The Long Case for American Express 10 comments
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Over the last couple of weeks, American Express (AXP) has become a favored whipping boy of the financial shorts, who point to the company’s recent bad quarter and exposure to consumer credit as reasons the stock will continue to decline. While the idea that Amex will continue to face problems isn’t wrong on the face of it, what a lot of people are missing is the fact that Amex is still outperforming the other credit card companies - and it took a year for the problems facing the rest of the credit card industry to catch up with Amex.
This, along with several other reasons, is why I think Amex will recover faster than its competitors once the economy picks up.
Charge Cards: One key difference between Amex and its competitors is that Amex isn’t really a credit card company - it's a charge card and travel services company that also issues credit cards, and in the U.S. nearly 80% of Amex’s cards in force are charge cards, not credit cards. This is important for a couple of reasons:
Charge Card customers have to pay their balances in full each month, so they can’t really use their charge cards to extend their purchasing power the way a credit card holder can.
A delinquent balance on a charge card is roughly 4-6 weeks’ worth of spending, while a delinquent credit card balance can have months, if not years' worth of spending.
Credit customers often pull back on their spending due to being maxed out/forced to by debt levels, while a charge customer is often pulling back due to cash flow, wanting to restrain spending, etc., more so then debt levels. As a result, when the economy picks up or their finances recover, it’s much easier for a charge card customer to resume spending.
When we look at the charge card business we find that the provision for losses and benefits only increased by 3.43% YoY, the delinquency rate grew by 14% and the net loss rate increased by 47% to 0.44%. We also see that net card fees (primary generated by the charge card business) increased 15% on a YoY basis. While these metrics are negative for AXP (in comparison to past performance), they would constitute stellar performance for any other credit card company.
Despite the issues mentioned above, the underlying charge card business is relatively healthy when you consider the current consumer credit environment and how AXP’s competitors are doing in comparison. This also means that the problems at AXP are primarily confined within its smaller credit card unit, and are probably the result of AXP acquiring weaker customers as it aggressively marketed credit cards during the housing boom. Once these weaker customers are “shaken” from the tree, AXP will still see higher delinquencies than the historical average, but will still have a strong core of customers to move forward with in the future.
Travel Services: AXP’s travel business is doing very well right now and saw a 17% YoY increase in revenue in Q2. This, despite higher fuel costs and the economic downturn. This seems to indicate that while there are some issues across Amex’s businesses, they still have a strong core of customers who are increasing their spending on travel and other discretionary items.
Credit Quality: FICO scores have actually increased since 2004 and are actually higher than 2006-2007 levels, indicating that AXP has managed to increased overall credit quality during a time period where nearly every other banking firm has seen credit quality decrease. It also means that nature of the economic difficulties facing Amex’s customers are of a different flavor then the ones facing other lenders - think "struggling to make ends meet" vs. "not being able to meet your obligations at all."
Proprietary Network & Partner Cards: Something else that American Express has going for it is the fact that they own the proprietary network that their cards are processed on, a network that charges higher fees than MasterCard (MA) or Visa (V).
Additionally, Amex now has partner arrangements with other banks that are now issuing American Express Cards. For the most recent quarter, Amex reported a 28% YoY increase in cards issued by partner banks, a 42% increase in spending on global network cards, and their Global Network & Merchant Services unit saw a 12% YoY increase in net income.
Outside of Visa and MasterCard, I can’t think of another company in the credit card business that can tout a double digit increase in net income in a business segment that’s related to credit cards. Not only will their network businesses help Amex mitigate its credit losses but it will also give Amex a piece of its competitor’s recovery. If they can generate a 12% YoY increase in net income in this environment, how will this unit perform once the economy comes back?
Affluent Customer Base: Amex has built its business by catering to high income people with stellar credit ratings; the fact that Amex was slower to succumb to the consumer credit bubble and has significantly lower magnitude problems is a testament to this. It also means that Amex’s high-end customers should enable the company to recover faster than its competitors. Amex’s affluent customers coupled with their charge card and travel services businesses are assets which, when compared to its competitors, better position the company for recovery.
Mortgages: Unlike practically all of its competitors, Amex isn't losing billions on mortgages, using write down related accounting tricks to inflate its balance sheet with paper profits and raising cash to offset losses. One of the reasons I like Amex is that beyond the structural advantages, it's not suffering under the weight of the malaise infecting the rest of the financial industry. I don't have to worry about the company suddenly announcing billions in write-downs related to mortgages.
