Perspective

Shareholder Value Creation: A Head-to-Head Case Study

Over the last 20 years, both Amercian Express and Capital One have built large and enduring businesses, yet one has had twice the shareholder returns.

This head-to-head case study explores how and why their distinct business models and capital allocation strategies produce such wildly different outcomes.
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Our Investment Team has recently spent time debating the alternative paths to success in consumer finance, primarily relating to one of our fintech portfolio companies. Today, this portfolio company is primarily a payments business, earning the bulk of its revenue through spend-related activities. Leveraging the customer relationships it has built, the company could materially increase the scale of its lending (credit) business to these same customers. Our discussion has centred around how much lending is optimal, the relative merits of different types of lending and even whether they should be pursuing lending at all.

If we were CEO or CFO, how would we act in this situation to maximise value creation?

To contextualise the debate between spend-centric and credit-centric business models, we reviewed two business which are representative of both approaches, American Express and Capital One. Both businesses have decades as public companies, giving us a rich data set and insights into how it could play out over the long term.

American Express and Capital One have built large businesses over long periods of time, yet have produced vastly different shareholder returns. Analysing them head-to-head, is a nice reminder that revenue growth and profit margins only present a two-dimensional view of value creation.

Over the long term, returns are ultimately driven by competitive advantage and return on capital.

The Last 20 Years

An unexpected set of numbers framed the analysis early on. Over the last 20 years, compared to American Express, Capital One has had:

  • 30% higher revenue growth;
  • 40% higher net income growth;
  • 6x greater asset growth; and
  • 3x higher headcount growth.

Both have produced similar amounts of ‘free cash flow.’ (Here defined as operating cash flow less capex).

Yet despite Capital One’s superior growth in almost every aspect, by comparison American Express has achieved:

  • 2x the total shareholder return; and
  • 50 – 100% valuation premium consistently through the cycle

See the comparative growth in the following seven charts:

What explains the difference in business growth and shareholder returns?

To break down the question, we have used a framework that focuses on three drivers of business performance that ultimately impact shareholder returns:

  1. Business Model: how the company generates revenue and growth;
  2. Competitive Advantage: how the company differentiates itself and achieves above economic returns; and
  3. Capital Allocation: how the company prioritises various types of spend.

All of these are intrinsically linked.

Case Study: American Express vs. Capital One

The first driver of relative performance, from which all others cascade is the difference in business model.

Revenue generation: Spend-centric vs. Credit-centric model.

American Express has a spend-centric model.

This model centres around a closed-loop network of card members and merchants (also called ‘Partners’) that generates revenue primarily (80%) through the volume and value of transactions that occur on their network. This non-interest income consists of discount fees, card fees, travel commissions, and other fees. Interest income (i.e. credit) makes up a relatively small proportion of total revenue (20%).

Capital One has a credit-centric model.

This model involves lending to mass market and subprime customer segments, generating revenue through Net Interest Margin (NIM) (80%). These sources of income are mainly driven by the size and growth of Capital One’s loan portfolio, as well as the interest rate and the credit quality of the borrowers. A small proportion of revenue is spend-based (20%).

Growth Models: Organic, Self-Perpetuating, Flywheel vs. Inorganic Loop

American Express has an ‘organic’ growth flywheel, which requires little additional capital to perpetuate. It is based on expanding its network of card members and merchants, as well as increasing the engagement and loyalty of its existing network participants. This enables American Express to charge a premium over competitors, which it then can reinvest into the network, rewarding participants for high levels of spend, in-turn encouraging more of it. Given the two-sided nature of the network, beyond a certain scale, which it surpassed years ago, growth of the network becomes self-perpetuating.

This organic flywheel is highly efficient and benefits from three key advantages: closed-loop processing (that is the network of card issuer and acquirer); having one of the world’s most recognisable brands; and benefiting from card interchange fees.

This compares to Capital One’s ‘inorganic’ growth loop, which requires continual external capital to maintain. It is based on expanding its loan portfolio, as well as diversifying its product offerings and customer segments.

In contrast to American Express, this is not self-perpetuating as it requires constant additional investment into the loan book, technology, M&A and brand to continue to grow the business. The implications of this are significant when it comes to the capital efficiency of the business.

American Express’ spend-centric model leads to higher margins and more capital efficiency. This superior model flows through to a valuation premium from investors.

We leverage Hamilton Helmer’s 7 Powers framework to understand the key competitive advantages of each business.

American Express

Network Effects

American Express benefits from two-sided network effects; the value of its network increases with the number and quality of card members and partners that join and transact on its network.

