U.S. Bancorp (USB) - Thesis

U.S. Bancorp (USB)
Rating: BUY
Current Price: $44.81
Price Target: $61.69

Thesis:
U.S. Bancorp (USB) has a strong balance sheet, an appropriate mix of business segments, it consistently generates lots of free cash flow, it is trading below its intrinsic value, and it has room for continued earnings growth if/when interest rates rise.

Valuation:
By discounting cash returned to shareholders (dividends plus share repurchases), USB is worth $61.69 per share, 37.7% more than its current market price.  In 2014 and 2013, USB returned 72% and 71% of earnings to shareholders (dividends and share repurchases), respectively.  In 2013, the company stated its target was to return 60%-80% of earnings to shareholders annually, and this target has come down since pre-financial crisis (for example, in 2006 USB stated their goal was 80% per year).  Discounting this cash returned to shareholders using a discount rate of 5.75% (weighted average cost of capital) and assuming a 2.0% perpetual growth rate (USB grows at about the same rate as the economy), yields a valuation of: ($5.85 billion [2014 earnings] X 70% [% of earnings returned to shareholders]) / (5.75% - 2%) = $109.2 billion.  Since there are approximately 1.77 billion shares outstanding, this results in a valuation of $61.69 per share.  And potentially more if interest rates rise allowing USB to achieve additional growth from a higher margin on deposits.

U.S. Bancorp’s Business: - Appropriately Diversified:
Headquartered in Minneapolis, Minnesota, the business of U.S. Bancorp (aka US Bank) is appropriately diversified.  The company has chosen to operate across four main market segments, and the company’s revenue generation is balanced between margin and fee businesses.  USB CEO, Richard Davis, believes USB operates in “precisely the markets where we compete the best, and we are confident this mix of businesses has us well positioned for the future.” (2014 Annual Report).  The four main business segment are: Consumer and Small Business Banking; Wholesale Banking and Commercial Real Estate; Wealth Management and Securities Services; and Payment Services.  Consumer and Small Business Banking is the largest generating around 39% of net interest income and 28% of non-interest income.  In 2014, USB’s interest income (taxable equivalent basis) was $11.0 billion and its noninterest income was $9.2 billion.  Consumer and Small Business Banking is largely regional, Wholesale Banking and Commercial Real Estate as well as Wealth Management and Security Services is national, and Payment Services and Global Corporate Trust is international.  

Relatively Safe:
U.S. Bancorp’s business is relatively safe, providing the company favorable funding costs, strong liquidity, and the ability to attract new customers.  For example, the company consistently receives credit ratings among the highest in the industry.  USB already exceeds advanced Basel III risk weighted asset ratios as if they were already fully implemented.  The company’s debt-to-equity ratio has come down considerably in recent years (from over 3.0 to under 1.5, driven in large part by regulatory requirements), and while this also reduces the bank’s earnings power, it also significantly reduces the bank’s risk.

Additionally, USB’s business mix (i.e. multiple business segments and the split between interest and non-interest income) provides a consistent income stream that can weather a variety of market conditions.  Further, Global Finance Magazine ranked USB as one of the World’s safest banks in 2012, 2013 and 2014.  And in February 2015 USB was named Fortune Magazine’s Most Admired Super-Regional Bank for the fifth consecutive year.  This relative safety helps USB to consistently deliver results.

Growth:
USB has multiple sources of potential growth including expanding margins, growing business segments, and simply increasing business as the overall economy grows.  For example, interest rates in the US are expected to increase within the next year; this will allow USB to earn a higher spread on the rate they pay depositors and earn from borrowers.  Also, USB has opportunity to grow non-interest income (currently roughly 46% of income) by increasing revenue especially from credit and debit card services as well as merchant processing services.  Further, USB’s non-interest income should grow in general as the economy grows.

Risks:
Major risks for USB include increased government regulations and the possibility that interest rates do not increase in the foreseeable future.   Regulatory reserve requirements have dramatically reduced leverage (and risk) in the banking industry, however these regulations have also reduced the earnings power of the banks as well as their ability to return capital to shareholders as they see fit.  If regulators were to increase or tighten requirements this could have an adverse impact on USB’s ability to earn profits.  Regarding interest rates, USB will not be able to grow earnings as quickly if interest rates do not start increasing in the next year as the US Federal Reserve has indicated they will.  Low interest rates have compressed margins for USB (and banks in general), and without raised rates and margin expansion USB’s earnings growth will be challenged.

