<THE RULE MAKER PORTFOLIO>
American Express -- Who?
by Matt Richey (TMF Verve)
ALEXANDRIA, VA (May 20, 1999) -- Tonight, we're going to examine financial and travel services giant American Express (NYSE: AXP). I think this company may be a Rule Maker worth consideration for this portfolio's purchase. Oh, hold on just a second, Tom Gardner is trying to get my attention. Say what, Tom? Amex is already in this portfolio? No way! We talk so much about Cisco, Microsoft, and Pfizer, that I guess I forgot.
All kidding aside, we haven't given this Rule Maker nearly enough attention in this space. Almost a year ago, we announced our intentions to purchase shares of American Express. Since then, our investment is up 22.6% (including reinvested dividends) -- not far behind the 22.9% return of the S&P 500. Considering the difficult economic environment in foreign markets, the company has performed quite admirably. Amex continues to gain share in the U.S. charge and credit card markets and still generates the solid return on equity that made it a compelling investment last year. So, why haven't we spoken one word about the company since our purchase?
American Express and other financial services companies simply do not fit our usual examination criteria of high gross margins, low debt, and a low Flow ratio. In fact, none of these metrics can be usefully applied here. Banks and other financial services companies borrow a great deal of money -- much of it on a short-term basis -- to fund their operations. Although we're not big fans of debt, this line of business is stable enough to support a high-degree of leverage.
But this type of leverage is not nearly so risky as the debt accumulated by a manufactured goods company. Here's an example:
Thirty percent of Amex's business comes from "discount revenue," that is the fees that come from facilitating transactions between merchants and consumers. When you type in your Amex card number to purchase $100 worth of books from Amazon.com, American Express pays Amazon $97.27 within one-to-four business days. Then, within 30 days, Amex receives (hopefully) the full $100 when you pay your charge card bill in full. The $2.73 difference ($100 - $97.27) is the fee that Amex earns, and this is called "discount revenue." So, to fund the $97.27 necessary for paying Amazon up front, Amex takes on short-term debt.
All told, Amex uses a lot of debt. During the first quarter of this year, the company had $13.10 of assets for every dollar of owner's equity. The difference between assets and equity is liabilities (as represented by the fundamental accounting equation: assets = liabilities + equity), and for Amex, most of its liabilities are interest-bearing. In this business, it takes a lot of capital to generate profits. Given this type of business, the best way to assess profitability is the return on average equity (ROE). For Amex's most recent quarter, the annualized ROE was 23.6%, up from 22.2% for fiscal 1998.
The first quarter was a strong one for Amex -- here's the 10-Q and the earnings press release. Revenue was up 10% year-over-year, and excluding some one-time events, net income increased 11%, as earnings-per-share grew even faster thanks to the company's aggressive repurchase of shares. Over the past twelve months, the company reduced its diluted sharecount by nearly 3%. All three major divisions -- Travel Related Services (TRS), Amex Financial Advisors (AEFA), and American Express Bank -- showed solid growth versus the comparable quarter last year.
Accounting for 69% of total revenues, TRS turned in 11% top-line growth and 15% net profit growth. With the bottom-line outpacing the top-line, net margins improved from 10.2% to 10.6%. The biggest portion (44%) of this division is the aforementioned "discount revenue," which grew 5.9% year-over-year. Elsewhere, this segment achieved growth through higher average cardmember loans and higher travel commissions and fees (did you know that Amex is the world's largest travel agency?) The company managed this solid performance even while the number of total cards-in-force dropped slightly (1%) due to the company's decision to withdraw from the U.S. Government card business, which no longer offered compelling profitability. Since the end of the quarter, this division has announced some promising initiatives including a deal to provide free shipping for a number of online merchants, including the Gap and Eddie Bauer.
Coming in second with 27% of total revenues, the AEFA business grew revenues by 10% and net income by 15%, thus boosting net margins from 15.2% to 15.9%. This is the asset management and corporate services side of the business. During the quarter, the company announced a partnership to provide Goldman Sachs mutual funds to Amex clients. Amex Financial Advisors now has 9,000 advisors nationwide and $212 billion in assets owned or managed. This division needs to boost its mutual fund offerings (currently only 200 funds, including many Amex-run under-performers with heavy fees to boot) to compete with Schwab's One-Source offering of thousands of no-load funds.
