American Express (NYSE: AXP) has rewarded the Rule Maker Portfolio with an investment loss of 2% since we first bought the stock in August 1998. Most of our gains were wiped out in recent months, however, with the share price falling over 35% since January because of tough economic conditions and sizeable losses in the junk bond portfolio of its American Express Financial Advisors (AEFA) unit.
Sales and earnings in the first-half of 2001 have fallen 5% and 49%, respectively. Excluding the junk bond losses, sales grew 4% and earnings fell 1%. While our confidence in management has taken a hit as result of the write-downs -- Bill Mann summed up our position in an earlier column -- we'd rather spend today's column summing up our long-term view of American Express, just as we've done with Intel (Nasdaq: INTC), Nokia (NYSE: NOK), and Microsoft (Nasdaq: MSFT).
American Express is the largest travel services and charge card company in the world, as well as one of the leading issuers of credit cards. (Charge cards must be paid in full at the end of each month, while credit cards allow users to carry a balance over.) With one the world's strongest brands, American Express has also sought to leverage its name and cross-sell additional financial services products.
We love the opportunities in the Travel Related Services (TRS) unit, which includes both its charge and credit card businesses, and made up 80% of sales last year. Discount revenue, a 2.7% fee that merchants pay per transaction, has grown 12% annually for the last seven years. Finance revenue, interest on revolving balances, has also grown steadily since it got serious in the credit card business in the mid '90s.
Discount and finance revenue growth have fallen this year, however, with corporate spending down because of tough economic conditions. Meanwhile, consumer and international spending have been holding up pretty well. It's no secret that as the economy goes so does American Express. If economic conditions worsen, consumer spending could slow, bankruptcies could increase, and its results would suffer.
We've already seen clear evidence its profitability has fallen, as measured by return on equity, a key measure of profitability in the financial services sector that shows how effectively a company is employing shareholders capital. American Express' return on equity fell to 18% in the most recent quarter, below the market's return on equity of 20%, and well down from 25% at the end of last year.
Still, over the next five to ten years, we think TRS has plenty of room to grow, as the number of cards in circulation and spending per card rises. Other opportunities include partnerships with merchants like its deal with Costco (Nasdaq: COST), grabbing more revolving debt balances, and growing its share of the small business market.
We think American Express' TRS business will be bigger and stronger over the next five years, but we're not nearly as sure about its AEFA unit. Not only has AEFA performed more or less average compared to its industry peers, but the competitive strengths, such as brand, that have made it a success in the credit business appear to be less significant in the asset management industry.
Using its brand to sell card members financial planning products, insurance, and banking services seems like a winning strategy, and there's been evidence of some success given that 30% of its financial planning customers in recent years have come from its card member base. Still, asset growth has been a modest 15% annually, which is only slightly better than the median industry growth of 14%.
We're more concerned with the performance of its mutual funds, however. For the 12 months ending June 30, only 27% of AEFA's funds performed in the top half of their Lipper performance indexes. Management has pointed to the positives, stating that 57% of its total fund assets were in the top half of their Lipper competitive groups, as larger funds have done better, but all that tells us is that its returns are only slightly better than the median performance of the mutual fund industry.
While the performances of its funds, particularly in an industry were results matter most, is less than stellar, we're also concerned with its earnings growth. Between 1997 and 2000 AEFA grew earnings roughly 13% annually, which is pretty poor when you take into consideration the market's performance over that time. The lackluster earnings growth was due in part to the company expanding its offerings to include third-party products, which are less profitable than in-house funds.
Jim Cracchiolo, who has a successful record with the company's global credit business, has been pegged to improve AEFA. His laundry list of initiatives include improving the funds results, which could take time given that performances are typically judged on more than one year of returns. Mass marketing, creating premium services for wealthy clients, and new products will also be important
Turning to price, American Express closed yesterday at $36.42 per share, leaving it with a market capitalization of $48.2 billion and trading at 25 times 2001 earnings. (Bill Mann has thoughts on the stock's price in today's Fool on the Hill column.) As Rule Maker investors, however, we want to know if the company's market cap can increase two times over the next five years, or what we call 2x5y returns.
Two times American Express' current market cap puts it at $88 billion in five years. We've assumed no dilution, give that its share count has actually been declining in recent years. We've also assumed an expected net profit margin of 11%. Currently, its net profit margin is 9.2%, but we think a slight increase in profitability over the next five years is reasonable, given management's focus on creating efficiencies.
With these assumptions, let's take a look at what level of sales growth will be necessary to achieve 2x/5y at various future P/E multiples:
Projected P/E 30 25 20 Year 5 Earnings $2.93 3.52 4.40 Year 5 Revenue ($B) 26.70 32.00 40.00 Growth Rate for 2x/5y 3.0% 6.9% 11.7%
For 2x5y returns, American Express would have to post $32 billion in revenue in year five, growing its top line 7% annually. That's under management's guidance, which calls for annual sales growth of at least 8%. Then again, we've assumed a P/E of 25. If we lowered its multiple to 23 times, in-line with its five-year average, it would need to grow its top line nearly 9% annually, still in the ballpark of current guidance. Either way, at the current price, we think the rewards outweigh the risks.
With a strong brand, the world's largest charge card business, and a leading credit card business, we think American Express continues to offer solid growth potential. Still, tough economic conditions and poor results in its AEFA unit have hurt overall results. The weakness in that unit isn't surprising given that its business moves with the economy, but the effect on the company as a whole is cause for concern. AEFA is expected to be a major growth driver and we'll be watching closely for any improvements or missteps.
After kicking the decision around, we're purchasing more shares of American Express with this month's $500 investment. As usual, we'll follow our Foolish trading guidelines and make this purchase within the next five business days.