Conclusion:
U.S. Bancorp (USB) is relatively safe compared to banking sector peers, and has demonstrated the ability to consistently deliver profits in good and bad market conditions.  Our discounted cash flow valuation model indicates the stock price is below its intrinsic value.  Additionally, a rising interest rate environment increases USB’s earnings power and provides additional upside to the stock price.  We value USB at $61.69 per share, and rate the stock a “Buy.”

McDonald's (MCD) - Thesis

McDonalds (MCD)
Rating: BUY
Current Price: $97.10
Price Target: $122.69

 

Thesis: 

McDonald’s earnings have declined recently due in large part to supplier issues in China, an unfavorable lower court ruling that resulted in a large increase to foreign tax reserves, the strong US dollar’s negative impact on non-US operations, and a brand that seems to be in decline.  However, the company continues to deliver enormous amounts of free cash flow, new management is pursuing significant top and bottom line improvements, and the stock’s recent declines are overdone.  Using a discounted cash flow valuation model, we believe MCD is worth $122.69 per share, giving it more than 26% upside versus its current market price.  We rate MCD a “Buy.”

Current Situation:

Things seem bad at MCD.  The company has delivered a negative earnings surprise (versus the consensus estimate) in all but the most recent of the last six quarters (they beat by $0.02 in calendar Q2).  Net income (2014) declined considerably versus previous years, and Q1-15 and Q2-15 EPS was well below Q1-14 and Q2-14.  The CEO was replaced in 2015, and public perception seems to be negative.  Additionally, it seems a daunting task for MCD to deliver significant growth considering it’s already very large, and consumers’ tastes seem to have shifted to prefer higher quality, higher-service competitors.

Free Cash Flow:

Despite negative public perceptions and declining earnings, MCD continues to generate an enormous amount of free cash flow.  Cash flow from operations minus capital expenditures continues to exceed $4 billion per year, and will likely increase in the future due to managements plans to limit capex to $2 billion (it’s been $2.5 to $3.0 billion in recent years), and to achieve $300 million of net annual savings in SG&A expenses by the end of 2017.  This will put free cash flow around $5.3 billion per year, leaving plenty of room for the company’s roughly $3.2 billion of annual dividend payments.

However, the free cash flow becomes somewhat concerning considering MCD is in the middle of a 3-year plan (2014-2016) to return $18-$20 billion of cash to shareholders.  It’s concerning because they’re only generating roughly $14 billion of free cash flow during this period.  The shortfall is made up through debt issuances and cash generated by refranchising of restaurants.  It doesn’t seem entirely unreasonable to finance dividends and share repurchases with debt (to an extent) if management believes the stock is undervalued especially considering they’re paying a 3.5% dividend yield on the equity and MCD’s cost of debt is in roughly that same neighborhood.  Further, MCD has plans to refranchise 3,500 restaurants by 2018 which will add to cash inflows.  However, there are only so many restaurants they can refranchise, and there is a limit to the amount of debt they can issue.  Something will need to change for MCD in the long-term because the current operating status quo will not allow this much cash to be returned every year beyond the next few years.

During the most recent post earnings conference call, MCD CFO, Kevin Ozan, announced they’ll be delaying their next dividend payment announcement two months until November which suggests there may be big changes coming with regards to how MCD uses its extra cash.  MCD may be announcing expensive restructuring, expensive growth initiatives, a big acquisition, a reduction in share repurchases, changes to the dividend policy, or some combination of the above.

Valuation:

We value MCD at $122.69 per share using a discounted cash flow model.  Our model assumes approximately $5.3 billion of free cash flow in 2016, a 6% required rate of return and a conservative 1.5% growth rate.  A 1.5% growth rate is very small, and could easily be eclipsed over the next two years simply if foreign currency exchange rates stop working against MCD (for example, MCD’s Q2 investor relations earnings report notes foreign currency translation had a negative impact of $0.13 and $0.23 on diluted earnings per share for Q2-15 and year-to-date, respectively.  And MCD lost 2% of net income to currency in 2014).  If MCD grows at 3% into perpetuity its worth $184.03, and if it grows at 0% it is worth $92.02.  And there is room for growth considering MCD’s 2013 (most recently available data) system-wide restaurant business accounted for only 0.4% of the outlets and 7.5% of total sales within the “Informal Eating Out” segment of the market (2014 MCD Annual Report).

