American Express: Grows At 10%+ A Year, Until It Doesn't
Summary
- AXP shares are near their 52-week high, and have attracted shareholders such as Berkshire Hathaway and Third Point.
- EPS growth was in low teens in 2018 and can be again in 2019, but the business carries large long-term risks.
- As AXP competes with large banks, it is vulnerable on the deteriorating economics of card member rewards and co-brand partners.
- These had already caused AXP revenues and earnings to stagnate once in 2013-17, and may do so again.
- At $110.77, AXP risk/reward seems finely balanced, and we recommend staying away from the stock.
Introduction
American Express (NYSE:AXP) shares have risen to near their 52-week high, after significantly underperforming credit card peers Visa (V) and Mastercard (MA), as well as the S&P 500 Index, over the last 5 years, as shown in the charts below. AXP has also attracted a number of high-profile investors: Third Point's Dan Loeb initiated a position in 18Q3, likely at a cost per share above $100, and announced a $135 target price for the following 18 months; Warren Buffett also retains a longstanding 17.9% stake, making AXP the 6th largest holding in the Berkshire Hathaway (BRK.A) portfolio as of 2018 year-end.
| AXP Share Price (Last 12 Months)
Source: Bloomberg Markets (20-Mar-19). |
| AXP Share Perfomance vs. Visa, Mastercard and S&P 500 (Last 5 Years)
Source: Bloomberg Markets (20-Mar-19). |
Management envisages that AXP will consistently achieve faster-than-industry revenue growth and operational leverage. Since 2018, this has translated into low-teens EPS growth – 13% actual in 2018, and 7-14% guided in 2019:
| AXP EPS – 2018 Actual & 2019 Guidance
NB. 2018 EPS (diluted) was $7.33. Source: AXP investor day presentation (Mar-19). |
Could AXP shares' recent strong performance be the start of a large multi-year bull run? This article reviews its business fundamentals to find out.
Company Overview
AXP operates a global integrated payment network for both consumers and enterprises, primarily with credit cards. Its "integrated" network means that, in most cases, AXP is responsible for all aspects of each transaction, including card issuance. This separates AXP from Visa and Mastercard, which operate their networks, but leave card issuance and payment processing to others.
85% of AXP's billed business comes from its proprietary cards (including cards co-branded with other companies, more below), the rest from network partners and licensees. 67% of AXP's net revenues (after provisions) are generated by discount revenue, collected as a percentage of the value of each transaction (called the "merchant discount", and averages approx. 240 bps). Other revenue streams include interest on card member loans, card fees, other fees and commissions.
AXP's revenues and pre-tax income from its different segments is shown below. The consumer business ("GCSG") is its largest segment, contributing 39% of pre-tax income; the commercial business serving enterprises ("GCS") is 31%. By billed business, AXP is roughly 60/40 split between consumers and commercial. AXP also generates revenues from operating its payment networks and serving merchants ("GMNS").
| AXP Revenue & Pre-Tax Income by Segment (2018A)
Source: AXP 10-K (2018). |
The U.S. is by far AXP's largest market, generating 74% of its revenues and 71% of its pre-tax income in 2018.
| AXP Revenue & Pre-Tax Income by Region (2018A)
Source: AXP 10-K (2018). |
Stagnated Financials in 2013-17
AXP grew strongly in 2018. However, both revenues and pre-tax income had experienced a period of slower growth or even declines in 2013-17, as shown below:
| AXP Net Revenues (2011-18A)
Source: AXP company filings. | AXP Pre-Tax Income (2011-18A)
Source: AXP company filings. |
(Notes: Net revenues are revenues net of interest expense and after provisions; 2014 figures exclude the $744m one-off gain from the sale of the Concur stake; 2016-18 revenues have been restated under a new accounting standard in 2018, with costs such as member rewards & partner payments changed from being deducted off revenues to being part of expenses.)
The slower growth in pre-tax income during 2013-17 was mostly due to: (1) The growth in billed business slowing from high-single-digits to low-single digits or negative; and (2) The pre-tax income margin contracting by 220 bps from 26.3% to 24.1% (under the old accounting standard), as shown below. (In addition, the average merchant discount also continued shrinking by 1-3 bps p.a., creating a 0.5-1.5% p.a. headwind to revenue growth.)
| AXP Billed Business Growth (2011-18A)
Source: AXP company filings. | AXP Pre-Tax Income Margin (2011-18A)
Source: AXP company filings. |
(Note: 2014 pre-tax income excludes the $744m one-off gain from the sale of the Concur stake.)
