American Express AXP
June 12, 2008 - 11:56am EST by
spence774
2008 2009
Price: 44.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 51,000 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

American Express is worth more than twice its current price. Despite being a mega-cap company, it has many years of growth left, a very durable competitive advantage, and is poorly understood because it is really two businesses - credit cards and payment network/merchant acquirer.

A fuller presentation can be found on the Value Investing Congress Website for those with access.


Thesis
·  American Express issues charge and credit cards and operates a closed-loop payments network.  The business model, which AXP calls “spend-centric”, is to attract premium cardmembers who spend more per card, which in turn allows AXP to get premium pricing from merchants, which AXP invests in rewards and services for cardmembers.  Due to its closed-loop network, AXP has an information and relationship advantage over other players in the industry.  We believe the closed-loop and spend-centric model are durable competitive advantages.  AXP has an attractive financial profile (mid-30s% ROE, over 65% of capital returned annually, double digit EPS growth rate) and historically traded at a premium market multiple.  Due to concerns about the US economy, increasing loan write-offs and funding costs, there is a lot of uncertainty around near-term earnings.  The shares have traded to P/E multiples not seen in years yet the company is stronger today than ever.  We believe this creates a compelling opportunity to buy a world class company at a significant discount to intrinsic value.
Key Investment Factors
·  Valuation: AXP trades at 13.3x 2008 consensus earnings estimates and 9.8x our 2011 estimate.  We believe that AXP should trade between 18-21x earnings based on historical precedent (20-year average P/E), comparable companies (18x P/E based on 1/3 of earnings from network/ processing and 2/3 from lending), and a conservative DCF (implies 19x multiple).  On this basis the shares have the potential to double over three years. 
·  Stable pricing: AXP has experienced a gradual erosion in its merchant discount rate over the years (currently ~2.5%).  However, rates have stabilized and the competition (Visa/ MasterCard) has been increasing its interchange fees.  We believe that AXP’s merchant discount rate is stable and any future decreases will be marginal and offset by volume gains.
·  Robust long-term growth prospects: 2007 was likely the first year that plastic (credit and debit) volume outpaced paper (cash and check) volume in the US.  The trend of plastic taking share is expected to continue for many years.  Outside the US, growth rates are even higher. 
·  Valuable network and processing segment: While a small contributor to earnings, the AXP partnership network business (similar to Visa and MasterCard) is profitable, growing fast and gaining scale.  AXP also earns fees as a merchant acquirer (similar to FDC).  Combined, these segments earn 90%+ returns on capital and represent a growing share of AXP’s net income (26% Q108, 33% 2011E).  We believe this segment is worth 25-30x earnings and underappreciated by the market.
·  Management: AXP management is experienced and aligned with shareholders.  CEO Ken Chenault’s pay package through 2014 is based equally on EPS growth, revenue growth, annual ROE and total shareholder return.
Risks/ What Would Make Us Wrong?
·  Credit quality: AXP has $80bn of charge and credit card loans.  Losses are expected to rise and could hurt earnings between $1 and $6 over the next couple of years.  Losses could exceed our estimates.
·  Political risk: Congress has introduced bills to regulate interchange fees.  Increasing regulation could have an adverse impact on profitability.
·  Funding costs/ securitization market: Spreads have widened on unsecured and securitization funding.  Additionally, a long-term disconnect between LIBOR and Fed Funds is a risk since customers are priced off of Fed Funds.  AXP relies heavily on the securitization market; a massive destabilization in this market is a risk.
·  Investment portfolio: AXP has a $16bn investment portfolio that contains ABS securities ($0.8bn) and muni bonds ($6.8bn).  Permanent impairments in the values of these assets would decrease earnings.
·  Recession duration: If the recession drags on for 2-3 years, we may not see the earnings level or earnings multiple which we believe is appropriate.
·  Change in competitive landscape: We believe that AXP has a sustainable competitive advantage through its closed-loop and spend-centric model.  The industry is highly competitive and AXP could lose share.
Monitoring and Evaluation
·  Read the Nilson Report for market share trends.
·  Monitor GNS segment disclosures and results (we expect this segment to have an increasing share of earnings).

