American Express: Don't Be Fooled By Q2 Numbers

| About: American Express (AXP)

Summary

American Express reported seemingly remarkable earnings growth in the second quarter.

However, the growth was anything but remarkable, driven primarily by one-off gains and financial engineering.

With a low dividend yield and lackadaisical growth prospects, American Express just doesn’t provide good incentives for dividend investors to initiate a position.

Analysis

Second-Quarter Earnings. American Express (NYSE:AXP) had a solid second quarter, though you wouldn't guess it from its stock price. While American Express' second-quarter revenues were marginally lower, it managed to report earnings of $2.10 per share on July 20, which beat the $1.95 that analysts were expecting. This was the third-straight quarter that the consumer credit giant beat estimates as the company's strategy of acquiring proprietary card networks, spending on its global network and expanding merchant coverage proved successful.

Despite its run of better-than-expected earnings, American Express' stock is down 7.6% in the year-to-date, trailing the returns of both the Dow and S&P 500 during this period. Investors' disaffection with the stock can be traced to a perceived lack of direction or 'spark' for the company, with some analysts suggesting that much of the improvement can be traced to financial engineering in the form of cost cuts and share buybacks.

Dividend and Outlook. Another reason why investors may not be favoring the stock is its very pedestrian dividend. At 1.83%, investors only receive $183 in annual passive income for every $10,000 they have invested in the stock. That puts American Express near the bottom of all Dow Jones Industrial Average components.

Unlike in the last three years when the company raised its dividend after four quarters, American Express has kept its dividend at $0.29 over the last five quarters, similar to what it did from Q1 2012 to Q2 2013. Since its May dividend of $0.29 was the fifth quarter in a row that its dividend was at this level, and the company has received approval from the Federal Reserve to raise its dividend to $0.32, it's likely to announce a hike in its dividend soon. Even so, the company's dividend yield would be at just under 2% - still on the low side for a Dow stock but on the high side for a consumer financial services firm.

Although American Express has relatively average financial strength metrics, its risk-weighted capital remains strong, with a Common Equity Tier-1 (CET-1) ratio of 12.6%. This is roughly the same level that JPMorgan (NYSE:JPM) has and well above the Basel III requirement of 7%. In the event of a recession, American Express' CET-1 ratio would fall to 6.6% at its lowest point - still well above the Fed's required 4.5%. What all this means is that American Express has more than enough capital to weather an economic down-cycle - an important consideration for investors who are hoping to hold onto the stock for a while.

Of course, the relative safety of American Express really shouldn't surprise anyone who follows the stock - unlike Morgan Stanley (NYSE:MS) or Goldman Sachs (NYSE:GS), it doesn't make its money through proprietary trading, investing in hedge funds or private equity. Instead, it is best known for extending consumer credit - and in that regard, its second-quarter performance was unspectacular: on a constant-currency basis, American Express' credit card revenues increased by 1%. Meanwhile, its loan loss provisions fell by 1%, an indication that its credit quality remained strong.

That said, there is some meat to the assertion that American Express' strong performance is the result of financial engineering. To wit, at the end of the second quarter, its share count had fallen to 941 million shares - a 7% reduction in its share count from a year earlier. Had its share count remained the same, the 48% annual increase in its net revenues (from $1.42 to $2.10) would have become a 37% increase instead (from $1.42 to $1.95). What's more, American Express' second-quarter revenues of $2 billion relied heavily on a $1.1 billion gain associated with the sale of its Costco (NASDAQ:COST) co-brand portfolio. Absent that gain, its net income would have fallen by 38% for the period.

Why is all this important to dividend investors? Simple: it will impact American Express' ability to grow its dividends in the future, leaving American Express with a stale dividend yield. To wit, once American Express raises its dividend to $0.32 some time in the next month, it will have raised its dividend by just 10% over its previous dividend - its slowest rate of increase since it raised its dividend by 2 cents in 2012 - right as the US economy was emerging from a prolonged economic downturn.

The truth is, a company that's confident of its future prospects would not be relying on one-off gains and stock repurchases to build a momentum narrative. This is a sentiment echoed by Charles Munger, Warren Buffett's long-time partner at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), one of American Express' largest shareholders.

It's also a sentiment held on Wall Street: they're forecasting just 2.2% growth for American Express this year and 7.7% average annual growth over the next half-decade - slower than the pace for similar companies. In that sense, it's understandable that American Express is trading at a Price-Earnings ratio that's at a discount to the market. As technology companies like Tesla (NASDAQ:TSLA) demonstrate, investors are willing to pay for growth and American Express is just not growing by much. What's more, it's under fire from competitors like Visa (NYSE:V), which is moving ahead in expanding its market footprint.

Conclusion

Given all the above, we are skeptical that American Express provides the best opportunity for dividend investors. While it's cheap, it's trading at about the same level as JPMorgan - but paying a much lower dividend yield (33% less to be exact). At the same time, American Express isn't reporting particularly strong growth in any of its main business segments, again unlike JPMorgan, which reported strong fixed income trading revenues on top of reporting solid credit card business growth.

Thus, in a world where investors have to make a choice when allocating their limited assets, we believe that American Express just isn't providing the right incentives (a high yield, good growth prospects) to warrant an earmark. Investors are far better off looking elsewhere.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.