American Express Needs A Catalyst (NYSE:AXP)

(FILE PHOTO) American Express

Mario Tama

Investors should “hold” shares of American Express (NYSE:AXP). Despite the firm’s profitability, macroeconomic uncertainty makes it challenging to justify buying AXP right now. The firm has some lingering issues with its capital structure that will need to be addressed if it is to keep up competition with other major credit card networks.

AXP – Background

Founded in 1850, AXP has provided customers with a variety of services for nearly 175 years. The firm has a distinguished history where it has grown from a freight company to one of the world’s largest credit card networks. It also spun off Lehmann Brothers in 1994, and Ameriprise Financial (AMP) in 2005. Today, Berkshire Hathaway (BRK.B) owns 20% of the firm’s outstanding shares and AXP is organized into three segments: Global Consumer Services, Global Commercial Services, and Global Merchant and Network Services. Based on the firm’s 2021 10K filing, Global Consumer Services accounted for 52% of consolidated revenues, Global Commercial Services 33%, and Global Merchant and Network Services 15%. Moreover, 70% of AXP’s customer base is located in the United States, while 30% are abroad.

AXP earns its revenues from products including credit cards, travel services, point-of-sale marketing, and fraud prevention. The majority of AXP’s revenue stems from “discount revenue.” Discount revenue is earned from merchants who agree to pay AXP a fee for transactions occurring at their businesses. The firm is therefore heavily dependent on relationships with its third party partners. This has been a contentious relationship because AXP charges higher merchant fees than its competitors. However, between 2014 and 2019, AXP increased its merchant acceptance to 10.6 million U.S. businesses. Moreover, AXP promotes its “closed loop system” where it both issues credit cards and interacts with merchants in a way that its competitors do not.

AXP has outperformed the Financial Select Sector index of the S&P 500 over the past decade. Moreover, AXP has slightly lagged the S&P 500 over the same time span.

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Peer Competition

AXP, Visa (V), Mastercard (MA), and Discover (DFS) are the four biggest credit card networks in the United States. Worldwide, companies such as China UnionPay and the National Payments Corporation of India also compete with AXP.

Price/book value is a key ratio to consider when valuing a company in the financial services industry. Because of fair value accounting principles, most of AXP’s asset values are genuinely represented on the firm’s balance sheet. This is demonstrated by the strong correlation between AXP’s book value and AXP’s price between 2012 and 2022. Moreover, investors should consider AXP’s reasonable price to book value in comparison to MA and V.

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With respect to market cap, V is the largest of the four major card networks. MA is not far behind, and has grown at a faster pace than V since 2012. AXP has a larger market cap than DFS, but is still significantly lacking V and MA. Since 2016, AXP market cap has lagged V and MA by a fairly constant amount.

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Relative to peers, AXP has struggled with its operating expenses rising faster than revenues. MA has managed to keep revenue changes above cost changes.

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AXP has lower return on equity than its peers. Albeit, AXP’s ROE does exceed the 8% return that is traditionally achieved by the S&P 500. In addition, AXP achieves a significantly lower ROA than its peers. It would be reasonable to conclude that AXP’s financial managers have some room to improve. However, AXP’s ROE and ROA ratios are quite good compared to the overall market. Investors should not be discouraged by the spread between AXP and its competitors. It simply means that AXP has room to improve, which could improve the stock price.

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Long term debt is an area of concern for the firm. AXP has roughly $26 billion in variable contract debt, meaning that its interest payments are subject to change. I am concerned that the cost of servicing this debt will rise substantially, and AXP will lose cash flow paying down the higher interest payments.

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AXP’s SG&A expense is more than double that of V, MA, and DFS combined. From an outsider’s perspective, this is hard to justify. AXP differentiates its product as a more prestigious alternative to its competitors. The company is committed to luxurious cardmember lounges, but it would seem like the firm could find some places to cut some costs here.

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AXP returns value to its shareholders through share repurchases and dividend payments. The firm’s current dividend yield is strong compared to peers. However, AXP’s dividend yield has grown at a significantly lower rate than competitors over the past decade. Despite management’s belief in continuing increases of the quarterly dividend, there have been some concerning insider sales of the stock. This past June, CEO Stephen Squeri sold roughly 20% of his AXP shares in a move that seemed to go beyond a simple rebalancing of his portfolio. Moreover, share repurchases have been a key part of AXP’s plan to return value to shareholders. In 2021, the firm repurchased roughly 46 million shares at an average price of $165.

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Risk Factors

Investors should be aware of a number or risks to AXP’s business. The credit card business is highly competitive, and while extreme profitability can persist during economic expansions, it is hard to predict the effects of a downturn. This section is a bit long, but I want individuals to understand what they are signing up for if they choose to invest in AXP. I think that AXP is a company that should be looked at from an endogenous perspective, so I am trying to keep comparable companies valuation out of this analysis as much as possible.

In my opinion, the most long-standing threat to the firm’s business is its credit card surcharges exceeding those of V and MA. There is usually at least a 1% difference in surcharge between AXP and competitors, which adds up over many purchases. AXP tends to market itself towards wealthier establishments and individuals as a way to justify its surcharge. This issue has long been well known regarding AXP cards, and the company is attempting to alter the existing surcharging structure.