The final and smallest division, American Express Bank, turned profitable to the tune of $41 million after an $83 million loss one year ago. This division includes the no-growth Travelers Cheque business, but is primarily a commercial bank to emerging markets. This is the division that made investors worried last fall with the collapse of Asian markets. But truly, Amex's Asian exposure is fairly low -- $3 billion in total exposure to the Asian/Pacific region, with another $1.4 billion in the Latin American market. With $9.7 billion in equity, the market's 30% hit to the stock's price last fall was discounting a total wipe-out to these assets.
I'd like to write more about this and other financial services companies in the future, as I think the Rule Maker port needs a exposure to this highly-profitable industry. In the meantime, consider the following DuPont ROE comparison among Amex and what I feel are its two primary competitors -- Charles Schwab (NYSE: SCH) and Citigroup (NYSE: C):
Net Asset Leverage Margin x Turns x Factor = ROE American Express 0.116 0.156 13.10 23.6% Charles Schwab 0.150 0.167 14.52 36.3% Citigroup 0.115 0.121 15.68 21.8% Annualized Q1 1999 numbers
If you're unfamiliar with the above way of arriving at return on equity, be sure to check out Fool analyst Dale Wettlaufer's excellent series on ROE (Part 1, 2, 3, 4) -- definitely worth a read! Whether this stuff is brand-new or old-hat, come to the Rule Maker Strategy board to discuss how to deal with financial companies. And, as always, feel free to ask any question on the Rule Maker Beginners board.
Tomorrow, Rob is back to discuss Coca-Cola's first quarter results.
'Til next week, Fool on!
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Day Month Year History R-MAKER -0.37% -3.63% 8.02% 36.68% S&P: -0.40% 0.27% 9.23% 35.12% NASDAQ: -1.36% -0.02% 15.94% 53.81% Rule Maker Stocks Rec'd # Security In At Now Change 2/3/98 48 Microsoft 39.13 78.44 100.43% 6/23/98 34 Cisco Syst 58.41 114.75 96.46% 5/1/98 55 Gap Inc. 34.37 62.06 80.57% 2/3/98 22 Pfizer 82.30 112.81 37.08% 2/13/98 44 Intel 42.34 57.69 36.26% 2/17/99 16 Yahoo Inc. 126.31 151.50 19.94% 5/26/98 18 AmExpress 104.07 123.38 18.55% 2/6/98 56 T. Rowe Pr 33.67 39.50 17.30% 8/21/98 44 Schering-P 47.99 48.75 1.58% 2/27/98 27 Coca-Cola 69.11 67.94 -1.69% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 64.34 80.00 24.35% 3/12/98 20 Eastman Ko 63.15 75.56 19.66% 3/12/98 15 Chevron 83.34 93.75 12.49% 3/12/98 17 General Mo 72.41 80.13 10.66% Rule Maker Stocks Rec'd # Security In At Value Change 6/23/98 34 Cisco Syst 1985.95 3901.50 $1915.55 2/3/98 48 Microsoft 1878.45 3765.00 $1886.55 5/1/98 55 Gap Inc. 1890.33 3413.44 $1523.11 2/13/98 44 Intel 1862.83 2538.25 $675.42 2/3/98 22 Pfizer 1810.58 2481.88 $671.30 2/17/99 16 Yahoo Inc. 2020.95 2424.00 $403.05 5/26/98 18 AmExpress 1873.20 2220.75 $347.55 2/6/98 56 T. Rowe Pr 1885.70 2212.00 $326.30 8/21/98 44 Schering-P 2111.7 2145.00 $33.30 2/27/98 27 Coca-Cola 1865.89 1834.31 -$31.58 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 1286.70 1600.00 $313.30 3/12/98 20 Eastman Ko 1262.95 1511.25 $248.30 3/12/98 15 Chevron 1250.14 1406.25 $156.11 3/12/98 17 General Mo 1230.89 1362.13 $131.24 CASH $70.09 TOTAL $32885.84
Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and
it adds $2,000 in cash (which is soon invested in stocks) every six months.