Turnaround Plans:

MCD is engaged in a variety of initiatives to stem the company’s slumping sales growth and declining profits.  One major initiative is improving the brand image.  The newly appointed CEO was formerly in charge of branding at MCD, and he will bring expertise in this area to the highest level of the organization.  There is a strong focus on enhancing the appeal of core products and addressing food perceptions; MCD is focused on improving and highlighting the quality of ingredients.  Another initiative is expanding breakfast, which is the company’s strongest day-part.  Market testing around all day breakfast availability continues.  Previously mentioned cost reductions are also an important initiative.  The company plans to reduce capital expenditures to around $2 billion and decrease annual SG&A expenses by around $300 million.  If successful, these reductions will improve free cash flow and profitability.

Conclusion:

We’re giving new management time to execute on its turnaround plans; especially considering the company is already worth significantly more than its current stock price suggests (we value MCD at $122.69 per share based on discounted cash flows); and because we are comfortable taking the contrarian stance on a stock that we believe has been overly beat up by public perception.  We own shares of MCD, and we rate the stock a “Buy.”

Procter & Gamble (PG) - Thesis

Procter & Gamble (PG)
Rating: Buy
Current Price: $81.63
Price Target: $99.79

Thesis:
Procter & Gamble’s stock price is depressed because of strong foreign currency headwinds and a variety of sub-optimal market ventures. The currency headwinds will likely subside as global monetary policies continue to normalize as the financial crises moves further into the rear-view mirror.  Additionally, the company’s current multi-year restructuring will increase profitability by increasing efficiency and by shedding sub-optimal market ventures.  Using a discounted cash flow model, Procter & Gamble is worth $99.79 per share, giving the stock more than 22% upside versus its current market price.

Foreign Currency Headwinds:
Approximately 61% of Procter & Gamble’s sales come from outside the United States.  This creates a variety of foreign currency challenges for the company, especially since the US dollar (the company’s reporting currency) has strengthened significantly in the last year.  In fact, the company expects to take an approximately $1.4 billion hit to earnings in 2015 because of the strong US dollar.  This is significant considering PG’s total earnings are only around $11.6 billion per year.  Foreign currencies have weakened versus the US dollar for a variety of reasons.  For example, the US economy is recovering from the global financial crisis quicker than other economies, and while the US is beginning to reduce accommodative monetary policies, non-US economies are still introducing more accommodative policies.  Regardless, recent currency volatility will eventually decline, and P&G will also tweak its foreign currency hedging programs.  The result will be less foreign currency challenges, and P&G’s earnings will pop up.  Also, there could be quarters and years in the future where PG’s earnings are helped by foreign currency moves in which case earnings will pop up even more.

Restructuring:
P&G is currently in the process of shedding a variety of less profitable brands.  According to CEO A.G. Lafley:

"P&G will become a simpler, more focused Company of 70 to 80 brands, organized into about a dozen businesses and four industry-based sectors. We will compete in businesses that are structurally attractive and best leverage our core capabilities.  Within these businesses, we will focus on leading brands or brands with leadership potential, marketed in the right countries where the size of prize and probability of winning is highest, with products that sell. We will discontinue or divest businesses, brands, product lines, and unproductive products that are structurally unattractive or that don’t fully play to our strengths… The 90 to 100 brands we plan to exit have declining sales of -3%, declining profits of -16% and half the average Company margin during the past three years."

