(FORTUNE Magazine) – Like many other CEOs who took the helm in 2001, Kenneth Chenault didn't exactly get off to a roaring start. But today, seated in his office with its master-of-the-universe views of New York Harbor, he's smiling. The company he runs, American Express, is posting record profits. It has one of the richest price/earnings ratios on Wall Street. An AmEx cardholder typically charges four times as much as a Visa or MasterCard customer. He is about to spin off a huge unit--American Express Financial Advisors--that has long been a headache. Most important, the courts have recently allowed banks to issue AmEx cards for the first time, essentially handing him the keys to a brand-new market.

Perching his athletic six-foot frame on a snow-white upholstered chair in his office, Chenault talks about the "new AmEx"--a supercharged version of the 155-year-old company. "I really want us to focus on the businesses that have terrific growth opportunities and terrific returns," says Chenault. He means credit cards and, to a lesser extent, travel services, which account for about 60% and 6%, respectively, of the company's $29 billion in revenues. (The soon-to-be-shed financial-advisors business makes up about 25%.) Now that big banks MBNA and Citigroup have agreed to issue AmEx's cards, AmEx could become a serious competitor to Visa and MasterCard in the consumer segment for the first time. And for AmEx, a little gain will go a long way. It has a modest 21% share of the $1.4 trillion charged on credit cards in the U.S. last year. It needs to claw only a few percentage points from Visa and MasterCard over the next couple of years to boost that share to 25% or more. That would sharply lift AmEx's profits and its valuation on Wall Street. "We're going to raise our return on equity for this company from 18% to 20% to 28% to 30% while steering revenues and earnings growth higher," predicts Chenault. "That's part of our quest to be one of the best-performing companies within and outside the financial services sector."

But that's only if he overcomes the significant roadblocks in his way. For example, AmEx has to change perceptions that its card isn't accepted everywhere customers want to shop. It has to convince merchants that AmEx and its well-heeled customers are worth the premium fees it charges (an average 2.6% of every transaction, vs. about 2.1% for Visa and MasterCard). And it has to entice banks to switch customers to its cards--a touchy area that already has some people up in arms.

Still, it's an awfully nice place to be for a man whose first year as CEO was one of the worst in AmEx's history. For one thing, in 2001, American Express Financial Advisors (AEFA) was in crisis. Acquired in 1984, AEFA hawks insurance, variable annuities, and mutual funds through its 12,000 brokers and financial planners. But during the late 1990s, the once-conservative division started betting on risky high-yield bonds. As the economy soured, those junk bonds imploded. In mid-2001, AmEx's earnings collapsed as it took a $1 billion charge to write down the worthless securities. "For so many years this company had done well, and then we get it, and it looked like we screwed it up in a couple of months," says AmEx CFO Gary Crittenden. "It's sobering to have your name on the front page of the Wall Street Journal in an unflattering way."

Meanwhile, the falling stock market and slowing economy meant that consumers and corporations were dialing down spending--a combination that struck directly at AmEx's consumer and corporate credit cards and its travel group, which books flights, hotels, and travel packages for corporate-card holders. Then came the Sept. 11 terrorist attacks on the World Trade Center, which was just across the street from AmEx's headquarters. The company lost 11 employees and was forced to evacuate for several months. Business travel plummeted. AmEx stock fell 27% in the week after the attacks. The company's 2001 results would be the worst in nearly a decade, with a staggering 53% decline in profits. Rumors began to heat up that the weakened AmEx would be taken over by the likes of Citigroup or Morgan Stanley.

Chenault had started a cost-cutting plan before Sept. 11, and now he went into hyperdrive. He slashed budgets and laid off about 13,400 employees, 15% of the company's workforce. He also concluded that the consumer could be the company's ticket to growth. Midway through 2002, while big corporations remained tightfisted, he noticed that consumers were starting to spend again. "We looked at other credit card issuers and their marketing investment at the time," recalls Chenault. "We saw that some were pulling back."

