[Research] American Express: How to Not 'Pay Up' for a Great Business
Unusual circumstances, a franchise business, and a low price
Not held.
If you like this piece, you might also like my original Moody’s write up, and its progenitor, Duff & Phelps:
"You can't create another American Express. I could create another shoe store. I could create another business publication. I could do all kinds of things with hundreds of billions of dollars. But I can't put in the minds of people what is in their minds about American Express."
Warren Buffett
Deep in the earliest value investing lore is Buffett’s first rodeo with American Express. The so-called Salad Oil Scandal drove shares of the company to plummet on the revelation that Anthony “Tino” De Angelis’s machinations may have incurred a nearly unlimited liability for the company. In an interesting wrinkle of history, American Express was structured in such a way that made individual shareholders personally liable for its outstanding commitments. Buffett stepped in and, after some old-fashioned scuttlebutt, put 40% of BPL’s assets into the shares. The rest, as they say, is history.
Buffett’s, and in fact Greenblatt’s, later bite at the apple is arguably even more instructive. Imagine getting to buy a consumer franchise for 9x earnings? It feels nearly illegal - given our current regime, anyway.
A Financial Services “Supercompany”
I’ve always thought Shakespeare’s line ‘the fault, dear Brutus, is not in our stars, but in ourselves’ is at least as descriptive of business as it is about human nature. To plagiarise the line, for over 70 years the occasional fault in American Express has not been in its core business, but in the nonsense that has happened around the periphery.
Beginning in 1977, American Express began a classical program of di-worse-ification under the auspices of James D. Robinson III, who enjoyed the joint positions of Chairman and CEO for the next 16 years. This picked up a gear in 1981 when the company acquired Shearson Loeb Rhoades, the then second largest securities firm in the United States.
In 1984, American Express acquired the investment banking and trading arm of Lehman Brothers. This veritable word soup of financial services firms would become known more familiarly as Shearson Lehman, and finally just Lehman Brothers. American Express’s somewhat baffling acquisition of two old-lined Wall Street partnerships was followed up with a string of other buy-outs including First Data Corporation, and Investors Diversified Services (IDS). Famously, Robinson played an important role in backing F. Ross Johnson’s management buy-out bid for RJR Nabisco. Not without some self-deprecation, Robinson noted in a 1990 interview that his growth by acquisition strategy was a “major miscalculation”.
Shearson was a particularly problem child for American Express’s expanding financial empire. The company paid almost $1B in the original acquisition and it consumed another $4B in shareholder capital over the following 13 years. This need for cash spurred Robinson to reach out to Buffett for $300M in financing in the early 1990’s - one of those very first sweetheart deals (convertible preferred stock) Buffett has become known for in recent decades.
Rationalisation
By the early 1990’s the consequences of Robinson’s strategy were clearly evident in heavily weighed down returns at the group level. Hervey Golub, a former McKinsey consultant, was chosen to replace Robinson. Golub’s ascent was interesting. He was first engaged by American Express to investigate Investor Diversified Services (IDS) as an acquisition target. After the deal closed they kept him on to run the company. It soon became a significant money spinner for American Express and Golub’s stock rose in the company. In time he was added to the board, while taking on additional responsibilities at the group level. In 1993, he took over as CEO.
Golub was faced with one very good business at American Express, and a handful of decidedly less good businesses. Firstly, and most importantly, were the Travel Related Services (TRS). This entailed the traditional travellers cheques business as well as the rather better known credit card business. By 1993, this part comprised almost three-fourths of group sales. Despite its enormous contribution, it was, of course, being watered down by the ravenous capital needs of the businesses which management had acquired elsewhere.
Buffett explained American Express’s interesting market position at the time:
American Express had a very special place in people’s mind about financial integrity, over the years. There was something about its ubiquity of acceptance. When the banks closed in the early [19]30’s, for a short time the travellers cheques substituted, to some extent, for bank activity during that period. The world wide acceptance of this name meant that when American Express sold travellers cheques, and despite the fact that they charged more than their two closest competitors - CitiCorp and BofA - they still controlled 2/3rds of the world wide market. Any time you can charge more for a product and increase your market share, you occupy a very special place in people’s minds.
