Investment Thesis
I haven’t covered American Express (NYSE:AXP) since late May, but overall shares have performed well, rising 7.72% (including dividends) compared to the market return of 5.77%.
However, since my last write-up in May, the market seems to have become far more bearish on the US consumer, largely driven by concerns of consumer budgets tightening (from rising interest rates and high inflation). What I find interesting about this is that general Wall Street pessimism persists despite new, optimistic data on the American consumer as a whole. Consumers are starting to become slightly more optimistic. American Express is in a great place to ride this.
Recent consumer confidence suggests that the outlook has become bifurcated and for American Express’ customer base, things may not be as dire as some investors fear.
Powering this (and my bull thesis on American Express) is the resilience of high-income households. High income households are benefiting from higher savings, a higher probability of locked-in mortgage rates that shield themselves from a big part of higher interest rates, and larger investment accounts that offset a huge part of inflation.
While the travel season may be ending (a big reason I was bullish on American Express before) I am confident that American Express is well-positioned to outperform over the coming months. The credit card giant’s portfolio of loans, supported by the spending habits of high-income consumers, should continue operating efficiently. Their stable credit card metrics also support my view and really suggest that the company’s focus on affluent consumers has been paying off.
With overall consumer confidence rebounding and the market’s concerns about the U.S. consumer now potentially overblown, I think that the remaining bearish sentiment surrounding American Express appears misplaced. In my opinion, the best investments are ones that allow investors to capture a big mismatch between market perceptions and reality. We could have that setup here.
I think shares continue to be a strong buy.
Why I’m Doing Follow-Up Coverage
Don’t get me wrong, the market has been super generous to shareholders (this is not an argument to say that shares have been beaten up).
Over the last 12 months (ending August 30th), American Express’ stock has surged by 61.48% to outperform the S&P 500 index, which rose by only 25.11% during the same period. Year to date, shares are up 37.35%. It’s been a solid performer. My argument is that this will continue.
Like I mentioned in the investment thesis, low-income consumers have been clouding the consumer spending outlook as they have been most affected by surging inflation. A great example of this has been their spending patterns at Dollar stores.
During their Q2 earnings call, Dollar store conglomerate Dollar General’s (DG) core customer segment, which contributes approximately 60% of their overall sales, comprises households earning less than $35,000 annually. Unfortunately, this happens to be the group hit hardest by inflation.
As mentioned by their CEO Todd Vasos:
More of our customers report that they are now resorting to using credit cards for basic household needs and approximately 30% have at least one credit card that has reached its limit. And in our latest survey, 25% of our customers surveyed noted they anticipated missing a bill payment in the next six months.
While middle and higher-income households are seeking value as well, they don’t claim to feel the same level of pressure as low-income households. As customers have felt more pressure on their spending, we have also seen corresponding elevation in the promotional environment beyond what we had anticipated coming into the year -DG Earnings Call.
I added these quotes from Dollar General to show that I understand that many consumer groups are struggling. But, like I mentioned in my investment thesis, these financial struggles do not appear to be nearly as pervasive in American Express’s core customer base.
Consumer Confidence Rebound
Last month, the University of Michigan’s Consumer Sentiment Index inched up by 1.5 points in August to mark the first increase after four consecutive months of decline.
Economists at the university attributed a big part of this improvement to a 10% surge in long-term economic expectations, which now show that consumers have a much more favorable outlook on where the economy is going.
Keep in mind that consumer sentiment is also now 36% higher than the historic low recorded in June 2022.
It’s not just Umich, Consulting and Auditing giant EY’s Future Consumer Index also posted growing consumer optimism, with 47% of respondents now expressing a positive outlook on the future. Despite concerns about rising living costs, nearly two-thirds (61%) of these same consumers reported feeling in control of their lives.
Consumers are increasingly adept at managing financial disruptions such as inflation. I think as we see consumers gain more confidence back, this will spill over further into spending.
I think this rebound in consumer sentiment, particularly among higher-income groups, suggests that the market’s negative outlook on consumer spending may be overstated.