Catalyst

Recession passes
Processing segment continues to grow despite a recession and becomes too big a part of NI to ignore
Buffett buys the company
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    Description

    American Express is worth more than twice its current price. Despite being a mega-cap company, it has many years of growth left, a very durable competitive advantage, and is poorly understood because it is really two businesses - credit cards and payment network/merchant acquirer.

    A fuller presentation can be found on the Value Investing Congress Website for those with access.


    Thesis
    ·  American Express issues charge and credit cards and operates a closed-loop payments network.  The business model, which AXP calls “spend-centric”, is to attract premium cardmembers who spend more per card, which in turn allows AXP to get premium pricing from merchants, which AXP invests in rewards and services for cardmembers.  Due to its closed-loop network, AXP has an information and relationship advantage over other players in the industry.  We believe the closed-loop and spend-centric model are durable competitive advantages.  AXP has an attractive financial profile (mid-30s% ROE, over 65% of capital returned annually, double digit EPS growth rate) and historically traded at a premium market multiple.  Due to concerns about the US economy, increasing loan write-offs and funding costs, there is a lot of uncertainty around near-term earnings.  The shares have traded to P/E multiples not seen in years yet the company is stronger today than ever.  We believe this creates a compelling opportunity to buy a world class company at a significant discount to intrinsic value.
    Key Investment Factors
    ·  Valuation: AXP trades at 13.3x 2008 consensus earnings estimates and 9.8x our 2011 estimate.  We believe that AXP should trade between 18-21x earnings based on historical precedent (20-year average P/E), comparable companies (18x P/E based on 1/3 of earnings from network/ processing and 2/3 from lending), and a conservative DCF (implies 19x multiple).  On this basis the shares have the potential to double over three years. 
    ·  Stable pricing: AXP has experienced a gradual erosion in its merchant discount rate over the years (currently ~2.5%).  However, rates have stabilized and the competition (Visa/ MasterCard) has been increasing its interchange fees.  We believe that AXP’s merchant discount rate is stable and any future decreases will be marginal and offset by volume gains.
    ·  Robust long-term growth prospects: 2007 was likely the first year that plastic (credit and debit) volume outpaced paper (cash and check) volume in the US.  The trend of plastic taking share is expected to continue for many years.  Outside the US, growth rates are even higher. 
    ·  Valuable network and processing segment: While a small contributor to earnings, the AXP partnership network business (similar to Visa and MasterCard) is profitable, growing fast and gaining scale.  AXP also earns fees as a merchant acquirer (similar to FDC).  Combined, these segments earn 90%+ returns on capital and represent a growing share of AXP’s net income (26% Q108, 33% 2011E).  We believe this segment is worth 25-30x earnings and underappreciated by the market.
    ·  Management: AXP management is experienced and aligned with shareholders.  CEO Ken Chenault’s pay package through 2014 is based equally on EPS growth, revenue growth, annual ROE and total shareholder return.
    Risks/ What Would Make Us Wrong?
    ·  Credit quality: AXP has $80bn of charge and credit card loans.  Losses are expected to rise and could hurt earnings between $1 and $6 over the next couple of years.  Losses could exceed our estimates.
    ·  Political risk: Congress has introduced bills to regulate interchange fees.  Increasing regulation could have an adverse impact on profitability.
    ·  Funding costs/ securitization market: Spreads have widened on unsecured and securitization funding.  Additionally, a long-term disconnect between LIBOR and Fed Funds is a risk since customers are priced off of Fed Funds.  AXP relies heavily on the securitization market; a massive destabilization in this market is a risk.
    ·  Investment portfolio: AXP has a $16bn investment portfolio that contains ABS securities ($0.8bn) and muni bonds ($6.8bn).  Permanent impairments in the values of these assets would decrease earnings.
    ·  Recession duration: If the recession drags on for 2-3 years, we may not see the earnings level or earnings multiple which we believe is appropriate.
    ·  Change in competitive landscape: We believe that AXP has a sustainable competitive advantage through its closed-loop and spend-centric model.  The industry is highly competitive and AXP could lose share.
    Monitoring and Evaluation
    ·  Read the Nilson Report for market share trends.
    ·  Monitor GNS segment disclosures and results (we expect this segment to have an increasing share of earnings).

