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.