On the last quarterly call, American Express’ management sounded a similar tone:
…the U.S. consumer was 6% up for the quarter. It continued to be strongly influenced by Millennial and Gen-Z growth. It’s now up to 33% of our total billings and they’re up 13%. And so we feel good where the U.S. consumer is. Obviously, organic spending, we’d like to see a little bit higher, but it is a slower growth economic environment -Q2 Call.
I think what is key about management’s tone here is that they are balanced. They are seeing what the data is now showing: that consumer spending among some groups is strong and heading higher. Sure, they (like myself) would like to see the economy grow faster, but much of this drag (in my opinion) has been driven by low-income consumer spending issues (as we saw on the Dollar General Call). American Express doesn’t appear to be suffering from many of these same consumer spending headwinds.
Valuation
Consumer spending is a segmented market, and (fortunately) American Express appears to be in a part of the market that is resilient. Interestingly, the company’s current PEG is only hovering right at the sector median, despite their strong market segmentation. American Express’ forward PEG ratio clocks in at 1.27, which is slightly below the sector median of 1.28.
What’s key here is that the current PEG ratio for American Express implies that the market assumes that the credit card giant’s ratio of forward earnings growth to their forward P/E ratio is approximately proportional to the growth/PE ratio we are seeing from other financial firms. I think this is misguided. Their growth assumptions appear conservative, especially given where EPS revisions are currently at. The best forward EPS revision group (Dec. 2027 estimates) only price in an EPS that is 11.08% higher than the previous forecast. Given how much consumer confidence has improved, I think this is misguided.
Besides their likely conservative EPS growth, the company is a great steward of capital today, which, I think, will help power shares to compound over the next few years. The company’s return on equity (ROE) remains strong, with a current ROE of 34.51%, well exceeding the sector median of 10.38%.
American Express is a much better financial institution than their sector median peers. I think they should trade at a 20% premium to the sector median PEG ratio to really reflect this strong performance against other financial institutions. If we saw the market re-rate shares to reflect this PEG premium, this would produce upside of about 20.9% for shares, not including dividends.
Risks
I think the consumer feels much better than they did over the last 6 months. This doesn’t mean this confidence can’t revert. Some Wall Street analysts, like those at Bank of America (BAC), have actually downgraded the company’s stock from a “buy” to a “neutral” after they believe they identified growing concerns over consumer spending patterns, particularly among higher-end consumers.
On this same note, overall US credit card debt now exceeds $1.14 trillion. If we saw this higher consumer debt compound to significantly higher delinquencies, this would clearly be a huge risk to American Express. American Express [unlike competitors like Visa (V) or Mastercard (MA)] also underwrites their credit card loans on their balance sheet since they have a banking arm as well. It’s fair to assume that American Express would have acute credit risk in this way.
However, I still think that American Express’ higher-income consumers are not in a position where this is currently happening. American Express customers tend to have stronger credit profiles, which help the credit card/banking conglomerate build a loan book that has lower default rates compared to industry peers, as shown through the company’s net charge-off rate, which was just 2.1% in July. Keep in mind that this 2.1% charge-off rate is actually below the 2.2% charge-off rate we saw in July 2019, before the pandemic.
American Express appears to have a strong strategy: integrate consumer discretionary spending into the core of the credit card franchise [through their skymiles partner Delta (DAL)], and use the combined data as both a bank and a credit card processor to have a much better control on the quality of your loan book.
I think this is a great combination and part of their secret sauce. It’s likely also why shares have continued to do well even though the market has become overall fearful of consumer-focused stocks.
Bottom Line
American Express has uniquely segmented the consumer credit-card market by focusing on higher-income consumers, who are less susceptible to economic downturns to power their business. This strategy has allowed them to capitalize on the upside parts of increasing consumer confidence while avoiding the downside risks associated with lower-income consumers impacted due to the effects of inflation.
With this, the company’s really stable performance in consumer credit card default metrics, powered by fairly consistent delinquency rates and a slight dip in the net charge-off rate (compared to 2019), tells me they have a resilient customer base. That’s something I want to be bullish on.
While the luxury-card company’s shares have run up a bunch since this time last year, I really do believe that there is more upside to go as the market realizes that American Express has the right business model at the right time to address the right part of consumer market. With this, I think shares continue to be a strong buy.
Read the full article here