Should You Buy Up Some Shares Of This Credit Card Stock?

Includes: AXP, COF, DFS, MA, V
by: Insider Monkey

By Matt Doiron

American Express (NYSE:AXP) was up about 30% in the first half of 2013, with the stock remaining at about that level after the company reported results roughly in line with expectations. Revenue net of interest expense grew by 4% last quarter compared with the second quarter of 2012. While American Express did increase provisions for loan losses and other expenses as well, net margins increased slightly with the result being a 5% increase in net income. Thanks to the company's significant buyback program earnings per share for the quarter increased to $1.27 compared to $1.15 in the prior year period. In the first half of the year most of American Express's cash flow from operations went to paying down debt, though over $2 billion in cash was used on share repurchases.

At current prices American Express trades at 18 times trailing earnings. Generally that might be considered a high valuation for a company, which is only growing its net income at a slow rate. However, in the case of American Express we do have high cash flow helping the company repurchase shares, and combining this reduction in share count with low growth in the business could help generate decent increases in EPS (as it did over the last year). Analysts expect earnings per share to increase 10% next year, in line with the recent results.

We track quarterly 13F filings from hundreds of hedge funds and other major investors, using the results to help us develop investment strategies. According to our analysis, the most popular small cap stocks among hedge funds generate an average excess return of 18 percentage points per year (learn more about our small cap strategy) and our own portfolio based on this finding outperformed the S&P 500 by 33 percentage points in the last 11 months. We can also use this database to track interest in individual stocks; for example, billionaire Ken Fisher's Fisher Asset Management owned almost 11 million shares of American Express at the end of March (see Fisher's stock picks). The company was also among Warren Buffett's Berkshire Hathaway's top picks (find Buffett's favorite stocks).

American Express's forward valuation occupies a middle ground between four other stocks known for their credit card businesses. Mastercard (NYSE:MA) and Visa (NYSE:V) are valued at forward P/Es in the 20-21 range. It should be noted that in these companies' most recent quarter each of them recorded significant increases in revenue compared to the same period in the previous fiscal year. Mastercard's revenue rose by 15%, with net income increasing at a slightly faster rate; however, judging from the trailing earnings multiple of 27 its valuation already assumes further increases in profits at least in the short term. Visa saw its revenue grow 17%, resulting in a large percentage increase in operating income even if we add back a large litigation charge to last year's results. We are skeptical that these companies can continue their high growth rates, but they may be worth watching just in case.

Capital One (NYSE:COF) and Discover (NYSE:DFS), meanwhile, are valued at forward earnings multiples of only 10. Capital One, aided by the additional business from acquisitions, delivered high growth on both top and bottom lines. In addition to the fact that the earnings multiple is in value territory, the company also trades right about at the book value of its equity. As such it may be worth thinking of as a value play. Similarly, Discover saw its earnings grow by 12% in the third quarter of its fiscal year (the quarter which ended in June) versus a year earlier and given where the stock is trading really any increase in net income going forward would make it attractive at the current price, even if it does not have the brand power of Mastercard or Visa.

As a result we think that value investors may want to consider Capital One or Discover as potential value stocks, and look into whether these companies will be able to maintain their current business in the future. American Express trades at a premium to these companies, and is dependent on continuing to grow its profits so that future buybacks can have a positive multiplier effect on earnings per share. We wouldn't rule it out but given that its earnings growth rate has been lower than that of these two peers recently it seems risky to invest on the theory that this trend will reverse.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article is written by Insider Monkey's writer, Matt Doiron, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article.