When the best of the best start with the shenanigans, what does that mean for the rest…

My team has finished the Amex analysis, and it is interesting. Amex is considered the creme de la creme of credit card lenders, with a premium upscale consumer and business clientele that generally does not carry balances on their cards. Well, don’t believe the hype. A little more on this later.A quick note… I will change the format in which I distribute my opinions by including highlights in HTML and reserving the bulk of the opinion (including valuation) for download and/or physical distribution at one of my events. Less work formatting and fixing stuff for me. In addition, if you meet me personally, you can get to ask me questions as long as it is not investment advice. Thus far, Amex and HSBC are up next, then the next two phases of my investment thesis are on tap.

SUMMARY OF MY OPINIONS ON AMERICAN EXPRESS

The deteriorating consumer credit environment in the US has seen large credit card companies, including American Express (AXP), witness large write-offs and provisions in the last two quarters. AXP reported 2Q2008 net income from continuing operations of $655 million, or 56 cents a share, down from $1.04 billion or 86 cents a share in 2Q2007, off higher-than-expected provisions on its credit card lending portfolio. Credit metrics for AXP continue to weaken with 30 days past due card loans and 90 days past due card receivables rising to one of their highest levels ever at 3.9% and 3.0%, respectively, in 2Q2008. Amid the continuing US housing price decline, rising unemployment levels and increasing energy, commodity and food prices borne from burgeoning inflationary pressures, we expect AXP’s delinquent credit card payments, credit cards defaults and losses to rise over the current levels. This coupled with rising funding cost off hastily dwindling liquidity in the credit markets, near non-existent securitization activities in the US, and deceleration in AXP’s core credit card income due to slackening consumer spending, should weigh on AXP’s near-to-medium-term earnings. However, we believe that AXP’s liquidity position remains reasonable to weather the current difficult operating environment, particularly as the Company is expected to receive approximately $880 million annually for the next three years consequent to a favorable settlement of antitrust lawsuit against MasterCard and Visa.

II. KEY POINTS

Credit card companies to face macro-economic headwinds. Problems of credit card companies are likely to amplify with rising probability of increased customer defaults. Higher inflation, rising unemployment levels and declining housing prices have intensified concerns about increased credit card losses that could dampen earnings of credit card companies. AXP’s credit metrics continue to weaken with a record rise in delinquent loans and receivables, necessitating increased provision for loan losses over the past few quarters.

AXP’s inadequate reserves and higher expected delinquencies to amplify provisions. AXP’s total reserves for loan losses increased from 3.2% at the end of 2007 to 4.1% at the end of 2Q2008 as the company created additional credit lending reserves of $600 mn in 2Q2008 in expectation of higher credit card losses. However, with rapidly growing credit card loan write-offs and lag in reserves-to-credit losses, AXP will have to create higher lending reserves in the coming periods, exerting downward pressure on its earnings.

Slowdown in consumer spending to impact AXP’s credit card billing business. With US consumer confidence index touching its lowest level since 1992, the effect of slowing consumer spending is expected to hit hard on revenues of credit card companies. AXP has already felt the brunt of decelerating consumer spending in its US credit card business, which witnessed a negative growth of 0.33% in 2Q2008. Consumer spending outside the US has also been impacted by weakening of the global macro-environment.

Lower discount rate to further intensify revenue slowdown. AXP’s discount rate has witnessed a persistent downward slide since 2006 off changes in business mix and pricing discounts led by competitive pressures. AXP’s discount revenues, which currently contribute nearly 47% to the Company’s revenues (gross of interest expense), are likely to remain under pressure, in the near-to-medium term, due to lower discount rates.

Lack of short-term liquidity and lower securitization activities to impact company’s funding strategy and net interest margins. Increased counterparty credit risk in the fast deteriorating credit market has resulted in the rapid dwindling of short-term funding sources. This has caused AXP’s increased reliance on higher cost long-term funds over the past few quarters. We believe that the funding cost is set for higher interest rates amid continuing widening of spreads and perceived higher losses in the financial sector. The problem is likely to be aggravated by AXP’s recently downgraded ratings by S&P and rapidly declining securitization activities in the US, forcing AXP’s net interest margins on a trip down south.

