Is Amex Setting the Stage for a Comeback?

Last week, wide-moat

In our view, these developments are promising, and we have increased our fair value estimate as the company begins to address three long-standing problems.

First, the company must justify its pricing to its merchant customers. The company’s loss of its acceptance and cobranding relationship with Costco and the Supreme Court’s plans to review an antisteering case against the company prove that the costs of card acceptance remain an issue for merchants.

Second, the company must improve its value proposition for cardholders; JPMorgan Chase JPM spent hundreds of millions of dollars rolling out a competing card with lucrative rewards, and Amex management admits that it does not have the desire to compete on undifferentiated rewards. Third, the company must adapt to a changing payment landscape.

Strategic priorities outlined in the earnings conference call were encouraging, if lacking specifics. We think American Express is well positioned to capitalize on the growing value of data thanks to its closed-loop network and connections between merchants and customers; management echoed these thoughts and mentioned the possibility of acquisitions on this front. American Express has lagged competitors in M&A, and past deals were less than successful, resulting in impairment charges this quarter. However, we think the maturing digital payment and data analytics markets provide fertile ground in which to deploy the company’s free cash flow. We also believe American Express’ corporate card business is arguably the crown jewel of the company, and the company plans to extend these advantages further into the small-business segment, where card payments still have room to increase share.

American Express provided useful information on the behavior of large corporate customers and small businesses during the quarter. Large firms are continuing to keep a tight lid on travel and entertainment expenses, while card spending at small and midsize businesses continues to grow as these companies turn to cards for their spending needs. The increasing sophistication and digitization of small-business activity bodes well for the company over the long run, given its stronghold in the commercial card space. We agree with management that competition is likely to be far less intense in this market than in the mature U.S. consumer card space.

The company’s cost-cutting efforts have borne fruit, and we’re encouraged to see that Amex is not planning extensive expense-reduction efforts going forward, given the changes occurring in the business. The company’s Plenti rewards network--a questionable effort to create a multimerchant loyalty effort under a new brand--was responsible for restructuring and impairment charges, and a significant change to the company’s prepaid card program added costs as well. Otherwise, operating expenses fell 4% during the past 12 months.

Amex is spending money on cardholders, though. Rewards costs rose 21% thanks in part to the company’s efforts to retain Platinum customers with more-attractive rewards terms. Services costs were up 31% as American Express chose to invest in unique offerings like airline lounge access and an Uber partnership. We’ll be looking for the company to develop more difficult-to-replicate programs over the next several years using its direct merchant and customer connections in order to mitigate the rising costs of competition.

American Express’ lending efforts provide cause for optimism as well as concern. Deposit balances rose 13% during the year as the company’s online banking efforts seem to be paying off. Management also mentioned that deposit beta--essentially, the percentage of interest rate movements passed on to customers--has been low so far at roughly 35%. In addition, American Express is targeting a higher percentage of customers’ borrowing activity, and net loans grew 10% during the year. Growth of the lending business is a balancing act, though, and credit quality is deteriorating even as loan balances and yields rise. Provisioning was up 53% during the year as the company built reserves. American Express stretched for growth leading into the financial crisis. We don’t foresee a repeat, but we will be keeping a close eye on credit quality, especially if the unemployment rate begins to rise.