The same thing happened when the credit card came around. Originally American Express went into the credit card business because they thought they were going to get killed on traveller’s cheques. It was a defensive move. It came about because a couple of guys came up with the Diner’s Club card. So they backed into the card business. American Express went in and started charging more for their cards and kept taking share from Diner’s. That’s a cache in people’s minds.
Over time they got into other businesses and they let the Visa’s and the Mastercard’s get established. But they occupy a very strange position - they segment their card now, people pay $1000 just to get one.
Warren Buffett, 1994 Berkshire Hathaway Annual Meeting
Both of the respective travel related businesses were (and indeed still are) clear royalty-like businesses - they charge a % of the transaction value in return for the certainty of completion. The economic value, however, was tied to brand value. This has allowed American Express to introduce ever more exclusive cards over the years, like the Centurion Card (a credit card that apparently has no limit), but this also seemed to have limited its ability to capture the much greater network for card payments. Over time, most payments businesses give up take-rate to court greater volumes, but American Express isn’t interested in any of that. The historical anti-factual is delicious, but ultimately off-point. American Express is a brand, not necessarily an aggregation business.
The essential mechanics of the credit card business are not difficult to divine. Customers pay incurred balances at the end of the month. Revolving balances incur high interest rates and additional fees. Most customers pay for the right to access their credit card yearly. Merchants foot very high fees for customers wishing to pay via an American Express credit card. In line with the old travel lines of business, American express had deep relationships with airlines and hotels. While a customer might hold several credit cards, certain purchases were always made with an AMEX. I’m just old enough to remember the absolute rort that was paying for airfares with an American Express, and reaping ungodly amounts of frequent flyer miles.
The remaining one-fourth of American Express’s then business comprised Shearson Lehman, IDS (both as mentioned above), but also financial data, planning, insurance, and investment product businesses. In a later episode American Express would in turn spin-off a collection of these businesses as Ameriprise Financial (originally American Express Financial Advisors).
Golub began a well worn program of what I have come to know as quality reversion. Firstly, the rubbish was cleaned out. In quick succession First Data Corporation (now apart of Fiserv), and The Boston Company were spun out and sold off respectively. Together both of these sales netted American Express over $2B. Next Shearson and Lehman were split up as operating entities. Shearson was sold back to Sanford I. Weill’s Primerica, and Lehman would be spun out into its own stand alone entity. Herein lay the opportunity.
Greenblatt is famous for making the following observations about the spun out Lehman entity:
Lehman had the highest expense ratio per dollar of revenue in financial services at the time,
It has lost money in 1993,
It had an extremely volatile earnings history,
While insiders received some of the highest cash compensation in the investment industry, most of them had completely neglected to actually common in the spun out entity.
Ominously bad.
The Lehman spin was slated for 1994, and for a relatively short period of time one was able to buy shares in American Express, pre-spin, at $29 a share or less. Lehman was expected to fetch between $3-$5 post spin, and the remainco was expected to earn $2.65 on a forward basis. As mentioned above, IDS remained with American Express, and it had historically grown earnings at a 20% clip in an unregulated and large market.
Golub’s goal for the remaining businesses was to grow earnings at between 12-15% a year, and for the company to earn a respectable 18-20% return on equity. After the Lehman disposition, the company authorised a 60M share repurchase program. Buybacks would be staple for American Express going forward:
For a period in 1994, investors could buy the remainco for less than 10x earnings, with increasing returns on equity and a generous share repurchase program. The reason for this? Simple - depressed returns and an unpredictable earnings history left American Express’s core franchises undervalued - until extraordinary corporate action catalysed a long term reversion to quality. In 1994, major leading card issuers traded for more than 11x trailing earnings. As returns normalised, predictability resumed, and the efficacious nature of the buyback program became obvious, the stock behaved perfectly. For the next 10 years shares compounded at more than 18% per year:
Buffett made several purchases after 1994 but the initial buy added up to about 8% of Berkshire’s equity portfolio:
They don’t call him the Oracle for nothing.
Larry.
How is the business positioned now though mate?