Cash In On American Express

Summary

• AXP has produced strong growth in its share price since 2016.
• Efforts made to reduce its discount rate with retailers and grow its consumer base are noteworthy.
• Large one-time tax payment disguises a company with impressive fundamentals.
• Current stock price of $92.14.

Introduction

American Express (NYSE:AXP) is a credit card company based in the US with the fourth largest number of cardholders in the world (58 Million). This stock pitch will argue that Amex is undervalued and therefore, recommends Amex as a buy recommendation.

The general narrative of how Amex fits into the market is as a premium brand that has been sluggish to adapt to innovations in the retail lending space. Other companies such as Square (SQ) have managed to reduce payment processing costs in exchange for daily inflows of data. Amex's system often requires extra fees, which led supermarket chain Costco (COST) to end their agreement with Amex to be the sole card payment processor in 2016. This decision massively depressed the stock price preventing the stock from rallying further.

Operations Led Growth

I believe the catalyst for the growth in this stock is an expansion of the consumer base it provides loans to, with loans revenue increasing by 14% in the last quarter and card member spending was up 11%. Amex also has agreed to cut its discount rate that it charges retailers to 2.37% from 2.42%, learning a lesson from the Costco incident. The board looks to grow consumer base over margins which will increase net income in the future.

In addition, the company may be able to increase long-run operating revenue by expanding OptBlue. OptBlue is a program pursued by Amex to increase the acceptance of Amex credit cards in small businesses. It might decrease margins in the short run due to the cost of additional free advertising and promotions for small shop owner. However, the growth in Amex's consumer base should provide strong revenue growth in the future.

Finally, the reduction in corporate tax rate will increase earnings in the future, leaving more free cash flow to be used for buybacks which will increase the company's share price over time. However, for the time, buybacks will be suspended until the second half of 2018 to recover from the large tax expense. The long-term effect of the decrease in corporate tax rate could be an increase in employee benefits and compensation and profit sharing schemes. Quarterly dividends last rose in July last year by 9% to $0.35/share and therefore, a dividend yield of 1.5%. Shareholder value will improve as the long-term effect of the tax cut begins.

Market-Led Growth

One could argue we are reaching the latter stages of the business cycle as the US economy reaches full employment at 4%. This will lead to inevitable rate hikes from the FED, with two more priced in this year. This increase in interest rate will widen the spread between interest rates earned on loans (assets) and interest rates paid to depositors (liabilities).

Intrinsic Valuation

Source: Excel DCF conducted by myself Data: American Express 2017 10-K

Based on last year's Amex 10-K, you will find a low net income figure of $2.7 billion. This is because the company had a lot of deferred taxation to pay in 2017. Amex had to pay $2.6 billion in one-time tax charges relating to profits Amex earned abroad. However, the corporate tax rate has fallen dramatically in the US to 21%, and the net income of Amex had been performing at levels consistently above $5 billion prior to 2017. Therefore, I used the net income in 2016 to grow cash flows.

I used a leveraged FCF analysis to capture the cash flows to equity holders only, as Amex has large leverage. I grew net incomes at 8% for the first two years, attributable to the large growth in consumer loans and increases in interest rate. I lowered the expectations by 2020 to be conservative. I also lowered the capital requirements currently at 9% to reflect possible deregulation in the banking sector in the future.

I found that the company is trading roughly at fair value, but I would argue that once net incomes are restored next year, ROE could double and P/E will fall making the stock much more attractive.

Source: Excel DCF conducted by myself Data: American Express 2017 10-K

I also conducted some sensitivity analysis on the Terminal Value to see the effect of my assumptions. As you can see, a conservative approach with WACC greater than 10% leads to values below the current market price of $92. But you can also see that, should market conditions be favourable for Amex, the current company could be even more valuable than its current price.

Risks of Owning American Express

The first point to note is that Amex being a financial company, it can be considered as a leveraged bet on the economy. With a D/E ratio of 3.24, Amex is a highly leveraged company and therefore, will produce returns greater than the S&P 500 while the market is on a bull run, but will be more heavily affected by losses in a less prosperous period.

Foreign exchange risk could also pose an issue as the company targets the growth of its international business. Amex has dollar-denominated earnings which would decrease if there was to be a substantial decrease in the value of the US dollar.

Conclusion

I have argued that the catalyst for American Express' growth is the perceived sluggishness to the adaptation of an evolving market culminating in the loss of a material contract with Costco. But this perception has depressed the growth of a company with strong fundamentals and exciting growth opportunities and possible benefits to shareholders in the form of buybacks and dividend growth in the medium to long run.

My recommendation is to buy and hold American Express over the long term.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.