    Catalyst

    Recession passes
    Processing segment continues to grow despite a recession and becomes too big a part of NI to ignore
    Buffett buys the company

    Messages


    Subjectinterchange
    Entry06/12/2008 03:15 PM
    Memberdurian966
    Spence, thanks for the idea. Could you be a little more specific on the US regulatory risks on the interchange fees, as it seems to potentially be a huge negative impact. Didn't Australia regulate interchange fees in the last few years? what has the effect been there?

    SubjectRE: interchange
    Entry06/12/2008 03:29 PM
    Memberspence774
    We think the risks are small because AXP negotiates with each merchant individually, arriving at a price based on the value the merchant gets from being a part of the axp system. This is the opposite of visa/mc who are the targets of most of the lawsuits and regulatory interest. That being said, we think it needs to monitored.

    SubjectValue Investing Congress
    Entry06/12/2008 03:30 PM
    Memberspence774
    A slide presentation with further details is posted at www.valueinvestingcongress.com"

    SubjectRE: I am a fan
    Entry06/12/2008 05:29 PM
    Memberspence774
    Thanks Danar. We are actually happy if the redemption rate goes up because it demonstrates value to the customer, improves customer loyalty and the increases the life-time value of the customer. Also, the higher the redemption rate, the more value the AXP spend-centric model adds to merchants who are realizing higher revenues from AXP point related marketing. Overall we think a high redemption rate increases AXP's long-term competitive advantage.

    Subjectcredit?
    Entry06/12/2008 05:53 PM
    Membercompass868
    Why arent you more concerned about credit? as is well understood they have massively grown the book the last few years at the peak of the cycle and in some of the worst geographies. i know its not going to matter when the stock is much higher in three years but still its going to be rough going for a while i am fairly certain...so really more a of an entry point/timing question

    Subjectconcerns
    Entry06/12/2008 06:41 PM
    Membergb48
    I've been long and wrong for a while. I am bullish about their third-party network, but balance sheet concerns are obviously more of an issue with investors at this point.

    I agree about the growth in intrinsic value longer term, but also concerned about near term credit performance.

    I also don't think Buffet will buy the whole company. He hasn't even added to his position in this price range.

    Good idea, may take a while to play in my opinion.

    SubjectCredit Concerns
    Entry06/12/2008 07:44 PM
    Memberspence774
    Credit may be a concern short-term, but is exceedingly unlikely to be of a magnitude that would impair intrinsic value. Even if they have serious charge-offs, it will hurt EPS for only 1-2 years and not impact their global growth in cards and processing. Given the very low valuation and high quality of the business we are comfortable being long this short-term, hard-to-game risk. It is probably the reason we can buy AXP down here. Liquidity is far less of a risk now that the Fed accepts credit card receivables at its window, basically insuring liquidity to the system.

    SubjectRE: RE: RE: I am a fan
    Entry06/14/2008 10:14 AM
    Memberdanarb860
    that is it emphasizes points more than it used to

    SubjectPoints and Credit
    Entry06/14/2008 09:03 PM
    Memberspence774
    Points: We agree that they emphasize points more than they did in the past. It is because they now realize that it improves the value they add to the card holders, and the more the card holders spend, the more value it represents to the merchants, who then pay a higher merchant discount rate reflecting the value they receive from being part of the system, and the better deals the merchants can give the points program through smart marketing. It is a slightly higher cost short term but we think it strengthens the competitive advantage and validates the spend-centric model. We think this is the key advantage AMEX has - it can have the best rewards program because all participants benefit from being involved. Credit/EPS It is a little tough to know what EPS could be at peak charge offs because of the offseting income from the processing business and from the monthly pay business during the period of the charge off. Optima was a disaster in 1991, and if this time is 50% worse (15% loss) applied across all businesses, not just the lend businesses, it would represent about $6/share of loss, which would be offset by a few dollars from the above mentioned businesses, so maybe a loss of 3-4 dollars. This would imply loss rates for the rest of the industry in the high 20's % range - a massive disaster for the country. Even under this very unlikely scenario, the companies long-term economics and competitive advantage would probably not be impaired.

