American Express (AXP) – Cheap “Buffett” Blue Chip or Value trap ?

Executive summary: Although American Express looks cheap based on their historic profitability, the company is subject to rapid technological change and fierce competition in the payment industry. To me it is not clear how this will work out going forward, so for the time being I will not invest but look deeper into the industry.

american-express

American Express is well known in value investment circles because Buffett owns ~15% of the company and made a lot of money with it.

Recently the stock price came under pressure mainly because:

  • they lost a big co-branding contract (Costco) which will materialize in 2016
  • EPS shrank for the first time since 2001
  • lost a court case (vendors steering clients to cheaper cards)
  • “fintech hype”: mobile payment & peer-to-peer lkoan platforms as disruptors

The stock price clearly has suffered and is down more than -40% from its peak in late 2014 /early 2015:

amex

The stock looks cheap from a P/E perspective at 11 times 2015 earnings. P/B is 2,5 which is ok for a stock that generated consistent 25% ROEs over the last 5 years. Especially if you compare it to Visa (33x 2015 P/E) and Mastercard (25x P/E), the stock looks cheap.

A quick look at the business

The best way to explain Amex is to compare it to the main competitors VISA and Master Card.

Main Differences:

  • AMEX owns the entire network, acquires the shops and card holders, isues credit card and extends credit
  • AMEX is therefore regulated as a bank
  • Visa/Maestercard are basically Franchise owners which rent their name to banks who actually do the work
  • they are not regulated

So if you own a Visa, card, the card is actually issued by a bank and the payments are processed along a chain of banks who operate under a common standard. There is a good post on the priceonomics blog explaining the history of VISA. If you own an Amex card, the payment is processed only on Amex systems, no banks are involved.

Wikipedia has actually a pretty good description of the business model in its Amex entry.

Business model

Typical credit card business model

When a consumer makes a purchase using a credit or charge card, a small portion of the price is paid as a fee (known as the merchant discount), with the merchant keeping the remainder. There are typically three parties who split this fee amongst themselves:

  1. Acquiring bank: the bank which processes credit card transactions for a merchant, including crediting the merchant’s account for the value charged to a credit card less all fees.
  2. Issuing bank: the bank which issues the consumer’s credit card. This is the bank a consumer is responsible for repaying after making a credit card purchase. The issuer’s share of the merchant discount is known as the interchange fee.
  3. Network: the link between acquiring banks and issuing banks. These banks have relationships with a network, rather than with each other, for fulfilling card purchases. This allows a card issued by a community bank in Peru to be used at a shop in South Africa, for instance, without requiring the banks to have a direct relationship with each other. The two largest networks in the world are Visa and MasterCard. American Express operates its own network.

The average merchant discount in the United States is 1.9%. Of this, approximately 0.1% goes to the acquirer, 1.7% to the issuer, and 0.09% to the network.[29]

Most Prime and Superprime card issuers use the majority of their interchange revenue to fund loyalty programs like frequent flyer points and cash back, and hence their profit from card spending is small relative to the interest they earn from card lending.

Overall, the electronic payment business has been growing steadily over many years as electronic payments have been taking “market share” from cash payments for many years.

The network effect

Credit cards are clearly one of the earliest and easiest examples for the network effect. A credit card network clearly gets more valuable the more it is accepted around the country and the world. For traditional payment cards the effort is twofold: You have to attract both, consumers to actually use the cards and merchants to accept them. On both sides that is not that easy and a competitive market. But once you have a big network, it is not that easy for any competitor to enter the market.

Payment cards are actually very wide spread, many retailers for instance issue their own cards like the Starbucks Card or the Ikea card. The disadvantage is of course that you can use them only within the specific chain of stores and many people (myself included) hate to run around with dozens of cards.

Overall, the network effect is clearly there but on the other hand, Amex clearly is not the largest network. Globally, Visa and Mastercard are bigger. According to some reports, Amex has also the disadvantage that they require separate machines for the merchants, whereas Visa, Mastercard etc. can all be processed via one machine.

If we look at market share, Visa as the biggest has been clearly gaining market share, interestingly at least until 2015, whereas MasterCard seems to have been the “market share donator”:

slide1

The main “value” of a card network is however not transferring money but detecting fraud and checking credit limits. There is a very good article on Forbes about Visa.

