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Mariusz Skonieczny
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Mariusz Skonieczny is the founder and president of Classic Value Investors, LLC, an investment management firm. He is the author of "Why Are We So Clueless about the Stock Market. He is also the editor of Ultimate Value Finder, a monthly newsletter that features three underfollowed,... More
My company:
Classic Value Investors, LLC
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Classic Value Investors Blog
My book:
Why Are We So Clueless about the Stock Market?
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  • If it's not the time to buy American Express, then when is it?
    Tuesday, July 28, 2009

    Every day I listen to experts argue about when is the best time to get back into the market, and I have to say that I am sick of it. They tend to find something to worry or disagree about. One day, it might be about future inflation, and another day, it might be the weakness of a dollar. When the stock market appreciates for several days or weeks, they start questioning whether the rally is for real and how long it will last. My take on this is: “Please, stop scaring people because they have had enough.” This article is not about the general direction of the stock market or the economy, but about American Express and how it just might be an excellent buy for long-term investors.

    At the beginning of this month, American Express’s stock was trading at $23, which is as low as the lowest price in 1998. Is the stock cheap? To answer this, let’s learn a bit about the company and its industry.

    Description of the Company and its Industry

    American Express is a leading global payments, network, and travel firm that was founded in 1850. The company’s business consists of two segments: Global Consumer and Global Business-to-Business. Global consumer includes products such as charge and credit card products for consumers and small businesses worldwide. Global business-to-business includes business travel, corporate cards, network services, and merchant services.

    American Express, just as other credit card companies, makes money from two primary sources: fees and interest income. Fees include merchant discount fees, annual membership fees, late fees, service fees, and foreign exchange fees. A merchant discount fee is a payment that a merchant makes when a consumer purchases its products or services. The amount of the fee ranges depending on what card is used. Interest income is earned simply when a customer carries a credit card balance and is charged a hefty 20 percent or more interest rate.

    How is American Express different?

    When people think of paying with plastic, three companies come into mind: Visa, MasterCard, and American Express. Visa and MasterCard operate in a similar way, but they are different from American Express. Visa and MasterCard are not credit card companies. They are networks, meaning that they do not extend credit and only process transactions.

    There are two types of credit card networks: open and closed. Visa and MasterCard participate in an open credit card network. In this type of network, the merchant discount fee is split among different members because each of them performs a different function. There is the card issuer, the merchant acquirer, and the network. The card issuer could be a bank, such as Bank of America or an insurance company, such as State Farm. The merchant acquirer is a company that pays the merchant and connects it to the network, which in this case could be Visa or MasterCard.

    American Express operates a closed network, where the company acts as the issuer, the merchant acquirer, and the network. As mentioned before, because the company performs all these functions, it keeps the entire merchant discount fee.

    The company is also different from other credit card companies because it follows a “spend-centric” business model instead of “lend-centric.” Most credit card companies have the latter business model, meaning that the majority of revenues are earned by charging high interest rates on credit card balances. American Express makes only 11 to 13 percent of total revenues from interest income. Because its business model is “spend-centric,” the majority of revenues come from the merchant discount fees. This is an important distinction because as more people default, American Express is less affected by it than other credit card companies, such as Capital One.

    American Express Advantage

    Not only does American Express keep the whole merchant discount fee, but also charges a higher fee compared to the competitors. The merchant discount fee is slightly over 2.5 percent for American Express and 2.0 percent or less for the competitors. Why is the company able to do that? It is because its card holders spend significantly more than card holders of competing cards. But why? To answer this, one has to understand the history of American Express.

    In the early days, the company was mainly a travel firm and people using its services were wealthy individuals. When it transitioned into being a credit card company, it already had relationships with big spenders who are more valuable to merchants. These merchants are willing to pay a higher fee to get these spenders in the door.

    The company also encourages its card holders to use the card as much as possible. It does so is by charging annual membership fees and offering rewards. Card holders who pay annual fees are more likely to use the card frequently to earn rewards to justify the annual cost. As a result, the company is able to offer the best rewards in the industry.

    American Express has another advantage, and it stems from operating a closed network. Because the company performs all the functions, it has access to information from direct relationships with merchants and card members. Because of this advantage, it is able to market and promote its services in more targeted way than competitors using the open network.

    Since a closed network offers advantages over an open network, why don’t other credit card companies operate in the same way? Because, it is not easy to build a closed network. Over the years, American Express had to recruit merchants that were willing to accept its card and also card holders that were willing to use it. In order for merchants to accept the cards, they want to make sure that there are card holders willing to pay with it. Card holders, on the other hand, are not willing to sign up for the card unless they know there are merchants accepting it. It is a Catch 22 for any company trying to duplicate what American Express has done. This gives the company a tremendous advantage.

    Profitability of American Express

    This advantage allowed the company to earn incredible returns on equity. According to Value Line, the company earned the following returns on equity:





















    The rest was used to grow earnings. The earnings per share are shown below:





















    Current Situation

    During the current recession, most companies are experiencing problems, and American Express is no different. During past recessions, the company was immune to problems shared by others because affluent consumers held up relatively well compared to the broader population. This recession, however, is different because it is hitting the affluent hard. Many of these consumers saw their home value, personal wealth, and job security erode. As a result, they cut back significantly on their discretionary purchases.

