Notes and Analysis from AXP’s Analyst Day

Shareholders of the American Express Company have had a pretty rough ride over the past few years. Since 2013, when AXP’s stock earned nearly twice the S&P 500, the stock has underperformed the broader market significantly, as shown in the chart below:

AXP v SPX 2013-2016

Although AXP is down 12.0% year-to-date (through March 18), it has rebounded 21.8% off of its February 11 low of $50.27. That could mark the beginning of a reversal in investor sentiment, but the rebound has also coincided with the broader market recovery.

AXP’s poor relative share price performance began in 2014, as MasterCard and Visa faced lawsuits from merchants over alleged anti-competitive practices. The stock then took a dive in February 2015 when it agreed to end its co-brand relationship with Costco. Later that same month, a U.S. District Court judge ruled that AVP’s anti-steering policy violated anti-trust laws. Both of these developments clouded the outlook for the company’s revenues and profits.

The Costco co-brand relationship accounted for 19% of Cardmember loans as of December 31, 2015 and 8% of AXP’s billed business in 2015. AXP’s revenues and profits had already begun to face headwinds during 2015 from the loss of Costco’s Canadian business; but they will take a bigger hit beginning in June when Costco’s U.S. credit card business is transferred to Citibank.

The loss of Costco blows a hole in AXP’s revenue base that can eventually be filled, but a loss of the antitrust case could accelerate the decline in the premium that American Express charges (over Visa and MasterCard) to merchants for processing their transactions. The company’s anti-steering policy prohibits merchants from directing customers to pay with credit cards that charge lower fees. Merchants have long complained that anti-steering and other policies of the credit card companies have raised discount rates well above transaction processing costs.

AXP’s appeal in this matter is still pending. A decision is expected sometime in the spring. In the meantime, the company is pushing to head off the potential negative impact of an unfavorable ruling by bringing new services to merchants and in some cases, working with merchants to lower their discount rates. It appears, therefore, that this is a manageable problem, even though it will likely result in continued pressure on AXP’s discount revenue.

Also looming on the horizon, however, is a court ruling or settlement that will allow merchants to charge a premium to customers who use credit or charge cards. That change would likely hurt Amex and the other card companies more because customers would use their credit and charge cards less often.

An Obsolete Business Model? The anti-trust lawsuits and loss of Costco have caused investors to wonder whether American Express’s business model is becoming obsolete. At AXP’s analyst meeting on March 10, however, CEO Kenneth Chennault asserted that the company is addressing these and other challenges that it faces in an environment characterized by slow economic growth, increased regulation and increased competition. The payments industry continues to evolve with consumers making less use of cash and checks and more use of cards, online payments and mobile payments. AXP believes that its closed loop model – i.e. its direct relationships with both consumers and merchants, end-to-end through the payments chain – and its strong balance sheet give it competitive advantages that will allow it to adapt better than its peers.

The Closed Loop. AXP’s closed-loop business model gives it detailed information about customer spending habits and merchant sales. It uses that data to help merchants create targeted marketing campaigns, provide special offers to Card Members, enhance its assessment of credit risks and protect against fraud. The closed-loop network also allows AXP to bring new initiatives to market faster than competitors, as evidenced recently by its quick roll outs of Apple Pay, Samsung Pay and Android Pay mobile services.

2015 Financial Performance and Outlook. The company’s 2015 financial performance was well off of its long-standing financial targets. Net income fell 12% to $5.2 billion. Diluted EPS declined 9% to $5.05. Excluding a $335 million impairment charge primarily related to AXP’s Prepaid Services, adjusted EPS was $5.38, still 3% below 2014’s $5.56.

Volume growth in its U.S. consumer business has moderated. Under a new business segment reporting format, billings rose 4.6% in 2015, less than the 7.2% increase in 2014. The slowdown in billings was due to Costco, a slower rate of growth in consumer spending and increased competition.