Amex “brand” & business model

Amex has historically been successful in attracting comparably richer people to use its card. Historically, Amex started out as a “travel and entertainment” card for business travellers, compared to “normal consumer” cards issued by the banks.

Amex charges merchants usually more than other cards, however part of this gets “rebated” to card holders in the form of extra services (Airport lounges etc.) and vouchers/bonus points. This clearly incentivizes card holders to use the Amex card if they have the choice as the price for the cardholder is the same, independent from the fee that Amex charges.

Merchants clearly have every incentive to steer clients to “cheaper” cards. So this is a continuing struggle. So far, Amex has managed that pretty well but it needs to be seen how this will work in the future, especially with the above mentioned change in legislation.

The Costco co-branding relationship was clearly a business where Amex didn’t really have any competitive advantages. Even worse, Amex is competing in this space with players who will accept deals at much lower returns (Bank ROEs are 10% or less compared to 25% for Amex).

Fintech Hype

There is currently a big hype how “fintech” will disrupt the financial industry. “peer-to- peer lending”, “peer-to-peer payments” are some of the buzzwords here.

In my opinion it is pretty clear that there will be changesm, but in my opinion it is less obvious who the winners will be.

For me, some companies have very obvious problems, such as Western Union who lives from charging 10% or more for money transfers into poor countries.

I am not so sure that credit card companies will be the losers in this game. Take Apple Pay for instance. Apple pay is “only” the surface of the payment process, the back end is actually operated by American Express. Paying with a smart phone still requires at one point debiting the account of the payer and crediting the account of the seller and this requires an infrastructure.

Paypal in my opinion to a certain extent is a threat as they do have a kind of similar “backbone” but compared to a credit cards, they just transfer money but don’t extend credit.

Interestingly even in “quality journals” like the WSJ you find articles like this which praise mobile payments without really understanding what’s behind it. The best indicator that the “Fintech boom” is about to hit a road blcok is the fact, that in this year’s Davos Economic Forum Fintech was the main topic and the big banks were claiming that they are all Fintechs now.

Technological change

However, as I said before, technological change is clearly happening and one needs to really understand how this could effect card networks. Amercian Express in its history was able to transform itself from an express mail service to money order to traveller cheques to credit cards. In the 1980ties, Amercian Express even tried its luck in Investment Banking, but got out in 1994 by finally spinning of its subsidiary Lehman Brothers (smart move….).

Nevertheless, there is a clear risk that, if for some reason, Amex is not able to adapt to the changing landscape,  it might be the typical “value trap”.

Reading the annual report 2015 of American Express makes clerar that they are aware of the risks.

It will be interesting to see, if andf how quickly mobile payments will take off. Clearly, Mobile payments have the potential toi change things, although it is difficult to understand how.

A few observations on the 2015 annual report

Positive: Clear communication with regard to the challenges. However I couldn’t find a real strategy how they will move forward.

Cost savings are OK, but the question remains why they didn’t start that earlier. One interesting aspect: Amex also has been hurt by oil (and gas) prices. Lower gas bills mean lower revenues if you charge % if volumes.

Summary so far:

It is pretty obvious that Amex is facing lots of challenges, the loss of the Costco account is only one of them. At the time being however I cannot judge if there is really a big threat to the business.

On the other hand, there is clearly also some structural change in the industry and it is difficult to charge if credit card networks are winners or losers in this game.

In cases where structural changes are highly likely, it is not a very good strategy to assume profit “mean reversion”, as this could lead investors into typical “value trap situations”.

I will need to dig deeper into payments and credit cards in order to better understand how the risk/reward scenario for Amex could look like. So stay tuned, maybe I even start a kind of “payment series” like last year’s “Watch series”.

 

 

 

 

 

 

 

20 comments

  • Dig deeper into Amex, and you’ll find that the company has a dominant position in corporate card spending. If memory serves, Amex’s market share amongst small and large US corporations is 45 – 50%. That corporate card spending– along with another business not mentioned here, GNS (leasing of the Amex network), accounts for the majority of AMEX’s earnings, generating very high rates of return on capital. The press is focused on the consumer card business because it’s the easiest to understand, but ~2/3 of the company’s earnings is on very solid footing. Sure, the other 1/3, the consumer piece, has challenges (dropped partnerships, fee compression)… but does it really justify a 45% drop in the stock price over the past year? Meanwhile, the company has a huge and growing base of deposits (yes, tens of billions of $ in deposits… AMEX is a bank) to fuel lending expansion. Capital ratios are a source of strength, and they have access to the Fed if needed. And the company is continuing to increase switching costs for its corporate card customers by tying into their A/P and expense reporting systems, and offering routine purchasing solutions. Off the top of your head, who ELSE do you know that offers a high limit corporate charge card (charge card, not credit card)? And by the way, that charge card commands a premium merchant discount fee for AMEX, and puts rewards into the pockets of corporate employees who didn’t spend a nickel of their own money. If you spend some time on the non-consumer side of the business, it starts to look pretty attractive in the low 50s (as a few weeks ago).