In addition to shedding some 90 to 100 brands, P&G is also in the middle of a multi-year productivity and cost-savings plan.  Per the company’s annual report:

"In 2012, the Company initiated a productivity and cost savings plan to reduce costs and better leverage scale in the areas of supply chain, research and development, marketing and overheads. The plan was designed to accelerate cost reductions by streamlining management decision making, manufacturing and other work processes to fund the Company's growth strategy.  As part of this plan, the Company expects to incur in excess of $4.5 billion in before-tax restructuring costs over a five-year period (from fiscal 2012 through fiscal 2016).  Approximately 62% of the costs have been incurred through the end of fiscal 2014. Savings generated from the restructuring costs are difficult to estimate, given the nature of the activities, the corollary benefits achieved (e.g., enrollment reduction achieved via normal attrition), the timing of the execution and the degree of reinvestment.  Overall, the costs and other non-manufacturing enrollment reductions are expected to deliver in excess of $2.8 billion in annual gross savings (before-tax). The cumulative before-tax savings realized through 2014 were approximately $1.4 billion."

P&G’s profitability will increase as the multi-year restructuring is completed and as less profitable brands are exited.  This helps create the room for significant upside to the current stock price.

Growth Opportunities:
In addition to restructuring, P&G does have some growth opportunities.  To some extent, P&G will grow as the total global population grows.  Additionally, the secular trend in emerging markets whereby populations move from rural to more urbanized and suburbanized areas benefits P&G because these populations tend to use more P&G products.

Additionally, P&G spent $2.0 billion on research and development in 2012, 2013 and 2014.  Examples of recent product introductions include the Fusion ProGlide (introduced four years ago, priced at the higher end of the premium segment, grew global share for 31 consecutive quarters, and reached $1 billion in sales faster than any other P&G brand in history) and Crest 3D White (a premium oral care regimen, has grown market share for 17 consecutive quarters, is a billion-dollar business, and is an important driver of toothpaste market share growth in developing markets).

Valuation:
We value PG at $99.79 using a discounted cash flow valuation.  We assume 2014 free cash flow of $10.11 billion grows at 3.5% in the future (conservative estimate roughly equal to global economic growth), $1.0 billion of the estimated $1.4B negative 2015 currency impact returns to a more neutral level of negative $0.4B (remember if the US dollar weakens it could actually help P&G), P&G restructuring amounts to $1.4 billion of additional annual cash flow (conservative estimate, less than P&G’s own estimate) and the required rate of return is 8.5% (long-term capital market assumption):
 [($10.11B x 1.035 + $1.0B + $1.4B) / (0.085 – 0.035) + 13.16B of cash ] / 2.71B shares = $99.79 per share.

As a double check, a “Dividend + Share Repurchase” model suggests the company is worth around $100.06 per share.  This valuation technique is relevant for PG because the company is very stable and consistently pays increasing dividend and buys back shares.  Here is the calculation:  [($6000 of share repurchase + $6900 of dividends) / (8.5% required return – 3.5% growth) + $13160 cash] / 2710 shares = $100.06 per share.

Conclusion:
Procter & Gamble has underperformed the S&P 500 by roughly 14% year-to-date, and trades more than 22% below its intrinsic value per our discounted cash flow valuation model.  A “dividend + share repurchase” discount model also suggests the stock is significantly undervalued.  PG stock is depressed as the company has been hampered by severe foreign currency headwinds (the US dollar is strong) and a variety of (soon-to-be eliminated) sub-optimal market ventures.  PG currently trades around $81.63 per share, and we believe it is worth more.  Our price target is $99.79 per share.

Facebook (FB) - Thesis

Rating: Buy
Current Price: $86.73
Price Target: $ 142.50

Thesis:
Facebook’s opportunities for continued advertising revenue growth are enormous.  Rather than maximizing these opportunities as quickly as possible, Facebook CEO Mark Zuckerberg is focused on continuing to improve the user experience which he believes is ultimately better for the company’s long-term success.  As Facebook continues to improve and integrate the Facebook application, WhatsApp, Messenger, Instagram, and new innovations, the monetization opportunities via advertising make this company worth far more than its current stock price suggests.

Valuation:
Using a Discounted Cash Flow (DCF) valuation model, Facebook’s is worth $142.50 per share.  The model assumes FCF will grow 30% in 2015 to $4.7 billion, and then grow at 27.2% for the next five years before reverting to a more market normal growth rate of 3% beyond 2020.  This five year expected growth rate (27.2%) is consistent with the average estimate of over 40 professional analysts according to Yahoo!Finance.

• Free Cash Flow

• Free Cash Flow

Facebook only needs to grow at about 12% for the next five years to be worth its current market price, and based on the advertising revenue growth opportunities available, Facebook is easily worth considerably more than its current stock price suggests.