A bigger hit on adjusted earnings will likely come in 2016, as a result of the end of the Costco co-brand business. Management has given EPS guidance of $5.40-$5.70 for 2016, but this includes an anticipated gain of $1 billion (or $0.65 per share, assuming a 35% tax rate) from the sale of the Costco loan portfolio to Citibank. Thus, its EPS guidance, adjusted for the loan portfolio gain on sale, is $4.75-$5.05. Neither of these 2016 earnings estimates reflects possible restructuring charges to lower operating expenses.

Management has set a goal of reducing annual operating expenses and marketing & promotion costs by $1 billion by the end of 2017. This represents about 7% of the $14.4 billion of addressable spending in these areas. The company expects to realize 50% of the cost reduction target from streamlining its organizational structure, 40% from reengineering key processes and 10% from leveraging policies on sourcing, spending and location strategy (for example, by relocating certain functions to lower cost geographies). Recent changes in AXP’s organizational structure, as reflected in its newly redefined business segments, will provide opportunities to eliminate certain duplicative functions, such as sales.

American Express typically spends much more than its peers on marketing and technology development. Yet management believes that its efforts to streamline from the organization and reduce costs will also improve customer service, speed product and service rollouts and thus enhance the company’s overall revenue growth prospects.

Preliminary 2017 Earnings Guidance. With current and future revenue growth initiatives and achievement of part of the anticipated $1 billion savings in annual operating costs, management has set a preliminary EPS target of at least $5.60 per share for 2017. That would represent an improvement of 11%-18% over adjusted 2015 EPS guidance of $4.75-$5.05, excluding possible restructuring charges. Realizing half of its $1 billion savings target in 2017, would increase EPS by $0.30-$0.35. The difference would have to come from a combination of revenue growth or margin improvement.

Pressure on non-interest revenue is likely to continue for some time. Without a meaningful pick-up in economic growth, it will probably be difficult for the company to grow discount revenue at target levels. In the current environment, businesses and consumers will likely keep a tight lid on spending and merchants will remain focused on lowering discount rates.

To compensate for this, American Express sees what it characterizes as a compelling opportunity to grow net interest revenue by extending more credit to its Card Members. Management believes that it can grow its loan portfolio profitably because its best Card Members have the capacity to borrow more and its monitoring systems have become more adept at spotting early warnings signs to avoid defaults. Still, any major move to expand the loan portfolio at this late stage in the economic cycle is risky.

Opportunities and Challenges in Billings Growth and Discount Rates. Although the company has a high estimated share – 45.9% – of its tenured U.S. Card Members’ total spending (i.e. wallet), its share of wallet has slipped over the past two years. Tenured Card Members are not increasing their spending on American Express cards as fast as they are increasing their total spending. Their wallets have also been growing at a steadily slower rate. Amex must defend its position with high spending Card Members; but it also sees opportunities to capture more business from Card Members who spend a lot elsewhere.

From 2012-2014, American Express grew its U.S. billings by an average of 8.3%, but real personal consumption expenditures grew by an average of only 3%. Consequently, billings growth in the mid- to high-single digits is a market share game. The company can win market share in different ways – for example, by encouraging greater use of its charge and credit cards as an alternative to cash; winning more share in fast-growing digital payments, both online and mobile; taking business away from its competitors through better service, including its membership rewards programs; and signing up more merchants, especially in exclusive co-brand relationships. However, growing billings faster than consumer spending will likely become less profitable as overall economic growth slows and new payment mechanisms mature.

Pressure on discount rates is also a big challenge for American Express. Regulators in Europe seem intent on driving down discount rates, probably to aid beleaguered merchants in a tough economic environment. The courts are doing the same in the U.S. at the behest of merchants, many of whom argue that discount rates are unjustifiably high and want to pass these costs on directly to customers.

No matter what the courts decide, the best way for American Express to get merchants to accept its discount rates is to convince them that access to its Card Members and marketing services are worth added cost. In 2014, the company launched OptBlue to expand penetration of merchant accounts with less than $1 million in annual volume. OptBlue allows for some flexibility on discount rates, a single processing interface for all credit cards through third party processors and direct marketing services to Amex Card Members. Small Business Saturday is another American Express program designed to bring Card Members and local merchants together.

