Buffett Stocks In Focus: American Express

| About: American Express (AXP)

This post was written by Nicholas McCullum for Sure Dividend

Warren Buffett is one of the most famous - and most successful - investors of all time.

As the chairman and chief executive officer of Berkshire Hathaway (BRK.A, BRK.B), he has an investment track record that is unmatched. Luckily, investors can piggyback off of Buffett's success by looking at Berkshire Hathaway's dividend stock portfolio. Buffett is required to disclose his holdings through 13F filings, which are filed with the Securities and Exchange Commission and detail the company's portfolio of common stock investments.

American Express (NYSE:AXP) is a core holding in Berkshire Hathaway's portfolio. As of 12/31/2016, American Express was Berkshire's fifth-largest holding, behind:

  • Kraft Heinz (NASDAQ:KHC)
  • Wells Fargo (NYSE:WFC)
  • The Coca-Cola Company (NYSE:KO)
  • International Business Machines (NYSE:IBM)

The story of Buffett's original acquisition of American Express has become a legend in the world of value investing. Buffett original invested in American Express back in 1964, when the company was going through the famous "salad oil scandal".

This major corporate scandal was centered around a company, Allied Crude Vegetable Oil, that discovered it could obtain loans based on its inventory of salad oil. Knowing that salad oil would float on water, company workers filled barrels mostly with water to fraudulently "increase" their inventory and qualify for larger loans.

These loans were disproportionately large given the economics of the underlying business. Eventually, the company defaulted, and American Express suffered losses as one of its creditors. The markets punished American Express' stock, presenting a buying opportunity for Warren Buffett and Berkshire Hathaway.

Now, decades after the scandal, Berkshire Hathaway owns 151,610,700 shares of American Express worth approximately $12 billion.

This article will discuss the investment prospects of American Express in detail.

Business Overview

American Express is a large credit services business. The company can trace its roots back to 1850, when it was founded by Henry Wells, William Fargo, and John Warren Butterfield.

The names Wells and Fargo likely ring a bell with many readers. This is for good reason - the duo also founded Wells Fargo. Buffett (and by extension, Berkshire Hathaway) are clearly fans of Henry Wells and William Fargo's businesses, with one-quarter of Berkshire's investment portfolio invested between American Express and Wells Fargo.

After more than a century and a half of profitable business, American Express is now a world-renowned company with a market capitalization of $74 billion.

The company recently reported earnings for the fourth quarter and full-year of fiscal 2016. Results were generally positive, as American Express reported a 5% increase in net income, a 7% reduction in diluted shares outstanding, and a 12% increased in GAAP diluted earnings per share.

(Source: American Express Fourth Quarter Earnings Presentation, slide 2)

Growth Prospects

In my eyes, there are three major growth drivers for American Express in the foreseeable future.

The first is the increase in interest rates. The Federal Reserve hiked interest rates in December 2015, December 2016, and has communicated the intent to raise rates three additional times in 2017. Many investors suspect that the first of these 2017 rate hikes will occur in March.

Since American Express is a financial business with a large portfolio of outstanding loans ($66.7 billion as of 4Q2016), it will see an uptick in net interest margins as rates increase. This will be reflected in the company's bottom line and boost its earnings per share.

(Source: American Express Fourth Quarter Earnings Presentation, slide 8)

Secondly, the company will benefit from the secular trend of consumers switching to cashless transactions. While there is a lot of commentary about how this will effect younger technologies like Apple Pay, American Express will certainly also benefit from this trend.

Lastly, American Express is continuing to focus on cost reductions. The company's top line has been struggling since it has ended its agreement with Costco (NASDAQ:COST). Also, it is suffering from the continued strength of the U.S. dollar, which makes the company's international revenues less valuable when swapped back to USD.

As a result, American Express is seeking to reduce costs and streamline its operations. On page seven of the fourth-quarter press release, it stated that the company aims to "reduce its overall cost base by $1 billion on a run rate basis by the end of 2017." These cost cuts will certainly benefit investors over the long run.

