American Express Calls Investment Banks' Bluff

Includes: AXP, BAC, C
by: Graham Summers

I guess it all depends on what you look for.

Analysts and the talking heads have largely chosen to ignore several key developments in their assessment that it’s time to buy financials stocks. As I mentioned in Monday’s essay, this current market rally, led by financials, was largely the work of the SEC crushing shorts. The icing on the cake for the “worst is over” crowd were better than expected results from Citigroup (NYSE:C) and Bank of America (NYSE:BAC).

Setting aside the fact that most of these “better than expected” results came from smaller write-downs—a bogus reason given that most of the assets on these firms’ balance sheets are valued in-house (subjective), not by the market (more objective)—consider that all of these firms are still losing money. For instance, Citigroup announced a 29% decrease in revenue from 2Q07, write-downs of $7.2 billion, and a total loss of $0.49 per share (analysts expected losses of $0.66 per share).

These results aren’t “better than expected,” they’re “less horrendous than expected.”

Beyond this, I have difficulty understanding how Citigroup and others are beating estimates while American Express (NYSE:AXP), the ultra-prime of the credit card companies, just announced that both results and credit conditions are worsening.

On Monday, American Express announced profits of $0.56 per share, compared to analyst expectations of $0.83 per share. All told, second quarter earnings fell 38%. That’s bad enough, but listening to AXP CEO Kenneth Chenault on the post-earnings conference call, it’s clear things are getting worse, not better.

Accord to Chenault, “Over the past month or so we have seen clear signs that the U.S. economy is weakening. Unemployment rates, as we know, took the largest jump in over 20 years. Home prices declined at the fastest rate in decades and consumer confidence is at one of the all time low points… This fallout was evident across all of our consumer segments, even our longer-term super prime card members… In other words, more and more consumers who are falling behind in their payments are remaining delinquent.”

AXP is the cream of the crop for credit card companies. AXP cardholders charge an average of $12K a year, roughly five times that of Visa or MasterCard holders. They spend more and default less. So to hear that AXP is experiencing a higher rate of defaults than expected, as well as a greater number of AXP cardholders remaining delinquent, is truly worrisome.

Chenault continued, “In light of the magnitude of the negative economic trends and our experience, we now believe the economic weakness in the US will likely worsen throughout the remainder of the year and negatively impact credit and business trends ... we now expect that our lending write-off rate in the third and fourth quarter will be higher than June levels.”

So we’ve got the top of the line, ultra-prime credit company missing analyst estimates and worrying that things are getting worse, while investment banks beat estimates and proclaim that conditions have improved dramatically.

Somehow I don’t think the banks are being totally candid.

Over the last three quarters, banks and other major financial firms have employed countless tactics to bolster their results. Whether it was public announcements—the CEOs proclaiming “the worst is over”—or fuzzy accounting—recording write-downs in debt as profits or moving more assets to Level 3, thus removing any mark-to-market valuation—these guys have done everything they can to make their results look “better,” I mean, “less horrendous,” than expected.

They’re still doing it now. And things are going to get a lot worse before they get better.

I’m looking around for more shorts in the financial sector. This latest rally has all the hallmarks of the last one—change in sentiment, better than expected results, worsening fundamentals. When the party’s over and the shorts have covered, financials will begin their next step downward. I want to profit when they do.