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