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Get 20% Upside With This Undervalued Prestige Brand

Thursday, November 21, 2013 8:30 AM

Once upon a time, using an American Express card could be nearly impossible. For some consumers, it may have felt like rejection to hear a cashier say, "Sorry, we don't take American Express."

However, as an AmEx cardholder myself, I always looked at it as a compliment -- as though I and other AmEx cardholders were a member of an exclusive club. However, that club isn't as exclusive anymore.

Yes, American Express (NYSE: AXP) remains the pinnacle of credit cards, signifying success, exclusivity and financial freedom. But while MasterCard (NSYE: MA) and Visa (NYSE: V) have seen their card portfolios shrink over the past couple of years as many consumers have cut up their cards, American Express has seen its portfolio grow.

The number of merchants and venues that accept American Express has grown exponentially over the past half-decade. While some cardholders might consider this a form of brand dilution, investors in AXP should consider it great news.

American Express' merchant fees have been on the decline, narrowing toward what MasterCard and Visa charge and allowing more businesses to accept AmEx. Merchants are becoming increasingly more open to accepting American Express, especially in light of the fact that AmEx cardholders generally spend more than others. The rising number of AmEx-friendly merchants has also promoted more spending by cardholders, thereby increasing revenues.

On the flip side, now that its transaction fees are lower, American Express has opened the door to more applicants to help boost spending volumes and offset those lower rates. Worth noting is that more than 80% of American Express' revenue comes from fees on card transactions.

Although American Express' card portfolio has grown much more quickly than its peers' over the past couple of years, it hasn't sacrificed quality, as write-offs and delinquency ratios are near historical lows. That creditworthy customer base also helped American Express weather the financial crisis fairly well.

Despite all this, the company has somehow underperformed its major peers.

Over the past three years, American Express is up only 100%, while MasterCard is up a whopping 208% and Visa is up 162%. AXP is trading at only 15.3 times forward earnings, compared with MasterCard at 24.1 and Visa at 19.

American Express is looking to boost earnings with a coupling of revenue growth and cost cutting. Its latest initiative includes entering a new market: prepaid cards. With the financial crisis putting a real strain on the availability of consumer credit, coupled with the rise in banking fees, some consumers are turning to prepaid options as an alternative.

Flickr/Philip Taylor PT
With merchant fees on the decline, businesses have become more open to accepting American Express, especially in light of the fact that AmEx cardholders generally spend more than others.

This strategy runs the risk of diluting American Express' brand, but the company expects it will more than pay off in increased transaction fee volume. The strategy is also expected to generate a higher level of "customer captivity" as prepaid customers upgrade to other AmEx products. American Express is also looking sell prepaid cards as an alternative to high-fee checking accounts.

In addition to prepaid cards, American Express is looking to target the fast-growing digital payments market, which includes mobile payments and e-commerce.

However, there's room for American Express to improve on the expense front. Selling, general and administrative expenses (SG&A) are up to 52.1% of revenue over the past 12 months, compared with 47.6% from 2006 to 2010. American Express is hoping to keep operating expense growth below 3% over the long term.

Meanwhile, American Express' cash-flow-generating capabilities allows the company to further buyback shares. The company has reduced its shares outstanding by 8% over the past two years. Driving this is a solid 24% return on equity and the fact it's converting more than 100% of its net income into free cash flow. Promisingly, its 1% dividend yield is only a 20% payout of earnings.

Risks to Consider: The company is heavily weighted toward the broader economy and spending patterns. Any signs of a weak economy could lead to decreased revenue. However, it's worth noting that American Express' creditworthy customer base tends to be able to better weather economic downturns.

Action to Take --> Buy shares of American Express for nearly 20% upside to $100. Although the stock is already at all-time highs, prior to the financial crisis, American Express traded as high as 7 times book value. However, it now trades less than 5 times book value -- but actually has a better balance sheet, in terms of leverage and debt-to-equity ratios, than before the crisis.

P.S. Did you know the StreetAuthority Research Staff recently named AXP one of its Top 10 Blue-Chip Stocks to Own in 2014? And now you can get this report absolutely free, just by signing up for our premium newsletter, Top 10 Stocks. You'll also receive our exclusive report on the absolute best stocks on the market to own in 2014. This annual list of stocks has beaten the market time and time again, including individual gains of up to 159.9%. To learn more, click here.

Marshall Hargrave does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.