FOREX and interest rate fluctuations during 2022 will most likely harm AXP’s earnings. From the 2021 annual report:

“As of December 31, 2021, a hypothetical immediate 100 basis point increase in market interest rates would have a detrimental impact on our annual net interest income of up to $206 million.”

The U.S. Federal Reserve and other central banks have dramatically risen rates throughout 2022 in an effort to fight inflation. AXP’s financial performance will be impacted and investors should be aware of this. Moreover, the U.S. dollar has been quite strong in foreign currency markets throughout 2022. AXP’s international operations will probably experience increased costs due to the strength of the U.S. dollar.

Credit ratings are important to AXP’s ability to access credit facilities. The firm is heavily dependent on the use of debt and any significant alteration to its capital structure will certainly impact earnings. AXP has made an effort to reduce its total debt over the past two years, but is still heavily in debt. The firm currently holds stable ratings from all three major credit agencies. These range from long term ratings of A (Fitch) to BBB+ (S&P).

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Risk management is absolutely essential to AXP’s long term success because the firm’s business is dependent on its customer’s credit worthiness. It would no longer exist if it could not give credit cards to individuals and businesses who would repay. AXP notes:

“Rising delinquencies and rising rates of bankruptcy are often precursors of future write-offs and may require us to increase our reserve for credit losses. Higher write-off rates and the resulting increase in our reserves for credit losses adversely affect our profitability and the performance of our securitizations, and may increase our cost of funds.”

Credit Card Delinquency Rate vs. Fed Funds Rate

Credit Card Delinquency Rate vs. Fed Funds Rate (Board of Governors of the US Federal Reserve System)

Delinquency rates across the U.S. have been slowly rising over 2022. As past history would suggest, delinquency rates generally rise with higher interest rates. This presumed rise in delinquency rates would certainly impact AXP’s revenue. However, it is worth noting that AXP has set a high barrier to entry for its cards. AXP cards require FICO scores of at least 670, meaning that its clients have good to exceptional credit scores. It is likely that many of the delinquencies are stemming from V, MA, and DFS customers. These credit networks provide cards to many customers with good credit scores but also to customers with fair and poor credit.

Two positive areas of AXP’s risk profile is that the firm has seen a decrease in write offs of nonperforming assets over the past two years. Moreover, AXP has solid credit facilities in place in the event that a liquidity issue is experienced. The company has over $80 billion of loans to sell in the even that capital is urgently needed.

Valuation Model

I conducted a scenario-analysis based discounted cash flow model. This DCF attempts to consider a drawn-out recession across the global economy where AXP experiences multiple years of negative/stagnant earnings growth.

Units are in millions to reflect the units used in AXP’s financials. Some key assumptions in the computation of free cash flow are that CapEx grows at a rate of 5% per year, which is a proxy for the inflation rate over the next five years. AXP’s 14% earnings growth in 2022 is based on metrics available in the firm’s quarterly reports.

AXP EBIT computations based on 10K data.

AXP free cash flow computations based on 10K data. (Author Calculations)

A few key assumptions were made when calculating AXP’s weighted average cost of capital. There was a 20% decline in market cap assumed due to a prolonged recession between 2022 and 2024. Data stemming from declines in market cap were taken from historical data. In addition, it was assumed that AXP would experience rising then falling costs of debt and equity. There is generally a direct relationship between economic instability and costs of debt and equity.

AXP WACC.

AXP WACC. (Author Calculations)

Calculating the terminal value of AXP’s cash flows involved assuming a low level of GDP growth between 2022 and 2027. 1% growth is pretty low, but I wanted to underline the bear case that this DCF illustrates. This 1% growth rate was used in the perpetuity growth method. In addition, an EBITDA multiple of 7.2 was used to compute the terminal value via the exit multiple method. I averaged the perpetuity growth and exit multiple methods to arrive at the terminal value.

Terminal value computations

Terminal value computations. (Author)

AXP’s enterprise value was computed by adding up the present values of the free cash flows and terminal value. I used a stub period to illustrate the fact that these cash flows do not occur at the beginning of each period. The firm’s WACC was used to discount these cash flows.

Enterprise value computed from present values of free cash flows.

Enterprise value computed from present values of free cash flows. (Author Computations)

After computing the enterprise value, two further adjustments were needed. I added cash back to the enterprise value, but subtracted debt. This yielded the equity value, which was divided by the number of shares outstanding to arrive at AXP’s intrinsic value. I was surprised that despite my recession-based scenario analysis, AXP still had an intrinsic value close to its current share price of $140. Prospective investors should be encouraged by this. AXP seems to be pretty fairly valued by the market right now, and if the stock becomes oversold it may be a buy.

Intrinsic value computations.

Intrinsic value computations. (Author)

Conclusion

I have chosen to primarily focus my “hold” recommendation on AXP’s high levels of debt. Debt is not a bad thing, as its main use is to invest in assets that will theoretically generate a higher rate of return that the cost of the debt. Moreover, the proper employment of debt capital can significantly magnify a firm’s returns when compared to a competitor not making use of debt. However, in a high interest rate environment, the cost of servicing debt increases. As previously mentioned, AXP has quite a bit of debt carrying variable interest rates. I am not personally comfortable with AXP being in this situation, especially in light of the fact that V, MA, and DFS have much less debt. Despite sounding somewhat bearish on AXP, I want to reiterate that it is an exceptionally profitable company. If the stock continues to be sold off by investors, it could become a buy.

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