I'd argue that one of our best-positioned Rule Makers is charge card company American Express (NYSE: AXP), the 151-year-old firm that's grown its stock 28% annually for the last five years.
Since 1996, American Express has grown its market value from $18 billion to $62 billion. The Rule Maker Portfolio bought AmEx shares almost three years ago at $34.53 and again last March at $41.91. Since then, the shares have grown to $46.63 (as of January 26). We're up 29% on average since our purchases, which represents annualized growth of about 11.8%. This, of course, is with the company's shares currently trading only 17.1% up from their 52-week low.
How has American Express achieved this growth, and can the company do it again over the next five years? Can American Express be a $120 billion company by 2006? That's the question we like to ask based on our goal of achieving 2x/5y.
Let's start with a few basics. American Express has three divisions: Travel Related Services (TRS), American Express Financial Advisors (AEFA), and American Express Bank (AEB). Most of the company's revenue and profits come from TRS, the division that offers charge cards and revolving charge cards.
This makes analyzing the company a little easier. Last year, TRS accounted for nearly 80% of the company's $22.1 billion in sales and 65% of its $2.8 billion in profits. This is where the company makes its money.
In the TRS unit, it's important to understand the difference between the company's traditional American Express charge cards, and its revolving charge cards, like Optima.
The basic American Express card isn't a credit card, since it doesn't provide financing. Consumers have to pay it off in full each month, so what the company is really doing is facilitating transactions for its merchants. Customers buy merchandise, American Express pays the merchant on behalf of the customer (minus an average charge of 2.7%, called the "discount rate"), then collects the full amount from the cardmember. Simple, elegant.
American Express' revolving charge cards, such as Optima, function like credit cards, with the firm providing financing for cardmembers. The cardmembers don't have to pay the balance in full each month. This revenue stream is aptly called finance-charge revenue.
Discount revenue and finance-charge revenue are the two big revenue-generating numbers on American Express' income statement. Here's a look at the growth of these two critical accounts over the last seven years ($ in millions):
Discount Discount
Rate Revenue
2000 2.70% $7,779
1999 2.72% 6,741
1998 2.73% 6,115
1997 2.73% 5,666
1996 2.73% 5,024
1995 2.74% 4,457
1994 2.83% 3,984
Finance Charge
Revenue
2000 $3,977
1999 2,884
1998 2,470
1997 2,105
1996 1,575
1995 1,529
1994 1,258
This is what Rule Maker investing is all about -- steady, predictable growth. Discount revenue is up 11.8% annually, despite a declining average discount rate. Finance-charge revenue is up 21% annually, as American Express keeps issuing a wider range of cards, services, and bonuses for its members. This is American Express' bread-and-butter business.
Next, let's look at the two drivers of these numbers, then come up for air. There are two main ways American Express can boost discount revenue and finance revenue: Increase the number of total cards and increase spending per card. (It can also try to get cardmembers to carry balances a little longer, but we'll save that for another day.)
It's a little like a retail chain. If we're tracking growth at The Cheesecake Factory (Nasdaq: CAKE), we want to know how many new restaurants it's opening each year, and we want to know what its comparable store sales look like (that is, how much sales are growing at existing stores). Similarly, with American Express we want to see the net number of new cards increasing every year, since this represents new revenue opportunities. And, we want to make sure people are spending more money on their cards overall, just as we want to know if existing Cheesecake Factory restaurants are steadily increasing sales or if the company is relying on new stores to boost sales as patrons tire of existing restaurants. Here's how it looks at American Express over the last five years:
Total cards in force (millions)
2000 51.7
1999 46.0
1998 42.7
1997 42.7
1996 41.5
Average basic spending per card
2000 $8,229
1999 7,758
1998 6,885
1997 6,473
1996 6,074
American Express grew its total cards in force about 6% annually --12% last year alone -- and grew its average spending per card about 35% since 1996. This has led the company's revenues and earnings on a steady, sustainable march upward. Over the last five years, revenues increased about 11% annually to $22.1 billion from $14.5 billion.
Where does this leave us? As consumers use less cash and American Express expands its merchant base, I see no reason why the company can't continue building its cardmember base and continue increasing annual spending. American Express needs to execute well, but it doesn't need to hit home runs every year to keep growing the value of its franchise. That's the advantage of investing in a company with a powerful brand name in a steadily growing industry. Partnerships with powerful retailers such as Costco Wholesale (Nasdaq: COST) and the company's growing small business services division helped add 400,000 new net cards in the fourth quarter of 2000 alone.
American Express is also stepping up efforts to purchase the credit-card portfolios from banks that no longer have the scale to earn a high return in a very competitive business. In the fourth quarter, American Express bought the Bank of Hawaii's $226 million credit card portfolio. It will manage the accounts and co-brand the cards. This boosts American Express' cards-in-force, gives it a local advantage with the customer base, and expands its brand. These efforts combined should be enough to keep earnings humming along, though over the next five years annual revenue growth will likely fall below our 10% threshold.
Looking at its valuation, American Express made $2.81 billion in earnings ($2.07 per diluted share) for 2000. (By the way, for a mature financial services company, net income is our preferred way to measure cash earnings power.) It expects to grow earnings 12% to 15% annually. Let's assume 12% annual growth for five years, which would give the company earnings of roughly $3.64 per share in five years. Some of the growth will come from share buybacks, so let's be a little conservative and take the lower earnings number. Its average price-to-earnings (P/E) ratio over the last five years is 23.4 (slightly higher than its current level).
If it can maintain this P/E --and its brand shouldn't deteriorate over the next five years regardless of what happens to the economy -- that gives the shares an estimated price of $85 a share, not quite enough for a double at the current price of $46.75. Based on these back-of-the-envelope estimates, which aren't perfect but give us some guidelines, I would feel comfortable seeing our portfolio invest in American Express at any price around $42. Hopefully the market will give us that pitch.
Have a great day.
