American Express AXP
December 31, 2008 - 1:22am EST by
2008 2009
Price: 18.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 21,000 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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American Express has fallen in price by approximately 60% since Spence774 recommended the company back in June 2008.  Although the company has been caught up in various aspects of the financial crisis, American Express is positioned to survive and thrive once the economic environment begins to stabilize.  Even if conditions continue to worsen, American Express has already taken a number of steps recently to get to the other side of the current financial chasm.

The company has been written up on Value Investors Club three times previously.  I recommend that you read previous posts to develop a detailed overview of how the company is positioned in its businesses and catch up on changes since the initial write up in 2005.  In a nutshell, although American Express is a "credit card" issuer, it is much more attractive than that due to a variety of factors including the somewhat differentiated nature of its customer base and business model.  In particular, American Express serves a higher end customer, on average, and also has an incredibly valuable brand as well as a tremendous closed loop payments network.  Because the company has a spend-centric and not just a loan centric business model, it generates and will continue to generate significantly higher earnings and returns on invested capital than the vast majority of financial companies can generate with a lending centric model.
Becuase there is already so much background material already, I would like to provide more details on the specific issues and opportunites embedded in the current situation, one which has really come to the fore in the last 3 to 4 months.

At a current price of $18 per share, Mr. market is assigning a $21 billion equity value to the firm.  This value is approximately one third of the company's worth 18 months ago.  And far below what the company is worth on a multiple of normalized earnings over the long-term. 
So why is it cheap (and getting cheaper?).  Besides the broad based sell off in all things financial, there are three main worries/uncertainties that have precipitated this dramatic decline in the stock price - which has been far worse than that of the market itself in the last 3 to 6 months. These three main worries are:

  1. Uncertainty regarding the ultimate magnitude of credit losses that will be experienced in the portfolio (asset side issue)
  2. Uncertainty regarding the cost of and its access to funding that the company needs to continue its spread based lending activities (liability side issue)
  3. Certainty that the earnings power of the company will be declining in the short term.  As consumers cut back spending in a recessionary environment and uncertainty as to the magnitude and timing of a recovery (income statement issue)

As others have pointed out, the market hates uncertainty and so it responds by applying an extraordinarily high discount rate.  As value investors, we get paid if we are able to identify a mismatch between the level of uncertainty and the price that discounts a far more pessimistic scenario.  My thesis is that a number of steps taken by the company and the federal government in the last few months have significantly reduced the likelihood of a level of financial distress that market participants fear - i.e. those scenarios that would prevent American Express from continuing as a going concern.  Since the chance of failure is greatly diminished and the likelihood of returning to a normalized environment has now increased, American Express represents a good long-term investment opportunity because it allows current investors to capture the high discount rate as their expected IRR with the likelihood that it will be even higher if the discount rate diminishes materially within the next two to three years.

The steps that American Express has taken to counteract the three issues above are the following:

  1. The company has announced very significant cost reductions.  A few months ago, American Express announced that it was cutting 10% of its workforce, as well as significantly curtailing its investments.  These cutbacks are expected to net more than 800 million of savings in 2009 alone.  These cost reductions will not significantly impact revenues - so will increase profitability and/or offset some of the revenue weakness.
  2. The company is also adjusting its pricing upward to offset some of the pressures being created by credit losses as well as funding costs.
  3. A few days ago, American Express announced that it will be receiving $3.39 billion in the form of a preferred investment by the treasury.  This preferred stock will have a 5% yield to the treasury and 15% warrant coverage, which represents the upside on approximately 28.25 million shares (strike price presumably at current prices).  This represents only 2.4% of the 1.16 billion shares outstanding.  This funding was received on very attractive terms, and significantly increases AXP's ability to absorb significant additional credit losses
  4. American Express became a bank holding company, specifically so that it could accept funds from the treasury.  In addition, American Express's status as a bank holding company may give it flexibility to solve or mitigate some of its funding issues through additional deposit gathering, and/or acquisitions of banks with deposits.  While this would not be an ideal outcome as a bank is not nearly as good a business model as American Express already has, the flexibility to solve a potential funding issue with greater number of tools is a positive as it also materially reduces the risk of failure.