Valuation, Assumptions, and Pro Forma sections are available for download via the full report: AXP Consolidated final (437.96 kB 2008-07-30 15:11:32) or through one of my BoomBustBlog events only.

Financial Highlights

AXP’s credit metrics continue to weaken

Increased delinquency as customers fall behind scheduled payment dates. A worsening macro-economic environment in the US has led to increased credit card delinquency rates and record charge-offs in the last two years. As per FDIC data, in 1Q2008 credit card charge-offs and delinquency rate in the US increased to 4.7% and 4.9%, respectively, from 3.1% and 3.9% in 1Q2006. The trend is expected to lead to a more difficult situation amid rising unemployment levels, slowing business activities and weakening fundamentals in the US.

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Source: FDIC

AXP’s card members 30 days past due loans in the US skyrocketed to 4.1% in 2Q2008, up from 2.7% in 2Q2007. As customers continue to fall behind their payment dates, delinquent loans have increased for AXP. Overall receivables 90 days past due increased to 3.0% of the total receivables, up from 2.7% in 2Q2007 while card members lending 30 days past due surged to 3.9% in 2Q2008 against 2.8% in 2Q2007. With the recent spike in current to 30 day past due roll rates in June 2008, write-offs for AXP could increase in the coming quarters.

Current to 30 Days Past Due

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30 days past due to write-off

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Rising credit losses indicating no near term sign of stopping. US credit card companies are witnessing increased charge-offs with housing prices continuing to slide steeply and rising inflation led by rising commodity price showing no sign of reversal. A steep increase in the number of average days of receivable outstanding in the books of these companies indicates a possible worsening of the situation in future.

Amid fast slowing business activities witnessed by a slow-down in retail sales and consumer spending, and rising unemployment levels, AXP’s large credit card receivables (including cardmember lending) could witness substantial losses in the form of charge-offs and provisions.

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Source: FDIC

The Company’s net write-off on its credit receivables increased to 2.94% in 2Q2008 compared with 2.64% and 2.41% in 1Q2008 and 2Q2007, respectively. For its card member lending loan portfolio, net write-off rates have increased consistently since 1Q2006, rising to 6.7% in 2Q2008 from 3.9% in 2Q2007, primarily led by increased net write-off in the US lending segment (which witnessed net write-off of 7.1% in 2Q2008 compared with 3.7% in 2Q2007). As credit card delinquencies continue to rise, net write-offs are expected to remain at elevated levels, necessitating AXP to increase its provision for loan losses and causing a continuing dent in the Company’s profitability.

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An interesting fact to note is that AXP’s 2005, 2006, and 2007 US credit card loan vintages have corroborated progressively steeper write-off curves than earlier vintages implying that loans originated during 2005-07 have greater stress compared with the earlier vintages. This drop in vintage quality just so happens to share a very high correlation to that of the MBS and CDO products that have given the monoline insurance and banking industry such fits over the last year or so. It is reasonable to assume that there is significant relationship between the excessive property and secured lending bust and the upcoming unsecured lending dilemma that AXP its peers are now facing.

Another cause of concern for AXP is that all vintage loans have witnessed a steep rise in write-offs for progressive buckets (or time periods) except for 2001 (For 2001 vintage although write-offs increased in the 13-24 month and 25-36 month buckets, write-offs improved subsequently for earlier buckets).

U.S consumer lending managed write-off rates by acquisition vintage

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Higher provisions to weigh on AXP’s bottom-line. AXP’s provisions for losses (including those on credit card receivables and card member lending) increased nearly 49% to $1.89 bn in 2Q2008 from $1.27 bn in 2Q2007 led by additional lending reserves of $600 mn created in expectation of higher future losses. As a result, reserves for card member lending as a percentage of loans increased to 5.2% in 2Q2008 compared with 2.9% in 1Q2008. However, despite this increase in reserve percentage, the actual write-offs on receivables and lending was much higher at 6.7% in 2Q2008, indicating that the Company might have under provisioned the amount of expected losses. With higher roll rates and continuing increase in write-off rates all vintage categories, we believe that AXP will have to increase provision in the coming quarters, albeit at lower levels than witnessed in 2Q2008. ‘

