V - American Express: Consumer Spending Will Be Challenged In 2024 May See Reset

2023-12-12 20:05:23 ET

Summary

• American Express has experienced a significant rally in its stock price, but its risk/reward profile is now diminished.
• The company's ability to acquire new cardholders, particularly from Gen Z, will be crucial for further appreciation.
• American Express has a premium consumer base and benefits from changing consumption trends, but it may face headwinds as consumer credit debt rises.

Investment Thesis:

American Express ( AXP ) is one of my favorite long-term companies within financial services and recently made a tremendous run up from the 145/share region to just over 170, a return of nearly 20% in the span of under 45 days. The company represents small business spending in the T&E (Travel & Entertainment) category as well as affluent credit card spending and consumption from high-income folks. The stock’s recent dramatic rally from its October lows to where it trades today represents investors’ willingness to believe that credit card delinquencies will remain low and that continued spending will remain strong. While that very much could be the case if we simply extrapolate the current spending patterns, the stock’s risk/reward is greatly diminished and is now at risk of overheating and becoming unhinged from fundamentals as their most premium user base - white collar workers - find the 2024 job market outlook to be more uncertain.

I believe from here on out, the key to further appreciation in AXP will depend on the firm being able to acquire new card holders (they are now targeting Gen Z) at an accelerated rate to allow their card fees to grow in tandem with their user network.

In this note, we’ll dive into AXP’s business model in the context of today’s macro environment to see what risk/reward looks like from here.

Current Context from fundamental standpoint

With less than 8% of their user network being cardholders with under a 660 Fico Credit Score, American Express boats a premium consumer base that is more resilient to economic shocks. The changing consumption trends towards spending on travel, restaurants, and entertainment (thank Taylor Swift this past summer) has kept AXP on the right side of consumer spending while several other pockets of the economy have clearly languished.

As a leader in credit card and charge card issuer, American Express works with most merchants around the world. AXP has something called a "closed loop system" with merchants that allows vendors to understand user spending patterns and likely consumption habits, which adds differentiated value as a partner beyond accepting payments.

The latest macroeconomic flashing point of credit card debt rising past $1 trillion dollars has meant that the dollars spent have been a net benefit to credit card processing firms like American Express, Visa, and Mastercard. At some point, the consumer will be tapped out (I expect in the coming quarters) and this will be a headwind rather than a tailwind. But with Millennials and Gen Z spending up 28% year over year, the company has been holding up very strong compared to other vendors.

Below is a visual of how American Express earns their revenue by segment and how their cost structure is composed. The firm essentially grew revenue in all of its segments (in green below) with card fees and net interest income growing the fastest while discount revenue (its largest segment) seeing growth tapered by a modest degree due to consumption spending leveling off.

Valuation & Risks

AXP’s valuation currently stands at around a 15X Forward P/E, which is a median level for its valuation relative to history since 2021. At its highest point over the past 2 years, AXP did see a forward multiple of near 20X and during periods where valuation sees a trough, the name traded as low as 13.5X.

In order for valuation expansion to continue, it is highly likely that Investors will be focusing on international expansion opportunities in EMEA, APAC, and LatAm. This is because the U.S. comprises of 78% of its revenues and the large aggregate consumer credit debt of $1 Trillion+ is going to eventually put a pause in spending as key retailers such as Walmart and Target have now warned on the consumer being weaker in 2024.

Any further cost structure management will continue to be closely monitored as AXP navigates through a more uncertain spending environment in 2024. Its largest expenses include marketing spend as AXP routinely allocates significant resources towards affiliate marketing to acquire new customers. To manage such expenses, AXP cut expenses by 15% year over year as of the last quarter. This balance needs to be made carefully as not allocating enough towards customer acquisition will ultimately lead to fewer new card signups and slowdown the flywheel compounding effect of its credit card fees revenue segment.

If we take a look at how AXP compares to peers Visa ( V ), Mastercard ( MA ), and Discover Financial Services ( DFS ), we can see that American Express trades at a discount to Visa and Mastercard but its focus on accelerating its premium user base and card fees may later help it close the gap. So from a long-term standpoint, AXP drifting towards the range high of its relative valuation history of 20X forward P/E is achievable given a long enough timeline.

AXP's annual revenue growth target of 15-20% by capturing a larger part of the affluent demographic within Gen Z and Millenial cohorts is a solid double-digit compounding story for their card fees segment in the face of a potential incoming stagflationary environment. Given that delinquencies in their consumer base are likely to remain low, this type of double digit growth profile merits the company to close the gap between its current valuation levels compared to industry averages, which we can see in the image below are higher than AXP.

Conclusion

Over the long term, American Express has essentially matched the returns of the S&P 500 but with a higher degree of cyclicality as the stock has a beta of around 1.2 (meaning that it is about 20% more volatile than the index returns). This larger variance in its longer-term return profile means that adjusted for risk, this name offers greater opportunity at swing lows rather than trying to dollar cost average into this name.

On the consumer side, Investors will be watching whether they can continue to add more than 3 million cards per quarter in the coming quarters (last seen at 2.9 million this past quarter) and whether they can grow their fees per user (which has now grown to about $93/user). On the small-medium business side, which accounts for 83% of their Corporate business, Investors will evaluate if small business confidence can stabilize in the face of this high interest rate environment.

We believe that the next market dislocation and growth scare is likely to impact AXP more severely than the S&P 500 and that the best opportunities for adding to AXP positions is likely in the future, and not yet today.

Make no mistake- AXP is a tremendous company, and will bounce back faster than other financial services companies in the next drawdown. Because American Express has a 6.3% earnings yield compared with the S&P 500's 4.59% earnings yield, investors are being paid a growth premium to own this name.

In the short-term, the major pillars of their business model (Gen Z/Millenial credit card growth, Net Interest Income, and Small Business Capital Expenditures) face a potential reset in 2024, so now may not the be the best time to chase AXP after a 20% rally.

Existing Investors can continue to hold their positions, and I'm waiting for better areas to add into this great long-term stock. This will be a good company to add to on consumer confidence growth scares as affluent consumers tend to bounce back the fastest and that will be reflected in AXP on the next corrective cycle.

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