Competitive Advantage and Recession Performance

The competitive advantage comes from its extraordinary brand. According to Forbes, American Express holds the 24th most valuable brand in the world with an estimated value of $24.3 billion.

The company also spends a significant amount of money on marketing and advertising, which ensures that no consumer is unaware of products that American Express has to offer.

(Source: American Express Fourth Quarter Earnings Presentation, slide 14)

As a financial company, American Express may not be the most recession-resilient business. A portion of the consumers that it lends money to will naturally default on their loans when economic downturns.

We can assess American Express' recession resiliency by looking at its performance during the global financial crisis. The company's earnings per share for that period are listed below.

  • 2007: $3.39
  • 2008: $2.48 (26.8% decrease)
  • 2009: $1.54 (61.0% decrease)
  • 2010: $3.35 (117.5% increase)

As suspected, its earnings suffered during that recession, although the company managed to remain profitable. Investors should not expect American Express to continue to grow earnings during severe downturns in the global economy.

Valuation and Expected Returns

American Express' future total shareholder returns will come from its dividend yield, earnings per share growth, and valuation expansion/contraction.

The company's last dividend was declared on November 22 and paid on February 10 in the amount of $0.32 per share. Annually, this is equivalent to $1.28 per share and represents a 1.6% forward dividend yield based on the current stock price of $80.17. American Express' current yield is about 20 basis points below the S&P 500's (NYSEARCA:SPY) average dividend yield of 1.9%.

Next, looking at its historical earnings per share growth, American Express has compounded earnings from $2.62 in 2006 to $5.63 in 2016. This is good for a cumulative annualized growth rate of 6.8%.

(Source: Value Line)

Share repurchases will also be a contributor to the company's shareholder returns.

American Express shareholders benefit from investing in a business with remarkably shareholder-friendly management. The company consistently pays out nearly 100% of its net income to shareholders via a combination of dividends and stock buybacks.

(Source: American Express Fourth Quarter Earnings Presentation, slide 15)

Looking ahead, I believe it is reasonable to expect annual earnings per share growth in the range of 6-8% for American Express, aided by rising interest rates, improving net interest margins, and share repurchases.

Looking at the company's valuation, it reported GAAP earnings per share of $5.65 and adjusted earnings per share of $5.63 for fiscal year 2016. Based on the current stock price of $80.17, the GAAP and adjusted price-to-earnings ratios of American Express are both 14.2.

This is significantly below the S&P 500's average price-to-earnings ratio of 26.6. American Express appears to be a bargain compared to the rest of the stock market.

Its forward valuation is similarly attractive. American Express expects GAAP earnings per share in the range of $5.60-5.80.

Source: American Express Fourth Quarter Earnings Presentation, slide 16

Taking the midpoint of this range ($5.70), it is trading at a forward price-to-earnings ratio of 14.0. These valuations (trailing and forward) are compared to the company's historical averages in the following diagram.

(Source: Value Line)

Based on the above diagram, American Express appears to be fairly valued compared to its historical averages. I do not expect valuation expansion/contraction to be a significant contributor to total returns for this company.

Rather, total returns for AXP shareholders will likely be composed of:

  • 1.6% dividend yield
  • 6-8% earnings growth

For expected total returns in the range of 7.6-9.6%.

Final Thoughts

Warren Buffett's investment in American Express has spanned decades. The fact that Buffett currently holds the stock might not be indicative of his belief in the company's near-term growth prospects - rather, he might be avoiding the tax that will come from the ~$10 billion capital gain that would result upon sale.

However, over the long term, American Express should deliver satisfactory results for shareholders. The company has a valuable brand, a strong long-term track record, and will benefit from rising interest rates.

It is also trading at a significant discount to the rest of the stock market. For investors looking for exposure to the financial industry, American Express is compelling investment at current prices.

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