American Express Co. is on the fast track.
The shares are up nearly 25 per cent this year, double the gain of the Standard & Poor’s 500. Cleared by the U.S. Federal Reserve in the recent financial industry “stress tests,” it said last week it would boost its quarterly dividend by 11 per cent, to 20 cents per share, and spend $5-billion (U.S.) over the next five quarters buying back stock.
And yet, even near its 52-week high of roughly $53, the shares remain below historical levels of valuation in several measures, such as forward price-to-earnings ratio and price-to-book value. It seems to be an opportunity to buy into a storied brand name at a reasonable price.
Before you do, however, consider the doubters, from a couple of skeptical analysts to a money manager who went public with his short strategy a few weeks ago. So far, they’ve been wrong, as the company’s shares have appreciated considerably during the time they’ve been negative.
But if they’re even a little bit right, American Express’ upside from today’s prices may be more limited than optimists believe.
Jason Arnold, an analyst at RBC Dominion Securities’ U.S. affiliate, initiated his coverage in May, 2009, near the bottom of the markets, with an “underperform” when American Express shares traded around $26. His primary concern then was the credit challenges American Express faced with the U.S. economy in turmoil.
The company has clearly fared better than Mr. Arnold feared – but investors may believe its recent earnings performance is the company’s new norm, which he doubts. Mr. Arnold says charge-offs in the company’s credit card lending portfolio have been “exceptionally low … well below card-issuing peers.” That has meant that American Express has been able to reverse or “release” previous provisions for bad loans. When made, provisions are deducted directly from profits; when reversed, they're credited back.
Without reserve releases and revenue from legal settlements, Mr. Arnold figures, the company’s return on equity over the last several quarters has ranged from 17 per cent to 20 per cent, rather than the 26 per cent to 29 per cent the company has reported per U.S. generally accepted accounting principles.
The reserve releases will “drop off to a significant extent” this quarter, Mr. Arnold believes, negatively affecting earnings – bad news when American Express’s valuation “continues to more than reflect high optimism for performance, in our view.” His target price? $45.
At Credit Suisse Securities LLC, Moshe Orenbuch has had his “underperform” in place for more than three years, similarly missing the doubling of American Express shares. Mr. Orenbuch also notes the diminishing effect of reserve releases and says it will put even more pressure on the company to cut costs.
American Express beat consensus earnings estimates in the fourth quarter by 4 cents (and Mr. Orenbuch’s number by a nickel), but the results included expenses that were 19 cents per share below his forecast. Of that, 17 cents was lower-than-expected marketing and rewards costs. Mr. Orenbuch, who has a $40 target price, questions whether the company can keep it up in a competitive market.
RBC’s Mr. Arnold notes that “competition is heating up at the upper end of the card space,” with JPMorgan Chase & Co. and Citigroup hiring key executives away from American Express, and Capital One and the rest of the card issuers looking to move up-market. “That will make it hard for [American Express]to contain expenses,” he said.
Seabreeze Partners Management in Palm Beach, Fla., is betting they’re right. The firm’s blog listed American Express as one of its just five short positions on Feb. 13, classifying the list as “companies that have challenged long-term business models and/or are expected to disappoint on the earnings front over the shorter term.”
And on March 1, it said it initiated another short position in anticipation of a correction. “The company had a so-so fourth quarter, and it's exposed to higher gas prices and lower real incomes.” In an interview with Barron’s, the firm’s Doug Kass added that recessionary Europe is 20 per cent to 30 per cent of American Express’ business, and the company’s expenses remain too high.
All of these skeptics have been rewarded with nothing but pain, both in the last three years and the last three months. But that’s history now – what counts more is the next three years, or even the next three quarters. Watch out if you’re holding these shares and they’re finally right.