Sources of Growth:
According to Facebook’s Chief Financial Officer, David Wehner, the company has three strategic priorities.  First, is to capitalize on the shift to mobile (see Q1’15 conference call).  This has been the highest priority since the company’s initial public offering (IPO) in 2012.  Thus far, the company has allayed fears that they would not be able to profitably convert to the small screens of mobile devices, but there is more opportunity ahead.  The company is still in the early stages of mobile advertising, and has foregone enormous short-term revenue opportunities in favor of building this business prudently for long-term success.  For example, according to the company’s annual report:

“We prioritize user growth and engagement and the user experience over short-term financial results.  We frequently make product decisions that may reduce our short-term revenue or profitability if we believe that the decisions are consistent with our mission and benefit the aggregate user experience and will thereby improve our financial performance over the long term. For example, from time to time we may change the size, frequency, or relative prominence of ads in order to improve ad quality and overall user experience. Similarly, from time to time we update our News Feed ranking algorithm to deliver the most relevant content to our users, which may adversely affect the distribution of content of marketers and developers and could reduce their incentive to invest in their development and marketing efforts on Facebook.”

The bottom line here is that Facebook is trying to build for the long-term and there is huge room for growth.

Facebook’s second strategic priority is to grow advertising revenue.  This goal is noticeably second, not first, because the company recognizes the long-term importance of putting users (not advertisers) first.  During Facebook’s most recent Q1 conference call, Chief Operating Officer Sheryl Sandberg repeatedly pointed out Facebook only has a small portion of companies’ advertising revenue, and this is a truly enormous growth opportunity.

Facebook’s third strategic priority is making their applications more relevant.  This is important because it helps Facebook retain, grow and improve users, which ultimately sets up the company for long-term success.  Facebook’s other applications include WhatsApp, Instagram, Messenger, and other initiatives designed to benefit users.  Facebook recently acquired WhatsApp and Instagram, and the company hasn’t even scratched the surface yet in terms of monetizing these businesses.

Worth noting, Facebook continues to spend a large amount of money on research and development.  This supports the notion that the firm is building for long-term success by serving users rather than simply trying to monetize everything as quickly as possible so the inside owners (e.g. Mark Zuckerberg) can “cash out.”

Risks:
Stagnant or Declining User Base:  Facebook’s number one risk is its ability to retain users.  According to the company’s annual report:

“If we fail to retain existing users or add new users, or if our users decrease their level of engagement with our products, our revenue, financial results, and business may be significantly harmed.”

In other words, if people stop using Facebook, then the advertisers go away and Facebook isn’t able to make any money.  Facebook combats this risk by focusing on user experience across everything they do.  They forgo revenues to improve user experience, they constantly innovate and introduce new features and applications through a large research and development budget and by acquiring businesses (e.g. Instagram, WhatsApp) that pose a threat and/or create integration benefits.  When invetors ask CEO Mark Zuckerberg questions, his go to response always seems to be that the company is just really focused on improving the user experience.

Corporate Governance:

Facebook’s corporate governance structure introduces a variety of risks for shareholders.  For some background, Facebook founder and CEO, Mark Zuckerberg, is the largest shareholder, he has virtually complete control over the company via voting rights (there are multiple share classes, and Zuckerberg own the class with the real voting rights), and Facebook’s board is comprised of insiders and friends.  This allows Zuckerberg to take actions that are not necessarily in the best interest of shareholders, and he has already demonstrated a penchant for taking questionable actions.

For example, Zuckerberg has made some very big acquisitions (WhatsApp, Instagram); these types of acquisitions are often a symptom of a company with more cash than it needs, and rather that returning it to shareholders it is spent on the types of acquisitions which have historically destroyed value for shareholders.  Facebook may be young enough with enough growth opportunity that these acquisitions may bunk the norm and actually add value in the long-term, but they may also be the beginning of a bad habit for Zuckerberg; additional acquisitions could prove quite destructive to shareholders as often is the case.

As another example, Facebook’s board could inappropriately increase the number of shares outstanding which would be dilutive to existing shareholders.  Facebook has historically used shares to pay for acquisitions (e.g. Oculus) and to reward executives with stock options.  These types of share issuances are often not in the best interest of existing shareholders.

