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American Express (AXP) - Thesis

Rating: BUY
Current Price $77.55
Price Target: $91.46

To paraphrase Baron Rothschild, “Buy when there is blood in the streets.”  American Express is currently suffering from several serious wounds (the stock price is down 17% year-to-date while the S&P 500 is essentially flat).  First, AXP’s stock price took a hit this year from its ending exclusive card relationship with Costco.  And second, AXP has been attacked by the US government’s antitrust ruling which will allow merchants to discriminate against American Express cards for charging higher point-of-purchase fees (in theory, merchants will be incentivized to do this because AXP charges merchants higher discount fees than other cards like Visa and MasterCard).  However, the impacts of these two wounds may be less serious than perceived, and AXP may still have a few tricks up its sleeve.

Regarding the antitrust lawsuit, it’s helpful to understand how American Express’s business model is different from competing cards like Visa and MasterCard.  AXP issues its own cards through its own banks (American Express Centurion Bank and American Express Bank, FSB).  And AXP’s primary source of revenue is the discount fee charged (as a percent of the charge amount) to merchants that accept American Express cards.  Therefore, AXP’s revenue depends on the total amount spent by customers and not on the volume of transactions.  On the other hand, Visa and MasterCard are not banks, and they make money based on the volume of transactions.  As a result, the charge card industry has evolved so it is cheaper for merchants to accept Visa and MasterCard over AXP.  AXP has defended against this risk by requiring merchants to sign agreements saying they will not encourage customers to use Visa and MasterCard over AXP.  Unfortunately for AXP, recent antitrust rulings have decided these agreements are unlawful and must be eliminated.  So now the question becomes, how much business will AXP lose as a result of the antitrust ruling (which by the way, the details of the implementation of this ruling are still being determined).

For some added color, in 2014 Visa had more than 2 billion cards in use worldwide and processed more than 60 billion transactions, while AmEx had just 107 million cards in force and processed just 6 billion transaction.  Despite this disparity, American Express had annual gross revenues of $33 billion while Visa brought in just $14 billion (Forbes).  The disparity exists because American Express has built its business to attract high credit quality high transaction size customers, whereas Visa has built its business simply to attract a lot of volume (they don’t care about credit quality because they’re not on the hook for defaults like AXP is).

Regarding the loss of Costco exclusivity, the media has spun this as a very bad thing for AXP, but in reality this may not be nearly as bad as perceived.  For some background, starting in April 2016, Citigroup will replace American Express as the exclusive issuer for Costco credit cards in the U.S. (AXP’s deal with Costco in Canada ended last year) because AXP and Costco couldn’t come to terms.  Costco accounts for roughly 20% of AXP’s loans.  According to Warren Buffett (his Berkshire Hathaway is AXP’s largest shareholder) “Somebody was going to get the bid, and American Express learned a week or two ago that they were not the one that was going to get it... I don’t know the terms of the new deal, but I don’t think Citi will get rich off of it."  Merchants (such as Costco) have been pressuring card issuers for better deals, and the loss of Costco likely isn’t as big of a hit to future earnings as many people perceive simply because the terms Costco was demanding were likely less profitable for AXP than the old terms. 

Valuation:
Regarding Valuation, it is important to remember the impact of these two wounds (loss of Costco exclusivity and antitrust rulings) are already baked into the price.  What matters at this point is whether you believe the market over- or under-reacted to these events, and what do you think will happened to American Express’s business going forward.

Regarding the antitrust rulings, I believe American Express’s high-end business (remember the company targets higher spending customers) may be “stickier” than perceived.  For example, even if merchants offer a 1% discount to use non-Amex cards, customers may use AXP anyway if they know AXP is still offering them a 2% reward for the transaction.  Additionally, AXP may be able to re-optimize its discount rate to attract the customers it wants and to maintain profitability.  Further, some merchants will do anything they can to serve customers therefore some merchants simply won’t discriminate against American Express.  Another alternative for AXP is to focus more on its small but fastest growing segment (GNMS) which utilizes a business model similar to Visa and MasterCard and therefore is not being targeted by government antitrust laws.

