Description

I am recommending American Express. It has a very high ROE, a reasonable PE multiple (15x next years EPS post the spin-off of American Express Financial Advisors), a substantial new market opportunity for which I think we are not paying much if anything for, and an important corporate restructuring event.

I am not going to make this an exhaustive write-up as it could go on forever, and I think people generally know this company. I am going to try to hit the key positives and risks as I see them and then try to be as responsive to particular questions and specific areas of interest that other members may have.

Let me begin with a couple of overall thoughts about what is going on in the market(s) to try to frame at least the valuation question and market impact question on this company. First, transaction processing companies are in many cases proving to be extremely valuable. Witness for example Sunguard which was recently agreed to be bought out at a PE multiple of roughly 23x. (Of course, SDS is not a take-out candidate given its size.) This is not a growing business; it does have certain issues; and it is already run at high margins. Additionally, companies like TNS, Global Payments, Efunds, etc. are trading at multiples of roughly 20x. However, First Data trades at a comparable multiple and DST is at about 16x next year’s earnings. My view is that AXP deserves a higher multiple than FDC given the fact that it serves both sides of the transaction and faces a different competitive environment. Given how I think AXP can grow, we also don’t need multiple expansion. Overall, I do think that larger companies are quite a bit cheaper than smaller cap companies across the board.

From a 30,000 foot view, I find the very nature of AXP’s business compelling. It’s earnings mirror FCF and are extremely high quality. If interest rates go down, its earnings become more valuable and so the stock should be very responsive. But if interest rates go up due to inflation, AXP’s basic business is an adjustment mechanism as its revenue truly adjusts. The company’s business still has true toll road characteristics; its revenue goes up as spending goes up. Anybody who has eaten at a restaurant or stayed at a hotel recently can attest to the fact that things are getting cheaper.

Not counting big deals to issue new cards with Citi and MBNA (more below), the company continues to show unit growth. The discount rate declined from 2.59% 2003 to 2.56% in 2004, only about 1%. Total card billed business (money spent with cards) is up from $234mm in 2002 to $304mm in 2004. (I note that it even grew marginally in 2001 and at about 3% in 2002.) Bottom line, this is and has been a substantial growth business. The company has roughly $8.00/share in discount revenue, nearly $10/share in discount revenue and card member fees. As such, even in the face of potential continued discount rate declines (which may slow down as will be discussed below), current inflation rates + read GDP growth more than offset these declines.

The company has announced its intent to spin off AEFA. When you cut to the core of this company, it is an insurance company. AXP will have to put perhaps $1bn of capital in to capitalize the business at $7bn, roughly $5.50 a share. This business should earn roughly $.65+ per AXP share next year, so I value this low double digit ROE business at about $7.00. This leaves AXP Bank which has a roughly 20% ROE but only earns up to $.15 a share and TRS, the company’s key and well known businesses which should earn roughly $2.65 next year—a total post spin of $2.80. Post-spin-off, we believe that the company will have no net debt (although it does carry substantial liabilities that fund its various loans.) There is total debt of $47mm, but the company could sell off receivables and retire, which in the case of this company I see no need to.

Let me dispense with one item here; net interest income is less than 20% of TRS revenue (lower if one nets out reserves). Consequently, this stock will not be substantially driven by what happens in the “traditional credit card” lending business.

A few years back, the Department of Justice instituted a lawsuit, the end result was the end of the Visa/Mastercard “Exclusionary Rules”. This means that banks that issue Visa and Mastercard are now allowed to issue American Express Cards. Last year, MBNA and Citibank were the first to announce a venture with American Express, the result of which was $1mm new cards for American Express. The pros and cons of these relationships are manifold-- branding, scale, litigation, pricing—some of which are positive, some negative. The net result however will be unit growth for American Express and given the network effects nature of its business, increased ROE. It remains to be seen how many banks will sign up American Express but the numbers could obviously be substantial, and there isn’t much downside from these ventures.

The key thing that is happening as result of this development is that Visa is RAISING its interchange fee. Visa has been under financial pressure, having lost money through 2003, last year being the first time in recent years that it made money (I think), and with its banks now being able to issue American Express Cards, it is raising its fees to try to minimize defections.

So net net, in addition to all or the above, AXP’s major competitor is raising price. So we have unit growth and price… a nice combination.

Let’s look at the risks:

1) market—AXP is highly correlated to the market. If the above is right, this will be true only in the short term
2) New competitors like GE and Discover and potential results of joint efforts. It is true that these things are going on, but I think they are at the edge of the market for the moment. Clearly worth looking at.
3) Retailer backlash. A definite issue. (I note that 25% of AXP’s spending is T&E related). Retailers are getting bigger and stronger (eg. KMRT/S, MAY/FD), and with Visa raising interchange, there will be war. There is no question about this. The retailers are exploring all kinds of different ways to go after American Express (including litigation as will be discussed next) as well as Mastercard and Visa. Interchange is a big issue right now. Two of the next Federal Reserve regional conferences will have large components devoted to this issue. There will be some blood and plenty of headlines; bottom line, I do think it reflects the strength of American Express’ business and that at the end of the day, if people carry the card and want to use the card, the retailers only have so much clout. Remember, this has been an issue for decades.
4) Let’s address the litigation issue because it is at the very least a negative wild-card.

Some regional supermarkets have sued American Express on their version of Honor All Card Rules. The lawsuit is grounded on the old Sherman Anti-Trust Law Tying provisions, and is somewhat modeled after the substantial Honor-All Card Suit that WMT won a large settlement from Visa in and forced an unbundling of Visa’s cards.

In this case, merchants want to be able to take American Express Charge cards and not credit cards, their goal being to nip in the bud American Express’ effort to sign up bank credit card customers, thereby reduce Visa’s need to raise interchange fees. One of the key (there are 4) linchpins of a tying case is that the two products comprise separate markets. In the Visa case, the judge ruled that debit and credit comprised two separate markets from the vantage point of the retailers, the key ruling that quickly led to settlement. It is much harder to make the case for charge and credit. In fact, there have been rulings that they are the same market; and the Visa settlement did not differentiate between charge and credit although it did separate the debit cards. Additionally, plaintiffs have to prove market power in the tied market (in this case credit… charge being the alleged tying market). Even if one can prove separate markets, one has to prove market power in the tied market, which may be hard; American Express credit card receivables are only the same size as MBNA’s. I can go on and welcome doing so if folks want to dialogue further on this point (but frankly, it is lunch time and I’m getting hungry). (PS. Do any of you guys have clients that ask you if you’re busy? How do you answer that question? I answer it: “very… I just beat the computer in chess and am moving on to solitaire.”) Anyway, the litigation is an issue and as somebody taught me, with perfect facts and perfect law, you only have an 80% chance of winning. But even if AXP loses one of these suits, it is unclear that the impact on the long term prospects of the business will be of any conduct remedies (setting aside short term settlement costs). But there certainly is headline risk.

Finally, company reports earnings tomorrow. A cynic might ask if management might save some powder until post spin-off. Anything is possible, but the spin-off piece is not that big a piece of the value, and this is a great and high quality management team.

While it could take some time for the thesis (if right to pay off), we are getting a double- digit earnings grower, high ROE, with a big new opportunity. Without PE expansion, the stock should do well. Moreover, while I never invest counting on PE expansion, the combination of variables in this case lead me to think it possible.

Catalyst

corporate restructuring, new business opportunities, earnings growth, competitor raising price