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.
http://dollarbillsforless.blogspot.com/2009/04/american-express-stock-analysis-and.html
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.
Monday, April 19, 2010
Sunday, February 14, 2010
Book about Jammie Dimon
I recently read a book titled 'The last man standing'. It's a good read to gain insight into Jammie Dimon's (CEO and chairman of JP Morgan chase) work. Few items of interest are listed below from the book.
1. Jammie Dimon likes fortress like balance sheet. Considering banks are leveraged businesses, it is surprising why more such bankers are not around.
2. Likes to be counter cyclical in terms of acquisition. No doubt Wa Mu acquisition is a good example. In contrast, Wachovia bought Golden West at the height of housing bubble. This essentially provides a margin of safety.
3. Jammie's crtierion to buy is as follows. Buy when it makes business sense, price is right and the acquiring company is operationally ready to integrate new business.
3. Cut costs and have lean operations. It somehow always seems that penny pinchers are better stewards of shareholder money. More on this in a later article.
4. Straight forward and no nonsense reporting to share holder. Buffett has appreciated Jammie on his share holder letters. Thats as good as it gets!
5. Jammie is the chief risk officer and has an intutive sense of identifying and acting on risk.
In short, banking is commodity business. In a commodity business, management makes all the difference. Further, the leverage in banking business adds inherant risk. So it is important to have a CEO who understands risk. If you find a small bank with an excellant CEO, it is worth considering for further research. Typically, it is difficult to identify a good manager in banking unless an entire cycle passes.
On the whole, this book helps understand why JP Morgan chase stands tall in this crisis. Simple answer is Jammie Dimon.
1. Jammie Dimon likes fortress like balance sheet. Considering banks are leveraged businesses, it is surprising why more such bankers are not around.
2. Likes to be counter cyclical in terms of acquisition. No doubt Wa Mu acquisition is a good example. In contrast, Wachovia bought Golden West at the height of housing bubble. This essentially provides a margin of safety.
3. Jammie's crtierion to buy is as follows. Buy when it makes business sense, price is right and the acquiring company is operationally ready to integrate new business.
3. Cut costs and have lean operations. It somehow always seems that penny pinchers are better stewards of shareholder money. More on this in a later article.
4. Straight forward and no nonsense reporting to share holder. Buffett has appreciated Jammie on his share holder letters. Thats as good as it gets!
5. Jammie is the chief risk officer and has an intutive sense of identifying and acting on risk.
In short, banking is commodity business. In a commodity business, management makes all the difference. Further, the leverage in banking business adds inherant risk. So it is important to have a CEO who understands risk. If you find a small bank with an excellant CEO, it is worth considering for further research. Typically, it is difficult to identify a good manager in banking unless an entire cycle passes.
On the whole, this book helps understand why JP Morgan chase stands tall in this crisis. Simple answer is Jammie Dimon.
Friday, January 22, 2010
Moody's intrinsic value
This piece attempts to value Moody's (MCO) share price.
My original purchase assumption was that Moody's will earn at least $2.00 eps once credit bubble pops and normal environment returns. This was when the company earned $2.58 in 2007. I did figure that regulatory environment will be tough and their moat may weaken. I figured that even if they turn out to be one of many players, they still have a good chance to get a decent size of the pie. I also thought that Moody's is exporting capital markets to world (think of Coke's world wide expansion!) and is in early stages of global capital expansion. Needless to say, credit market world has changed.
Now it is time to reevaluate what the security is worth. First, Warren Buffet is selling Moody's for the past few quarters. One obvious reason is that he thinks security is fairly valued considering future prospects of the company. It is also possibe that his decision is precipitated by a moral responsibility of being a part owner of the company (up to 20% owner at peak) and not able to influence it's role in credit crisis. If I have to bet, it is not in Mr. Buffet's genie to sell undervalued security. So it is likely a combination of all of the above.
Moody's moat at it's core comes from trust it's customer's place on it's ratings. The credit crisis has shaken that. Moody's is addressing some of the issues but changes are not as drastic as the problem requires. The regulatory environment will be changed and it's shape unknown.