    American Express saw a decrease in overall spending, which affected the merchant discount fee. It also saw an increase in late payments and defaults in the charge cards and lending portfolios. The company had to add more money to its credit reserves to protect it from future losses.

    When consumers purchase items from merchants, they do not pay for the purchases immediately. Usually, they have 30 days to pay off the card. Meanwhile, the merchants get the money advanced by American Express, which finances these amounts through various types of financing. During the fourth quarter 2008, some of the financing options, such as commercial paper froze up, making it difficult for American Express. This is when the company searched for other financing alternatives. As a result, the company became a bank holding company, because this classification allowed it to benefit from government assistance and permitted it to accept retail deposits. The company received $3.39 billion from the government, which in return received preferred shares of American Express. On June 17, 2009 the company announced that it has repurchased the $3.39 billion of preferred shares.

    Things got so bad that the company only earned $0.32 the first quarter of 2009. On an annualized basis, this is $1.28, and it represents a considerable drop from $3.29 and $2.33 in 2007 and 2008, respectively. Because the company’s management forecasts that fundamentals will deteriorate further, Value Line estimates that earnings per share will be $0.90 in 2009. The last time earnings per share were this low was in 1994. The good news is that the company is still profitable due to its flexibility in its cost structure, which can be adjusted with the level of revenues.

    American Express Valuation

    Some experts argue that American Express’s stock is undervalued and others disagree. Perhaps the bears see nothing but negative news and continued deteriorations in the economy. But, I tend to agree with the CEO of American Express who said,

    “… just as good economic times don’t last forever, neither do bad times.”

    So what exactly is American Express’s stock worth? I will not get into too much detail here. I teach investors how to value companies in my book, Why Are We So Clueless about the Stock Market. In this blog, I will do a comparative analysis of 2008 vs. 1998 and let readers draw their own conclusions on whether American Express is overvalued or undervalued and whether it is a good buy.

    I chose 1998 because this is the level that the stock is trading at as of this posting.




    $19.1 billion

    $28.4 billion

    Net Income

    $2.1 billion

    $2.7 billion

    Cards in Force

    42.7 million

    92.4 million

    Card member Spending



    These findings tell us that if we bought the stock in 1998, we would acquire a company with $19.1 billion in revenues, $2.1 billion in net income, 42.7 million cards in force, and $6,885 average card member spending. Fast forward to 2008 and 2009 - we could purchase this same company but with a much better earning power of $28.4 billion compared with $19.1 billion, with 94.4 million cards in force compared with 42.7 million, and with $11,594 average card member spending compared with $6,885. The only metric that is almost the same is the net income. What did it take to increase net income from $2.1 billion in 1998 to $3.9 billion in 2007? It required more card members, which resulted in more cards in force, and higher average card member spending.

    Today, the company already has it all. It has more card members than it did in 1998, and these members also spend significantly more dollars than they did in 1998. But, the market is pricing it identically to what it did in 1998. What needs to happen now for net income to return to more normalized levels? Card members have to stop seeing their home values, personal wealth, and job security erode. This will only happen when the economy improves. The improvement will not happen overnight, but eventually it will take place. When net income recovers to a more normalized level, what likely to happen with the stock price? Well, readers can make this determination themselves.


    Disclosure: Long AXP at the time of this article
    Tags: AXP
    Dec 02 8:49 PM | Link | Comment!
  • Arctic Cat: Is this a SCREAMING DEAL or not?
    Thursday, June 18, 2009 from Logical Stock Market Investing Blog

    Arctic Cat manufactures snowmobiles and all-terrain vehicles (ATVs) and sells related parts, garments and accessories. The company was formed in 1983 as a snowmobile manufacturer.

    In 1995, the company entered the fast-growing market of ATVs. Because it had already established its brand among snowmobile customers, it was logical to cross-sell them and offer ATVs. In 1996, only 3 percent of revenue came from ATV sales. By 2007, 55 percent of revenues came from ATVs and only 32 percent came from snowmobiles. From the time that Arctic Cat entered the ATV market, its sales grew faster than the industry's. Based on several conversations with dealers of Arctic Cat, some of the reasons for Arctic Cat's success in the ATV business are:

    • brand loyalty from the snowmobile clients
    • superior suspension system
    • high durability
    • faster response time for customer demand as a result of the company's smaller size
    • innovation where competitors, such as Honda, are too complacent

    Arctic Cat has a better brand name in the snowmobile market and faces fewer competitors (Polaris, Yamaha, and Bombardier) than in the ATV market (Polaris, Honda, Yamaha, Kawasaki, Suzuki, and Bombardier).

    Its stock is extremely attractive because of the trading price. As of the date of this posting, the market capitalization (total # shares x price per share) for the entire company was approximately $70 million. Its inventory cost the company more than the price tag of the entire company. But some might argue that the inventory value is declining because fewer customers are buying snowmobiles and ATVs in this economy. While this is true, it does not mean that the stock is not a good deal.