  • Amex seems to have a moat in Travel services, with protection and insurance as well. I do not know any rich person who would not want to have the best services to simplify their lives and not having to worry about anything. Now how big is that part of the business for them?

    I read many articles about Amex and no one seems to really understand them, me included. The cash flow statement is very complex, what do they do with investing activities. They have a low PE, and the strong dollar is impacting their results. They are a reasonable buy in my opinion. They have their niche and return cash to shareholders.

    Mobile wallets are not going to replace cards but integrate them for the most part, customers like the double intermediation security and banks still provide them with cards. Also if you do not have the network that the cards have, its hard to build the whole network. Its easier to build your mobile wallet and use the existing infrastructure and take a cut.

  • Alex der Clown

    “So stay tuned, maybe I even start a kind of “payment series” like last year’s “Watch series”. ”

    Da freu ich mich wie ein Schnitzel drauf 🙂

  • Why wouldn’t Amex simply transition its overall card business to that of VISA/MCD. Accept lower merchant fees, retain the perceived brand benefits, enjoy far wider acceptance (potentially become the biggest network in the market), issue its own cards in addition by retaining the bank aspect to its business which Visa and MCD do don’t have, compete for volume and bank/issue business and join the enormously successful, profitable and growing oligopoly that is the credit card/debit card payment network industry. i.e. cut of an arm or two and become a less special body, but one that survives and thrives in a different form? It can’t keep charging nose bleed prices for something that is increasingly being seen as of limited of any extra value by the distributors (merchants). Cut the fees now, become like another network and focus on the network itself. I guess like all people with an existential problem, the hardest part of recovery is accepting that you have a problem. They are “paddling hard”. But they should stop paddling and change sails, because the sooner they change sails and accept a slower pace (less profitable model), they quicker they will reach smoother waters, even if those waters are nothing like what whey were in before. It’s not work killing the patient, if you can amputate a couple of limbs early on. I just don’t think the price is low enough to buy an amputee yet. Start with a 3 handle and it might be heading there.

    • Nath,
      thanks for the comment. Although I am not an expert on credit cards (yet ;-), let me try to answer some questions:

      Why would Amex not transition its platform to Visa ? This would mean they would become an “ordinary” card issuer. However this would also mean that they lose almost all direct customer data, which they claim is their big advantage compared to the others. Although they don’t really explain how this advantage could be really monetized.

      Your proposal would compare with Porsche and VW: You basically sell a Volkswagen at twice the price because people like the image. This could work.

      Let’s see but maybe some activist gets the same idea ? WHo knows….

  • American Express (AXP): Initial Thoughts On Amex Takeout Report

    News reports today suggest AXP could be an acquisition target of Wells Fargo (WFC), though sources are investment bankers not mgt. In addition, the report raised the prospect of senior mgt changes and that Chairman & CEO Ken Chenault is having conflict with the Board. Note that Berkshire Hathaway (Warren Buffett) owns a 15.6% equity stake in AXP and a 9.8% stake in WFC. Our Thoughts – Historically (pre-credit crisis), there have been investor discussions on whether or not a large bank could acquire AXP, so with the stock underperformance we are not surprised to hear them resurfacing. And this follows the activist investment from ValueAct, who bought a $1B equity stake then ultimately exited the position. More recently after weak Q4 results, we have heard investors theorizing about a potential WFC/Amex combination, due mostly to the Berkshire involvement. In terms of valuation, AXP shares are clearly cheap at 10x our ’17 est, and the stock is at a steep discount to the S&P500 vs the historical 1.02x relative multiple. Moreover, as we show in Figure 1, a sum-of-the-parts suggests a normalized multiple of 14.5x (or $81 per share), given that ~31% of net income is from the higher multiple card network & acquiring segment. While sum-of-the-parts is an important data point for perspective on a potential take out, we are not believers that it makes sense for AXP to separate their network/acq segment. On mgt changes, a frequent topic in our discussions with investors is whether or not current mgt is willing to right size the business for the more competitive, lower ROE environment. We reiterate our Buy rating and believe M&A discussions could support a better bid for the stock and counter some secular decline concerns

  • I think more attractive are companies having the transaction processing and payment technology like FISERV. Better to have the shovel producers than the miners….