Mark Zuckerberg has done an exceptional job growing Facebook, but the company is still early in its public company lifecycle.  For this reason, Facebook is able to do things now that may be totally unacceptable in the future (e.g. big acquisitions, dilutive stock issuances). Inevitably, Facebook will eventually focus less on growth (because Facebook’s untapped markets will continue to decrease) and focus more on increasing the value of the business (because that will become the more profitable priority).  And as this shift occurs, Facebook’s current corporate governance will become more of a risk.

Conclusion:

Facebook continues to have significant growth and monetization opportunities ahead.  Despite some questionable corporate governance for this young public company, and despite the possible risk of a stagnating user base, Facebook is still easily worth more than it's current stock price suggests.  We own shares of Facebook, and we value the company at $142.50 per share.

S&P 500 ETF (SPY) - Thesis

SPDR S&P 500 ETF (SPY)
Expected Return: 8.5% per year
Expected Volatility: 16.0% per year
Rating: BUY

Thesis:
As long-term investors, we believe the equity markets will increase over time, and the SPDR S&P 500 ETF (SPY) offers reliable exposure to equity market returns while avoiding the many pitfalls that are common among other ETFs and among other equity investments in general.

Holdings:
SPY generally holds all of the securities in the S&P 500 Index (it may omit a few during transitional periods, but not enough to significantly impact performance).  The index is one of the most commonly followed equity indices in the world, and many consider it one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy.  Unlike other ETFs, SPY does not hold risky derivative instruments such as futures and swaps.  The performance of SPY has historically matched the performance of the S&P 500 index very closely, and it should continue to track closely in the future because it has essentially the same holdings as the index (investors cannot purchase the actual index, and SPY is the next best thing).

Volume and Liquidity:
SPY is the world’s largest ETF, and the world’s most highly traded ETF and equity security.  This scale has two significant benefits to investors.  First, because of the volume and liquidity, the bid-ask spread is small (the bid-ask spread is the difference in price at any given time for someone buying the security and someone selling it.  There is a difference because the middle man takes a very small cut).  A small bid-ask spread is good because it saves you money when you trade.  Second, SPY trades very close to its net asset value (NAV) because of the large volume and liquidity.  NAV is the actual value if you add up the value of all the securities held within SPY.  For many less liquid ETFs, the NAV may vary from its actual market price (the price the ETF trades at in the market).  This makes SPY much less risky for investors compared to other ETFs that may vary widely in price versus NAV.  Additionally, small investors don’t have to worry about some big investor coming in, buying or selling an enormous amount of SPY, and subsequently adversely moving the market price away from its NAV because the volume of SPY is already so great that this risk is essentially non-existent.

Low Fees:
The net expense ratio on SPY is currently less than 10 basis points (0.0945%).  This is extremely low for an ETF and extremely good for investors because it allows them to achieve better returns on their investment.  For comparison, mutual funds (a common competitor to ETFs) may charge 1-2% per year, and they tend to deliver worse performance over the long-term.  Additionally, there is no expensive sales charge or separate investment advisor fee because SPY can be purchased directly through a discount broker (e.g. Scottrade, E*TRADE, TD Ameritrade, Interactive Brokers, etc.).  The discount broker may charge you a one-time trading fee of $8 or less, but this is much better than the 2-5% sales charge/management fee you’d get charged by a full service financial advisor.  Additionally, there is no hidden 25 basis point (0.025%) annual 12b-1 fee paid to someone for “servicing your account.”  The bottom line here is that SPY is a very low cost way to get great exposure to the equity market and to build considerable wealth over the long-term.

Dividend Reinvestment:
One last point of consideration, SPY pays a quarterly dividend (around 2.0% per year), and this dividend is NOT automatically reinvested back into SPY (this is standard protocol for ETFs and stocks).  This mean you’ll build up a cash balance in your account if you don’t withdraw it or manually reinvest it.  As a long-term investor, cash is generally a drag on investment performance.  Unless you plan to withdraw and use the cash, we highly recommend you develop a process to reinvest it.  Most discount brokers (Scottrade, Interactive Brokers, etc.) offer automatic dividend reinvestment programs.  We highly recommend you sign up for these programs to avoid the situation where cash builds up in your account and becomes a drag on your long-term investment performance.  Reinvesting dividends is important.

