As we called it earlier in August, Costco Canada is ending its 15 year-old credit card partnership with American Express and beginning a new one with Capital One.
CapitalOne has already soft-launched its new product in select stores, and our understanding is the new co-branded MasterCard with Costco will fully launch by the end of September, 2014. American Express will no longer be accepted at Costco as of January 1st, 2015.
With over $17 billion in Costco Canada revenues at stake, this is a significant win for CapitalOne and MasterCard. However, we’re not so sure CapitalOne is going to come away from the deal profitably.
We believe CapitalOne will face 4 significant challenges to succeed with the Costco program:
1. Profitability: One has to imagine that CapitalOne offered more compensation to Costco than American Express was able or willing to match. But remember, the incumbent always has insider knowledge, meaning American Express knew more about how the Costco credit card portfolio behaved than CapitalOne did when Amex walked away from the table. In all likelihood, CapitalOne gave away most of the interchange revenue to Costco, thereby relying on Costco customers to spend out of store on their co-branded credit cards. We’re not convinced that’s going to happen nearly often enough.
There has always been a self-fulfilling prophecy when issuers fall into the trap of relying on cardholder out of store spend to drive profitability. It goes like this: the issuer gives away in-store interchange revenue to their partner and rely on out of store spend for interchange profits. However, because the issuer is relying on the out of store spend to fund their interchange revenues, they offer a weaker rewards rate to cardholders for out of store spend. As a result, the cardholder uses the co-branded card almost exclusively in the partner store, and then uses another card that offers them a better value proposition for their out of store spend. Then the issuer only gets the unprofitable in-store spend, and not much of the more profitable out of store spend. It’s a spiral of self-fulfilling declining margins.
More than a handful of issuers have found themselves in that predicament with retailers. The only winners are the retailers, in the short term, and the cardholders.
2. Size: Another challenge CapitalOne will face is competition from other Mastercard issuers for Costco customers’ share of wallet. As we know BMO, MBNA, National Bank, ATB, Sears, Hudson Bay, Shoppers, Target, Petro-Canada, WestJet & TD cash back are all MasterCard programs. In fact, Costco customers can earn more from BMO’s World Elite MasterCard in Costco (2%) or the MBNA Rewards World Elite MasterCard (2%), than they can with Capital One’s Costco card (less than 1%). When American Express had the Costco program, if a customer wanted to use a credit card within Costco, they had to get the Costco Amex card (very few people already had an alternate Amex card). Now, more Costco customers already have a MasterCard, than they did an Amex card. As a result, we actually believe there will be fewer CapitalOne Costco cardholders, than there were Amex Costco cardholders.
3. Interchange: The Minister of Finance has asked both MasterCard and Visa to lower interchange by 10-15% within the next few months. While MasterCard may exclude the “wholesale warehouse” merchant category from an interchange reduction, thereby protecting CapitalOne’s interchange within Costco’s stores, it can’t do anything about protecting CapitalOne’s interchange margin outside of Costco stores. This is when a CapitalOne Costco cardholder would use their card outside of Costco. This will put even further strain on CapitalOne’s out of store spend margins, which we surmise is the primary place CapitalOne is relying on making its money. As a result, it will either have to eat the margin reduction, reduce the cardholder value proposition or reduce Costco’s compensation.
3. Slow-Start: Capital One is not buying the American Express Costco credit card portfolio. That means Capital One is starting from scratch. In most cases, the new issuer buys the co-branded accounts from the incumbent issuer, so cardholders don’t have to re-apply. CapitalOne did this with HBC, RBC did it with Shoppers, TD did it with Aeroplan, CIBC did it with Petro-Canada. Growing organically will slow things down for CapitalOne.
In the meantime, American Express will do everything in its power to convert and retain former Amex Costco cardholders. They’ve already launched two new cash back credit cards (not charge cards), which somewhat mirror the Costco cash back card, but nonetheless both offer market leading earn rates.
- The no fee SimplyCash card offers 1.25% on all spend with no caps, and a bonus of 5% on gas, groceries and restaurants up to $250 cash back in the first 6 months. There is no annual fee
- The Preferred SimplyCash card offer 1.5% on all spend up to $100K then it goes to 1.25%, and a bonus of 5% on gas, groceries and restaurants up to $400 cash back in the first 6 months. It comes with a $79 annual fee.
All that said, we are excited to see what the new CapitalOne Costco cardholder value proposition will look like. Perhaps we’ll proven wrong. With an exclusive deal like this, both at the issuer and network level, perhaps MasterCard subsidized CapitalOne and contributed to the cardholder value proposition. We’re skeptical it will be enough.