Financials have been one of my strongest picks. Since I first touted American Express (AXP) here, the stock has gained around 20% beating the Dow Jones by 815 basis points. As strong of a return as this was, I still urged investors to look for even more undervalued financial companies. My top choice, Barclays (BCS), has been a total grand slam. Investors who just followed my advice would have seen their holdings gain 62.4% - more than tripling the return on an already strong Dow Jones. Going forward, I urge investors to steer away from American Express and immediately buy shares in Capital One (COF) and Discover Financial Services (DFS).
In this article, I will run you through my DCF analysis on Amex and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Capital One and Discover. The aim is to definitely prove that my original price target has been fully appreciated by the market and that you should now invest in Capital One and Discover.
First, let's begin with an assumption about revenues. Amex finished FY2011 with $32.3B in revenue, which represented a 7.6% gain off of the preceding year: deceleration. Analysts model a 10.6% per annum growth rate over the next half decade. This is reasonable as it is in-line with what is expected for the S&P 500.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model OPEX as 80% of revenue versus 2.5 - 3% for capex. Taxes are estimated at 30% of adjusted EBIT (accounting for non-cash depreciation charges).
We then need to subtract out net increases in working capital. This is estimated to hover around 2% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by 8.5% yields a fair value figure of $59.03. This is almost precisely where the stock is now and where I said it was going to be four months ago.
All of this falls within the context of better-than-expected performance:
Now this is a full year slide for 2011, and total revenues net of interest expense was $30 billion. That's up 7% on an FX-adjusted basis. That's very favorable compared to most of the other issuing competitors. EPS was $4.09, up 22%. So that's strong performance well above our EPS target of 12% to 15% growth.
From a multiples perspective, Amex is no longer attractive. It trades at a respective 14.3x and 12.4x past and forward earnings versus just 8.2x and 8.4x for Capital One and 7.7x and 9.2x for Discover. Assuming a multiple of 15x and a conservative 2012 EPS of $4.09, the rough intrinsic value of AXP is $61.35/share.
Consensus estimates for Capital One's EPS forecast are that it will decline by 14.1% to $5.84 in 2012 and then grow by 14.9% and 12.1% in the following two years. Assuming a multiple of 10x and a 2013 EPS of $6.90, the rough intrinsic value of the stock is $69. The firm has transformed itself from a diversified commercial bank into a bit of an online bank. While I am reserved about the extent to which ING Direct and HSBC's card business will be accretive to EPS, I think the solid balance sheet and brand hedges against more risk than what the market acknowledges.
Discover, on the other hand, has limited upside. Margin pressure from member banking and uncertainty over financing are considerable risk factors. While this will help to generate higher returns in the event of a recovery, it adds to the downside. Assuming a multiple of 9x and a conservative 2013 EPS of $3.33, the rough intrinsic value of the stock is $29.97. Since I believe there will be a recovery instead of a double dip, I strongly recommend opening a long position.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.