Value is in the eye of the beholder. I hate to even look at a company trading at more than 15 times normalized earnings power. However, I will readily admit that some companies are of such high quality that they deserve seemingly nosebleed multiples. Paychex (NASDAQ:PAYX) and Moody's (NYSE:MCO) are two companies that seem to have justified their lofty P/E ratios. And after reviewing the company's prospects, I believe there's a pretty good chance American Express' (NYSE:AXP) shares could be revalued at a higher multiple.
The "bouncer" effect
American Express is like the bouncer between merchants and customers. When choosing a credit card, customers can either get a card with a lot of rewards or a card with few rewards, so the decision seems easy. However, to give out more rewards, American Express needs to charge the merchant more to pay for them.
Merchants don't want to pay American Express higher fees. But to prevent that, they'd basically have to not accept AmEx cards. According to its annual report, spending per card for AmEx in the U.S. is four or five times higher than on Visa or MasterCard (NYSE:MA) plastic. That's almost impossible for most retailers to turn down.
Customers are the ones who pick the card. To them, the higher fees AmEx charges the merchants are invisible, so they basically go for the rewards, which are, in reality, subsidized by all customers. The key here is that the one making the decision (customer) isn't the one paying the fee (the merchant). As a result, by paying higher rewards, AmEx can cherry-pick the best customers. Average spending on rewards cards is four to five times higher than non-rewards cards, and the customers tend to be more loyal and less likely to default on their debt.
A branded moat
AmEx has been around for 156 years. During that time, it has instilled its brands in our minds. Whipping out an AmEx card gives the cardbearer instant status. It's like carrying a Mercedes-Benz in your wallet. Every year, AmEx spends a vast amount of money on commercials, rewards, and promotions to further train us Pavlovian dogs that its card is superior.
The closed loop
Unlike competitors who use third parties (for example, Capital One (NYSE:COF) issues Visa and MasterCard cards), American Express is vertically integrated. It directly markets to customers, issues the card, processes the payments through its own network, and directly acquires the merchant relationships. This is known in AmEx-speak as the closed loop.
This is a tremendous advantage. Because it directly touches every part of the process, it gets more and better data. That data allows it to better price rewards, fees, and finance charges. It allows AmEx to market better. It helps build more and deeper relationships with merchants -- which in turn help them accurately gauge its rewards program. It also allows AmEx to share data with merchants to help increase customer spending. Merchants like that. Lastly, the startup costs to build each component of the closed loop are daunting.
Economies of scale
The credit card industry is one of economies of scale. Central fixed costs, like advertising and IT expenses, need to be leveraged over a wide base of customers. Once a card company hits critical mass, incremental returns are through the roof.
Breaching AmEx's moat seems like an impossible task. Competitors can't offer the same level of rewards because, unlike AmEx, they don't have the lucrative customer base to go to war with, and will get pushback from retailers. They also aren't vertically integrated, so have to pay markup costs to third parties and don't have the same access to data.
One word: plastic
Payment by plastic still has plenty of legs. According to AmEx presentations, worldwide, 86% of the estimated $24 trillion in consumer spending was paid by cash or check. China, India, and Russia all have less than 25% plastic penetration. In 2005, plastic accounted for roughly 40% of the $7 trillion in U.S. payments -- this percentage is expected to increase to 56% by 2010, meaning that payment on plastic would grow 12% a year.
Also, spending on AmEx cards issued by third parties grew (on an organic basis) 36% in 2006 and has a 32% annual five-year growth rate. This is still a relatively new area, and in the last couple of years, AmEx has signed distribution partners like Citigroup, Bank of America, GE and HSBC.
AmEx is also innovative, with a real push for contactless payment, which would help it with smaller, quicker payments (at the gas station, drugstore, and so on). It's also pushing to get really, really big purchases on AmEx cards, like $1 million condo mortgages.
The numbers speak for themselves. Since 2003, the amount of spending on AmEx cards increased at an annualized 16% growth rate. This was driven both by more AmEx cards being issued and more spending per AmEx card. AmEx growth rates exceed those of its competitors', indicating that it is taking market share.
As the company takes share, it can leverage its costs and continually widen its moat. Since 1999, the percent of sales that AmEx spends on human resources and other operating expenditures has declined. Meanwhile, the percent spent on marketing and rewards has gone from roughly 15% to 25% of sales. This is a good thing. Customers don't care how many servers AmEx has (as long as they don't crash); they care about how many rewards they get.
None of what I am saying is meant to detract from strong and very capable competitors, like Capital One, Discover (a soon-to-be Morgan Stanley (NYSE:MS) spinoff), Visa (a soon-to-be IPO), or MasterCard. Instead, my optimism about AmEx is more dependent on its unique advantages, impervious moat, and industry headwinds.
Valuation
American Express is currently trading at 20 times trailing earnings and 16 times forward earnings estimates. However, I think AmEx's earnings are understated. The company spent $6.5 billion on marketing, promotions, rewards, and cardmember services in 2006. I don't know how much, but it's pretty safe to say some of that spending was to attract new cardholders, given that total cards in force has been growing at about 8% over the past four years.
Advertising costs are expensed as incurred, but AmEx card members are loyal and provide earnings for many years. As a result, some of AmEx's customer-acquisition costs should be amortized over a period of years.
As a result, I look at it in two ways. Either you can give AmEx credit for future growth, or you can assume it has a higher "normalized" earnings yield. To me, it's a very simple thesis. AmEx has more than 30% returns on equity, seems to have no problem growing earnings faster than 20% a year, has a robust and sustainable competitive advantage, and has understated income.
In my opinion, AmEx should trade at closer to a 25 P/E ratio. At the current 20 P/E ratio, you are getting a 5% earnings yield (simply invert the P/E ratio) -- and I've already argued that earnings may be understated. After one year of more than 20% earnings growth, you'd be getting a rate better than what long-term government bonds yield. Given that I think AmEx has minimal credit risk and can grow its "yield" more than 20% a year, I'd much prefer AmEx stock. At a 25 P/E ratio, AmEx would trade more in line with its expected earnings growth rate, and its earnings yield would be at a more appropriate discount relative to long-term interest rates.
Related Foolishness:
MasterCard is an Inside Value recommendation. Discover more of the market's best bargains with a free 30-day trial subscription. Moody's is a Stock Advisor recommendation.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
