<THE RULE MAKER PORTFOLIO>
Reviewing American Express
By Bill Mann (TMF Otter)
ALEXANDRIA, VA (Sept. 8, 1999) -- Yesterday, we spent some time going over the qualitative aspects of American Express (NYSE: AXP), one of the components of the Rule Maker Portfolio. Today, we'll change gears a bit and dive into the numbers. Both components are crucial for a proper analysis. The qualitative is the "who, what, when, why, and how" of a company; the quantitative is the "how much."
The verbal and the math portions of the SAT.
"Nice beat, easy to dance to."
Great action scenes, stupid plot.
Our world is full of these tandems. To be successful, you gotta excel on both sides of the equation. The garbage heap of history is lined with companies sporting absolutely brilliant story lines but faulty underlying fundamentals. Iridium. Edsel. Ishtar. These are not the best places for your long-term dollar. How do we discover the Fakers from the Makers? By watching for dominant performance on both sides of the ball.
So, for the three readers still with me, let's dive into the financial side of American Express.
Oh, and just to complicate things, we have to mix up our quantitative signals a bit when analyzing financial companies such as AmEx. Why? Well, when cash is your product, receivables are your inventory, and you have the ability to turn anything and everything into a short-term liability, your performance cannot be judged by quite the same rules. More on this as we go along, but a comprehensive explanation of these concepts can be found in the original buy report written by Dale Wettlaufer.
On with the show....
6) Sales Growth of at least 10% year-over-year -- Time to move over to the left brain for some math. For reasons we just talked about, certain factors in financial companies must be computed differently than they would be for other companies, as their reserve requirements and high capital needs tend to skew their performance in many standard metrics. In layman's terms, this means financial companies require a huge amount of money to generate profits. Fortunately, this first quantitative category is in fact universal. Rule Makers should see incremental sales growth of at least 10% per year. We're not looking to rescue a Bethlehem Steel (NYSE: BS) with our investment dollars here.
Since we're looking at a review from the purchase date, I'll take the year-over-year comparison from the most recent 10-Q. For this, we are looking for revenues from operations, which means that we take total revenue and subtract out interest income. The year-over-year comparison shows sales growth at 12.6%, so it meets our standard quite handily since our purchase last year.
7) Gross Margins of at Least 50% -- Here's where financial companies begin to diverge from our typical Rule Maker analysis. Gross margins of 50%? That's not banking, that's loansharking. With financial companies, the gross margins do not hold the same importance as they do with other companies. With a company like American Express, instead of gross margins we will look at the efficiency in which they utilize their capital.
We create a different set of rules with financial companies to account for the fact that they can create cash at will by issuing short-term debt. What we are looking for is a model to ensure that a financial company returns at least 50% more on its equity than the cost of that equity. AmEx's cost of capital has remained steady at 11% over the last year since the buy report, and the return is 22% (100% above the cost), well beyond the bar and much higher than the industry average.
So what does this mean? Well, let's break out the abacus and figure it out. Every company has a capital value and an expense associated with that capital (financing, depreciation, commercial paper, etc.). But each company also has an annualized return on that capital. If a company's return on capital is below its cost of capital, it is going the wrong way. In this case, AmEx pays, for each dollar of capital, $1.11, but it earns $1.22 per year on that same capital. This, as they say in France, is good.
8) Net Profit Margins of at Least 7% -- Even though gross margins cannot be universally applied to financial companies, net profit margins fit in nicely. Again, the reason has much to do with financials' ability to create cash without necessarily creating earnings. But it is much harder to create net earnings (profits) without actually running an effective business. So, AmEx's annualized net profit of 11.6% moves it right to the front of the class. Not much more to say on this issue, except maybe Woo-hoo!
9) Cash No Less Than 1.5X Total Debt -- The Rule Maker loves cash, no doubt about it. But what do you do when a company's business is cash? Is it cash, or is it inventory? Do you see the problem? In general, companies do not want huge inventories, but a financial company without much inventory (cash reserves) is in big trouble. So how do you separate cash from short- or long-term assets? You can do it, but it most likely won't be very scientific. Personally, I'd love to be faced with the "how do we account for all this money" problem.
Now we have another rule that does not apply. So what do we look for?
We look for leverage, or debt. Specifically, we look for companies that are not highly leveraged. The metric I use measures how much equity the shareholders have for each dollar of assets. The higher the ratio of assets to equity, the more leveraged the company is (and the more debt the company maintains as a percentage of equity). Less debt is good. More debt, not good.
American Express has $12.62 of assets for every $1 of owner equity. AmEx's ratio compares favorably to the $14.84 of assets per dollar held on average by the large financial institutions, according to the trade magazine Credit Card Management. This means that AmEx maintains $0.92 of debt for each asset dollar, as compared to an average of $0.933 by its competitors.
10) Efficient Use of Cash (Flow Ratio below 1.25) -- The final key to the Rule Maker quantitative puzzle is, again, one for which we will have to go "off the menu." The Foolish Flow Ratio is a metric that does not work very well for financial companies. The simplest reason to explain this would be to look at the components of the Flowie's denominator: all current liabilities. How do you define a current liability for a company that creates its profits by issuing and managing liabilities? How do you subtract cash from inventory when the inventory is cash? The answer is, you can do it, but it won't tell you what you want to know.
So what do we want? We want return on our investment dollars. We want return on equity in excess of 20% per year. How does American Express measure up? Its equity return of 22% comfortably surpasses the hurdle, and is significantly higher than the average of 17.6% returned by its peers.
So what do we have? American Express surpasses each of the basic rules on the quantitative side as well as qualitative to allow it the Rule Maker designation. The company has outperformed the S&P since we purchased it, and, if this exercise can be any guide, AmEx has a good chance of excellent future performance.
So AmEx passed the test. Did you?
Eyes on the Wise Update
Last year, The Red Herring made the following prognostication:
"American stocks are irrationally overvalued, and they may yet become more so. But not for much longer. Interest rates must rise. Come this time next year, the Dow will be around 7,500."
Oops, wrong. Guessing the direction of the market in the short run is a lowercase-f fool's errand.
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