Regarding the loss of Costco, American Express has other growth opportunities.  For example, the company has the world’s largest integrated payments platform (i.e. a global network connecting millions of consumers, businesses and merchants) which is a source of powerful data and creates many growth opportunities to better serve customers.  For instance, AXP has recently integrated with the Uber app to let AmEx card members earn double rewards points or redeem points for rides.  AmEx also formed a significant partnership with Apple Pay. Apple has designed a simple, secure, user-friendly payments feature into its latest-generation iPhones, and AmEx believes that integrating their capabilities with Apple Pay can help fuel growth in mobile payments. AmEx is also active in the startup community with ventures in a range of startups combining commerce and data science.  More broadly, AmEx has large untapped potential to benefit from the ongoing global shift into electronic payments and away from cash and checks.  According the AXP CEO, Ken Chenault “It’s not easy to see a longstanding partnership [Costco] end. But when the numbers no longer add up, it’s the only sensible outcome.”

Forward Price-to-Earnings Ratio:  Based on historical data, AXP averages a forward price-earnings ratio of 95%-100% that of the S&P 500 Index.  Using a 2015 AXP EPS estimate of $5.72 (Yahoo!Finance) and the S&P 500 forward P/E ratio recently sitting at 16.4 times, that gives American Express a price target of $91.46/share (5.72 x 16.4 x 0.975).


Financial Management:
From a financial standpoint, American Express is well-run.  First off, AXP has come under intense regulatory scrutiny since the financial crisis, and as a result its financials are very strong.  Even though AXP generates more cash than it needs to profitably operate, it still requires regulatory approval before issuing dividends or repurchasing shares.  According to the American Express annual report

“Historically, capital generated through net income and other sources, such as the exercise of stock options by employees, has exceeded the annual growth in our capital requirements. To the extent capital has exceeded business, regulatory and rating agency requirements, we have historically returned excess capital to shareholders through our regular common share dividend and share repurchase program.”

AXP has a dividend yield of around 1.5% and it has a regular share repurchase program (it repurchased over 4% of its total shares outstanding in each of the last two years).  The company returns four times as much cash to shareholders through share repurchases versus dividends signaling that AXP management may believe its stock price is undervalued.

AXP continues to make significant reallocations of its resources to optimize its business.  For example, at the end of 2014 AXP sold its investment in Concur Technologies (a travel management company) for $719 million (pre-tax), and reallocated a large portion of the proceeds to other area of its business such as marketing, promotion and awards.

Additionally, with over $44 billion of customer deposits, AXP will likely benefit if and when interest rates rise as they’ll be able to more easily cover the costs of deposits and earn an increased spread between the rates they pay and the rates they earn.


Risks and Challenges:
American Express faces a variety of risks and challenges in growing and maintaining its business.  For example, expanding outside the US presents challenges; the US economy is growing, but growth outside of the US is weak.  Additionally, the strong US dollar makes international growth a challenge.

As mentioned earlier, new regulations and the cost of co-brand relationships are both increasing.  Antitrust rulings against AXP’s discount fees and the loss of the Costco relationship are examples.

Competition in general is intensifying as both traditional players and new entrants want to disrupt the marketplace.

The derivatives used by AXP may lower volatility, but they are expensive, reduce profitability, and slow long-term growth.  For example, the forward contracts AXP uses to reduce foreign currency volatility are good for short-term earnings consistency, but bad for long-term profitability and they are making the groups that underwrite them very rich.  The same can be said of the interest rate swaps used by American Express.

AXP’s investment securities have a very large concentration of state and municipal obligations.  While these instruments may offer higher yields than treasuries they concentrate risk and have a higher likelihood of default.

Conclusion:
Buy low, sell high.  American Express (AXP) stock price has suffered in 2015, but it’s not going out of business anytime soon.  The market has reacted very negatively to recent antitrust rulings and the loss of AXP’s exclusive relationship with Costco.  However the company is still extremely profitable, it has opportunity for continued growth, and the market is valuing the stock too low.

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