American Express (AXP) 2017 Third Quarter Results

  • Ken Chennault announces retirement in February 2018 and Steve Squeri will become Chairman & CEO
  • Third Quarter EPS of $1.50 vs. $1.20 last year and consensus of $1.48
  • Management raised full year 2017 guidance from $5.40-$5.80 to $5.80-$5.90
  • Earnings growth driven mostly by decline in tax rate and decline in share count.  However, one-time impairment charges offset the increase in tax credits booked in the quarter.

American Express Company (AXP) reported 2017 third quarter EPS of $1.50, up from $1.20 in 2016 and slightly ahead of the consensus estimate.  Total revenues, net of interest expense, were $8.44 billion, up 9% from a year ago.

The increase of $662 million in revenues was split evenly between non-interest revenues (e.g. discount revenue from merchants, net card fees, etc.) and net interest income.  Billed business (i.e. the total amount charged by cardmembers on their cards) was up 8.2% to $271.9 billion, but the discount revenue earned from merchants on those billings rose by only 5.7% to $4.77 billion because the average discount rate declined once again by 5 basis points (bp) to 2.42%.

AXP’s third quarter net interest income increased to $1.68 billion from $1.33 billion.  That increase was driven by both an 11.3% jump in average loans outstanding to $67.1 billion and a rise in the annualized net interest margin earned on those loans from 8.8% to 9.9% (according to my estimates).  I calculate that the annualized rate on AXP’s average outstanding loans increased by about 173 bp to 14.1%, while the annualized rate paid on average deposits and loans outstanding increased by 36 bp to 2.0%.  The increase in loan and deposit costs was much less than the Fed’s 100 bp increase in the Fed Funds rate. AXP said that much of the rather large increase in the average rate on loans is due to the transition of the loan portfolio away from co-branded relationships (especially Costco) to its broad base of cardmembers.  In addition, low teaser rates, offered for a limited time to cardmembers to encourage balance transfers, are now expiring.

The increase in loans outstanding has been accompanied by an increase in AXP’s provision for credit losses.  The 2017 third quarter provision rose 53% to $769 million from $504 million in 2016.  Despite that jump, the 30+ day past due rate on cardmember loans increased only modestly from 1.1% to 1.3% of total loans and the annualized charge-off rate on principal has increased from 1.7% to 1.8%.  Yet, AXP raised its provision to build up its loan loss reserve to 2.2% of total loans outstanding from 1.8% a year ago.  It thus expects that charge-offs will increase in the quarters ahead.  Since charge-offs remain at a very low level, however, the company says that it can absorb this increase.  It therefore believes that it has significant running room to grow its loan portfolio going forward.

Besides the increase in loan loss provision, AXP also experienced a meaningful rise in expenses.  Overall, total expenses increased 5.5% to $5.84 billion; but a surge in expenses for card member rewards and services and the booking of $155 million in asset impairment charges on the U.S. Loyalty and Prepaid businesses were partially offset by declines in marketing and promotion expense and professional services expense.

Still, the increases in loan loss provisions and total expenses offset much of the 9% increase in total revenues.  As a result, AXP’s pretax income rose at a slower pace than revenues, by 5.3% to $1.83 billion.  The reduction in the income tax provision from $593 million to $471 million, due primarily to the realization of certain foreign tax credits, also helped boost net income. AXP’s effective tax rate declined from 34.2% in the prior year quarter to 25.8%.

As noted, AXP’s EPS increased 25% from $1.20 to $1.50.  I calculate that 5.5 percentage points of the increase was due to a reduction in the share count; 11.0 percentage points was due to the reduction in income tax provision and 8.3 percentage points was due to the improvement in pre-tax profits.  Management points out, however, that the reduction in taxes was essentially offset by the asset impairment charges taken on the U.S. Loyalty and Prepaid businesses; so the increase in what would be considered non-GAAP EPS was still similar to the increase in GAAP EPS.

Looking solely at the numbers, much of the sharp increase in AXP’s 2017 third quarter EPS was accomplished by additional leverage – increasing cardmember loans outstanding and reducing the share count.  Management acknowledges that the additional loans are riskier, but it still does not view them as risky.  Even so, the combination of higher loans and share repurchases resulted in a modest decline in AXP’s Tier 1 capital ratio from 18.4% to 17.9%.  That’s still a strong ratio, but the quality of earnings growth achieved by AXP declined.

As a result of AXP’s performance for the first nine months of 2017, management has lifted its 2017 earnings guidance to $5.80-$5.90, from $5.40-$5.80.  Consensus estimates currently anticipate another 10% increase in earnings to $6.46 per share in 2018.  At the same time, AXP has raised its annual dividend by 9.4% from $1.28 to $1.40 per share.  That works out to a yield of 1.5%.

At the current quote of $93.53, AXP shares 16.0 times anticipated 2017 earnings and 14.5 times projected 2018 earnings.  That’s a higher multiple than other credit charge card companies, like Capital One and Discover, but a much lower multiple than payment providers Visa and Mastercard.  It is also below the average market multiple for the broader market.  In the current market environment, if AXP is able to meet its guidance and current Street expectations, its share price could continue to advance along with other financial stocks.

AXP’s quick rebound from the loss of the Costco relationship has been impressive; but it is unclear how sustainable it will be.  The 7% year-on-year growth in U.S. billings reported for the third quarter is well above 3.4% increase in retail sales for July and August.  (September retail sales have not yet been reported.)  While AXP cardmembers most likely have a higher propensity to spend, the billings gains recorded by AXP in the third quarter were also driven by market share gains bought to some degree by increasing cardmember rewards.

Although AXP has been aiming to get a larger share of cardmember loan balances, those gains come with increased risk of credit losses.  The third quarter increase in loan loss reserves supports that view.  While the additional business was profitable for AXP, it comes clearly with greater risk.

In the short run, AXP may be able to sustain its recent growth, especially if tax reform gives the economy a jolt; but barring a fundamental shift in the economic outlook, this growth will eventually prove to be temporary.  Such growth also raises the risk of a more significant decline in earnings during the next economic downturn.

If so,  AXP’s financial targets – 6% revenue growth and 10% earnings growth – are too aggressive over the long haul.  I have previously suggested that AXP should consider changing its value proposition with investors to provide a dividend yield that is above the rate of inflation in exchange for lowering revenue and profit growth expectations.  I think that this would be a fair deal for investors.  Although I acknowledge that such a move would not likely produce the double-digit returns to which investors may have become accustomed; it could very well reduce the potential downside risk in AXP’s shares.

October 25, 2017

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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