Is American Express Worth the Risk?

One of the major developing stories this week is the conversion of American Express (AXP) to a bank holding company in order to receive funds from the government’s Troubled Asset Relief Program (TARP). This situation is similar to the Fed’s decision to allow the immediate conversion of Goldman Sachs (GS) and Morgan Stanley (MS) into bank holding companies a few weeks ago. We now know that American Express will seek $3.5 billion in order to relieve the strain on the company being applied by tight credit markets. This move will also allow AmEx greater access to the Fed’s discount window for its short term lending needs. However, as a bank AmEx will be subject to Fed supervision, which will in all likelihood place additional restrictions on its capital-to-debt ratios.

Under its former business model, AmEx pooled credit card debt into bonds which it then sold to institutions seeking the stream of income from consumers paying off those credit cards. Lacking the deposit base of a traditional bank, this was the only way for the company to raise capital to lend to its customer base. This structure allowed AmEx to partially shield itself from delinquencies while still receiving a majority—53%—of card revenue via merchant fees. However, ongoing difficulties in the credit securitization market worsened in October’s carnage, leaving AmEx with few funding sources. Investors were unwilling to take on the risk of American Express’s credit card holders, and the company was left with responsibility for more debt than it could comfortably handle.

American Express has felt the effects of the credit crisis for many months now—its profits declining for four straight quarters. In its most recent quarterly report, profits fell 24% to $815 million or $.70/share. This is certainly a byproduct of reduced consumer spending generating fewer transaction fees. Even more telling, the company boosted its provision for losses to $1.36 billion, an increase of 51% from a year ago. So, clearly AmEx anticipates more defaults in the near future, and with debt securitization as a funding source pretty much off the table for the time being, the company faces direct exposure to more bad debt. Thus, it only makes sense for AmEx to want to participate in recent government programs to boost the capital levels of financial services firms. Thus far, 52 companies have received approval to access more than $172 billion of the proposed $250 billion program. As Oppenheimer’s superstar analyst Meredith Whitney said in a note: “Whether institutions like it or not, the only prudent thing to do is assume a protracted worst-case funding scenario.”

We tend to agree with Whitney on this; it would be foolish for a company struggling in this awful credit environment not to take the government “bailout”, especially with so many of its competitors participating. However, it must give investors pause that American Express needs this shot in the arm. It is possible that, with defaults rising and no one to sell securitized credit card debt to, AmEx could have failed. That is very unlikely now with a bank holding company structure and a credit line from Uncle Sam.

As value investors, you have to consider the valuation of AXP. There is no doubt that compared to former historical norms the stock looks cheap, but we are not recommending AmEx in this circumstance. As much as we like the low valuation, you must consider the uniqueness of this situation. There are few trends suggesting that the consumer will be more able to pay his credit card bill in the near future than right now, which will hurt AmEx’s bottom line for at least a quarter or two. In addition, the Fed announced Wednesday that the TARP program will not be buying back distressed assets; however, they will be recapitalizing struggling institutions in an attempt to lubricate the credit markets. This course of action may take longer to produce results and we know that AXP needs the credit markets to return to some state of normalcy. At this point, American Express, while undervalued by historical norms, is simply too risky.

Comments

[investor88]

Agree AXP is too risky, it is not top quality investment grade in the light of current shaky business model.

2008 Nov 13 09:43 AM

[Chris B]

It is just me, or is it just freaking great that my tax dollars are now funding those social parasites known as credit card companies, the production of bling Hummer SUV's, and the same "investment" banks that moved their headquarters offshore to avoid paying taxes into the system they now suck money from.

2008 Nov 13 12:16 PM

[mdmrjsds]

On Nov 13 12:16 PM Chris B wrote:

> It is just me, or is it just freaking great that my tax dollars are
> now funding those social parasites known as credit card companies,
> the production of bling Hummer SUV's, and the same "investment" banks
> that moved their headquarters offshore to avoid paying taxes into
> the system they now suck money from.

I'm with you Chris B. I don't see how Amex is *essential* to the functioning of the American economy. If you allow Amex to receive money, there is no ethical way to deny GMAC, and thus GM, access to the same program. Actually, any firm that has a financing arm has to be granted access. So retail is now acceptable as well and Circuit City can suck at the public teat too.

