4 Reasons Why Capital One's Costco Canada Partnership Might Fail
* This article was published in 2014 at the onset of the Capital One-Costco partnership; the partnership has since evolved, and the article’s contents may be outdated. Those interested in learning more about which credit cards are best for earning back at Costco are advised to read this article instead.
As we called it in August of 2014, Costco Canada ended its 15 year-old credit card partnership with American Express and began a new one with Capital One.
Capital One 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 1, 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 Capital One is going to come away from the deal profitably.
We believe Capital One will face four significant challenges with the Costco program:
One has to imagine that Capital One 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 Capital One did when Amex walked away from the table. In all likelihood, Capital One 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 relies 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 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.
Another challenge Capital One will face is competition from other Mastercard issuers for Costco customers’ share of wallet. A number of major financial institutions—including BMO, MBNA, and Tangerine—offer attractive Mastercard options. 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, a large number of Costco customers already have a Mastercard to start with. As a result, we actually believe there will be fewer Capital One Costco cardholders than there were Amex Costco cardholders.
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 Capital One’s interchange within Costco’s stores, it can’t do anything about protecting Capital One’s interchange margin outside of Costco stores. This is when a Capital One Costco cardholder would use their card outside of Costco. This will put even further strain on Capital One’s out-of-store spend margins, which we surmise is the primary place Capital One is relying on to make its money. As a result, it will either have to eat the margin reduction, reduce the cardholder value proposition, or reduce Costco’s compensation.
4. 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. TD did this with Aeroplan, Capital One with HBC, RBC with Shoppers, CIBC with Petro-Canada, etc. Growing organically will slow things down for Capital One.
In the meantime, American Express will do everything in its power to retain former Amex Costco cardholders and convert them toward opening a card within the Amex suite. 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 SimplyCash® Card from American Express 2% cash back on eligible gas purchases in Canada, 2% cash back on eligible grocery purchases in Canada (up to $300 cash back annually), and 1.25% cash back on all other eligible purchases with no caps at the base rate, and a bonus that can add up to $100 in statement credits in the first 10 months. Terms and conditions apply. There is no annual fee.
- The SimplyCash® Preferred Card from American Express offers 4% cash back on eligible gas station purchases in Canada, 4% cash back on eligible grocery store purchases in Canada (up to $1,200 cash back annually) and 2% cash back on all other purchases. The annual fee is $9.99/month (Equals a total fee of $119.88 annually). There’s also a Welcome Offer: In your first 10 months as a new SimplyCash® Preferred Card from American Express Cardmember, you can earn a $40 statement credit for each monthly billing period in which you spend $750 in purchases on your Card. This could add up to $400 in statement credits in the first 10 months. Terms and conditions apply.
All that said, we are excited to see what the new Capital One Costco cardholder value proposition will look like, and we’ll hopefully be proven wrong. With an exclusive deal like this, both at the issuer and network level, perhaps Mastercard subsidized Capital One and contributed to the cardholder value proposition. We’re skeptical it will be enough.
This post was not sponsored. The views and opinions expressed in this review are purely my own.
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Recommended Read: Is a Costco Membership Really Worth It?