Now lets look at numbers. In 2008, Moody's earned around $1.8 eps. Estimating future growth is tough. World will likely not get back to high levels of leverage any time soon. In particular structured finance business will likely dry up and not return to any where it was in 2006 and 2007 (as stated by CEO in 2008 annual report). Further, 2008 is a baseline year as stated by CEO in 2008 annual report. Company will likely have more competitor's in future in it's regular plain vanila bond rating business. For example, Morningstar has come out with ratings on bonds. Regulation is likely to tighten. If you add all up, Moody's will likely grow few points ahead of inflation because of it's Analytics business and some rating business growth with world economy growth. I will pull up some numbers here. Lets say 5 to 7% revenue growth with 10% eps growth (because of share repurchase).
These figures are not bad. Moody's throws out lots of cash. But the big rub is that shareholders do not benefit from high free cash flow. Moody's repurchases shares regularly instead of giving high dividends. Further, this occurs even when stock price is high. For example, from Oct to Dec 2006, company repurchased 2.2 million shares at around $65 per share. It is not difficult to figure out even in boom period that this price is not a screaming bargain. Share repurchase benefits option holder more than regular share holder. So not much can be expected in terms of value creation due to capital allocation of excess cash. So a lower valuation is warranted.
Over the next few years, Moody's non rating business will grow faster than ratings business due to consumption of risk analysis products. This segment has lower operating margins than the ratings business. As of Q3 2009, op margin of Moody's Analytics business is 34% (still healthy) compared to 40% for ratings business. So op margin expansion is not likely.
Another piece of interest is that 2009 has had good growth in Corporate Finance segment of the Moody's ratings business. This is the ratings on investment grade and speculative grade bonds due to company's refinancing. Likely, this level of activity may not not occur every year since company's have refinanced to avoid any near term maturities.
I think it is not unreasonable to give 15 to 20 as P/E without doing DCF. So this translates to valuation between $27 to $36 based on 2008 eps. Mr. Buffet is selling in lower end of this valuation indicating future prospects are not that great. It is best to take note of when Buffet sells based on past experience.
Please leave your thoughts...
My original purchase assumption was that Moody's will earn at least $2.00 eps once credit bubble pops and normal environment returns. This was when the company earned $2.58 in 2007. I did figure that regulatory environment will be tough and their moat may weaken. I figured that even if they turn out to be one of many players, they still have a good chance to get a decent size of the pie. I also thought that Moody's is exporting capital markets to world (think of Coke's world wide expansion!) and is in early stages of global capital expansion. Needless to say, credit market world has changed.
Now it is time to reevaluate what the security is worth. First, Warren Buffet is selling Moody's for the past few quarters. One obvious reason is that he thinks security is fairly valued considering future prospects of the company. It is also possibe that his decision is precipitated by a moral responsibility of being a part owner of the company (up to 20% owner at peak) and not able to influence it's role in credit crisis. If I have to bet, it is not in Mr. Buffet's genie to sell undervalued security. So it is likely a combination of all of the above.
Moody's moat at it's core comes from trust it's customer's place on it's ratings. The credit crisis has shaken that. Moody's is addressing some of the issues but changes are not as drastic as the problem requires. The regulatory environment will be changed and it's shape unknown.
Now lets look at numbers. In 2008, Moody's earned around $1.8 eps. Estimating future growth is tough. World will likely not get back to high levels of leverage any time soon. In particular structured finance business will likely dry up and not return to any where it was in 2006 and 2007 (as stated by CEO in 2008 annual report). Further, 2008 is a baseline year as stated by CEO in 2008 annual report. Company will likely have more competitor's in future in it's regular plain vanila bond rating business. For example, Morningstar has come out with ratings on bonds. Regulation is likely to tighten. If you add all up, Moody's will likely grow few points ahead of inflation because of it's Analytics business and some rating business growth with world economy growth. I will pull up some numbers here. Lets say 5 to 7% revenue growth with 10% eps growth (because of share repurchase).
These figures are not bad. Moody's throws out lots of cash. But the big rub is that shareholders do not benefit from high free cash flow. Moody's repurchases shares regularly instead of giving high dividends. Further, this occurs even when stock price is high. For example, from Oct to Dec 2006, company repurchased 2.2 million shares at around $65 per share. It is not difficult to figure out even in boom period that this price is not a screaming bargain. Share repurchase benefits option holder more than regular share holder. So not much can be expected in terms of value creation due to capital allocation of excess cash. So a lower valuation is warranted.
