I reviewed the 2009 annual report that Amex sent. I had written in detail about changes in Amex business model last year and it's implications. You may want to refresh that first and here is the link.
Here are some thoughts from this year's annual report and it's valuation.
1. First, credit loss is decreasing and write off rates are improving. This is a combination of better underwriting of new cards, closing some cards and agressive action to react to the market (like credit line reduction where appropriate etc). Also, some of it is due the location in credit cycle and some general improvements even though risks like high unemployment remain.
2. In otherwords, the crisis seems to be past to say the least. That is, credit losses is unlikely to require raising equity capital. This is very important for shareholder. It makes no sense to buy back shares at peak prices during good times only to issue shares at bargain basement price when economy falls like some companies have done. On this score, AMEX escaped the worst even though had their share of mistakes in underwriting like issuing cards in areas with peak real estate boom. This point is very important and meaningful good news.
2. Amex hinted at making some subtle shifts and this is good for long term shareholder. Amex is planning to issue lesser number of new lending based cards and limit it to certain premium and co-branded cards where credit performance is better. So, AMEX should get back to better credit underwriting when the next down turn arrives. This impacts the premium market places on AMEX earnings (P/E multiple). In last year's comments, I had serious doubts if AMEX will become a more conscious underwriter and hence suggested a P/E of 14. After this shift, likely AMEX's multiple (P/E) will be better and correctly so. This is good news. We will get to specifics in valuation section.
3. The downside of lesser new card members is it's negative impact on earnings growth. AMEX plans to improve earnings by focussing on spending in it's existing cards. However, the new Normal environment means lesser spending by consumers. The impact on earnings growth may be compensated at least partly by multiple expansion and lower risk.
4. Another negative and less advertised fact is higher capital standards from this point on due to new regulation and AMEX becoming bank holding company etc. AMEX is thinking this will result in ROE of 20%'s as opposed to past ROE's of 33%+. This is a significant impact to long term share holder. Basically more capital is required to create the same earnings growth. This causes AMEX to move from superb economics to one that is very good.
5. AMEX is considering to look for growth in other fee based services in payment industry. AMEX seems to be serious about this and has reorganized accordingly. This action may be a direct result of shift in plans to limit issuing new lending based cards. So AMEX is looking for other avenues of growth rather than just relying on increasing spending on existing cards which is not easy in "new normal" environment. My views are conflicted in this. Additional earnings from non credit risk sources are good. But they also mean less growth in core areas where management has better experience. It may be positive since AMEX is not a bad allocator of capital.
6. To summarize: AMEX will become better underwriter due to issuing lesser number of lending based new cards, closing some poor performing cards and improved underwriting model to take real estate into account. These actions will reduce earnings growth but increase p/e.
AMEX will Focus back on driving up spending. Considering new normal and this is difficult.
Higher capital standards will be in force in future resulting in lower ROE. Hence lower earnings growth to be expected and possibly lower payout ratio (unlike 65% in the past for dividends and share buyback).
Internatinal expansion will be positive.
AMEX in general is a better steward of capital than some other companies. It provides good dividends and not focusses only on share buyback to give back capital. I give a B+ (and not A) because some of their buy back does not add much value especially at the peak but helps stock options become valuable.
7. Valuation: ROE of 25% and payout ratio of 50% seems appropriate. This results in earnings growth of 12%. I will settle for 70% of revenues (discount fees + other fees) without big credit risk and 30% of reveunue based on lending model. A p/E of 18 seems appropriate (.7*22 + .3*10).
Settling on normal earnings number is difficult. It should be possible to get to at least 2005 earnings of $2.38. lets say $2.4. This results in valuation of $44. So AMEX is fully valued current market price of $45.23 (4/19/2010).
8. I own shares in AMEX now. My average cost basis is $36. I should have bought more at around $10 in Mar 09. Warren Buffet advised as much in CNBC. I did not have enough cash in hand. So one lesson is to have cash in hand. Other question always is, do you double down or buy another stock that has fallen but is not directly impacted(like Infosys). I guess some of both is not a bad idea if this were to ever happen (I hope it does not!).
Please leave your comments. I will update next year again.