Description

Background

Compound248 posted a high quality and comprehensive write up on Amex, Feb-20. The timing was inopportune on the eve of the market melt down associated with the pandemic. If the case could be made in Feb-20 when Amex was trading at $135, the case is likely stronger now trading at c.$100 today. We have the view that the business still trades at a reasonable discount to Intrinsic Value. An investment today may be less risky with the extreme downside case arguably taken off the table. This post builds on Compound248’s with some focus on how to get comfortable with the bear case.

Amex was founded in 1850 as an express mail business.  It extended into financial services and has had various guises until it simplified in the 1990s to the pure play credit card company we recognise today.  Amex is different to almost every other credit card company in that it operates a Three Party ‘closed-loop’ Network.  More commonly, there are 4 separate agents in a Four Party Network: bank issuer, merchant acquirer, merchant and the consumer, with a network (typically Visa or Mastercard) interlinking them.  For example, Barclays Bank may acquire merchants and support them in receiving credit card payments, Visa will act as the payments network that facilitates flows between the merchant acquirer and their issuing bank, say Lloyds Bank, who issue cards to consumers and extends them credit.  Amex undertakes all of the functions of the merchant acquirer and bank issuer as well as providing the network. This means it captures all of the revenues, and all the costs of credit card transactions. It makes this trade off work with average Return on Equity of 27% in the last 15 years, a period which included the GFC (Global Financial Crisis).

There were 114m Amex cards in issue as of December 2019, of which some are credit cards to consumers and some are charge cards, mostly directed to businesses.  Charge cards are typically paid off in full and often used as a means by which employees pay business expenses, such as for travel and entertainment.

There are 3 principal sources of income – discount revenue, card fees and net interest income – which account for c. 90% of Amex’s revenue.  Discount revenue is a fee charged to merchants when people pay using an Amex card.  This is typically c. 2% of the transaction value.  Net interest income is the interest received on credit extended to cardholders, net of provisions for bad debt.  Card fees stem from an array of different products offered to cardholders.  This will often involve a cardholder paying a monthly fee to enhance rewards and services such as air miles, concierge or use of airport lounges.

An attractive business model

Let us briefly outline why we believe Amex has an attractive business model.  We will then focus on how we became comfortable with the risks and the bear case.

The Amex closed loop network would be very difficult to replicate today.  For it to be useful for participants, it requires dual scale in widespread merchant acceptance and material spend coming from consumers who are attracted to, and trust, the Amex brand and proposition.  As with most networks, as it becomes more extensive (i.e. more merchants and more consumers) its value to both parties increases.  Merchants attract more spend, consumers have more places to spend, and Amex generates more revenue, some of which it retains, and some it re-invests in greater rewards for consumers. The network effect is regularly invoked in investment theses.  Rarely is it as directly observable as in Amex’s financial and KPI reporting in the last decade.  Total billed business (i.e. total spending through Amex’s cards) has increased from $620bn to $1.24trn.  Total cards-in-force has increased from 49m to 114m. Rewards and service as a percentage of billed business has increased from 0.73% to 1.02%. Fixed costs have declined from 44% to 29% of revenue.  Amex’s profit margins and ROE% have increased.

Amex benefits from a long-term tailwind from the increasing share of spend on plastic that drives billed business and with it discount revenue.  In the US, credit card plastic’s share of consumption expenditure has risen from 20% in 2006 to 27% in 2019.  The comparable share for the Rest of the World (‘ROW’) was 6% in 2006 rising to 12% in 2019.  In the United States, Amex’s share of credit card spending has been robust as it has achieved parity in merchant acceptance with the Visa and Mastercard networks.  It has lost a little share in ROW, having prioritised certain geographies over others.  This switch from offline to digital and online payments is a trend which has much further to run.

Examining the bear case

Amex’s share price halved from February to March 2020 as the market worried about two main risks: reduction in T&E (Travel & Entertainment) spend and write-offs on the loan book. Most of our time was focused on understanding these risks; determining how resilient Amex would be in light of this and estimating whether they were accurately reflected in the valuation.