Over the next few years, Moody's non rating business will grow faster than ratings business due to consumption of risk analysis products. This segment has lower operating margins than the ratings business. As of Q3 2009, op margin of Moody's Analytics business is 34% (still healthy) compared to 40% for ratings business. So op margin expansion is not likely.
Another piece of interest is that 2009 has had good growth in Corporate Finance segment of the Moody's ratings business. This is the ratings on investment grade and speculative grade bonds due to company's refinancing. Likely, this level of activity may not not occur every year since company's have refinanced to avoid any near term maturities.
I think it is not unreasonable to give 15 to 20 as P/E without doing DCF. So this translates to valuation between $27 to $36 based on 2008 eps. Mr. Buffet is selling in lower end of this valuation indicating future prospects are not that great. It is best to take note of when Buffet sells based on past experience.
Please leave your thoughts...
Tuesday, January 12, 2010
Warren Buffet's role in Kraft
A lot is written about why Mr. Buffet pays part of Burlington North Fe transaction in equity. Check this link if interested (http://www.rationalwalk.com/?p=4035). But the more interesting question is why Mr. Buffet is opposing Kraft's offer of issuing more equity to buy Cadbury's.
Buffet in the past two decades has chosen to be passive investor. His key was to associate with good managements rather than to direct or influence management actions. This has worked well for him in general. His rationale was that managements usually do not listen even if such advice is provided from within the board room. Usually CEO ego takes precedence over advice from elders!
However, investment in Moody's may have changed his opinion. Mr. Buffet was criticized for not taking more active role in Moody's operations during the boom years even though Berkshire owned 20% of the company. In effect, Berkshire was a silent partner in company's role in the credit crisis. In the annual meeting, Mr. Buffet was questioned about this and he gave the same standard answer that managements will not listen.
I think that Mr. Buffet has had second thoughts on this issue. While being a passive investor is still his first choice and correct choice most of the time, he has a responsibility to exercise his responsibility as an owner in circumstances when value is destroyed or when the direction of company is wrong. Ben Graham in intelligent investor asks all investors to take an active role in the companies in which you invest. I think Mr. Buffet may be taking more such active role in future and that is good for all investors who invest along side him or with him.
Please leave your thoughts....
Buffet in the past two decades has chosen to be passive investor. His key was to associate with good managements rather than to direct or influence management actions. This has worked well for him in general. His rationale was that managements usually do not listen even if such advice is provided from within the board room. Usually CEO ego takes precedence over advice from elders!
However, investment in Moody's may have changed his opinion. Mr. Buffet was criticized for not taking more active role in Moody's operations during the boom years even though Berkshire owned 20% of the company. In effect, Berkshire was a silent partner in company's role in the credit crisis. In the annual meeting, Mr. Buffet was questioned about this and he gave the same standard answer that managements will not listen.
I think that Mr. Buffet has had second thoughts on this issue. While being a passive investor is still his first choice and correct choice most of the time, he has a responsibility to exercise his responsibility as an owner in circumstances when value is destroyed or when the direction of company is wrong. Ben Graham in intelligent investor asks all investors to take an active role in the companies in which you invest. I think Mr. Buffet may be taking more such active role in future and that is good for all investors who invest along side him or with him.
Please leave your thoughts....
Monday, October 12, 2009
Warren Buffet on Ben Graham.
Warren Buffet's video about security analysis. You can see how he feels about ben Graham.
http://www.gurufocus.com/news.php?id=70961
http://www.gurufocus.com/news.php?id=70961
Wednesday, May 6, 2009
How to invest in banks
It is important for investors to not fight yesterday's battle. I am referring to financial and banking business. Considering all that has happened, it is tempting to avoid financial forever into future but that would be a mistake. Here is why.
1. Once the current crisis passes, banks will still be needed. Their business is ever green and needless to say is tied to economic growth. That is more true now that shadow banking has taken a hit.
2. It is likely that over next 5 or 10 years, banks will not repeat the past mistakes. This will mean banks will take prudent risks going forward and make loans to credit worthy customers. Eventually similar mistakes will be made, but that is not likely anytime soon.
3. There is less competition since some banks have gone out of business or acquired. The shadow banking system is out of business for most part.