To take advantage of that lull, AmEx sharply ratcheted up promotions and reward programs for the holders of its consumer cards: green, gold, platinum, and Centurion (or black) American Express cards, which users must pay off each month, and Blue and Optima cards, which have revolving balances just like Visas and MasterCards. Meanwhile, Chenault expanded AmEx's corporate-card base by going after small and medium-sized business customers. The moves worked: By 2003 and again in 2004, AmEx posted record earnings of $3.0 billion and $3.4 billion, respectively.

But Chenault believed the company could do even better without its financial-advisors division. He had tried to shore up AEFA by hiring some big guns from Fidelity Investments and buying London-based Threadneedle Asset Management. But the cross-selling opportunities he had hoped for never emerged. Turns out investors care little about "brand" or cachet when it comes to mutual funds--they want good results. And the bulk of AmEx's funds weren't keeping up with their peers, causing investors to yank $5 billion from its equity funds last year.

Worse yet, AEFA had landed in the cross hairs of regulators. Earlier this year New Hampshire regulators accused the division of defrauding customers by giving its sales force secret incentives to sell its in-house funds. And in March the NASD fined AEFA $13 million for steering customers into higher-cost funds. (The NASD is still investigating other sales practices there.) None of the charges are life-threatening to AEFA, nor are they nearly as bad as the scandals that rocked Janus, Strong, or Putnam Investments in the past two years. Yet the cloud hanging over the group could have dampened profits and eroded AmEx's premium brand image.

Chenault decided it was time to cut AEFA loose. He announced in February that it would be spun off in a tax-free transaction to American Express shareholders in the third quarter of 2005. (It will also get a new name that has yet to be announced.) As a stand-alone asset-management firm, AEFA, which has a return on equity of 12%, should trade at around 15 times earnings, or $11 a share. (Many analysts expect it will be acquired by another company in the next two years or so.) The slimmed-down AmEx will grow faster and be more profitable and therefore should earn a higher valuation. The company already has a lofty P/E of 16, compared with 11 for Citigroup and Goldman Sachs. But if Chenault executes right, analysts say, AmEx could trade with a 20 multiple, or for around $56 a share.

The consumer will be key to growing AmEx's credit card operations. To get better access to that market, Chenault had long known he would need to crack Visa and MasterCard's stranglehold. Those rivals control 73% of the purchases made on credit cards in the U.S. largely because of their exclusive partnerships with the big banks that issue those cards. Visa and MasterCard's agreements forbade the banks from issuing competitors' cards. AmEx spent years lobbying the U.S. Department of Justice to file suit against Visa and MasterCard, arguing that those agreements violate antitrust law. In 1998 the Justice Department did just that.

Let's take a step back and explain how the credit card business works. Visa and MasterCard are associations formed by banks to provide a centralized network to complete credit card and debit card transactions. In a typical sale merchants pay an estimated average of 2.1% every time they swipe a credit card through Visa's network. Put another way, when you buy a $100 sweater at Saks Fifth Avenue, $2.10 of that purchase goes to three parties: The bank that issued the card gets about $1.75; another bank that processes the transaction gets roughly 38 cents; and Visa gets roughly 2 cents.

AmEx, too, charges merchants a fee--a hefty 2.6% last year, on average. (That's why some merchants still balk at accepting AmEx cards.) But unlike Visa and MasterCard, AmEx controls the electronic network that processes the transaction. And it issues its own charge and credit cards rather than relying on banks to do it. That means it gets to keep that entire fee for itself.

At least, that's how it used to work. Then, last fall, the U.S. Supreme Court refused to hear Visa and MasterCard's appeal of a 2001 judgment that found the two entities had violated antitrust law. Suddenly banks were free to issue AmEx cards. Almost immediately Chenault signed up MBNA and Citigroup--two of the largest Visa and MasterCard issuers in the country--to issue AmEx's cards. (AmEx sued the banks that didn't sign up, seeking unspecified monetary damages for the years it was shut out of the banks' networks.) Analysts say AmEx is cutting MBNA and Citi in on a bigger chunk of the action than they get from Visa or MasterCard--something it can do easily, since its merchant fees are so much higher. It also swayed the banks by arguing that its customers are more profitable. Last year the average AmEx customer rang up $7,618 in charges per card--about four times as much as the average Visa or MasterCard customer. "I want AmEx to be known as the network for the high spender," says Chenault.