Spending on Amex cards skews to T&E: mostly air travel, hotels and restaurants.  In 2019 this represented 29% of all spending on proprietary Amex cards.  Amex is the #1 issuer to US small businesses. It has a relationship with 63% of FORTUNE Global 500 Companies.  Therefore, a significant amount of corporate spending on T&E is routed through Amex cards.  This expenditure has sharply declined in 2020.  Related to this, Amex issues several dual branded cards with co-brand partners.  The larger partners are generally airlines and large hotel chains, notably Delta, BA and Marriott.  Cardholders will use these cards for all types of spending and indeed 90%+ of their spending will be outside of the co-brand partner, but their spending skews to T&E spend, and they may be less motivated to use the card to accrue T&E rewards given the limited opportunity to redeem these in a lockdown.

The market also worried about impending harm to Amex’s loan book from the economic downturn as reflected in provisions and write-offs.  As Amex extends credit to customers and earns net interest income, it provides for expected losses from poorly performing loans though their income statement.  As these losses materialise, they are charged to its balance sheet in write-offs. Economic downturns induce weaker credit performance. This was manifestly observable in the Global Financial Crisis.  At Amex, provisions as a percentage of the loan book increased from c. 3% in 2006 to c. 8% in 2010.

Our view is that the market was right to worry about these risks directionally and neither can be entirely dismissed.  However, our research allowed us to invest opportunistically for two reasons: i. neither threatened Amex existentially, and ii. both reduced our estimates of Intrinsic Value but by less than has been perceived during the pandemic.

We segmented billed business between the different components of spend.  This allowed us to isolate pockets of spend that would be most acutely impacted and make more modest assumptions about declining spend for other areas.  Overall, we estimated total billed business would decline over 20% in 2020 vs 2019.  Declines would be much sharper in T&E categories, or those through co-brand cards.  Total billed business would not return to 2019 levels until 2025.  Put in perspective, we modelled Amex reverting to trend growth in 2022, from a base in 2021, 10% below its 2019 level, i.e. 10% of spending was permanently impaired.  An example of this may be the fly-in-fly-out meetings at airport hotels that we now realise we can do online.  These forecasts were notably more conservative than market consensus.  However, we saw no reason why Amex’s long-term business model and growth opportunity had been threatened.  Indeed, the shift to plastic spending described earlier has probably been accelerated by the shift to cashless online spending in the pandemic.  Note we did not need to form a precise view on when and to what extent different forms of travel would recover, or not.  Instead, our variant perception was guided by short term conservatism but long-term confidence in the business model and market opportunity.

We considered the threat of heightened provisions and write-offs at length.  Amex is registered and regulated as a bank for its lending operations.  Credit risk appraisal does not just inform how a bank performs in any quarter but can become an existential question.  Amex has the best performing credit card portfolio in the market (see charts below). Charge offs as a percentage of loans have been consistently lower than other credit card specialists such as Discover and Capital One and versus the broader market issued under the Visa and Mastercard networks.  Amex seeks, and is sought out by, a more affluent, higher FICO score customer group.  Cognisant of the fragilities revealed by the GFC, Amex has invested significantly in strengthening its credit appraisal capabilities.  As such, going into the pandemic, Amex had a lower base of provisions than pre-GFC and a higher FICO score loan book.  We conservatively modelled increases in provisions exceeding the GFC to appraise the potential hit to net income and capital buffers.  It became clear that within all reasonable scenarios, including some heavy ‘shocking’ of the model, Amex’s balance sheet was solid.  We have closely watched this throughout the year. Every month Amex is required to file updates on the credit quality of its US loan book through Form 8-K.  We have been surprised on the upside at the resilience of the loan book. Write-offs have barely increased.  We remain cautious as this may be due to fiscal support which is impermanent.

Source: Bank of America, Jun-19

We take some comfort that Amex’s flexible cost structure allowed it to remain profitable throughout the GFC.  Net income fell from a peak of $4bn in 2007 to a low of $2.1bn in 2009. Total operating expenses were reduced by $2.3bn from 2008 to 2009, mostly in fixed costs such as salaries.  Amex has committed to $1bn of OPEX reduction this year.  The P&L will be further supported by a quirk of the specific downturn caused by the pandemic.  Cardmember rewards and services totalled $12bn in 2019.  Due to lockdown restrictions, cardmembers will not have the same opportunities to redeem these benefits in 2020.  We wouldn’t want this to be a continued source of support as we want Amex’s customers to redeem and enjoy rewards as that is fundamental to its proposition, but it is not unhelpful as a buffer in the short term.

Catalyst

This thesis is not predicated on a catalyst