Regarding the three issues cited above, it is helpful to have a sense for the scope of each concern:

Issue#1:  magnitude of potential credit losses

Before driling into the specifics of the credit losses, it's important to keep them in context, because American Express has a spend centric and not just a lend centric business model - as pointed out above.  This means that the majority of their revenue is of a very profitable, fee based, growing, recurring annuity type income stream. 
Keeping aside the credit part of their business for the moment, AXP generated $11.5 billion in revenue in the first 9 months of 2008 from this Discount Revenue alone.  I.e. the company's roughtly 2.56% cut of all the money spent on their cards during that time period.  During the 1st 9 months of 2008, AXP cardmembers numbering approx 52.3 million in the US and 37.8 million outside the US spent a total of $522.8 billion on their cards (This spending was up from $469 billion last year due to both higher average spending per card member and growth in cards-in-force despite the recession).  In addition to the discount revenue, the company also generated an additional $1.7 billion in revenue from the annual fees that members pay to have an American Express Card (on average).  The beauty of this part of their model is that it is fee for service and it is a toll bridge type revenue stream based on the growth of electronic payments and global growth.  This business requires very little capital, throws off lots of free cash flow and is far larger than their lending business.  As we will discuss in Issue #3, this portion of their business is certainly sensitive to the level of spending and in a consumer recession, growth will slow.  It would be unlikely to go negative for perhaps more than 1 or 2 quarters (and it has not done so yet).  In the other hand, nominal inflation will actually be fine as it is likely that costs will not increase as fast as revenues.
Now compared to the total charged on the cards, the company's recievables/loans to cardmembers outstanding are far smaller.  As of Sept 30, 2008, total Cardmember Loans were $43.1 billion (this excludes approximately $28.9 billion of additional cardmember loans in a Master Securitization Trust which has been securitized, but includes AXP's retained undivided sellers interest of approximately $13.5 billion in this trust) and card member recievables (not loans) were approximately $40.6 billion.  The latter figure represents the delay between when the money is spent (paid to the merchant) and when the customer pays American Express (i.e. it is reverse float).  The former are actual loans against which the provisions are $2.64 billion at the end of Q3 2008 - and this is the figure (loan provisions) that could and probably will go much higher.  One indication for the quality of the business is its ability to absorb a higher level of loan losses.  In Q3 2008, AXP provisioned $958 million for loan loses (as compared to $579 million in Q3 2007).  The Q4 provision will probably be higher still.  However, in Q3 2008, after absorbing higher loan loss "reserves", the company still generated net income for $815 million.
Depending on the level of provisions in Q4 2008 and Q1 2009 which could very will deterioriate from Q3 2008 levels, net income could go negative.  The company did expand its loan portfolio more aggressively that it should have in 2006 and 2007 and loan losses on part of its loans will be much higher than expected.  Even if they turn out to be 10% of loans outstanding (which would be surprising), AXP has significant ability to absorb a temporary hit to earnings.
Issue #2:  Funding the balance sheet
AXP funds the aforementioned recievables and loans with short-term and long term debt as well as customer deposits.  As of Q3 2008, ST debt was $13.9 billion (down from $17.7 billion in Q3 2007), long-term debt was $57.7 billion (up from $55.2 billion) and customer deposits were $11.8 billion (down from $15.4 billion).  This is a substantial balance sheet and parts of it frequently have to be refinanced.  Access to short and long-term funding in the commercial paper, interbank, medium term notes and long-term notes were all impaired this year.  Recent actions by the Fed and the Treasury have significantly eased liquidity.  AXP has the ability to go to the Fed and borrow (probably the entire amount) if it needed to.  However, it appears likely that with Washington focused on easing and getting lending going again, AXP will be the beneficiary of policies designed to insure that refinancing risk is mitigated for companies that have relatively viable businesses and assets (but that might run into refinancing risk).  Recently, the FDIC backstopped a debt issue for AMEX (by providing a guarantee) and subsequently, AXP issued the aforementioned Preferred Stock to the Treasury as well.  Given current government policy, it seems highly unlikely that AXP would be allowed to fail simply because markets are not willing to finance financial companies for the time being.  In the intermediate term, of course, the cost of funding may go up, but AXP can pass along much of this cost to its customers over time.
Issue #3: Earnings Hit
So the impact of slower spending and loan provisions and higher cost of borrowing in a credit constrained environment are simply that margins compress in the near term.  Dec 2009 estimates decreased from $2.92 90 days ago to $1.92 today.  However, AXP is not standing still.  The company is simultaneously increasing fees and interest charges, significantly cutting costs, and also tightening credit standards.  Meanwhile, spending and electronic spending in particular will continue its upward March over time so the company is likely to recover and go above peak earnings again.  Earning may be lower in 2009 and perhaps even in 2010.  However, they should recover thereafter.  In 18 to 24 months (at the outside), investors should be looking past current issues around provisioning, borrowing, and earnings compression.  Applying a 15x multiple of a mimum of $3.00 in earnings in 2011 give a stock price north of $45.00 in 18 to 24 months for an IRR north of 30% per year from current levels.


* Earnings normalization 2 to 3 years out

* Moderate growth

* Getting past provisioning and credit issues by end of 2009
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