4. My sense is that cost of credit will likely rise once government is out of the picture. I don't know when this will happen. But until then banks can make tons of money.
Now, some thoughts about basics of bank investment and what to look for.
1. First, one thing to learn from credit crisis is that it is important that financial be part of your portfolio and not the entire one. However, talented investor one may be, companies that operate with leverage is inherently risky. It depends on trust of others to lend money (customer deposits) and allow it to operate (regulator). So, limiting exposure (but not avoiding) is best for most investors.
2. A bank makes money by spread between the cost of money that it collects from depositors and the lending rate. I have a simple equation.
Profit = (lending or interest income) - (cost of money) - (cost of running a bank) - (loan losses) + Any fee income.
It is worth thinking about this for a minute. Mr. Buffet likes Wells Fargo because of it's ability to collect low cost deposits (cost of money). However, there is more to this. The variables in above equation are not independent. Here is why. Lets say two banks (Bank A and Bank B) have ability to collect deposits at 1.5% and 2.5% respectively. To get the same spread of 2.5%, Bank A would have to lend at 4% while Bank B would have to lend at 5%. Which of the two loans is more risky? The one at 5% is more risky than at 4% for obvious reasons. So loan losses for Bank B will be more than Bank A over a credit cycle thereby, making Bank A more profitable over the cycle. So low cost deposits are important, not only to reduce cost of raw material (cost of money) but also to reduce lending losses.
3. Find a CEO who has a clearly articulated simple strategy and will not follow the crowd. This is key since banks invariably get into trouble in the same area once every two decades. Usually, in an area that creates lot of profits before the bubble bursts.
4. CEO must be in control of the show and must be the chief risk officer. It is true that getting to know the bank management is not an easy job for small investor. However, downturns provide an excellent opportunity to evaluate their past actions. It is not difficult to infer that JP Morgan and Wells Fargo had better managements than few other big banks. So study their record in down markets and likely there is no better way to evaluate their past actions.
5. Prefer a bank that attempts to grow organically and not by big acquisitions. In particular, it is best to avoid merger of equals. Targeted acquisition of a small bank works better. In this downturn, acquisitions have been opportunistic and I think in all most all cases, the acuiring company may have been better off without those. Some exceptions do exist. As Jammie Dimon (JP Morgan CEO) replied in an interview about why he only agreed to pay $2 for Bear Stearns initially. He said there is a difference between buying a home and buying a home that is burning. That illustrates the risks in quick opportunistic acquisitions.
6. Costs do matter. Since banks are commodity business, cost of running the bank is important. Lower the better. All things being equal, lower the cost of running a bank, lower the risk bank needs to take to earn the same spread.
Conclusion:
Finally, all things said, consider banks that focus on profitability than growth. Focus on those that take thoughtful credit risks and never tries to loosen on credit standards. Focus on cost of running a bank. Last but possibly most important, never buy if you do not have a sense of the management capability and temperment to avoid profitable (in short term) but risky ventures.
Good luck and leave your comments.
1. Once the current crisis passes, banks will still be needed. Their business is ever green and needless to say is tied to economic growth. That is more true now that shadow banking has taken a hit.
2. It is likely that over next 5 or 10 years, banks will not repeat the past mistakes. This will mean banks will take prudent risks going forward and make loans to credit worthy customers. Eventually similar mistakes will be made, but that is not likely anytime soon.
3. There is less competition since some banks have gone out of business or acquired. The shadow banking system is out of business for most part.
4. My sense is that cost of credit will likely rise once government is out of the picture. I don't know when this will happen. But until then banks can make tons of money.
Now, some thoughts about basics of bank investment and what to look for.
1. First, one thing to learn from credit crisis is that it is important that financial be part of your portfolio and not the entire one. However, talented investor one may be, companies that operate with leverage is inherently risky. It depends on trust of others to lend money (customer deposits) and allow it to operate (regulator). So, limiting exposure (but not avoiding) is best for most investors.
2. A bank makes money by spread between the cost of money that it collects from depositors and the lending rate. I have a simple equation.
Profit = (lending or interest income) - (cost of money) - (cost of running a bank) - (loan losses) + Any fee income.
