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American Express looks cheap


merkhet
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I saw that there was a thread on Visa and Mastercard, but there wasn't a discussion of American Express.

 

I've only taken a cursory look here, but it looks like AXP is trading at a ridiculously price to free cash flow multiple.  I'm wondering if I'm missing something here.

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Ah, the antitrust case?  I'll have to look into that.  Thanks.

 

Still, on a 10-year historical free cash flow average of around $7 billion a year, a $50 billion market cap just seems... wrong.

 

But if credit card fees are reduced/limited, that FCF average from the past 10 years is rather meaningless.

 

http://www.bloomberg.com/news/2010-12-20/amex-leads-dow-index-lower-as-stifel-says-credit-fees-may-be-next-target-.html

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I am not an expert by any means.

 

A great name. A great franchise. Owned by WEB

 

I am just reading thru latest 10Q, trying to understand the company

 

Is there not a lot of balance sheet risk?

 

Balance sheet looks more like a bank's. They have made a lot of loans (card member loans),  and ~ $35 billion in cardholder receivables  offsetting~ $68 billion in long term debt, versus shareholder equity of only~$15-16 billion.

 

AXP at risk of credit card defaults

 

Different model then V or MA.

 

Also can someone have a look at the following summary of AXP

 

http://www.gurufocus.com/financials.php?symbol=AXP

 

and explain how company can have $3-almost $7 in free cash flow per year, dividend out <$1 per year yet BV  has risen from $8.70 in 2000 to only $13.23 in most recent quarter. Does that make sense?

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I assume FCF is being calculated by subtracting capex from operating cash flow. You can't do this with a bank or axp because it adds back provision for loan loss which is a very real expense despite being non cash. I know value investors are head over heels in love with free cash flow, but normalized earnings are much better indicator of the true economic earning power of a business as long as cash flow confirms the earnings over time. I.e Caterpillar had huge FCF in 2009 because of massive inventory liquidation. That is not an economic reality over time because eventually that inventory must be built up.

 

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Thanks bmichaud,

 

we should conclude then that we should look at book value as the proper metric for AXP as we do for banks & insurance companies.

 

Then AXP does not look to be bargain.

 

"Still, on a 10-year historical free cash flow average of around $7 billion a year, a $50 billion market cap just seems... wrong" -it would appear that you right as the $7 billion does not include reserves for bad loans...

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Something's off with how profits are distributed across the payment system. MA, V print 40-70% margins (less so for AXP, a bank holding co) while merchants do mid-single-digit, if that, and the issuing banks  regularly lose money. Maybe that's a sustainable equilibrium, but I'd think the other players might disagree.

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"Still, on a 10-year historical free cash flow average of around $7 billion a year, a $50 billion market cap just seems... wrong" -it would appear that you right as the $7 billion does not include reserves for bad loans...

 

 

Ah, that makes more sense now.  Thanks guys.

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and explain how company can have $3-almost $7 in free cash flow per year, dividend out <$1 per year yet BV  has risen from $8.70 in 2000 to only $13.23 in most recent quarter. Does that make sense?

Book value rose from 8.7 to 12.83 in 2004. I think 2005 was ameriprise spin off, so 2005 book value was 8.5. since then it has risen again to 13.23 in current quarter

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You might want to be a little cautious.

 

1) We’ve all heard nothing but the housing bubble, foreclosures, unemployment, etc. But what about all the credit cards that those people were holding ? At some point folks are no longer going to be able to kite all the minimum payments amongst those cards, which can only result in tears.

2) Amex/Visa has not had to put up a reserve requirement against credit card loans, yet how is a credit card loan really any different from an ordinary bank loan ?  – where there is a reserve requirement? Impose a reserve requirement, & you restrict leverage - permanently reducing the historic valuation metrics.

3) The US is not an island. Where countries cannot increase interest rates to dampen inflation (increases their  FX  rate), they can increase/impose reserve requirements instead (China) -  to both reduce the $ available for lending & make the credit system more robust to shock. If one G-8 does it, how long can it really be until the rest do it as well?

4) Playing fields change. In a modern economy, credit is a fundamental necessity no different to healthcare, clean water, sanitation, telephone & internet. What is to stop a government giving everyone a basic credit card, &  recharging it every month with whatever social benefit (unemployment, pension, social program, etc) has been earned ?. Greater dignity for all, no more paper, ability to track spending, etc - & a large part of the existing playing field permanently removed.

 

SD

 

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You might want to be a little cautious.

