American Express
American Express is undoubtedly a company you're familiar with. It was founded in 1850, 170 years ago, and still pervades our daily lives. Yet most people, and many investors, underestimate how powerful its business model is.
American Express embodies many of the traits of a good business:
It earns high returns on capital.
It's business model is self-reinforcing and provides value to all stakeholders.
It operates a simple, replicable business model with a large and growing addressable market.
1. It earns high returns on capital.
Since 2005, when American Express spun off Ameriprise Financial, it has averaged a 27% ROE. That's an incredible result considering the period spanned the worst financial crisis in a generation. American Express's lowest ROE was 15% in 2009. There's not too many businesses in the world whose "worst" year is a 15% return.
Berkshire Hathaway's 1987 annual report cites a Fortune study which shows just how remarkable this record is. The study examined the 1,000 largest American companies between 1977 and 1986. They found that only 25 of the 1,000 averaged over a 20% ROE and had no single year lower than a 15% ROE. Further, they found at 24 of these 25 "business superstars" outperformed the S&P 500 during that decade.
2. It's business model is self-reinforcing and provides value to all stakeholders.
American Express operates a closed-loop credit card network. Visa and Mastercard operate open-loop networks. That means they allow other issuers and merchant acquirers to access their network and extend credit. They merely operate the network which facilitates the transaction.
American Express operate the network and acts as the issuer and acquirer. This provides American Express all of its cardmember's spending data. American Express uses this data to craft desirable rewards for its members and help merchants better target cardmembers.
American Express's closed-loop model also provides it with multiple revenue streams: discount revenue, card fees, net interest income, and other fees.
Discount revenue is American Express's largest, at $26 billion. It consists of fees merchants pay when they accept an American Express card. Last quarter these fees averaged 2.34% of billed business. That's not too shabby when you consider American Express's billed business was $1.1 trillion last year.
Net interest income is American Express's second largest source of revenue, at $9 billion. In the 2007 annual report then-CEO Kennth Chenault wrote: "Our business model is built on driving cardmember spending. Lending is a planned and profitable outcome of our spend-centric strategy." Credit card lending is risky in the sense that it is unsecured, but lucrative in that the rates charged are high. American Express cardmembers tend to be affluent and creditworthy. American Express's credit costs have historically been the lowest among credit card lenders. Since 2005 the net write-off rate has been 3.3% of loans and 2.4% of receivables (balances on charge cards). Over the same period provision for loan losses, as a percentage of loans and receivables, has averaged 2.8%.
Card fees are American Express's fastest growing source of revenue. They tend to be subscription-like and sticky, even in downturns. In 2019 they were $4 billion. Last year 70% of new cardmembers opted for a fee-bearing card.
Finally, other fees consist of everything else: foreign currency conversion fees, travel commissions, investments, etc. These are non-negligible, totaling $5 billion last year.
Each of these businesses are remarkable on their own. Together, they become even more valuable because they reinforce themselves in a positive feedback loop.
American Express cardholders tend to be affluent and have excellent credit. Spending per card is 3x higher on the American Express network than others. These are the most sought-after consumers, so American Express is able to charge merchants premium discount rates for access. American Express's discount rates are 2.5-3.5% while Visa, Mastercard, and Discover's are 1.4-2.6%.
American Express, armed with premium discount revenue and cardmember spending data, can offer its cardmembers unparalleled rewards. These rewards make cardmembers loyal and encourage higher spending.
3. It operates a simple, replicable business model with a large and growing addressable market.
There are generally three phases of a business lifecycle: proof of concept, replication, and maturity.
The proof of concept phase is generally explosive to the upside, and more frequently, to the downside. It is also difficult to predict. We leave this area to the venture capitalists and focus on companies in the replication and maturity phases.
The replication phase occurs when a business has a profitable model it can reproduce over and over. Walmart in 1972 is a good example. Then they had 51 locations and were aggressively building new stores. Today they have over 11,500. Net income is up over 5,000x since then.
The maturation phase begins when a company's addressable market is saturated. That's Walmart today. Walmart’s existing stores continue to throw off cash, but they can't reinvest that into new stores. So, they return the cash to shareholders as dividends and stock repurchases. When this is done intelligently and opportunistically, stocks in the maturation phase can continue to produce attractive returns. The best example is probably Teledyne under Henry Singleton. Between 1972 and 1983 Singleton bought back 85% of Teledyne's shares outstanding while growing net income 315%. This produced a 3,000% rise in the stock price.
American Express is somewhere between the replication and maturation phases. Between 2005 and 2019 they reinvested 20% of net income at a 25% incremental rate. American Express's incremental returns are high, but their reinvestment rate is somewhat low.
The mitigating - and under appreciated - factor is that American Express's addressable market is growing and will continue to grow forever. Imagine if Walmart never ran out of stores to build. American Express's spend-centric model relies on growing billed business. That's grown 130% over the last 15 years, a 6% annual rate.
Population growth, GDP growth, and inflation all point towards perpetually increasing annual spending. The trend towards e-commerce and digital payments are a further tailwind to billed business growth.
To sum up, American Express is a remarkable business because it earns high returns on capital (25% average, 15% at the "worst"), has a self-reinforcing value proposition, and large and growing addressable market it can expand into.