It is worth thinking about this for a minute. Mr. Buffet likes Wells Fargo because of it's ability to collect low cost deposits (cost of money). However, there is more to this. The variables in above equation are not independent. Here is why. Lets say two banks (Bank A and Bank B) have ability to collect deposits at 1.5% and 2.5% respectively. To get the same spread of 2.5%, Bank A would have to lend at 4% while Bank B would have to lend at 5%. Which of the two loans is more risky? The one at 5% is more risky than at 4% for obvious reasons. So loan losses for Bank B will be more than Bank A over a credit cycle thereby, making Bank A more profitable over the cycle. So low cost deposits are important, not only to reduce cost of raw material (cost of money) but also to reduce lending losses.
3. Find a CEO who has a clearly articulated simple strategy and will not follow the crowd. This is key since banks invariably get into trouble in the same area once every two decades. Usually, in an area that creates lot of profits before the bubble bursts.
4. CEO must be in control of the show and must be the chief risk officer. It is true that getting to know the bank management is not an easy job for small investor. However, downturns provide an excellent opportunity to evaluate their past actions. It is not difficult to infer that JP Morgan and Wells Fargo had better managements than few other big banks. So study their record in down markets and likely there is no better way to evaluate their past actions.
5. Prefer a bank that attempts to grow organically and not by big acquisitions. In particular, it is best to avoid merger of equals. Targeted acquisition of a small bank works better. In this downturn, acquisitions have been opportunistic and I think in all most all cases, the acuiring company may have been better off without those. Some exceptions do exist. As Jammie Dimon (JP Morgan CEO) replied in an interview about why he only agreed to pay $2 for Bear Stearns initially. He said there is a difference between buying a home and buying a home that is burning. That illustrates the risks in quick opportunistic acquisitions.
6. Costs do matter. Since banks are commodity business, cost of running the bank is important. Lower the better. All things being equal, lower the cost of running a bank, lower the risk bank needs to take to earn the same spread.
Conclusion:
Finally, all things said, consider banks that focus on profitability than growth. Focus on those that take thoughtful credit risks and never tries to loosen on credit standards. Focus on cost of running a bank. Last but possibly most important, never buy if you do not have a sense of the management capability and temperment to avoid profitable (in short term) but risky ventures.
Good luck and leave your comments.
Friday, April 10, 2009
American Express - stock analysis and review
Recent share holder letter provides some valuable insight. Here are some that will interest long term investors.
1. Consumer spending pattern: The most important driver of value for AXP is consumer card spending. The US consumer card spending reduced 12% in fourth quarter of 2008. International card spending showed some growth but much less than last year. The reduced spending was particularly visible in luxury goods which is especially important for American Express. The key question is how much of this decline is attributed to secular shift in the consumer spending patterns. Are consumers temporarily withdrawing or will we see a cautious consumer whose prefers to save for next few years. By all accounts, it seems that we will have a cautious consumer at least for next few years. Since American Express depends on consumers spending and transactions, this can have a significant impact on revenue and bottom line.
2. Underwriting decisions: Management is candid about some of their actions that resulted in increased credit loss. First, AMEX card member base is skewed towards states hit hard by real estate crash. [Btw, I understand Discover was more cautious in this regard.]. Second Amex added more card members than industry (higher growth). Third, they have more small business accounts. These decisions are elaborated below as they are significant in my view.
3. Floor for credit losses: The above three actions illustrate that Amex fully participated in the credit boom. This resulted in significant growth in good years which is coming back to bite in bad years. The net result of above actions resulted in middle of the pack past-due and write-off rates (bad loans that cannot be collected). Further, this loss cycle is far from over since unemployment is expected to continue over many months to come. The exact level of credit card losses is difficult to predict in this environment. Historical indicators may be misleading as the current credit bubble induced recession differs from either the valuation driven tech bubble or a general economic slowdown without structural issues. It is difficult to estimate future losses and considering credit card loans are unsecured loans, uncertainty definitely exists in this regard. It is for this reason that I believe that valuing Amex at this point is not possible with any level of certainity.
4. Business model: American Express traditionally commands a higher multiple in the market for a reason. Historically, American express business model is based on spending by high networth customers who will pay the bill rain or shine. The focus is on discount fees from merchants and membership fees from card holders. Increasing balance was not the primary focus. This meant that Amex had low credit risk and market rewarded this handsomely with high multiple. [There is a reason Banks have low multiple for same earnings. One is leverage and other is possibility of credit loss.)
