMedia's Card Industry Directory, a CCM sister publication.
To build merchant acceptance, AmEx needs more cardholders. Thus the deal with MBNA, an issuer with a customer base that includes high-spending, affluent cardholders. AmEx and MBNA already were sending out letters to prospective cardholders in November. AmEx and Citi have been quiet on their pending relationship.
The deals and the suit put AmEx in a tricky position of allying with issuers as it competes with them, a conflict that Visa attempts to exploit to keep restless members from straying from home.
AmEx separates the two sides, romancing potential issuing partners with its worldly Global Network Services group. The division has forged relationships with 87 partners in 98 countries, says Godfrey, the division's president.
"We're a premium brand," Godfrey says. "We insist on premium standards and that service is of the highest level. We seek to give (partners) a premium opportunity."
AmEx brings its infrastructure, brand, service standards and closed-loop network, while the partner is responsible for the customer base, portfolio receivables and distribution channels, says Godfrey.
Early returns on the MBNA-AmEx card have been strong, according to Kenneth I. Chenault, AmEx chairman and chief executive. But it remains to be seen whether the Global Network approach can be applied to the U.S.
The payoff for AmEx and its bank partners is uncertain, says a longtime industry analyst. "It remains to be seen if the partners' cards will cannibalize AmEx (cards) or if it can build a franchise with banks," says David S. Evans, co-author of the book "Paying With Plastic."
Meanwhile, AmEx will not back down from battling those partners for customers and market share. That's the bailiwick of Alfred F. Kelly Jr., AmEx group president, U.S. consumer and small business services.
Kelly sees Amex's evolution, and his division's part in it, in cut-and-dried terms. "We've entered into a second business-the network business. We were the sole entity. Now other banks run on it," says Kelly. "My objective is to target high-spending customers. If we get more (volume), it makes the network stronger. That helps me do my business."
At the end of the day, "MBNA and Citi remain competitors of mine. I expect to compete hard every day," he says.
Kelly and Godfrey endorse what they call the "spend-centric model," as AmEx urges its customers to use its card at dry cleaners and gas pumps, a marked move away from its more glamorous travel and entertainment roots. "We realized there was an imbalance in targeting T&E. We decided to expand into everyday spend," says Kelly.
And T&E has become a difficult arena. Last October, AmEx loaned $600 million to Delta Air Lines, sponsor of the American Express/Delta SkyMiles card, at a time when the carrier was warning it might file for bankruptcy ("Troubles for Cobranded Cards," January). Travel, particularly business travel, has changed, hit by the 9/11 terrorist attacks, a switch to low-cost carriers such as Southwest Airlines, Web conferencing and a rise in fuel costs.
So AmEx embraced the spend-centric with open arms and began distributing rewards in single-, double- and triple-point deals. This approach works, says Godfrey, because increased use of the card "helps merchants, issuers and the consumer. The enemy is cash."
Bottom line, "there is about $3 trillion to $4 trillion in volume on credit cards, but $20 trillion in consumer spend," says Godfrey.
AmEx does not break out what it pays for its rewards, listing the expense under its marketing budget where costs rose 30% last year, to $4.9 billion. That's a hefty bill, but executives contend it is money well invested.
Rewards programs help build average cardmember spend, and they lower cardmember attrition, two of Chenault's major goals. Chenault told analysts in February that attrition rates in 2004 had improved, but he did not share specifics.
Still, everyday spend is no bed of roses compared with T&E. In December, AmEx received a public black eye when Walgreen Co., the world's largest drugstore chain, said it would stop accepting AmEx because of its high discount rate. AmEx sniffed that Walgreens did not contribute much to AmEx volume anyway. Walgreens had net sales of $37.5 billion in fiscal 2004.
The two companies soon made up, saying they had signed a long-term agreement but declining to discuss whether AmEx made any concessions on its rate.
Rewards programs also have become intensely competitive. Visa has been on a promotional binge for its Signature rewards brand. Signature goes right to the heart of the AmEx market, targeting consumers who make at least $125,000 annually.
Visa is no stranger to the everyday-spend concept either. It chooses to refer to displacing cash and check as its goal, while downplaying the threat constituted by the alliances formed by AmEx and Discover.
"We will see some banks experiment with AmEx and some with Discover. At the end of the day we do very well focusing on cash and checks as the primary competitor," says Paul Cohen, Visa vice president. "We respect (AmEx and Discover), but we have a broader product suite and better acceptance."