    Let's say we want to get into the business of manufacturing snowmobiles and ATVs because we believe that eventually the economy will be better than it is today. What things do we need to start? Besides technical knowledge, we would need a factory, equipment, tools, raw materials (inventory), etc. These are all the things that are listed on Arctic Cat's balance sheet. Let's say we spend a total of $100 million, of which $50 million is spent on inventory and the other $50 million on equipment, tools, and a factory. Would it make any sense for us to say, "Well, we are losing money this year so we will sell it all for $25 million, which is half of what we spent on inventory?" Clearly, it would not make any sense, but this is what Arctic Cat is selling for.

    But even if we could produce these snowmobiles and ATVs, how are we going to sell them? Most of these products are sold by dealers and trying to convince them to carry our product would not be easy. Without an established brand name, building a network of dealers is extremely hard and it would take a significant amount of time and money. The Arctic Cat brand has been around for 45 years, and the company established itself as a leader in snowmobiles and a significant player in the ATV business.

    The company already has a strong dealer network. It is not hard to see that its brand name and dealer network are assets to a company such as Arctic Cat. Since they are assets, they must be included on the balance sheet, right? Actually, they are not, even though they probably are worth more than any single item listed on the balance sheet. A balance sheet mainly includes historical costs such as inventory, equipment, and properties. Arctic Cat did not purchase its brand or its dealer network but built both by promoting and advertising over many years. Promotion and advertising are expensed as incurred, and they flow through the income statement and do not create an asset. The only way for Arctic Cat's brand and dealer network to appear on the balance sheet would be when an outside company such as Polaris or Kawasaki purchases the company outright. Then, all the tangible assets such as inventory, equipment, and property would be recorded on the acquirer's balance sheet and the difference between the purcahse price and tangible assets would be recorded as goodwill.

    Even if the brand and dealer network were worthless, buying the stock of Arctic Cat is still below net working capital (current assets - current liabilities). Anybody buying Arctic Cat outright could liquidate the company by selling inventory, equipment, and properties and still end up with more money than the $75.5 million dollar price tag.

    So, why is the stock so cheap? As a start, Arctic Cat is bleeding cash. Because the economy is weak, people tend to postpone purchases of discretionary items such as snowmobiles and ATVs. Also according to the article "Thin Ice at Arctic Cat" by Dee DePass (, some institutional holders bailed out, selling 12 million shares on the market. Keep in mind that there are only about 18 million shares outstanding and Arctic Cat's stock does not trade on huge volume. Imagine what can happen to the price of a stock when 66 percent of shares are being sold. Driving the price to the current levels is beyond logic. Professional money managers are people and just like individual investors, when the fear of losing money is present, logic goes out the window. The good news is that when the stock is purchased before some of the institutional investors return as the economy improves, the stock price has a chance to take off like a rocket.

    But since the company is losing money, it can go bankrupt, right? What is the requirement for a company to go bankrupt? It first must have debt, and Arctic Cat has no debt. Arctic Cat learned its lesson in 1981 when it went bankrupt after lenders called all the loans due. The original founder and some key managers went to the auction and bought up the company in pieces and started Arctco, which later became Arctic Cat.

    Even though Arctic Cat has no debt, it is still losing money because of large fixed expenses associated with the manufacturing business. To preserve cash, the company already suspended share buybacks and divideds. From my estimation, the company will lose anywhere from $30 to $50 million in 2010, and it does not have enough cash on hand to weather this situation. But just because the company is losing money does not mean that the stock price will drop more or is not a good buy. As of this posting, the market knows the company will continue to lose money, so this information is already priced into the stock.

    The bottom line is this - Arctic Cat will have to get the cash to cover the shortfall. Some market participants are worried that Arctic Cat will not be able to raise any cash because no one will want to lend them money. I have a different view. If the company cannot secure any conventional financing, it still has many options. First, it can get an asset-based loan against accounts receivable and inventory. Second, the company owns some real estate: manufacturing/corporate office (558,000 square feet), distribution center (220,000 square feet), test & development facility (3,000 square feet), and manufacturing facility (60,800 square feet). Many investors overlook real estate. Having experience in commercial real estate, I know that Arctic Cat could easily sell these facilities to raise cash and lease them back from the buyer. This is called a sale-leaseback transaction. Third, even if all of the above fail, the company may sell itself to the bigger players such as Polaris, Kawasaki, Suzuki, etc. All of these players would love to acquire the brand name of Arctic Cat.

    Last time I invested in a similar situation where financing was in question, I more than quadrupled my money. The company was called Teck Resources (NYSE:TCK), and I bought it for $3.32 and sold it for $14.35.

    Arctic Cat is a great company with a recognizable brand name. Currently it is going through tough times due to the economic recession. Patient investors might find the stock to be attractively priced. But before investing in the company do you own research and consult your financial advisor.

    Disclosure: Long ACAT
    Tags: ACAT
    Dec 02 8:45 PM | Link | Comment!
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