The question to be evaluated now is whether the Amex business model has changed as a result of expansion past few years coupled with poor underwriting decisions (outlined in #2)? The write-off rates are in the middle of the pack for a top quality company. If American Express continues to expand in good times and creates higher write off rates in poor economy, it will be treated more like cyclical business and will not justify premium multiples (correctly so). This affects long term share holder value. The key issue is whether American express moves back to a business model of low credit risk. I suspect Warren Buffet did not anticipate holding a company with middle of the pack write-off rates. If so, that will inevitably mean more subdued growth in the future.
5. Risk conscious culture: The net charge off being in the middle of the pack for a top class company like American express is unacceptable to say the least. Was there too much focus on growth? How did the company miss out on risks during real estate bubble when at least one competitor recognized it? For a financial company, growth can be dangerous if it is not accompanied with sound underwriting. I understand American express has tweaked their models in response to the crisis but it is equally troubling that the culture within the company did not catch this earlier. Holding a financial company is meaningful only if it has risk conscious culture. Any deviations can be fatal and as well difficult to rebuild the culture. I do not see anything else that has changed other than tweaking models. Note models are a result of human decisions anticipating risks not the other way around. This point is key.
6. Compensation: I tried to read through the proxy for compensation details. It was complex to say the least and based on many parameters. I think it should be simple enough and depend on few critical drivers of the business. Some combination of underwriting profit growth and write-offs over a cycle would make sense. In a year like 2008, anything other than base pay is excessive.
7. Credit card securatization: It is an open question as to how the credit card receivable securatization market will function after the current crisis is past? Could it be relied upon for funding? Since credit cards are unsecured loans, it is always possible that this market will freeze whenever investors are nervous. This risk applies to all credit card companies. In this regard, American express has brand advantages to raise capital from other funding sources. However, as a whole, the total credit issued will be reduced in the future as securatization market will demand higher credit quality.
8. Cost expenses: American Express has announced 10% reduction in work force. I think this is in keeping with realistic view of future growth after years of expansion. However, it also shows that future growth is going to be subdued.
9. Regulation: New regulation is inevitable and it is not going to be friendly to credit card companies. It is difficult to predict the nature of this. I suspect regulation will affect the credit card companies whose business model is based on balances more than AMEX.
Conclusion: I think future growth of Amex will depend on a number of factors outlined above. At this time, AMEX is in "too hard to value" pile. Here is a recap why it is so.
First, Amex has to survive the credit losses in the short term without raising expensive equity capital. I do not think we have reached peak write offs and that anyone can predict this with any accuracy since economy is still in poor shape.
Second, will AMEX learn from this downturn and go back to the business model that results in low credit risk across entire cycle? It is an unknown. This will decide the multiple market provides (correctly so).
Third, credit card industry has a number of external factors that can influence it's future like regulation, consumer deleveraging, securatization market etc. These are hard to predict.
Fourth and most important, will management create an environment that is focussed on sound risk management? This is the most important aspect of a financial company and in last bubble risk controls failed the company. Without this, owning financial company is a gamble.
Considering all of the above, I think it is not possible to meaningfully value the company at this point. As a disclaimer: I do own Amex shares and plan to continue to hold. Please leave your comments by clicking the comment button below.
1. Consumer spending pattern: The most important driver of value for AXP is consumer card spending. The US consumer card spending reduced 12% in fourth quarter of 2008. International card spending showed some growth but much less than last year. The reduced spending was particularly visible in luxury goods which is especially important for American Express. The key question is how much of this decline is attributed to secular shift in the consumer spending patterns. Are consumers temporarily withdrawing or will we see a cautious consumer whose prefers to save for next few years. By all accounts, it seems that we will have a cautious consumer at least for next few years. Since American Express depends on consumers spending and transactions, this can have a significant impact on revenue and bottom line.
2. Underwriting decisions: Management is candid about some of their actions that resulted in increased credit loss. First, AMEX card member base is skewed towards states hit hard by real estate crash. [Btw, I understand Discover was more cautious in this regard.]. Second Amex added more card members than industry (higher growth). Third, they have more small business accounts. These decisions are elaborated below as they are significant in my view.