Estimating Forward Returns
Since American Express is in the replication phase, its future should resemble its past. However, American Express's earnings are cyclical. 2019 will mark the cyclical high, and hopefully 2020 marks the cyclical low. The best way to value American Express is on its through-cycle earnings power.
There are a number of ways to normalize American Express's earnings power. We use three to triangulate its value.
The first method is to apply American Express's average net write-off rates for loans and receivables to its current book. Since 2005 the net write-off rate has been 3.3% for loans and 2.4% for receivables. On $57 billion of loans and $90 billion of receivables, normalized credit costs are $4.3 billion. Subtracting that from $12 billion of pre-tax pre-provision earnings yields $7.7 billion or $9.5 per share.
The second method is to apply American Express's average provision, as a percent of loans and receivables, to its current book. Since 2005 that's been 2.8%, which puts normalized credit costs at $4.1 billion. Subtracting that from $12 billion of pre-tax pre-provision earnings yields $7.9 billion or $10.0 per share.
The third method is to apply American Express's average ROE to its current equity. Since 2005 American Express has averaged a 27% ROE. Before the financial crisis American Express's ROE was in the thirties, but it has never gone that high since. Since 2008 ROE has averaged 25%, which seems more indicative of the future. Applying this to equity of $23.1 billion and backing out taxes at 21% yields $7.3 billion or $9.0 per share.
Our three methods suggest American Express's normalized pre-tax earnings are $9-10 per share. In 2019 they earned $10.4, which confirms that they were over-earning modestly at the top, as you'd expect.
Determining how much to pay for these earnings depends on how much we expect them to grow. Since 2005 American Express has reinvested 20% of its earnings at a 25% incremental rate to grow at 5%. This should be worth 21x using a 10% discount rate. However, American Express's median PE multiple the last ten years has only been 14.0x. That's a more conservative value and implies 2.5% growth.
What we're really interested in is buying stocks we think can double in five years. To back into 50% of American Express’s 5-year price, we first estimate American Express's business return. That's its growth plus yield.
We've already establish that growth should be about 5%. Buybacks will add further to per share growth. They've historically averaged 60% of earnings. Since buybacks are pro-cyclical, it's best to assume that they're done at the median PE (14x) not the purchase PE. That implies a 4% yield (60%/14). Dividends, the final 20% of earnings, add another 1-2% (20%/14). In total American Express's business return should be 10-11%.
Since the business return is below 15%, we'll have to rely on some multiple expansion to hit our target. If we pay 11.0-11.5x normalized after-tax earnings and sell at 14.0x after five years, we'll add 4-5% per year to our returns. Here's the math on that: (14/11)^(1/5)-1 = 5%.
This works out to $79-$82 per share, which we'll call $80. $80 happens to be 8.8x normalized pre-tax earnings, which fits right in that 9-10x range Buffett often pays for his best investments.
Getting to the Long Term
In order to earn these long-term returns, American Express has to make it through the current crisis.
Credit card losses are highly correlated with the unemployment rate. In past recessions, American Express's credit quality held up better than peers due to the average cardmember's affluence. That didn't quite work out in 2008 because the financial crisis hurt the wealthy particularly hard.
It's hard to say exactly how this round will go. On one hand, unemployment is largely affecting blue collar workers. American Express has little exposure to these clients. On the other hand, unemployment is likely to rise higher than ever before. Hopefully it will be brief.
American Express does have exposure to small businesses and travel and entertainment (T&E) spending. Loans breakdown like this: 70% US consumer, 20% US small businesses, 10% international consumer. About 30% of spending is T&E, which is down 95% at the moment.
Cardholders are primarily prime and super-prime. They're not used to feeling financial stress, and are usually good credits. About 6% of loans and 8% of receivables are participating in American Express's Consume Pandemic Relief (CPR) program, which offers forbearance. These are people like dentists and plumbing contractors who will resume paying once they get back to work. They're good for the money, just temporarily illiquid. So long as the lockdowns don't last too long, the US consumer book should bounce back.
So far American Express has provisioned 5.7% of loans and 1.0% of receivables. That's about 2/3rds of what they experienced in 2008/09 and in-line with what many peers provisioned. Still, I'd expect more reserve builds next quarter. Charge-offs will lag and we probably won't see them meaningfully increase until Q3. By then, we should know if the economy is turning around or stalled.
One further benefit of American Express's model is that its balance sheet is counter-cyclical. During times of stress businesses and consumers lean on their banks to extend more credit. These loans experience disproportionate write-offs. However, American Express's loans and receivables actually decrease in a recession as consumers and businesses pare back spending on their own. Although charge-off rates rise, they're on a lower base. Loans that roll off release capital, fortifying American Express's position.
American Express has an 11.7% CET1 ratio, which is well above their target of 10-11%. This gives them flexibility to weather the storm. Many expenses, like cardmember rewards and services, and business development, naturally decline in proportion to billed business. American Express can cut back other expenses, like marketing. But, traditionally they have used their financial strength to gain share during a downturn. They have committed to zero layoffs through the end of the year, which speaks to their strength and respect for employees.
No one knows how the next couple of months will look, but American Express is in a position to weather the storm from a position of strength. That gives us confidence to look beyond the short-term to the long-term opportunity.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.