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Changes in charge-off policy to result in lower reported charge-off. AXP, in its 2Q2008 earnings conference call, indicated that going forward the Company would report charge-offs on principal amount only as opposed to the current practice of reporting write-offs on both interest and principal, in line with industry reporting standards. This would have caused a lower write-off at 5.3% compared to 6.5% on AXP’s credit card lending managed portfolio in 2Q2008. The change in the Company’s policy towards a more lenient method would result in under-reporting of actual write-offs and creation of lower provisions than warranted in this turbulent environment, and is against the conventional accounting principle of conservatism. We have discovered similar financial shenanigans in the reporting of companies as far ranging as the REIT GGP (see GGP and the type of investigative analysis you will not get from your brokerage house) to major banks such as Wells Fargo (see Wells Fargo Q2 2008 Highlights). These financial shenanigans appear to be increasing in occurrence and magnitude as the asset securitization crisis matures and comes into its own.

Slowdown in consumer spending and reduced credit lines to impact top-line growth

Macro economic conditions continue to worsen. Deteriorating credit market conditions and fast declining housing prices have significantly impacted the US economic and business environment. This coupled with higher inflation off rising food and energy prices, and increased unemployment levels is dampening consumer confidence beyond popular sell side analyst and consensus expectations. In June 2008 US inflation jumped to 1.1%, the biggest increase since 1982, while the economy shed 62,000 jobs, the sixth consecutive month of job losses. With consumer confidence reaching the lowest level since 1992, consumer spending is expected to slowdown, impacting billed business for credit card companies.

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Recent data from the Federal Reserve confirms a slowdown in revolving consumer credit growth. In May 2008, growth in revolving consumer credit slowed down to 7.1% from 12.8% in the same month last year. This was preceded by a negative growth of 0.5% in April 2008 versus a positive of 0.6% in April 2007.

For AXP, growth in 2Q2008 average US card member spending (over the previous quarter) turned negative while international card member spending remained at moderate levels with slowdown in growth. Even in its wealthy segment portfolio AXP is witnessing a declining trend in consumer spending as customers reduce discretionary credit card spending. The continuing slowdown is likely to impact AXP’s card discount revenue and credit card fee income with moderating growth in number of new card issues and lower average consumer spending on its cards.

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Reduction in consumer lines of credit to impact revenue growth. After promoting significant growth in consumer receivables and lending over the past couple of years through attractive promotional offers, credit card companies are now reducing credit and margin limits for customers with high debt burden and those living in affected areas of U.S housing crisis to limit the impact of future losses. A decline in consumer spending coupled with credit card companies’ efforts to reduce credit lines will exert increased pressure on revenue growth (both present and potential future revenue stream) as a result of members’ likely disassociation with the product and company.

Lower discount rate to affect yields. Discount revenues (fees charged to merchants when card members use cards to purchase goods and services) contribute the largest proportion (around 47% in 2007) of AXP’s total revenues (gross of interest expense). In 2Q2008, despite a higher 12.3% y-o-y growth in billed business, discount revenues grew only 8.7% due to reduction in discount rate. Owing to competitive and pricing pressures AXP’s discount rate has been witnessing a downward trend over the last 2 years, declining to 2.21% in 2Q2008 from 2.33% in 1Q2006. Amid current difficult operating environment, a reversal in the downward trend in discount rate is not likely to be witnessed in the near-to-medium-term, impacting AXP’s discount revenues.

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Lack of short-term funding to impact interest expenses. AXP had primarily relied on three sources of funding – commercial paper market, unsecured market and securitization. However, as a result of increased counterparty risk, liquidity in the financial markets has significantly dried-up, and the short-term credit market has been affected the most. As a result, AXP’s reliance on long-term debt has increased over the past few quarters. Long-term debt-to-total debt for AXP increased to 45% in 2Q2008 from 31% in 1Q2006 while short-term debt-to-total debt decreased to 55% from 69% in the corresponding period.

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Increasing interest rate scenario coupled with higher debt cost associated with long-term debt (with yield on 30 year municipal bond at 5.10% against 2.37% for 2 year municipal bond – a difference of nearly 273 basis points) could significantly increase the interest expenses for AXP. We expect interest rate margins for AXP to compress as increased funding costs are not likely to be matched with an increase in interest rates on card member lending.

