We once again welcome back guest contributor Shawn Allen, the Edmonton-based founder of InvestorsFriend Inc. Shawn takes a conservative approach to stock selection and has an excellent track record. Today he takes a close look at one of the best-known names in the U.S. financial sector, American Express. Here is his report.
Shawn Allen writes:
American Express Company (AXP, Financial) is a type of lending operation. Its traditional cards were, and are, convenience cards, not credit cards as such. The difference is that with convenience cards, users charge goods and services but are required to pay the bills in full each month. However, Amex also now offers credit cards. In addition, it has a travel agency operation.
Like almost all lenders, it is highly leveraged. At the end of 2013 its common equity was 12.7% of its assets. It funds its large receivables and loans to its customers through debt and through wholesale bank deposits as well as securitizations. While it is legally a bank, it does not accept retail deposits.
The business is about two-thirds from the United States and one-third outside.
Traditionally, American Express was an integrated company that did not partner with banks. Unlike Visa and MasterCard, it issued most of its cards directly. However, it has recently done partnership deals to allow certain banks to issue American Express branded cards. It has also made arrangements with some rewards programs like Air Miles for branded cards.
Current valuation. At the time of this analysis, Amex was trading at a price of $89 per share (currency figures in U.S. dollars). The price to book value ratio is unattractively high, in isolation, at 4.9, but this reflects the high return on equity (ROE). The dividend yield is modest at 1% and reflects a payout ratio of just 18% of earnings.
The ROE is very high at 28%. This can be broken down to 16.2% profit on sales, which is reduced to 3.6% profit on assets due to the large asset levels and then leveraged up to 28% through a common equity level that is only 12.7% of the asset level. The trailing p/e ratio is moderately unattractive, in isolation, at 18.1.
Revenues per share have grown at a compounded average of only 4.4% since 2008 weighed down by a dip in 2009. Adjusted earnings per share have grown at a compounded 14% per year since 2008 despite the 2009 dip. If earnings per share grow at a compounded 7% per year for the next five years and the p/e regresses slightly to 16 then we calculate an intrinsic value of $80. If earnings per share grow at a compounded 10% per year for the next five years and the p/e regresses to 16 then we calculate an intrinsic value of $91. This assumes a required rate of return of 8% per year. Overall the value ratios indicate a very strong company, which is, however, about fully valued and would theretofore indicate a rating of (lower) Buy.
Warren Buffett (Trades, Portfolio) likes it. Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway is the largest shareholder and owns 152 million shares or 13.7% of the company. These shares were purchased almost entirely in 1994 and 1995. There was a small additional purchase in 1998. There were no sales or purchases since then. As of today, Berkshire is up about 950% on the purchase, which is about 13.2% per year, not counting the substantial dividends.
Back before he took control of Berkshire Hathaway, Warren Buffett (Trades, Portfolio) really fell in love with American Express. In 1964 American Express shares had fallen precipitously due to loan losses in an episode known as the Salad-Oil Scandal. Buffett put about 40% of his investment partnership's money into American Express, a huge commitment on his part that represented a 5% ownership stake in the company. These shares were sold just a couple of years later for a very substantial gain. Buffett had correctly bet that American Express's brand value would allow it to recover from its temporary setback.
I have no idea if Buffett would consider American Express shares to be a Buy today or not, but he clearly likes the company itself.
Outlook. The company has a goal of growing earnings per share at 12% to 15% annually. American Express is benefiting from the continuing switch to electronic payments. The company is addressing its speed of payments to become more attractive to small businesses. The company continues to partner with others in growing its business. It seems reasonable to conclude that American Express will continue to grow over the long term.
Competitive advantages. American Express has strong advantages in terms of its prestige brand image. In terms of funding the credit card receivables and loans it is likely at a disadvantage compared to the system used by Visa and MasterCard (whose cards can be funded by banks with low-cost retail and commercial bank deposits) but this may be offset to some degree by its integrated structure. Write-off and fraud levels are materially lower than the industry average.
Summary and conclusion. In all cases we should remember that there is a difference between a company and its shares and it is possible to like one and not the other. In this case I like the shares as a long-term investment. But I love the company due to its competitive advantages and high returns on equity. (Happy Valentine's Day, American Express.) If the shares were a little cheaper I could love them too rather than merely liking them.
Importantly, American Express appears to be the type of business that can be reliably predicted to continue to grow for the foreseeable future. The value ratios would indicate a (lower) Buy rating. Management quality appears to be strong. The insider trading signal is quite negative, but is often not a reliable indicator. Executive compensation is high but this is not a concern given the size of the company. The recent earnings trend has been very strong.
The outlook seems positive as the company benefits from the continued switch to electronic payments and as it grows its business through partnerships and an increased focus on smaller merchants. It has the competitive advantage of a strong brand image. Overall, I would rate American Express a Buy at the current level. I would favor taking perhaps a quarter or half position with a view to adding to the position on dips.
Action now: Buy for long-term growth. The shares closed on Friday at US$89. Disclosure: I have purchased 150 shares for my personal account.
