This Credit Card is Ready to Charge Higher

Financial stocks of all stripes, from traditional banks, to multiline insurance firms to asset managers, have been under pressure over the past few months as it became clear interest rates will remain near zero for longer than expected. Once the prospect of a steepening yield curve faded, which is so crucial to the profits made on loans or the returns generated for assets under management, so did enthusiasm for the sector.

One company, American Express (AXP) has been hit particularly hard, as it not only operates within this tough macro headwind but has a host of company specific challenges. But as Warren Buffett, whose Berkshire-Hathaway also happens to be one the largest shareholders with a 15% stake in Amex, often says, “be greedy when others are being fearful.”

So is now, with AmEx shares down some 30% from their 2015 peak and analysts still issuing negative reports, a good time to get greedy and scoop up shares? After a long period of sideways consolidation, the stock appears ready to break out to the upside.

axp-chart-9-8-16

The company is set to report earnings on October 19 and I want to establish a bullish position ahead of that event.

Let’s acknowledge a great deal of criticism and poor performance over the past year has been warranted in recent months. From items it can’t control, such as an appreciating dollar which negatively impacts it overseas business, to the quickly changing digital payment landscape with new competitors, to some of the company’s own missteps such as the loss of key partnerships such as Costco (COST). These issues have been mostly priced and will smooth out over time.

A Different Card, A Different Model.

One item that is often misrepresented and we would do well to clarify is the comparisons of American Express to Visa (V) and Mastercard (MA). They have very different business models. Cards branded ‘Visa’ or ‘MasterCard’ are not issued by Visa or MasterCard: they are issued by banks and financial firms joining those respective companies’ credit networks. Purchases made with those cards levy a merchant fee, which must be split between the actual card issuer and the credit network provider. This means that Visa and MasterCard are not responsible for the balance on the cards and are not exposed to the loan risk. Visa and MasterCard generate their revenue from transaction volume.

By contrast, American Express issues their own cards. This means it takes responsibility for transfers of funds with credit card purchases, entailing additional risk, which forces American Express to charge more for their credit card purchases than Visa or MasterCard do. This situation makes retailers less likely to accept American Express in lieu of Visa and MasterCard and is the main reason why it is not as widely accepted.

The closed-loop system allows AmEx to generate incredible amounts of revenue with fewer issued cards. American Express cardholders are an affluent customer base who tend to spend more than Visa and MasterCard clients do, which means the merchant fees incurred from this greater volume of purchases generates more revenue.

Thus, what American Express lacks in card circulation is made up for in revenue from their higher-end clientele.

axp-revenuw-graphic-4-18-16

There also strengths and additional upside to American Express’s model. While Amex remains largely skewed to spend vs. lend revenues, loan growth in the form of small businesses is a key part their strategy. AXP’s lending growth should remain well ahead of industry growth, thanks to new products (American Express EveryDay, Bluecard) and its investment in more effective marketing and distribution. American Express is marketing unsecured loans to its existing charge card customer base, which should drive incremental growth of its lending portfolio.

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This brings up the undeniable issue that American Express has lost several card partnerships over the last few years, the most-high profile and impactful was its separation from Costco, which accounted for 8% of American Express’ billed business and 20% of their interest-bearing credit portfolio. Compounding that, airline JetBlue also ditched AmEx as its co-branded card partner around the same time in Feb 2015.

AmEx, in my opinion, has demonstrated it can compete and do so effectively. Even taking the Costco breakup into consideration it’s still an extremely profitable enterprise. It’s hardly the first setback in its long history and the company is trying to make up for those losses by signing up new partners. It’s had some success, inking a co-branding deal with big-time brokerage Charles Schwab and winning acceptance for its cards to be used for purchases at Wal-Mart’s warehouse outlet chain Sam’s Club.

As you can see, revenue ex-COST has actually been growing of late.

axp-revbue-ex-cost-9-9-16

P/E Gap to Fill

This goes a long way in explaining the extreme disparity in valuations; not only does American Express’ market capitalization of $57 billion trail Visa and MasterCard’s $169 billion and $103 billion respectively, but its p/e is puny 12.5 x forward estimates vs the 29x that Visa and MasterCard trade.

But as you can see much of the recent p/e compression came after the Costco loss. It has been almost a year and a half and revenues have stabilized.

axp-p-e-ratio-image-9-9-16

I think the p/e multiple should also begin to normalize and trend higher. If it can simply move back to its average of 15x the share would gain some 20% in value to $75 per share.

The Trade:

I’m using a bullish diagonal call spread.

-Buy October (10/21) 65 calls

-Sell September (9/16) 67.50 call

For a $2.20 NET DEBIT

Here is the risk graph for the position

axp-risk-graph-9-9-16

Note, the October calls we are purchasing include the 10/19 earnings report so they should hold their premium. The diagonal spread gives us the ability to roll and reduce the cost basis while maintaining upside potential.

Like this article and want more great market insight and trading ideas? Find out about my $20K Portfolio. The 20K Portfolio is an option based newsletter providing specific trade recommendations. Since its inception in January, 2015 it has gained 87% in the 18 month period ended June, 2016.

— Steve Smith

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About the Author: Steve Smith