Downgrade in ratings to further compound difficulties for AXP. AXP’s problems of rising interest cost could be further aggravated by a downgrade in its ratings. In July 2008, S&P downgraded AXP’s ratings with a negative outlook as a result of increased credit deterioration. The rating downgrade was accompanied by rising credit default swaps on AXP’s debt, which widened by 10 basis points to 200 basis points ($200,000 per year for five years to insure $10 mn of debt). Higher risk perception in the liquidity-squeezed financial markets will seriously impact the Company’s average cost of funding, in our view.

However, we believe that the annual inflow of around $880 mn per annum for next three years, as a result of recent favorable antitrust settlement against MasterCard and Visa will ease some liquidity and funding concerns for AXP. Under the settlement, AXP would receive quarterly payments of $70 mn till 4Q2011 from Visa and quarterly payment of up to $150 mn till 2Q2011 from MasterCard.

Securitization activity has dropped significantly. AXP has historically relied on securitization of its credit card receivables and loans to manage its portfolio risk and generate adequate funds to finance its growth and expansion plans. However, as a result of drop in the securitization activities, AXP could find it difficult to securitize its loan portfolio and might have to keep them on its balance sheet for a longer duration. Any delay in securitization could force AXP to source alternative higher cost funding and the Company may be required to create higher provisions for loan losses. In the past two years, at least 25% of the Company’s total debt (on managed basis) comprised (on an average) securitized debt, signifying AXP’s significant reliance on this mode of funding.

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In 2008, the Company plans to raise nearly $34 bn through debt issuance (including securitizations). With credit conditions not expected to improve in the near-to-medium term, we believe that AXP will find it difficult to raise the required funds at the current historical cost levels. This is likely to compress AXP’s interest margins in the future as it will be difficult to raise interest rates on credit card lending amid rising delinquencies and charge-offs. In 2Q2008, AXP’s interest spread contracted to 3.48% compared with 3.68% in 1Q2008 and is expected to remain under pressure until the second half of 2009.


Originally published at Boom Bust Blog and reproduced here with the author’s permission.

6 Responses to "When the best of the best start with the shenanigans, what does that mean for the rest…"

  1. 2cents   August 5, 2008 at 10:40 pm

    Reggie,Good to see you over here @ RGE!I commend you for your level of analysis. It is always factual and comparatively/historically evaluated.

  2. interested reader   August 7, 2008 at 3:03 pm

    An always right to the point:American Express’s Ratings May Be Cut by Moody’shttp://www.bloomberg.com/apps/news?pid=20601087&sid=anMSsIXkzB8g&refer=home

  3. Anonymous   August 7, 2008 at 8:38 pm

    Insane level of detail, nicely done!

  4. London Banker   August 28, 2008 at 1:31 am

    Reggie,You are younger than I would have thought possible! I always enjoy your detailed, fact-based analysis – telling the story through the numbers rather than through opinion. Well done here on Amex, as ever.

  5. PhilT   August 29, 2008 at 12:13 pm

    Excellent view … but I do have a question, Sir.In terms of your analysis, is it relevant to distinguish between charge card and credit card when referring to AMEX as the creme de la creme or is your analysis covering both?At its core, the charge card (i.e. Green, Gold, Platinum, etc.) is not a revolving credit facility and thus its balance is payable in full every month. I always thought that the premium AMEX customer that you refer to in your opening paragraph resides here.With the advent of Optima, AMEX created a series of revolving credit facility products that function as credit cards and cater to a different demographic (much less premium customer) than the charge card.Looking forward to your reply …

  6. Guest   September 1, 2008 at 6:51 am

    Mr. Middleton,To PhilT’s point above, AMEX has had a trip down the credit card path once before (early ’90’s). At the time, they did not appreciate the difference between a charge card and revolving credit.One wonders as to the asset quality of a credit card launched:a)into a completely saturated market, and,b)near the end of the biggest debt fuelled boom in historyTime shall tell.Your analysis is superb. Thank youCrocodileChuck