These weaknesses in AXP financials appeared, despite the well-known structural move from cash to electronic payments, both in the U.S. and globally. We believe this was due to specific vulnerabilities in AXP’s business:
- Reliance on co-brands for much of its volume, which has led to repeated deterioration in AXP's economics
- Reliance on rewards to attract/retain card members, which has led to margin shrinkage
Both vulnerabilities are made worse by how they can be exploited by AXP’s competitors, which include many large banks with huge financial firepower.
Competition with Large Banks
AXP’s fundamental problem is that it is competing head-on with large banks, such as JP Morgan (JPM) and Citi (NYSE:C), which issue credit cards with either Visa or Mastercard. The large banks are attracted by the high net interest rate yield (1,040 bps in 2018) and return on equity (34%) in AXP’s premium credit card business (see first chart below). AXP has been trying to expand its own lending to card members, which give banks even more reason to compete.
In particular, JPM has been a tough competitor to AXP, with its Sapphire Reserve card (launched 2016) competing for the same high-end customers, and a co-brand partner portfolio that, like AXP's, includes many large airline and hotel names.
| AXP Return on Equity vs. Other Card Issuers (2018)
Source: AXP investor day presentation (Mar-19). | JPM Co-Brand Credit Card Portfolio
|
AXP’s integrated model means that, unlike Visa and Mastercard, it is responsible for the full costs of competing.
Reliance on Co-Brand Partners
Co-brand partners are companies, mostly airlines and hotels, with which AXP issues credit cards that carry both companies' brands. The slowdown in AXP's billed business growth in 2015-16 was primarily due to the loss of Costco (COST) as a co-brand partner, with the Costco Canada loss materializing at the start of 2015 and the Costco U.S. loss materializing at the start of 16Q2. The impact of these losses are clearly visible in AXP's growth rates below:
| AXP Billed Business Growth by Region (2014-15A)
NB. Canada is part of LACC. Source: AXP results presentation (15Q4). | AXP Revenue Growth – Costco Effect (2016-17A)
Source: AXP results presentation (17Q4). |
Even after the Costco loss, co-brand partners remain a key part of AXP's business – responsible for 17% of billings and 36% of loans in 2018, as shown below. Delta (DAL) is by far the most important co-brand partner; other key ones include Marriott (MAR), Hilton (HLT) and British Airways (OTCPK:BABWF):
| AXP Co-Brand Loans & Billings
Source: AXP investor day presentation (Mar-19). |
Co-brand partners do often switch between credit card issuers for better economics. In addition to Costco, AXP also lost Continental Airlines in 2011, after it was acquired by United Airways (UAL), and Jetblue (JBLU) in 2015. AXP has in turn won Hilton from Citi in 2018; Hilton previously had both AXP and Citi as co-brand partners.
Co-brand partners appear to have the upper hand in renewal negotiations with credit card companies like AXP. On each renewal, economics for AXP tend to reset to a lower level, reducing AXP profits. For example, the renewals of the Marriott and Hilton co-brand relationships reduced AXP's pre-tax income by $200m in 2018 (equivalent to 2.7% of 2017 pre-tax income). Here is how AXP's CFO described the renewal dynamics there:
“On Marriott and Hilton ... as you commonly see in these larger co-brands where you have very long-term agreements, as they are renewed, there tends to be a step down in economics and we work over the course of the subsequent five, seven, eight years to really rebuild the economics. You’ve seen that pattern several times with Delta, you’ve seen it with some of the hotel partners before ... So, over $200 million impact to PTI in 2018 is one of the hurdles that we have to overcome as we think about our EPS growth in 2018; it goes away in 2019.”
(Jeff Campbell, AXP CFO, 17Q4 earnings call)
The Delta co-brand relationship is the most important for AXP. Should this be lost, it would be as damaging as the Costco loss was in 2015-16. Just as Costco US co-brand cards were 8% of AXP's billed business and 20% of its loans in 2014, Delta co-brand cards were 8% of AXP's billed business and 21% of its loans in 2018. The Delta relationship was last extended in 2014, and could be soon up for re-negotiation.