3. Floor for credit losses: The above three actions illustrate that Amex fully participated in the credit boom. This resulted in significant growth in good years which is coming back to bite in bad years. The net result of above actions resulted in middle of the pack past-due and write-off rates (bad loans that cannot be collected). Further, this loss cycle is far from over since unemployment is expected to continue over many months to come. The exact level of credit card losses is difficult to predict in this environment. Historical indicators may be misleading as the current credit bubble induced recession differs from either the valuation driven tech bubble or a general economic slowdown without structural issues. It is difficult to estimate future losses and considering credit card loans are unsecured loans, uncertainty definitely exists in this regard. It is for this reason that I believe that valuing Amex at this point is not possible with any level of certainity.
4. Business model: American Express traditionally commands a higher multiple in the market for a reason. Historically, American express business model is based on spending by high networth customers who will pay the bill rain or shine. The focus is on discount fees from merchants and membership fees from card holders. Increasing balance was not the primary focus. This meant that Amex had low credit risk and market rewarded this handsomely with high multiple. [There is a reason Banks have low multiple for same earnings. One is leverage and other is possibility of credit loss.)
The question to be evaluated now is whether the Amex business model has changed as a result of expansion past few years coupled with poor underwriting decisions (outlined in #2)? The write-off rates are in the middle of the pack for a top quality company. If American Express continues to expand in good times and creates higher write off rates in poor economy, it will be treated more like cyclical business and will not justify premium multiples (correctly so). This affects long term share holder value. The key issue is whether American express moves back to a business model of low credit risk. I suspect Warren Buffet did not anticipate holding a company with middle of the pack write-off rates. If so, that will inevitably mean more subdued growth in the future.
5. Risk conscious culture: The net charge off being in the middle of the pack for a top class company like American express is unacceptable to say the least. Was there too much focus on growth? How did the company miss out on risks during real estate bubble when at least one competitor recognized it? For a financial company, growth can be dangerous if it is not accompanied with sound underwriting. I understand American express has tweaked their models in response to the crisis but it is equally troubling that the culture within the company did not catch this earlier. Holding a financial company is meaningful only if it has risk conscious culture. Any deviations can be fatal and as well difficult to rebuild the culture. I do not see anything else that has changed other than tweaking models. Note models are a result of human decisions anticipating risks not the other way around. This point is key.
6. Compensation: I tried to read through the proxy for compensation details. It was complex to say the least and based on many parameters. I think it should be simple enough and depend on few critical drivers of the business. Some combination of underwriting profit growth and write-offs over a cycle would make sense. In a year like 2008, anything other than base pay is excessive.
7. Credit card securatization: It is an open question as to how the credit card receivable securatization market will function after the current crisis is past? Could it be relied upon for funding? Since credit cards are unsecured loans, it is always possible that this market will freeze whenever investors are nervous. This risk applies to all credit card companies. In this regard, American express has brand advantages to raise capital from other funding sources. However, as a whole, the total credit issued will be reduced in the future as securatization market will demand higher credit quality.
8. Cost expenses: American Express has announced 10% reduction in work force. I think this is in keeping with realistic view of future growth after years of expansion. However, it also shows that future growth is going to be subdued.
9. Regulation: New regulation is inevitable and it is not going to be friendly to credit card companies. It is difficult to predict the nature of this. I suspect regulation will affect the credit card companies whose business model is based on balances more than AMEX.
Conclusion: I think future growth of Amex will depend on a number of factors outlined above. At this time, AMEX is in "too hard to value" pile. Here is a recap why it is so.
First, Amex has to survive the credit losses in the short term without raising expensive equity capital. I do not think we have reached peak write offs and that anyone can predict this with any accuracy since economy is still in poor shape.
Second, will AMEX learn from this downturn and go back to the business model that results in low credit risk across entire cycle? It is an unknown. This will decide the multiple market provides (correctly so).
Third, credit card industry has a number of external factors that can influence it's future like regulation, consumer deleveraging, securatization market etc. These are hard to predict.
Fourth and most important, will management create an environment that is focussed on sound risk management? This is the most important aspect of a financial company and in last bubble risk controls failed the company. Without this, owning financial company is a gamble.
Considering all of the above, I think it is not possible to meaningfully value the company at this point. As a disclaimer: I do own Amex shares and plan to continue to hold. Please leave your comments by clicking the comment button below.
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