The bad news for American Express over the last 18 months has been large and steady. And so too has the share price decline. We believe the bad news is now in the rear view mirror (knock on wood), there is good reason to be optimistic, and the shares could easily rise 30%. We own shares in our Blue Harbinger Disciplined Growth portfolio.
Bad News Over the last 18 months:
American Express has had to deal with a lot of bad news over the last 18 months, and we believe the market is now overly pessimistic…
The biggest piece of “bad news” was the loss of AXP’s exclusivity deal with CostCo. The media spun (and continues to spin) this as a very bad thing for AXP, but in reality it’s not nearly as bad as perceived. For some background, starting in April 2016, Citigroup replaced American Express as the exclusive issuer for Costco credit cards in the U.S. (AXP’s deal with Costco in Canada ended in 2015) because AXP and Costco couldn’t come to terms. Costco accounted 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… that they were not the one that was going to get it... I don’t know [all] 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.
Another big piece of bad news for American Express has been 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). But in reality, this is not as bad as many people perceive because many mercharts (the more important ones in particular) will continue to allow the higher fees because they really want the business in the first place. To better understand, it’s helpful to review how American Express’ business model is different (see “American Express Business Model” section below).
Other pieces of bad news have included the loss of a big deal with JetBlue as well as the media’s constantly pounding the table about how great Visa and MaterCard are. However, a closer look at a few of American Express’ valuation metrics suggests that it is actually an extremely attractive company with lots of potential upside price potential.
American Express Business Model:
American Express’ 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. In reality it won’t be that much simply because AXP has built its business to be attractive to certain high-end customers and retailers really want this business anyway.
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).
For starters, American Express’ price-to-earnings and forward-price-to-earnings ratios are near historically low levels suggesting the stock has significant upside potential.
Specifically, its price to earnings ratio sits at around 12.4 versus a historical average of 16.4 over the last 10 years. And its forward PE ratio sits at around 11.2 versus its 5-year average of 14.0. Both metrics indicate the stock may be undervalued by as much as 26% and 32%, respectively.
And beyond PE ratios, there’s more reason to believe the stock is a great value. For example, American Express has an amazing return on capital. For example, according to the reasonable assumptions at GuruFocus, American Express’ weighted average cost of capital is only 6.1% and its return on invested capital is 9.6%. This is a very attractive spread. It means for every dollar AXP invests, it earns a return of 3.5%. And this return is magnified by the company’s use of leverage (debt) as shown in the following charts
Even more impressive is the company’s return on equity (ROE). It was 26.9% for the quarter ended in March 2016. It means the company returns 26.9% (net income) for every dollar of equity (stock) outstanding. This is amazing.
Also important, American is able to return very large amounts of cash to shareholders in the form of dividends and share repurchase. The dividend yield is a healthy 1.9% but the consistent share repurchase have historically meant more net income for each share of stock. That has (and will) help generate price appreciation for shareholders.
Business is Picking Up For American Express:
As the following chart shows, business is growing for American Express.
And it’s important to recognize the business is growing despite the loss of CostCo as shown in the following chart.
Also worth noting, loan balances (which drive a big part of American Express’ earnings) are also growing, even after you exclude the losses of CostCo and JetBlue. This is a good thing.
And a big part of the reason American Express is able to grow, despite competition from American Express and MasterCard, is because American Express has its own proprietary network for processing payments, and they have a very loyal following of affluent (big spending) individual and business customers that they attracted over the years with attractive rewards plans. And with regards to businesses, they’re often very loyal because it can be expensive to switch cards for all of their employees. In other words, American Express has a healthy competitive advantage in the space in which it operates. Further the company has been, and likely will continue to, cut costs in order to further increase profitability. Additionally, American Express is starting to let some third-parties utilize their closed payment processing network which acts to grow revenue and profitability further.
Of course American Express faces a variety of risks. For example, it may have to deal with new types of payment processing networks in the future that may bypass traditional networks such as American Express’s network. Additionally, American Express always faces competition with regards to rewards programs as other company’s try to steal away American Express’ affluent individual and business customers. Additionally, American Express faces the risks of more regulations and lawsuits such as the antitrust lawsuit mentioned earlier. And a slowdown in the economy poses a risk because it work mean less business for American Express, as well as a higher percentage of losses on its outstanding loans.
We own shares of American Express because it pays a healthy dividend (1.9%), and because the shares have significant price appreciation potential. The market has overreacted to bad news, and the shares are now 30% undervalued relative historical price-to-earnings ratios and based on the company's strengthening business. If you are a long-term investor, American Express is worth considering. We own it in our Blue Harbinger Disciplined Growth portfolio.