I suspect this is a function of Hank Paulson's connections and favoritism towards finance, not any kind of rational policy. Hey, he's going to be looking for a job in a few months. ;-)

There was another post on Seeking Alpha about creating a new financial system with the 700 billion instead of just giving it to the failed institutions. seekingalpha.com/artic... Put them into chapter 7, and sell off their assets to the new institutions. Just like it is difficult to get union workers to think non union, it is difficult for these managements to think different business model. Better to just put them back into the job market and salvage the going concern parts of their business under new management (lop off three or four tiers, say all headquarters management levels).

Or they go into Chapter 11. Their boards of directors' made mistakes. Who selects the board of directors? Executive management, who also made mistakes. So the creditors force out executive management and the board of directors and everyone else pays. That's capitalism.

2008 Nov 13 01:10 PM

[isherlock]

this simply proves again how intelligent Ken Chenault and rest of the AMEX managements are. It's the very reason Warren Buffett invested in this company

2008 Nov 13 05:51 PM

[tshk1221]

Well, the interesting point is that the Oracle has been keeping this company very long time. Probably, his long-term holding of this company is because he knows that this company has proven survival skills accumulated for the last 50 years or more. Even if this financial crisis is directly hitting this company right now, I don't see this company will die soon. Price is very ok. However, fundamentally, there is a big issue for this company. Retained earnings are shrinking every year from 2005 to 2007. It is depleting retained earnings due to hefty interest rate costs it relies on for credit card lending. A real bad sign..ExxonMobil and Chevron's retained earnings are growing 15% - 20% every year. One thing this company must achieve to attract strong attention from real, long-term value investors..Investment in this company now could be very risky in consideration of its risky business nature, uncertain future as bank holding company and shrinking retained earnings, but, as you know, greatest return comes from greatest uncertainty.

2008 Nov 13 07:48 PM

[Skip Olinger]

Sorry, but WRONG! Amex's shrinking retained earnings is a result of their repurchasing stock, not high interest rates. Actually, securitizations, until recently, had very low interest rates. And, interest expense does not deplete retained earnings. Net losses, dividends and comprehensive income (loss) deplete retained earnings. In case you had not noticed, Amex generates about 30-35% return on equity in normal times. It does not require high reinvestment of its net income to grow its business. Therefore, they can pay dividends and repurchase stock thereby reducing shareholder equity. This increases returns to shareholders.
Hope this explanation helps


On Nov 13 07:48 PM tshk1221 wrote:

> Well, the interesting point is that the Oracle has been keeping this
> company very long time. Probably, his long-term holding of this company
> is because he knows that this company has proven survival skills
> accumulated for the last 50 years or more. Even if this financial
> crisis is directly hitting this company right now, I don't see this
> company will die soon. Price is very ok. However, fundamentally,
> there is a big issue for this company. Retained earnings are shrinking
> every year from 2005 to 2007. It is depleting retained earnings due
> to hefty interest rate costs it relies on for credit card lending.
> A real bad sign..ExxonMobil and Chevron's retained earnings are growing
> 15% - 20% every year. One thing this company must achieve to attract
> strong attention from real, long-term value investors..Investment
> in this company now could be very risky in consideration of its risky
> business nature, uncertain future as bank holding company and shrinking
> retained earnings, but, as you know, greatest return comes from greatest
> uncertainty.

2008 Nov 14 10:03 AM

[kurt walter]

AXP will be a $7.00 stock when the dust settles.

2008 Nov 14 02:26 PM

[Mowog]

I was surprised to learn AXP began lowering its standards to issue more cards and garner more customers, some of whom became (and will become) losses. But that's the US side of the business. AXP Japan refused me (despite being a shareholder, which doesn't matter) because I was working full-time at a salary nearly twice the national average, yet under contract; being a foreigner who can rack up debts then leave the country didn't help, either. I'll just hold my AXP shares for now and hope they return to being the pay-in-full customers' card. Repolish the brand and shore up the balance sheet.

2008 Nov 14 09:43 PM