Visa also is entrenched in debit, with 59% of its transactions being initiated with check cards last year, says Cohen.
AmEx committed itself completely to payments when it announced the spin-off of its American Express Financial Advisors investment unit. In 2004, the division generated about $7 billion of AmEx's total revenues of $29 billion. The unit also posted net income of $700 million, or about 20% of the $3.4 billion that AmEx earned.
Plans call for the division to be sold to AmEx shareholders by the third quarter and to operate as an independent, publicly owned company. Details on the sale and value of the division have not been announced.
Chenault told investors the deal would enable AmEx to "focus on its card-payments and network-processing businesses and concentrate its investment resources in these high-growth, high-return areas."
At one time, Financial Advisors was supposed to bring new cardholders to AmEx and open up cross-sell opportunities. Chenault brushed off that concept, saying there were few linkages between the payments and investment divisions. Instead, the court rulings and structural changes in the financial services industry suggest the "separation was the best course to take," he said.
Chenault also plans a renewed emphasis on the segment AmEx labels travelers cheque and prepaid sales. Revenues for the product group rose 4% in 2004 after falling 13% the previous year and dropping 6% in 2002. Chenault is confident that combining plastic with its travelers cheque, once a top brand worldwide, will reinvigorate the product.
AmEx also is looking at new markets and new concepts.
It is signing up large apartment management firms so cardholders can automatically pay their monthly rent with their card and quickly bulk up their reward points. AmEx claims it has deals with managers in over 100 cities nationwide.
The spend-centric approach fits with the ExpressPay contactless tap-and-go technology that AmEx has been testing for three years in Phoenix. The ExpressPay card or key fob has an embedded chip and antenna and can communicate via radio signals with a device at the point of sale.
In December, AmEx announced that drugstore chain CVS Corp. would be the first national merchant to accept ExpressPay. CVS had already installed the reader in about 500 stores and reported it would be in place at all 5,300 of its outlets by the third quarter.
The tap-and-go and related contactless radio frequency identification systems have been introduced in the high-volume, low-ticket retail segment, such as fast food restaurants. AmEx claims that consumers using a tap-and-go card spend 20% to 30% more than consumers paying with cash.
Discover gained its new technology badge by introducing in 2002 its To Go card, a teardrop-shaped credit card that fits on a key chain. Competitors have since co-opted the minicard idea.
Now Discover is looking into biometric technologies that read personal characteristics such as a fingerprint or retina to confirm the consumer's identity before authorizing a transaction. The issuer has aligned with Pay By Touch, a San Francisco-based provider of fingerprint biometric systems. Consumers register their fingerprints with a participating merchant, at which time they also enroll payment account options, such as a credit or debit card or a checking account.
Pay By Touch has installed its technology at several supermarket chains, though consumers seem to be drawn more to using the system to cash checks than to buy groceries.
Discover has some clouds in its blue skies. Analysts have long suggested that parent Morgan Stanley might sell Discover.
The fit has appeared a little odd, what with Morgan Stanley's image as an upper crust Wall Street investment house and Discover's as a low-key Midwesterner. The cleaning up of Discover's balance sheet helped to keep the rumors going.
In January, Philip J. Purcell, Morgan Stanley's chairman and chief executive, fed the flames at an analyst conference, saying he would consider selling Discover in two or three years if it showed little growth. Purcell led the creation of Discover nearly 20 years ago.
Nelms says that the rumors of a sale have been swirling for close to a decade but nothing has changed in the relationship with Morgan. Indeed, Discover has become more valuable for Morgan in recent years, he says.
"We have grown from 15% of (Morgan's) earnings to 20% of earnings. We had record profits last year," says Nelms. Speculators should consider that AmEx is selling off its Financial Advisors group to concentrate on the higher growth card business, he says.
The rain on the AmEx parade is its dual personality. It must take on Visa and MasterCard, as it both competes with and aligns with the associations' members. Meanwhile, AmEx encourages its cardholders to buy shampoo and soda with its card, while telling merchants they must pay a premium discount rate to accept its card.
Despite these difficulties, Discover and AmEx appear to be on solid footing as they move forward. Each has formed important alliances and made smart strategic plans as they drive to change the payments landscape.
Authoritative analysis and perspective for every segment of the payments industry
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