American Express’ competitive advantage is based on its ability to create and share value with both sides of its network, by offering attractive rewards, services, and experiences to its card members, and by offering access, data, and marketing to its merchant and brand partners.

Scale Economies

American Express has taken the approach of using its scale to increase value to customers over time, rather than increasing margin or driving down costs to customers – Costco’s ‘Scaled Economies Shared’ being the exemplar of the latter.

The chart below shows the percentage of maintenance spend versus investment spend over time as a percentage of revenue. Interestingly:

  • the split has changed from 1/3 ‘investment spend’ back in 2003 to 2/3 investment spend in 2023. However;
  • overall OPEX as a percentage of revenue has held roughly flat at 70%.

This becomes far more evident on the second chart which shows, looking at absolute values, that the investment spend has increased 810% versus maintenance spend that has only increased 50%.

Despite having the ability to raise margins, American Express has instead chosen to invest the incremental dollars back into the network, and by doing so increasing the network value. This disciplined approach to prioritising long-term sustainability and durability of the network over short term margin expansion has allowed their competitive advantage to significantly strengthen over time.

Brand

For American Express, the power of the brand is obvious. Key to brand development is the exclusive and unique partnership/offers that drive engagement and value for both members and merchants. This is reflected in the 98% member retention the company achieved in 2023. This value, for both network and members alike, has taken decades to compound.

You can’t create another American Express. I could create another shoe store. I could create another business publication. I could do all kinds of things with hundreds of billions of dollars. But I can’t put in the minds of people what is in their minds about American Express.

Warren Buffett

Capital One

Process Power

Capital One’s Process Power is based on its ability to leverage its internal and external data to underwrite and price risk more effectively than its competitors. The company uses its “Information Based Strategy”, a combination of insourced IT, digital talent, and big data/analytics, to out innovate their competitors.

This Process Power is evident when comparing Capital One’s superior risk adjusted loan yields to American Express through the cycle. Given that Capital One’s customer base skews to mass market and subprime, this is all the more impressive.

Capital One are proof that lending with an ‘advantage’ can be used to grow a very big, although less valuable (comparably), business over time. 

Brand

Looking at the top 10 largest banks by assets in the US, Capital One has shown the ability to create a nationally-scaled brand, even against heavily entrenched legacy banking institutions. Achieving a Top 10 status in 30 years compared to its closest peer, Truist Bank at 152 years, is an incredible achievement. Capital One has heavily reinvested this scale into brand advertising, as shown by its absolute dollar investment into marketing with c. $4bn spent in 2023.

Pulling this Together: Competitive Advantage and the ‘Return on Capital’

The relative strength and trends in competitive advantage should eventually become evident in financial performance, particularly seen through the key metric of ‘Return on Capital’. Interestingly this has played out on both a relative and absolute basis for both Return on Equity (ROE) and Return on Assets (ROA).

These trends show that American Express has been incrementally improving over time whereas Capital One has struggled to improve.

The primary cause of this is that American Express’ ongoing growth is fuelled more efficiently by its capital-light business model and self-perpetuating competitive advantage. By comparison, Capital One’s model is inherently capital and asset-heavy, requiring it to deploy and tie-up significant amounts of cash to generate further growth. With these structural issues, Capital One’s return on capital (and its progression) over time has been impeded.

Unsurprisingly, spend-centric and credit-centric business models produce significantly different outcomes when it comes to the availability of cash flow for capital allocation. These differences compound over time to cause large divergences in shareholder returns. American Express’ spend-centric growth model, coupled with the buy back of stock, has been able to drive shareholder returns over multiple decades.

American Express has been able to allocate a far higher portion of FCF to dividends and buybacks over the last 20 years, at 27% compared to 8% for Capital One. Conversely, Capital One has spent 5x what American Express has on M&A, not including equity issuance to fund the acquisitions!

This has led to vastly different numbers of shares outstanding over the years. American Express has reduced shares outstanding by 43% as compared to Capital One having increased it by 156% after adjusting for the Discover acquisition, which was all scrip financed.

While obvious, generating FCF per share is the most important driver of long-term value creation and understanding a company’s potential FCF conversion is a key variable to any investor’s returns.

For more TDM perspectives on ‘Capital Allocation’:

About the author

Harrison has taken a circuitous route to TDM. From his time as a gunner in the Australian Army, followed by a stint as a SCUBA instructor in Asia, and international investment roles, he’s covered some ground over the years. As part of the investment team, Harrison currently leads our portfolio work on Block Inc. (fintech) and is a core part of the team working with Culture Amp (HR B2B SaaS).

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