 

1) We’ve all heard nothing but the housing bubble, foreclosures, unemployment, etc. But what about all the credit cards that those people were holding ? At some point folks are no longer going to be able to kite all the minimum payments amongst those cards, which can only result in tears.

2) Amex/Visa has not had to put up a reserve requirement against credit card loans, yet how is a credit card loan really any different from an ordinary bank loan ?  – where there is a reserve requirement? Impose a reserve requirement, & you restrict leverage - permanently reducing the historic valuation metrics.

3) The US is not an island. Where countries cannot increase interest rates to dampen inflation (increases their  FX  rate), they can increase/impose reserve requirements instead (China) -  to both reduce the $ available for lending & make the credit system more robust to shock. If one G-8 does it, how long can it really be until the rest do it as well?

4) Playing fields change. In a modern economy, credit is a fundamental necessity no different to healthcare, clean water, sanitation, telephone & internet. What is to stop a government giving everyone a basic credit card, &  recharging it every month with whatever social benefit (unemployment, pension, social program, etc) has been earned ?. Greater dignity for all, no more paper, ability to track spending, etc - & a large part of the existing playing field permanently removed.

 

SD

 

 

1) & 2) Um, AXP did reserve heavily through the cycle (and continues to reserve), cut-off some of their riskiest clients and re-oriented their product mix toward charge cards versus revolving balances (loans).  They remained profitable through the crack-up.  AXP focuses on a more affluent customer and their business model tries to optimize spend, not credit.  It is a unique franchise that, as of yet, no one has been able to effectively replicate.  There is a first-mover advantage to the affluent network they have built.

3) They do reserve and they already carry considerable excess capital and liquidity

4)This seems a bit far-fetched

 

I think the main risks here are 1) governments limiting interchange fees (a key component of AXP's attractive economics) and therefore indirectly limiting a company's ability to offer rewards (a key component of AXP's customer offer) and 2) this business is, over time, dependent on economic growth and therefore macro-crackups.

 

The company does some pretty innovative things with its data, being one of only two issuer/processors in the industry (Discover is the other).  It has consistently generated 20%+ ROEs and returns ~60% of annual earnings to shareholders, retaining the rest for growth.

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Mandate a industry reserve requirement of 8% & everybody can only lend up to 12.5x their capital. To do the same level of business they would need more capital, or for the same level of capital, disengage from some of their existing business. With an industry requirement there is no one concern with how any one individual firm does its business - you reserve to the industry expectation of loss, not your estimate for the riskiness of the business that you are doing.

 

The loss of 5 I-Banks, & the move to debit card vs cash was also far-fetched at the time.

What is so far-fetched about giving everybody one piece of plastic that is both a credit/debit card & also serves as ID for various social services ? - you pay by giving your card, with the charge going to your card, & no service unless you have the balance. Cheap, every transaction visible, no checks, no cash, & every card automatically recharging every month if youre eligible. Why would you NOT move in this direction ?

 

The industry moat is not as wide, or robust, as the industry might like you to think.

 

SD 

   

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Mandate a industry reserve requirement of 8% & everybody can only lend up to 12.5x their capital. To do the same level of business they would need more capital, or for the same level of capital, disengage from some of their existing business. With an industry requirement there is no one concern with how any one individual firm does its business - you reserve to the industry expectation of loss, not your estimate for the riskiness of the business that you are doing.

 

The loss of 5 I-Banks, & the move to debit card vs cash was also far-fetched at the time.

What is so far-fetched about giving everybody one piece of plastic that is both a credit/debit card & also serves as ID for various social services ? - you pay by giving your card, with the charge going to your card, & no service unless you have the balance. Cheap, every transaction visible, no checks, no cash, & every card automatically recharging every month if youre eligible. Why would you NOT move in this direction ?

 

The industry moat is not as wide, or robust, as the industry might like you to think.

 

SD 

   

 

In my opinion, it is far fetched.  The world lurched toward more regulation as the result of crisis, but there is no popular mandate to permanently socialize credit and consolidate payment processes, ID and social services across the spectrum.  Who really believes, deep down, that credit and risk should be untethered?  Who is demanding this?  From a regulatory perspective, my guess is that things calm for the next few years as the pain of the crisis fades.  A few more palpitations and I suppose we could get there, and admittedly memories are short, but I think it is unlikely that we will experience something like this again for at least a decade.

