AmEx Taps the TARP; Not the Same AmEx Buffett Bought

The investing thesis behind American Express (AXP) has always been that it has a higher quality of user and thus its defaults will be lower than the typical credit card issuer. Unlike Visa (V) and Mastercard (MA) who issue their cards through banks and collect a "toll" each time the card is used, Amex holds the credit balances and is essentially its own bank. This has enabled Amex in good times to earn a high return on equity as it collects the interest payments that go to the banks from the other card issuers.

All that seems to have changed. It seems, being hit by slowing consumer spending and rising defaults, AmEx is seeking roughly $3.5 billion from the TARP program.

It isn't clear if the application under the Troubled Asset Relief Program [TARP] came before or after AmEx got Federal Reserve approval Monday to become a bank-holding company.

Why? Even the most affluent AmEx customers are cutting back on discretionary purchases, the company has acknowledged. A spending slowdown is particularly problematic for AmEx because its business model revolves around consumers who pull out plastic for their purchases.

That alone would not cause the problem. What would? Delinquencies and defaults on credit cards are rising. Meanwhile, the company is virtually locked out of credit markets because investors who buy consumer loans are sitting on the sidelines.

All this is causing a liquidity problem. Again, like other institutions, not a solvency issue, but a liquidity one. It is also the reason we are hearing stories about AmEx card holders with no credit problems getting credit limits decreased. AmEx is trying to decrease its liabilities.

Not good news for shareholders for two reasons. The decrease in consumer spending reduces the "toll" AmEx gets when a customer uses his card. The credit limit decreases the company is placing on customers now further reduces that effect and reduces interest AmEx wil earn on outstanding balances. When you add this to the increasing defaults, you have a trouble stew.

This is not the "salad oil" fiasco that hit AmEx when Berkshire's (BRK.A) Warren Buffett bought a huge chunk of the company in the late 1970s. This is a fundamental change to the company's structure and the way it does business. The AmEx model back then was to essentially "front" customers money who would then pay it back a month later in full. Now Amex extends payment terms on almost all cards and has branched out into business lending. Now more than ever it is exposed to the consumer and his or her credit condition, not just their current spending patterns.

Previously if you did not pay your AmEx bill each month it was shut off. Now, consumers can continue to rack up debt to their limits while making minimum payments until they are tapped out. In this case, the monetary default risk for AmEx is far higher. This is causing increasing credit losses for AmEx.

The old thought that "AmEx is less sensitive to a recession" has never really been tested. The last real recession we had in the US was the 1990 one (the 2000 "recession" was a pothole). AmEx then was not nearly as exposed to the consumers' credit condition as it is now. Only now are we going to be able to test the thesis. Based on early results, it was wrong.

It also means the old investing thesis needs to be rethought as it has now become less valid.

This is not the same AmEx Buffett bought....

Disclosure: None

Comments

[investor88:]

Warren Buffet will not cut loss on AMEX because his holding period is preferably forever. I wonder what will make him cut AMEX from his portfolio, I guess never.

2008 Nov 13 07:56 AM

[Skip Olinger:]

There is nothing new in your analysis and it offers no insight into the current opportunity with Amex. I believe the question are:
- how bad can the write off rate go? It went to 10% (now roughly 6.5%) in '91. That is the big known that can really affect value. I doubt it will go to 100%. There most recent vintages of receivables have the lowest credit scores so that is where the problems are likely to arise.
- yes, rich people spending will go down, likely more than most people project but it won't go to 0.
- securitization gains will go down as well
BUT:
- the company's liquidity problems seem to be addressed with TARP and becoming a bank holding company
- it is still a fantastic franchise head and shoulders better than dealing with MC/V bank people and the rewards are far better.
- times will return to normal and the company will earn and grow at normalized levels
- it is selling at historical lows.
CONCLUSION
Watch the write off situation carefully. Wait for normalacy to return to the credit markets. You may miss the bottom, but there is a lot of upside here.

2008 Nov 13 10:17 AM

[Hanoch:]

There is no doubt AXP is subject to more credit risk than in the past, but I think the fear is overblown. Certainly AXP will suffer in the near term due to the current economic conditions, but couldn't one say that about nearly every company at this point? It seems to me, when you buy a business, you have to expect to go through rough times as well as good. The questions are (1) whether the business model is fundamentally strong, (2) whether management is talented and trustworthy, and (3) whether the company has the staying power to outlast the current economic downturn. It seems the answers to those questions are yes.

2008 Nov 14 10:57 AM

[kurt walter:]

Maybe so. But St. Warren has a belly full of AXP.

2008 Nov 14 02:26 PM

[oldgoldbug:]

I think I remember having a chat with the "Salad Oil King" in Pennsylvania around 1969 or 1970. He commented how hard a life of crime was and how he realized he had a hole in his shoe as he was scamming AXP out of millions.
I believe he worked his scam in the early 60's and Warren picked up a bunch of AXP in 1964 or so.
Whatever AXP is trying to do, the chart doesn't look so good.

2008 Nov 16 02:53 AM