Conclusion:
SPY is a very low cost, relatively low risk, security that allows investors to build significant wealth over the long-term.  We consider SPY to be a basic building block for long-term wealth, and we rate SPY as a “Buy.”  For more information, you can view the SPY fact sheet here.

American Express (AXP) - Thesis

Rating: BUY
Current Price $77.55
Price Target: $91.46

To paraphrase Baron Rothschild, “Buy when there is blood in the streets.”  American Express is currently suffering from several serious wounds (the stock price is down 17% year-to-date while the S&P 500 is essentially flat).  First, AXP’s stock price took a hit this year from its ending exclusive card relationship with Costco.  And second, AXP has been attacked by the US government’s antitrust ruling which will allow merchants to discriminate against American Express cards for charging higher point-of-purchase fees (in theory, merchants will be incentivized to do this because AXP charges merchants higher discount fees than other cards like Visa and MasterCard).  However, the impacts of these two wounds may be less serious than perceived, and AXP may still have a few tricks up its sleeve.

Regarding the antitrust lawsuit, it’s helpful to understand how American Express’s business model is different from competing cards like Visa and MasterCard.  AXP issues its own cards through its own banks (American Express Centurion Bank and American Express Bank, FSB).  And AXP’s primary source of revenue is the discount fee charged (as a percent of the charge amount) to merchants that accept American Express cards.  Therefore, AXP’s revenue depends on the total amount spent by customers and not on the volume of transactions.  On the other hand, Visa and MasterCard are not banks, and they make money based on the volume of transactions.  As a result, the charge card industry has evolved so it is cheaper for merchants to accept Visa and MasterCard over AXP.  AXP has defended against this risk by requiring merchants to sign agreements saying they will not encourage customers to use Visa and MasterCard over AXP.  Unfortunately for AXP, recent antitrust rulings have decided these agreements are unlawful and must be eliminated.  So now the question becomes, how much business will AXP lose as a result of the antitrust ruling (which by the way, the details of the implementation of this ruling are still being determined).

For some added color, in 2014 Visa had more than 2 billion cards in use worldwide and processed more than 60 billion transactions, while AmEx had just 107 million cards in force and processed just 6 billion transaction.  Despite this disparity, American Express had annual gross revenues of $33 billion while Visa brought in just $14 billion (Forbes).  The disparity exists because American Express has built its business to attract high credit quality high transaction size customers, whereas Visa has built its business simply to attract a lot of volume (they don’t care about credit quality because they’re not on the hook for defaults like AXP is).

Regarding the loss of Costco exclusivity, the media has spun this as a very bad thing for AXP, but in reality this may not be nearly as bad as perceived.  For some background, starting in April 2016, Citigroup will replace American Express as the exclusive issuer for Costco credit cards in the U.S. (AXP’s deal with Costco in Canada ended last year) because AXP and Costco couldn’t come to terms.  Costco accounts for roughly 20% of AXP’s loans.  According to Warren Buffett (his Berkshire Hathaway is AXP’s largest shareholder) “Somebody was going to get the bid, and American Express learned a week or two ago that they were not the one that was going to get it... I don’t know the terms of the new deal, but I don’t think Citi will get rich off of it."  Merchants (such as Costco) have been pressuring card issuers for better deals, and the loss of Costco likely isn’t as big of a hit to future earnings as many people perceive simply because the terms Costco was demanding were likely less profitable for AXP than the old terms. 

Valuation:
Regarding Valuation, it is important to remember the impact of these two wounds (loss of Costco exclusivity and antitrust rulings) are already baked into the price.  What matters at this point is whether you believe the market over- or under-reacted to these events, and what do you think will happened to American Express’s business going forward.

Regarding the antitrust rulings, I believe American Express’s high-end business (remember the company targets higher spending customers) may be “stickier” than perceived.  For example, even if merchants offer a 1% discount to use non-Amex cards, customers may use AXP anyway if they know AXP is still offering them a 2% reward for the transaction.  Additionally, AXP may be able to re-optimize its discount rate to attract the customers it wants and to maintain profitability.  Further, some merchants will do anything they can to serve customers therefore some merchants simply won’t discriminate against American Express.  Another alternative for AXP is to focus more on its small but fastest growing segment (GNMS) which utilizes a business model similar to Visa and MasterCard and therefore is not being targeted by government antitrust laws.