 

Let's just say that everybody else had to raise capital.  That would raise the cost of capital and therefore require higher returns on said capital, not lower ones. One could argue the cost of credit would rise (as it became more scarce, unless otherwise mandated), and AXP would be at an advantage under such circumstances.  And it's already leveraged 9x today.  Credit card issuers already carry a lot of capital.  Again, in the States, Congress just passed the CARD act.  In their minds, mission accomplished.  I do not think this will come up again for a while.

 

We might move toward the scenario that you describe but: 1) you place way too much faith in government's ability to execute; 2) there is little chance industry will elect to fuse with social service entities unless it is a) profitable or b) mandated.  Even if there were the option, people like their AMEX rewards and refunds.  It is a buying club in some ways like a Costco.  Merchants may balk, but particularly with AMEX, the processor does supply some value-add that justifies a discount.  The merchant doesn't have to finance the sale. AMEX has affluent cardholders.  The merchant gets marketing support and access to valuable data.  Nobody has a legal obligation to accept AMEX and many merchants don't. AMEX is a bit different.

 

All of that said, I think there is risk that the government could try to regulate discount rates like they are proposing to do on debit cards.  I simply think the legal footing for doing so is less stable than debit.

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Mandate a industry reserve requirement of 8% & everybody can only lend up to 12.5x their capital. To do the same level of business they would need more capital, or for the same level of capital, disengage from some of their existing business. With an industry requirement there is no one concern with how any one individual firm does its business - you reserve to the industry expectation of loss, not your estimate for the riskiness of the business that you are doing.

 

The loss of 5 I-Banks, & the move to debit card vs cash was also far-fetched at the time.

What is so far-fetched about giving everybody one piece of plastic that is both a credit/debit card & also serves as ID for various social services ? - you pay by giving your card, with the charge going to your card, & no service unless you have the balance. Cheap, every transaction visible, no checks, no cash, & every card automatically recharging every month if youre eligible. Why would you NOT move in this direction ?

 

The industry moat is not as wide, or robust, as the industry might like you to think.

 

SD 

   

As cayale mentioned, American Express has a spend-centric business model, not a lend-centric one like the operations of most of their competitors. AMEX's capital ratios as of Q3 2010 looked like this:

 

Tier 1 Capital: 11.7%

Total Capital: 13.9%

Leverage Ratio: 9.2%

Tier 1 Common Risk-Based Capital: 11.7%

Common Equity to Risk-Based Assets: 14.6%

Tangible Common Equity to Risk-Based Assets: 11.5%

 

AMEX only has about 57 billion in loans outstanding (this includes stuff they securitized but had to bring back on the books earlier this year). I think an 8% reserve requirement will have no impact on the way AMEX does business. Btw, despite maintaining the above capital ratios, AMEX had an ROE of 27% or so last quarter.

 

Prior to the credit crisis, I believe AMEX was running with much lower capital ratios. They also had an ROE of 30%+. Management has already conceded that ROE will drop to the 25% range thanks to higher capital requirements.

 

As for your futuristic scenario, I'll wait until I see some sign of at least one major country moving in this direction before worrying about it. I am more concerned about online payment options like Paypal than about the combo debit/credit/id card.

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What you are getting if you buy Amex at this price is GARP.  It's neither a bargain nor overpriced.  That's okay if that is what you want.  I bought it in fall 2008 and winter 2009 and sold it out later in the spring and summer.  My last sale was around $35.

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The point is being missed:

 

- The government doesn't give you a EI (or other social benefit) cheque - it credits your debit/credit/ID card electronically (at a big savings) - & you spend it. No credit involved, no net debit, & no purchases unless you have the money on the card - ie: entirely spend centric. The government interest is in your back office processing capability, & you'll take the deal because you will be able to update & modernise your IT essentially for free.

- To get the money you have to use an ATM machine or a merchant. With 1 card/per person (170 Million cards?) there are not going to be any withdrawal fees, and there is going to be an electronic record of where every $ was withdrawn from the card. The government gets an electronic copy of each card statement at maybe 2c a pop? & Homeland Security perhaps pays you a visit if your spending is suspicious ?

- Cheque cash stores exist primarily because patrons cannot get credit, a position that most Americans who have had to walk away from their houses are in. Want a government guaranteed loan ? give me your card number, electonically apply standard underwriting principles based on documentation, & verify acceptance with a code (everyday underwriting practice). If its too slow for you, or you dont like the idea, go elsewhere - as you clearly have better options. But a lot of new enterprises will start because they can now get the credit that they could not get before.

 

Choosing not to consider alternatives because its too 'radical', can cost you.

 

Best of luck to you

 

SD

 

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