Some of the other large co-brand relationships could also be at risk. The British Airways relationship was last renewed in 2015, and will be up for re-negotiation in next few years. The Marriott relationship is both a risk and an opportunity - AXP originally partnered with Starwood before it was acquired by Marriott, while Marriott historically partnered with JPM. Marriott has so far retained both partners, but Hilton has just moved from two to one co-brands.
Reliance on Card Member Rewards
Rewards are a key part in how credit card issuers attract and retain card members, and their costs have been rising as the issuers compete.
Card member rewards are part of the “engagement costs”, and this margin has been rising 150-200 bps p.a., including a reset of the Platinum Card rewards to a higher level in 2016. The decline in AXP's pre-tax income margin can largely be attributed this increase, as shown in the charts below:
| AXP Engagement Cost Margin (2011-18A)
Source: AXP company filings. | AXP Pre-Tax Income Margin (2011-18A)
Source: AXP company filings. |
Further increases are on the way. AXP management has guided to reward costs growing in line with proprietary card billings – which will be dilutive to profit margins. (AXP revenues grow at 0.5-1.5% less than billed business growth, due to contracting merchant discount.) Thus far, AXP has been able to partially offset the rising reward costs through efficiencies in other operating expenses, but this may not always be possible.
Competitors do not appear to be relaxing their efforts to compete on card member rewards, as JPM's CFO stated:
“Rewards is a very important part of driving engaged relationships with our customers … So, while we will always make adjustments to our offerings, it’s not the case that we are looking at a meaningful pullback in rewards … we are continuing to offer rewards-based incentive to drive engagement with our customers … It’s fair to say that we’ve seen a lot of competitive response and competitive products in the marketplace that are driving high rewards offerings too and we’ve not seen that lower our ability to acquire new accounts.”
(Marianne Lake, JPM CFO, 18Q4 earnings call)
Risk from U.S. Economic Downturn
More than 70% of AXP’s pre-tax income is from the U.S., where the economy may be peaking after years of strong growth. With its dependence on spending (especially in travel & entertainment) and its increasing exposure to card member loans, AXP would be particularly vulnerable in any U.S. downturn.
During the 2008-9 crisis, AXP saw its revenues fell by 11% and net income by 47%, due to lower revenues & higher loan losses, as shown below. While we are not predicting another such crisis in the near term, these numbers show how AXP would be disproportionately impacted in a weak U.S. economy:
| AXP Key P&L Lines (2007-9A)
Source: AXP 10-K (2009). |
Valuation
AXP has returned substantially all of its net income in dividends and buybacks in recent years, as shown below. (2018 was an exception, as the one-off book tax charge from the U.S. tax cut meant AXP had to rebuild its capital first.)
At the current price of $110.77, AXP shares are trading on a LTM P/E of 15.1x, in the upper half of the range since 2014, also as shown below:
| AXP Return of Capital vs. Net Income (2011-18A)
Source: AXP company filings. | AXP P/E at Year-End (2011-18)
NB. Each P/E is takes year-end price and that year’s EPS. Source: AXP company filings. |
Conclusion
For 2018, AXP management is guiding for revenue growth of 8-10% and EPS growth of 7-14%, which AXP will likely be able to meet. The risk to investors is in whether such strong growth will continue for thereafter. If it does, and assuming no re-rating for AXP shares, investor returns would be in the low-teens – 1.3% p.a. from the dividend, and 10%+ p.a. from EPS growth.
However, there are key downside risks in the next renewal of the Delta co-brand relationship and the intensifying competition in card rewards competition over the next few years. AXP’s high exposure to the U.S. is also a concern, given the economy there may be peaking. If these downside risks materialize, earnings could stagnate or decline, and AXP shares could easily de-rate by 2-3x back to late 2018 levels, meaning a 15-25% downside.
Overall, the risk and reward in AXP shares seem finely balanced, and we recommend staying away from the stock.
This article was written by
Disclosure: I am/we are long AXP, BRK.B, JPM, MAR. 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.