    SubjectRE: RE: Points and Credit
    Entry06/16/2008 02:33 PM
    Memberspence774
    Hi Danarb, I am not quite sure what you mean by the lending business subsidizing the network business. Could you please elaborate? Usually when we think about one business subsidizing another it is a case of a good one helping a bad one. We consider the network business the better of the two, so I don't understand how lending would subsidize it? Thanks, Ken

    SubjectRE: RE: RE: Points and Credit
    Entry06/16/2008 05:56 PM
    Memberdanarb860
    Receivables have grown quickly. The spending (and therefore discount revnue) generated by this growth in borrowing is lower quality revenue than if balances were paid off. Therefore, there is some concern that discount revenue results as AXP is willing to lend.

    Another concern I think weighing on the stock is I think exposure to travel, not just the economy on fuel.

    SubjectRE: RE: RE: RE: Points and Cr
    Entry06/17/2008 08:21 AM
    Memberspence774
    Thanks Danarb. Your points make total sense and I agree this issue is worth watching. Yesterday they released data in a 10-D from their securitizations, showing that defaults were higher than expected, so near term things could get worse before better. We don't have a clear idea of how much worse, just that the future a few years out should be good.

    Subjectcharge card credit concern
    Entry06/18/2008 09:51 AM
    Memberad188
    You mentioned the EPS sensitivity given a 10% chargeoff on the lending business, but are you ignoring the charge card business? If I recall in the early 1990s chargeoffs rose for that biz too. Given the huge charge volumes even a 10-20bp "blip" up could have a material impact on EPS on top of that from the lending business. No?

    Subjectflummoxed
    Entry06/19/2008 12:32 PM
    Memberjsc60
    The cfo of Citi layed-out some metrics today on their credit card charges. Over the last three credit cycles, charges have averaged 540bp. Peak to trough, the swing on charges has been 200bp, and are currently 125bp above trough. This would imply that charges should be 540bp plus or minus 100bp, or about 640bp at their high. If these data are analogous to AXP (and there are good reasons to expect better numbers from AXP), current reserve levels seem adequate. When discussion drifts to 10% charges, I am somewhat lost.

    SubjectRE: flummoxed
    Entry06/19/2008 05:00 PM
    Memberspence774
    While we cannot speak to the Citi CFO's comments, peak write-offs for AXP's lending card were 9.6% in 1990-91 (Optima card disaster) and 6.0% in 2001. So the 10% is a "what if this is another 1990-91" scenario. We'd be curious to look at Citi's 1990-91 performance and also how they define charge-offs.

    For further reading, on 11/13/07 AXP gave a presentation to Merrill Lynch that goes into further detail about performance in prior recessions (on their Investor Relations website).

    SubjectRE: charge card credit concern
    Entry06/19/2008 05:12 PM
    Memberspence774
    Our EPS sensitivity assumed a 10% chargeoff across all businesses (charge and credit cards).

    Subjectcharge card credit concern (2)
    Entry06/23/2008 01:58 PM
    Memberad188
    AXP present writeoffs on the charge card business as % of billed business in the year (i.e. 30 bp of annual billed business in 2007); is your 10% worst case assumption consistent with 1991 charge card write-off rate of 90 basis points? Thanks in advance for clarifying.

    SubjectYesterday's announcement
    Entry11/11/2008 01:08 AM
    Memberotaa212
    Spence--can you help us understand the implications of becoming a bank holding company?
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