By: Steve Smith
Financial stocks of all stripes, from traditional banks to multiline insurance firms to asset managers, have been under pressure over the past few months as it became clear interest rates will remain near zero for longer than expected. Once the prospect of a steepening yield curve faded, which is so crucial to the profits that can be made on loans or the returns generated for assets under management, so did enthusiasm for the sector.
One company, American Express (AXP) has been hit particularly hard as it not only operates within this tough macro headwind but has a host of company specific challenges. But as Warren Buffett, whose Berkshire-Hathaway also happens to be one the largest shareholders with a 15% stake in Amex, often says, “be greedy when others are being fearful.”
So is now, with AmEx shares down some 30% from their 2015 peak and analysts still issuing negative reports, a good time to get greedy and scoop up shares? The company is set to report earnings on April 20 so we better get cooking with our analysis.
Let’s acknowledge a great deal of criticism and poor performance over the past year has been warranted. in recent months. From items it can’t control, such as an appreciating dollar which negatively impacts its overseas business, to the quickly changing digital payment landscape with new competitors to some of the company’s own missteps such as the loss of key partnerships such as Costco (COST). These issues have been mostly priced and will smooth out over time.
A Different Card, A Different Model.
One item that is often misrepresented and we would do well to clarify is the comparisons of American Express to Visa (V) and Mastercard (MA). They have very different business models. Cards branded ‘Visa’ or ‘MasterCard’ are not issued by Visa or MasterCard: they are issued by banks and financial firms that join those respective companies’ credit networks. Purchase made with those cards levy a merchant fee, which must be split between the actual card issuer and the credit network provider. This means that Visa and MasterCard are not responsible for the balance on the cards and are not exposed to the loan risk. Visa and MasterCard generate their revenue from transaction volume.
By contrast, American Express issues their own cards. This means it takes responsibility for transfer of funds with credit card purchases, and that entails additional risk, which forces American Express to charge more for their credit card purchases than Visa or MasterCard do. This situation makes retailers less likely to accept American Express in lieu of Visa and MasterCard, and is the main reason why it is not as widely accepted.
This goes a long way in explaining the extreme disparity in valuations; not only does American Express’s market capitalization trail Visa and MasterCard $57 billion versus $169 billion and $103 billion respectively but its p/e is puny 11.5x forward estimates vs the 29x that Visa and MasterCard trade. Basically, American Express gets valued more like a bank due to the loan default risk it carries.
But there are also strengths and additional upside to American Express’s model. This closed-loop system allows AmEx to generate incredible amounts of revenue with fewer issued cards. American Express cardholders are an affluent customer base who tend to spend more than Visa and MasterCard clients do, which means that the merchant fees incurred from this greater volume of purchases generates more revenue.
Thus, what American Express lack in card circulation, they make up for in revenue from their higher-end clientele. In 2015, AXP generated $32.8 billion compared to Visa’s $14.1 billion. They generated more than double the revenue while having only 9.1% of the market share compared to Visa’s 51.8%.
Aside from higher revenue per customer, AMEX is able to leverage its brand to generate higher margins. The company is able to analyze the data transactions and target them with specific rewards and drive them to certain merchants. Part of what attracts these affluent clients is the very customized rewards and incentives directed towards them which in turns directs them to specific businesses such as high end hotels or retailers. It’s a virtuous and mutually beneficial ecosystem.
This brings up the undeniable issue that American Express has lost several card partnerships over the last few years, the most-high profile and impactful was its separation from Costco which accounted for 8% of American Express’ billed business and 20% of their interest-bearing credit portfolio.
But before construing it as total loss American Express CEO Kenneth Chenault explained it made no “economic sense for us and our shareholders”. The two sides could not come to terms, this is important point to bear in mind about the fallout: American Express was not willing to hold onto Costco at any price, and was prepared to accept this situation as a possibility when the re-negotiations took place. To play up the loss as an unmitigated disaster, therefore, is little more than hyperbole. Instead, it is a short-term problem the company willingly took on to avoid being tied into a bad deal. Short-term it’s problematic, yes, but it’s not a long-term problem.
Indeed, in recent weeks shares of AmEx have recovered quite a bit and now sit above important support at the $60.50 level. Also, first quarter earnings major banks such as JPMorgan (JPM) and Bank America (BAC) cited strong performance from their credit card divisions. This bodes well heading into AmEx’s earnings report due on April 20.
I want to set up a bullish position in ahead of the earnings report. But to mitigate the impact of the decline in implied volatility occurring after the event I want to use a basically vertical spread. Specifically;
-Buy the May $60 Call
-Sell the May $65 Call
For $2.50 net Debit
I like this trade because it already has over $2 of intrinsic value (in-the-money) and can deliver a 100% return on a relatively small price move. Here is what the risk graph looks like: