Charge Ahead With Amex
06/16/2008 12:00 am EST
Paul Larson, editor of Morningstar StockInvestor, says American Express has a unique franchise in the credit card business and it's priced attractively, too.
American Express (NYSE: AXP) operates the most successful "closed-loop" credit-card network in the US and many other profitable card businesses around the world. Although the Amex card isn't yet as widely accepted as Visa (NYSE: V) or MasterCard (NYSE: MA), the firm has evolved from a niche player into a global payments giant.
Thanks to its closed-loop network, Amex essentially owns the entire value chain and, as a result, retains the full economic value that's being created by the card scheme. Unlike Visa and MasterCard, Amex can issue its own cards and doesn't have to rely on merchant acquirers to process transactions. Servicing cardholders and merchants as opposed to large financial institutions provides Amex with pricing power.
[Also,] while most issuers make the bulk of their profits by extending revolving credit to cardholders, Amex's earnings mostly come from fees charged to merchants. [So,] Amex focuses on enticing cardholders to use its cards as frequently as possible.
We also like the firm's recent strides to grow by reaching agreements with most of the major banks in the United States to issue its card to their clients. We think this is wise, because it enables Amex to reach new clients-which would be tougher to acquire on its own-with minimal investment.
On the merchants' side, Amex has started to boost its acceptance level by teaming up with third-party acquirers that will acquire transactions on Amex's behalf. We like this move, because it will most likely boost acceptance of Amex cards.
Its former financial advisor segment, American Express Financial Advisors, was spun off to shareholders in 2005. Chief executive officer Ken Chenault has managed admirably through some difficult times. Top brass compensation has been commensurate with the company's strong recent performance, but total pay levels do not make us queasy.
We expect Amex's revenues to increase by about 8.5% annually through 2012, driven primarily by growth in discount fee revenue. We expect Amex's total billed business-the amount spent on Amex cards-to grow by almost 14% over the next five years.
Amex generates a high return on invested capital and enjoys excellent long-term growth prospects. Amex's return on capital is near 40%, by our calculation, which is well above our estimate of its cost of capital. Although we expect this supernormal return to come down to earth over time, we think Amex's return on capital will remain significantly higher than its cost for many years, given the firm's wide moat.
Amex is a shareholder-friendly firm and has an explicit goal of returning 65% of its free cash flows to shareholders through dividends and share repurchases, and it has lived up to this promise during the last several years. We also admire management for maintaining a good balance between managing for immediate results and investing in the future. Our fair value estimate is $70. (It closed below $45 Friday-Editor.)