Regarding the loss of Costco, American Express has other growth opportunities.  For example, the company has the world’s largest integrated payments platform (i.e. a global network connecting millions of consumers, businesses and merchants) which is a source of powerful data and creates many growth opportunities to better serve customers.  For instance, AXP has recently integrated with the Uber app to let AmEx card members earn double rewards points or redeem points for rides.  AmEx also formed a significant partnership with Apple Pay. Apple has designed a simple, secure, user-friendly payments feature into its latest-generation iPhones, and AmEx believes that integrating their capabilities with Apple Pay can help fuel growth in mobile payments. AmEx is also active in the startup community with ventures in a range of startups combining commerce and data science.  More broadly, AmEx has large untapped potential to benefit from the ongoing global shift into electronic payments and away from cash and checks.  According the AXP CEO, Ken Chenault “It’s not easy to see a longstanding partnership [Costco] end. But when the numbers no longer add up, it’s the only sensible outcome.”

Forward Price-to-Earnings Ratio:  Based on historical data, AXP averages a forward price-earnings ratio of 95%-100% that of the S&P 500 Index.  Using a 2015 AXP EPS estimate of $5.72 (Yahoo!Finance) and the S&P 500 forward P/E ratio recently sitting at 16.4 times, that gives American Express a price target of $91.46/share (5.72 x 16.4 x 0.975).

Financial Management:
From a financial standpoint, American Express is well-run.  First off, AXP has come under intense regulatory scrutiny since the financial crisis, and as a result its financials are very strong.  Even though AXP generates more cash than it needs to profitably operate, it still requires regulatory approval before issuing dividends or repurchasing shares.  According to the American Express annual report

“Historically, capital generated through net income and other sources, such as the exercise of stock options by employees, has exceeded the annual growth in our capital requirements. To the extent capital has exceeded business, regulatory and rating agency requirements, we have historically returned excess capital to shareholders through our regular common share dividend and share repurchase program.”

AXP has a dividend yield of around 1.5% and it has a regular share repurchase program (it repurchased over 4% of its total shares outstanding in each of the last two years).  The company returns four times as much cash to shareholders through share repurchases versus dividends signaling that AXP management may believe its stock price is undervalued.

AXP continues to make significant reallocations of its resources to optimize its business.  For example, at the end of 2014 AXP sold its investment in Concur Technologies (a travel management company) for $719 million (pre-tax), and reallocated a large portion of the proceeds to other area of its business such as marketing, promotion and awards.

Additionally, with over $44 billion of customer deposits, AXP will likely benefit if and when interest rates rise as they’ll be able to more easily cover the costs of deposits and earn an increased spread between the rates they pay and the rates they earn.

Risks and Challenges:
American Express faces a variety of risks and challenges in growing and maintaining its business.  For example, expanding outside the US presents challenges; the US economy is growing, but growth outside of the US is weak.  Additionally, the strong US dollar makes international growth a challenge.

As mentioned earlier, new regulations and the cost of co-brand relationships are both increasing.  Antitrust rulings against AXP’s discount fees and the loss of the Costco relationship are examples.

Competition in general is intensifying as both traditional players and new entrants want to disrupt the marketplace.

The derivatives used by AXP may lower volatility, but they are expensive, reduce profitability, and slow long-term growth.  For example, the forward contracts AXP uses to reduce foreign currency volatility are good for short-term earnings consistency, but bad for long-term profitability and they are making the groups that underwrite them very rich.  The same can be said of the interest rate swaps used by American Express.

AXP’s investment securities have a very large concentration of state and municipal obligations.  While these instruments may offer higher yields than treasuries they concentrate risk and have a higher likelihood of default.

Conclusion:
Buy low, sell high.  American Express (AXP) stock price has suffered in 2015, but it’s not going out of business anytime soon.  The market has reacted very negatively to recent antitrust rulings and the loss of AXP’s exclusive relationship with Costco.  However the company is still extremely profitable, it has opportunity for continued growth, and the market is valuing the stock too low.