To keep its elite image, AmEx wants to steal only the Visa and MasterCard customers who charge the most--about 10% of their customers, analysts estimate. But doing that is fraught with problems. For example, last November, MBNA started replacing some of its MasterCard and Visa cards with American Express cards without asking customers first. Many of them loudly objected. Some compared the practice to the "phone slamming" changeovers by 1990s telecom companies that were subsequently declared illegal. While MBNA insists the practice was on the up-and-up, it nonetheless announced in December that it would ask before switching customers. Since then, MBNA says it has signed up "hundreds of thousands" of new AmEx customers. (Citigroup has more time to iron out these issues; it won't start issuing AmEx cards until late 2005.)

Simply doing business with the banks could be problematic for AmEx, because they are competitors as well as allies. There's nothing to prevent MBNA or Citigroup from trying to steal AmEx's customers. And the banks continue to launch competing cards. In fact, two months after joining up with AmEx, Citigroup launched the Chairman card, a MasterCard-based clone of AmEx's high-end platinum card with similar features like companion airline tickets and reservations at hot restaurants.

As for Visa and MasterCard, they insist that AmEx's dalliances with the banks will have little impact on their business. Yet analysts note they recently slightly raised their merchant fees--most of which, you'll recall, go to the banks--to persuade them not to switch their customers to AmEx.

Merchants pose a bigger challenge. AmEx has to convince them that the higher fees it charges are worth it. The company has had some success, especially with retailers that peddle high-end goods and services. "I didn't know whether I would be able to see the value of the AmEx brand when we signed up with the company last year," says Steve O'Neill, CEO of CitationShares, which sells shares on private jets. "But the power of that card has been extraordinary." One man laid down his black AmEx card (which comes by invitation only, thank you) earlier this year to buy 150 hours of flight time. The cost? $645,000.

Less upscale retailers, though, may strike back. Last December drugstore chain Walgreen briefly stopped accepting AmEx's cards. It said charges from its cardholders had not been high enough to justify the higher fees. Eventually Walgreen caved. But this brief rebellion won't be the last. "It is inevitable that all the card issuers are going to do battle with merchants in the coming years," warns David Robertson, publisher of The Nilson Report, an industry newsletter. "The rising fees are intolerable as far as the merchants are concerned and untenable as a business model going forward." David House, who heads up AmEx's merchant network operations, insists he isn't worried about a retailer revolt: "Merchant cancellation is not something that keeps me up at night."

One reason may be that he and his boss, Chenault, are successfully signing up a whole bunch of unconventional "merchants," such as landlords. Last year AmEx started cutting deals with luxury apartment buildings in New York City and elsewhere, allowing customers to charge their monthly rent (and earn reward points for doing so). AmEx is also exploring ways to move payments for insurance, college tuition, health care, and mortgages onto its network. To convince landlords, hospitals, and others to accept its cards, AmEx is almost certainly discounting its fees--but the company won't confirm that. Says House: "I want you to be able to use the American Express card for everything that you buy."

In that spirit, AmEx is also rolling out a system called ExpressPay that packs radio frequency identification technology into a small key fob. Simply wave the fob across a reader and walk away with your coffee and doughnut--no signature needed. The charge will show up on your next monthly statement. Big drugstore chain CVS has already agreed to offer the service across the country.

Most Wall Street analysts are enthusiastic about Chenault's plans. If he does bump up AmEx's P/E to 20, he'll make the company a much less attractive takeover target. If another company wants to acquire AmEx anyway--and rumors continue to swirl--it will have to pay current shareholders handsomely for the privilege. Either way, Chenault wins. No wonder this man is smiling. ■

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