New offerings of value-added services help to differentiate American Express from its competitors, but merchants will still remain focused on lowering discount rates. Consequently, it is a fair bet that American Express will realize at least some erosion in its discount revenue over time.

Business Model vs. Investment Model. While American Express claims that its business model is not becoming obsolete, it is harder to make the same claim about its financial targets. In recent years, the company’s has sought to deliver (on average and over time) revenue growth of 8% or more, EPS growth of 12%-15% and a return on equity of at least 25%.

Up until 2015, its financial results had generally achieved those targets. Revenue growth has fallen short, exceeding the 8% target only in 2010 and 2011, over easy, recession-driven comparisons. EPS growth and return on equity, on the other hand, have met or exceeded their targets. EPS growth was quite strong coming out of the recession and, except for a dip in 2012, remained strong until 2015. AXP’s return on equity has consistently been above 25% since the financial crisis.

In its presentation to analysts, management offered two growth scenarios for its business after Costco. One scenario, based upon its recent revenue performance (adjusted for FX and one-offs), assumes 4% revenue growth and 5%-7% EPS growth. The other, based upon a stronger, 6% revenue growth rate, would deliver EPS growth of 10%-12%. Both scenarios are below the previous financial targets, an acknowledgement that the pace of growth is likely to be slower from here.

Valuation. At its recent closing price of $61.22 (3/18), AXP is trading at 11.1 times projected 2016 earnings per share or 12.6 times projected adjusted 2016 earnings per share. (Both figures do not include an estimate for potential restructuring costs.) That is well below the S&P 500’s current valuation of about 17-18 times projected 2016 earnings.

AXP’s average P/E multiple from 2005 to 2015 was 15.7 times, according to Value Line. This was about 90% of the average market P/E of 17.4 times. That discount was roughly consistent with that given to other major financial services companies, such as credit card lenders and money center banks. AXP trades at a higher forward multiple than Capital One (COF) and Discover (DFS); but at a significant discount to MasterCard (MA) and Visa (V), whose businesses are almost entirely fee-based (i.e. they make no loans).

Coming out of the recession, Amex was able to grow earnings at a faster pace than the overall market. Its EPS grew 8.5% on average from 2010 to 2015 vs. 3.5% for the S&P 500. Up until 2014, its stock delivered total returns in excess of earnings growth. Thus, AXP’s P/E multiple expanded and its discount to the overall market multiple narrowed.

Since 2014, however, AXP has significantly underperformed and now trades at a much wider discount to the market. To a great degree, this reflects concerns about whether the company can deliver on its 2016 and 2017 guidance.

AXP Value Metrics 160318

Assuming that the economic recovery continues (and especially if it accelerates a bit), I believe that there is a good chance that the company can deliver and even surprise on the upside. Clearly, management has been aware of the challenges that it faces and has been working to address them for some time now. Amex appears to be making progress on addressing the concerns and complaints of its merchants. Card Member spending will also come in stronger than expected, aided by the company’s marketing initiatives and perhaps a pick-up in economic growth. The upcoming decision by the appellate court and a potential settlement with merchants are wildcards; but the delay in their resolution has given the company more time to work towards addressing the potential fallout.

In the near-term, AXP’s wide discount to the market reduces downside risk and offers greater upside potential. That said, the stock, like the broader market, has come a long way in a very short period of time. In five weeks, it has gone from significantly oversold to nearly overbought. Assuming that the market recovery continues, AXP share price seems due at least for a pause before marching higher.

AXP (D) 160318

Over the longer term, however, I believe that management would better serve its various constituencies, including its shareholders, by dialing down earnings growth expectations. Although there may be a first mover advantage in the development and deployment of mobile payment systems (and a risk of losing market share if it falls behind), eventually (and quite possibly soon) these new payment systems and services will mature. As that happens, the company’s (and the industry’s) growth potential will fall back toward the rate of growth in consumer spending. As that happens, AXP can adjust shareholder expectations by raising its dividend payout and reducing or even eliminating its share buyback program.  If a higher dividend rate is perceived to be sustainable, that could help narrow the discount in AXP’s share price to the broader market.

March 20, 2016

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036
(908) 448-2246

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