Overall, I think the best way to view Amex is as a company whose weaker businesses (traditional credit cards) are overshadowing strong growth in its fee, network services and travel businesses. I also think that Amex’s current problems need to be viewed in the proper perspective vs. their competitors' because at the end of the day they’re still out-performing the other credit card issuers. This means that Amex is still the cream of the crop in the credit card business. If you’re looking for a beaten down credit card issuer to invest in so you can profit when the market recovers, you could do a lot worse than investing in Amex and all of its strengths.
Does this mean that Q3 won’t be worse or that I expect the company to recover in 3-6 months? No. It means that Amex still has the strongest business amongst credit card issuers and will be the one to recover first. 18-24 months from now, I expect Amex shares to be trading higher than where they are now, even if they go down a bit first.
Disclosure: At the time of publishing, the author didn't own a position in any of the companies mentioned in this article.
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AXP, you've got to be kidding!
Visa, yes.
People conclude the world is ending because AXP has some credit losses. But AXP has been building share with the knowledge that increased losses will result as the new clients are seasoned: an investment in the future. They aren't too worried because V and MA are in effect funding those losses with the $4B pretax they need to fork over. Once the good loans are seasoned and the bad ones are written off, AXP will be sitting pretty.
V/MA investors are full of themselves now because they don't have credit risk. But the cycle will turn and they won't have credit profit. Further, they won't have a friend in the banks anymore. They are simply processors with a monopoly, and they still have a big target on their backs from antitrust regulators. As Markham points out, they don't own their customers so AXP will try and pick off their best ones. They will be targets of merchant ire. They don't really have a strong position in foreign intracountry charges so don't benefit from that growth. They are overvalued.
This idea that "V/MA good, AXP bad" regardless of current valuation is so simplistic it would be funny except that a lot of naive investors may end up getting burned.
You could literally wait until the end of the year- and jump in with little to no loss of profit in the meantime. So if you want to buy the stock cheap and sit on it- yes, the author is right- AXP is a good buy.
Or, you could buy V shares right now - in the 73 range- and actually make money on your investment- It is entirely up to you.
AXP is the largest card issuer in the world based on total billed business. It billed $181B in 2Q08. The next largest was Citi at $106B (1Q08). That is 71% more than its closest competitor. They have about 24% of total US purchase volume. Discount revenue was up in 2Q08 by 8.7% YOY and their average discount rate was 2.56%. I am pretty sure that is significantly higher than V or MC. (Let me know if you have that stat) You did not mention their superior rewards program that they can afford through their higher rate that locks in customers. Also, Basic cards in force grew 11% (7% US, 17% non US). Their average FICO at acquisition in 1Q08 was 733 charge, 750 credit. This company produces a great ROE of 35% in normal times and they expect to grow EPS 12-15% per year again in normal times. Their earnings declined 36% this quarter. But all in all, this is a great world wide franchise producing great returns with shareholder oriented management and is not going to go away.
The big issue right now is increasing credit losses on their LOAN portfolio. As you point out their CC receivables are showing higher wirte offs but it is not that bad. It is their loan portfolio of $49.7B ($77B including their OBS securitization) that has blown their credit models and incured a 141% increase in 2Q08 YOY. And the company has said they can't predict where it will stop.
So how bad can it get? Looking at a historical chart provieded in their 2/08 presentation, Net Write Offs went as high as 10% in '91 and dropped to around 7% the following year. It reached 7% 2 more times in '98 and '02. It looks like it averages around 4.1%. AXP would make the case that they are better at credit evaluation now. Who knows? Their charge off rate in 2Q08 was 6.7% on a managed basis or $827M on a loan portfolio of $49.7B. This write off rate and the related provisioning caused them to lose money in their US card business for the quarter. So if their write off rate increased to 10% over the next 12 months, that would be an additional $416M in expense per quarter on top of the $827M. I assume the loss provisioning ultimately equals the write offs. While not good at all, the company would still make money. Pretax earnings for this depressed quarter were $766M.
Bottom line - this is a well run company with a very powerful worldwide brand that produces great returns on capital. It is going through a significantly difficult time. Like with all financial companies you never know how bad it will be until its over. But 12-18 months of below target performance does not kill the company. The stock is trading at depressed levels. At $36 per share it is around 15-16x depressed earnings. If you look out 3-5 years and assume the company will be earning what it did in '07 it is trading at 10.6x. Their model is not broken. The stock is cheap.
There model is not broken- agree 100% - and their default rates are actually reasonable- BUT- you must be willing to sit on your shares- and I repeat the same question; WHY??
Why would you want to do so- when you can actually make money. You will have months to move into AXP- there is no rush. If anything- why not just buy some LEAPS on AXP if you really want to sit on the shares- without tying up all your capital?
V is still a much better buy right now.
Final thoughts: Visa is a great long term play- and I have no doubts about that. Wish you all the best of luck on all your holdings and making it through the rest of the year in one piece!
GOOD LUCK