To: Dr. David L. Anderson

Fr: Michael Renderman

Da: January 14, 1997

Re: Credit Card Industry

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Description of the Credit Card Industry

Credit card services, such as Visa, MasterCard, American Express and Discover, are highly recognizable. These services are offered through credit card issuers, such as Citibank, MBNA America, First USA and Dean Witter Discover. The theory behind the offering of credit cards is simple. The credit card issuers are supplying consumers with a line of credit, or loan, at a certain percentage rate. This business is different than a bank offering a loan. There is no set time frame in which the borrower has to pay back the loan in full. Actually, the credit card issuers would rather have consumers that pay a minimal amount month after month. This will allow interest charges to build to substantial amounts.

The credit card industry remains a very profitable industry. The average APR on a credit card hovers around 18%. Yet, there is trouble ahead. Some of these problems are building credit costs, slowing receivables growth and stronger competition. The most disturbing trend is the increase in credit card delinquencies, which have been steadily rising.

Financial Analysis

According to an October 1996 study by Alex. Brown & Sons, Inc., the credit card industry remains the fastest growing and most profitable of all banking businesses. The specialty card issuers continue to achieve returns on equity of 25% and generate EPS growth in excess of 20%. There are a few reasons for this continuing trend: Increasing overall consumer

expenditures and debt, consumers utilizing credit cards instead of checks or cash, better merchant acceptance, and reward program offerings.

The credit card industry generated $1.6 trillion in net sales in 1995 while managing $956 billion dollars in gross profit. The industry itself is very liquid, with cash and account receivables making up 57% of its total current assets.

Past years have shown the success of issuers to generate healthy receivables. Although many issuers have firmed credit card pricing , profit margins are under pressure. Why? Partly because account acquisition costs are generally rising and net interest margin expansion has not kept pace with the rise in credit costs. Also, credit card delinquency rates are hitting unprecedented levels. Veribanc Inc. reported serious credit card delinquencies totaled $4.07 billion as of September 30, 1996.

As mentioned, accounts receivables make up a large portion of the credit card issuers assets. A disturbing trend is the fact that credit card losses are affecting the bottom line. Chase Manhattan, Citicorp, and Wells Fargo and Company were hurt by credit card losses in the fourth quarter of 1996. The charge-offs for each company reached $311 million, $608 million and $101 million, respectively.

Stock/Investment Outlook

According to a Bear, Stearns & Co., Inc. report, credit card stocks look attractively valued. Current premiums on projected year-end 1996 receivables for credit card stocks range from 7% to 16%. Historically, premiums have averaged 19%. Credit cards are affected by recession but even without recession, poor credit quality trends are negatively affecting credit card stocks. Yet, the Bear, Stearns report feels that certain stocks, such as First USA, MBNA Corporation, Capital One Financial, and Advanta will continue to deliver strong results in the long run.

The top twenty largest credit card issuers continue to capture a greater share of the market and even more significant if one looks at the growth of the top ten issuers.

Competitive Structure of the Credit Card Industry

The credit card industry is extremely competitive. Competition has force prices down, which has led to compression in both the net credit and profit margins. The top twenty credit cards issuers control the greater share of the market. The top ten credit card issuers are Citibank, MBNA America, Discover Card, Chase Manhattan, First USA Bank, First Chicago NBD, Household Bank, AT&T Universal, Advanta, and Banc One.

The top five market share percentages are: Citibank 10.3%, Discover 6.4%, MBNA America Chase 5.9%, Manhattan First Chicago 5.5%, and NBD First USA 4.0%.

Potential/Prospective for Growth

First, I will list the negatives. Consumer credit expansion has slowed. Typically, consumers reduce their need for credit card services when payments begin to grow to large compared to their monthly cash flow. At the same time, issuers are taking a more defensive stance by limiting growth through tightened credit standards.

Despite the negatives, there is room for growth. A major key for earnings growth, possibly double digit growth, is by cost effectively gaining credit card market share. According to the Bear, Stearns report, consumers are becoming more savvy shoppers for credit and payment products. Credit card issuers must meet this challenge by offering varies product mixes. MBNA showed success in 1995 by offering affinity credit cards which resulted in six million new accounts.

Capital One Financial earned $1.1 billion in net new receivables with a more aggressive marketing scheme as well as a more diversified package of credit cards such as secured, joint account and student cards. Advanta earned $1 billion in net new receivables by the use of a 5.9% introductory rate offer and new marketing campaigns.

Another means of gaining market share is through a merger. Recently, Banc One Corp. and First USA merged, creating the third largest credit card issuer in the country.

Role of Research and Development

The credit card industry will continue to be affected by competitive pricing, rate wars, and increasing delinquency rates. The role of research and development will be important to control these factors. Issuers of credit cards must find ways to gain market share. The key is not only to find customers but to find customers that will pay their bills. Credit card issuers must use research and development to develop products and find ways to get the right customers.

Technology Investment and Analysis

Technology is beginning to make strides in the credit card industry. Issuers are building sophisticated, proprietary systems to monitor and manage the hanging risk profile of their accounts an to improve the efficiency of the collection process, according to the Bear, Stearns report. Another example of this technology in the credit card industry comes from Schlumberger Industries of France. Customers can make payments and have financial information exchanges whenever and wherever desired through the use of a hand held computer. The Newton, as its called, becomes the equivalent to an automated teller machine if cash value can be loaded. This is being marketed to French health professionals first.

Recommendations for the Future

I believe that the credit card industry will continue to grow at a modest pace. Intense competition, lower rate credit cards and increasing delinquencies will continue to slow down profits of credit card issuers.

Credit card issuers must continue to diversify its product lines. This has proven to be successful. Also, credit card companies must be smarter about their growth of market share. An example is how MBNA has changed its typical new customer. In 1991, a new customer had a family income of $46,000, 13 years employed and a 12 year history of paying bills. This has resulted in retention of 98% of its profitable customers. Finally, because consumers are smarter, it is necessary to offer a value added product. Those that can meet these standards will likely absorb a disproportionate of the market growth.