Financial services monster American Express (NYSE: AXP) has been causing problems for the Rule Maker Portfolio this week. Monday, the company said first-quarter results would be below expectations. Just as the initial sting from the news began to subside, Rule Maker Co-Manager Todd Lebor and I visited a favorite Old Town establishment and learned that it no longer accepted American Express.
I don't know which is worse: your portfolio taking a hit or a favorite restaurant terminating your preferred form of payment. Taking some time to discuss the burn that both Todd and I felt after learning of the latter might be therapeutic, but it's unlikely to score points with the regular readers of this column. In that case, we'll use this space to discuss American Express' recent announcement.
American Express expects first-quarter profits to fall 18% from the year-ago period because of losses on its junk-bond business and the slowing economy. The company will take a pre-tax loss of $185 million for the write-down or sale of junk bonds in the investment portfolio of its American Express Financial Services (AEFS) unit. That's quite an increase from the $18 million loss it reported in the year-ago period.
Following junk-bond write-downs of $49 million in the fourth quarter, American Express had indicated that weakness in the junk-bond market would hurt earnings in the early part of 2001. According to the company, the write-downs would prevent bigger losses than those that would occur upon maturation of a number of the bonds.
American Express won't retire from the junk-bond business, but does intend on reducing the size of its holdings. Its returns thus far have paled in comparison to the rest of the junk-bond industry. According to mutual fund information provider Lipper, the average junk-bond portfolio returned about 4% in the first quarter; meanwhile, American Express wrote off 5% of its portfolio.
With $185 million in junk-bond losses, you've got to wonder where American Express has been putting its money. Apparently, its $3.5 billion junk-bond portfolio is hurting because of holdings in businesses -- such as movie theatre chains and health-care providers -- that have fallen on tough times recently. Loews Cineplex Entertainment and United Artists Theatres, for example, have filed for bankruptcy protection.
The portfolio has also been hit because of holdings in companies that filed for bankruptcy protection related to asbestos litigation. According to American Express, Owens Corning (NYSE: OWC) and Armstrong World Industries are two such companies.
The company's junk-bond problems are far from a long-term strategic weakness, but instead present a onetime problem. That's good news, but the way AmEx recognizes the value of its junk bonds is worth noting. Junk-bond funds typically revise the value of holdings in accordance with their market value (a.k.a. mark-to-market), but insurance regulations permit otherwise. American Express and other insurance firms recognize bonds on the balance sheet at face value until maturity, sale, or default. That means a significant drop in value upon default could happen with little or no sign.
Excluding its junk-bond problems, the company's earnings would have been flat compared to the year-ago period, which indicates other parts of the business are sluggish. The company said its AEFS unit is slowing because of reduced asset management fees, lower sales of investment products, higher compensation for advisors, and deferred acquisition costs. With the S&P 500 down 14% for the year, none of this is surprising.
American Express' credit card business has also slowed because of the economic slowdown. Consumer and international spending has held, but corporate spending has decreased as businesses tighten budgets. American Express also said credit card delinquencies have trended higher, but remain within expectations. The company expects first-quarter worldwide billed business (or credit card volume) to grow between 8% and 10%, compared to 20% growth in the year-ago quarter.
The company's international and consumer billed business could begin to slow, as the economic slowdown extends its reach. Credit card delinquencies also potentially threaten earnings, if consumers start defaulting. But these risks have always been present at American Express. As the economy goes, so goes its business.
American Express has enjoyed an unparalleled run of growth for more than a decade, but economic conditions leave the stock exposed to some volatility. Short-sighted investors might find this week's news disappointing, but we'll keep our sights set five years out. The company's disappointment thus far has been mostly the result of onetime effects, not strategic weakness, and its billed business is holding up. As for Todd and me, we've already found a new restaurant that takes American Express.
Note to reader: The Rule Maker Portfolio purchased five shares of pharmaceutical company Johnson & Johnson (NYSE: JNJ) yesterday at $87.30 per share for a total price of $436.50.