Friday, April 23, 2010

American Express

Not surprisingly, the earnings strength of American Express (AXP) was reinforced by yesterday's report. Earnings are normalizing quickly. AXP's net income was $ 885 million in the 1st quarter of 2010, more than double 1st quarter 0f 2009. Revenue in 1Q 2010 increased to $ 6.6 billion from $ 5.9 billion in 1Q 2009.

It's worth noting that American Express remained profitable throughout the crisis whereas most other financial institutions posted at least one, if not multiple, quarters of losses. This has a lot to do with AXP's "spend-centric" model, where most revenue comes from the "tolls" collected each time someone uses one of their cards. They get in the neighborhood of 2.5 percent of the transaction value each time a card is used. Most competitors get only a small fraction of that amount and rely on a "lend-centric" model. Also, the average AXP customer spend at least 3x more than customers of other credit card companies.

Some comments by Ken Chenault, chairman and ceo of American Express from the 1Q 2010 Earnings Report:

"Cardmember spending was up 16 percent, rebounding strongly from the recessionary lows of last year," said Kenneth I. Chenault, chairman and chief executive officer. "Credit metrics also continued the improvement that began in the second half of 2009."

And,

"Our ability to generate strong volumes comes at a time when cardmembers are paying down their outstanding debt. This compares favorably to the major issuers who traditionally have had to rely on lending-oriented customers to generate billed business. At a time when so many consumers are focused on value, our relative strength also reflects the importance of pay-in-full charge cards and the appeal of our rewards, customer service and benefit programs."

The company should earn over $ 3.5 billion this year with a return on equity among the highest in the financial services industry. So the earning power is there and should grow in the coming years.

Of course, AXP is not perfect. Its balance sheet is solid now but I did not consider it a strength a few years back. That changed during the financial crisis. The strain of the crisis put pressure on AXP to strengthen its funding sources. Prior to the crisis, my biggest concern with AXP had been too much reliance on capital markets for short-term funding (commercial paper). That does not seem like a dangerous thing until a time like 2008 when capital markets stopped functioning properly and seized up.

Today, they rely very little on commercial paper and have continued to increase their use of FDIC insured deposits. These days most funding comes from 1 of 3 sources: long-term debt, FDIC insured deposits, and securitizations (they also have other sources of liquidity...since they converted to a bank holding company this includes the discount window from the fed). The important thing to me is they no longer need to routinely roll over so much short-term debt and that they are increasing their insured deposits. Also, AXP has more equity and less total debt (including what was previously off-balance sheet securitizations*) and generally carries more cash compared to back in 2007. Not perfect...but a better situation.

So the pressure of the crisis pushed the company to make its balance sheet more sturdy. As a result, I think AXP is a better company. It can still be messed up much more easily than a Coca-Cola or Diageo, but in the context of financial services, it has a great model.

Unfortunately, the stock is no longer cheap. As of a few minutes ago it was trading at ~$ 48.80/share giving it a ~$ 58 billion market cap.

Adam

Long position in AXP

* The off-balance sheet securitizations were moved onto the balance sheet this quarter.
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