  • Radioactive Man

    What has not been touched in the blog post, is the status aspect of Amex cards. People pay $450/year for getting a Platinum Card or $2500 for a Centurion Card (invitation only), for benefits like a concierge service, which will book a trip or reserve a table at a restaurant, or will buy a difficult to get ticket. This I find hard to understand: Why would I call Amex so that they call the restaurant to make a reservation? What’s wrong with calling the restaurant directly (or using an app)? Is it the time saving of not having to look up the restaurant’s number? Is it worth $2500/year (Centurion)?
    Some people say, there is a prestige attached to paying with a Centurion card. I don’t understand that. Whom do I want to impress? The hourly clerk at the check out? The people waiting behind me in line? If it is an expensive store, there won’t even be a line. And why would I want to impress the Wal*Mart crowd? What message do I send to the world? “They tricked me into paying $2500/year for a card that is less well accepted than Visa/Mastercard, but I am rich enough not to bother.”
    If this really is attractive to many people, what about the following business idea: I sell Facebook friendships. Everyone who wants to be in my exclusive list of friends has to pay me $100,000/year. This proves you are really rich and everybody can see it. I might even send them a t-shirt with my face on it.

    • Good points, but people do crazy things to achieve status.

      The “trick” with many Amex cards is that if you spend enough via thee, they actually cost you nothing and you get the services for free.

      Here is an example of a Chinese “Centurion client” who paid a 170 mn USD painting with Amex:
      http://www.theguardian.com/world/2015/nov/24/billionaire-earns-first-class-travel-for-life-by-putting-modigliani-nude-on-amex

      For Chinese rich people, status is pretty much everything……

      • Radioactive Man

        The buyer was smart here, getting a nice kick-back that would have gone to Christies if he had paid by a wire transfer. For him, the $2500 make economic sense. But I still fail to understand how it can make sense for the more typical client.

    • Yes they could do them with an app, but “concierge” type tasks take time. Imagine you’re in an unfamiliar city, how long does it take you to find the right app among the garbage in the app store, read enough reviews to pick a restaurant, etc? May well take you an hour, and be a pain. For someone whose time is worth say 500 an hour that’s a lot, they can as well delegate to the concierge dude whose time is worth 20 an hour. That service alone may easily be worth the $2500/year to them.

  • If you are looking at AXP you might also want to look at DFS. They have a similar but smaller business that caters more to the middle class, and they have a debit payment processing network. I think to an acquirer who just wants a debit/credit processing network DFS might be more interesting because of the lower price.
    Another thing to keep in mind is normalized credit losses, DFS and AXP have pretty low loss ratios right now, but normalizing their credit losses based on the last 12 years leads to higher P/Es.
    A third thing I think about in regards to credit card companies is that they came through the last recession/semi-depression in better shape than most banks because people were ducking out of their underwater mortgages rather than their credit cards, but in the next recession people’s houses might not be underwater so they might prefer to default on their credit cards rather than their mortgages.

    • DFS looks less interesting to me at first sight, catering to the middle class these days is not a growth business…..

      Defaulting on credit cards is not that easy because then you have nothing to pay with.

  • Leonardo von Prellwitz

    I would look at some interesting dynamics in the US such as:

    1) 70% of millennials resort to debit cards instead of credit cards
    2) The rise of firms like Affirm with direct integration in online big ticket purchases

    Offline the credit cards might be losing momentum but it will take time for that market to shrink, online is a completely different ballgame

  • “Paypal in my opinion to a certain extent is a threat as they do have a kind of similar “backbone” but compared to a credit cards, they just transfer money but don’t extend credit.”

    Paypal is in the early stages of getting into the credit business but, until now, this business is not material to Paypal. Paypal’s CEO is an ex-AmEx man and there were some rumours, that AmEx could be interested in a Paypal acquisition (but not confirmed until now, as far as I know).

    Tom

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