- I still see downside risk in US equity markets. Wait for another pullback before buying into American Express.
- Earnings and sales multiples have not been lower over the last 8 to 10 years despite having much more robust cash flows and earnings.
- Over 40% of Amex's earnings are tied to the dollar. 2017 EPS projections have been dropping ever since the announcement of fourth quarter earnings. When this metric turns, it will be another sign that the bottom is in.
Investors should be very cautious about U.S. equity markets going forward. I now believe that recent volatility has practically derailed any possibility of the Federal Reserve raising interest rates a further four times this year. Why? Well in Janet Yellen's address to congress, she mentioned that negative interest rates could be on the cards in the near term especially if volatility increases or the U.S. economy slips back into recession. If this were to happen, investors should be aware of a few things. Firstly, negative interest rates or another round of quantitative easing would actually be bullish for equity markets. The S&P500 went from 666 in March 2009 to well over 2100 in 2015.
This huge rally was caused by low interest rates and easing measures on a scale that we have never witnessed before in the U.S.A. However, the huge difference between 2008 and now is that significant strength has been priced into the U.S. Dollar. The Dollar has appreciated meaningfully against the majority of currencies since mid-2014 and this has coincided with economic strength in the U.S. economy. The Fed's tightening cycle which only began in December with a 25 basis points hike (but had been promised for well over 12 months) is the main reason for the Dollar's appreciation. Therefore, if the Fed has to turn around and announce negative interest rates (or more easing measures), I think the market will take a very bearish stance on the Dollar.
If we take a look at the technical chart of the S&P500, we can see that the next major support is at its 200 week moving average of 1790 and then the index's 2007 top of 1557. I do not see the Fed moving until the index is somewhere between these levels, which is why investors should be ready to go long on stocks such as American Express (NYSE:AXP) (due to expected meaningful dollar weakness) for the following reasons.
I believe the American Express stock is a bargain when you take into account its current valuation. An earnings miss in its fourth quarter in January made the stock lose another 10%+ which has the stock now trading at sub $53 levels. The market in my view has viewed the Costco (NASDAQ:COST) fallout last year too bearishly which has presented a real opportunity for value investors. American Express managed revenues of $34.44 billion with net income of $5.13 billion in 2015 compared with revenues of $27.73 billion and net income of $4,012 in 2007.
Why do I mention 2007? Well, American Express is trading at a very similar price to sales multiple and the stock also traded under $60 a share in 2007. Operating margins and free cash flow levels are substantially higher than 2007 but because growth has been muted on both the top and bottom lines recently, Wall Street has taken a short-term bearish view. American Express' $1 billion cost-cutting plan will attempt to address the recent slowdown. Value investors should note that American Express has a 3-year dividend growth rate of 20%. So any delay in returning meaningful growth in earnings will be offset by robust, rising dividends. Furthermore, the float has come down by almost 300 million shares over the last 10 years and expected buybacks should keep earnings per share elevated until growth resumes.
However, the main reason you want to be invested in American Express is its international diversification. Many U.S. stocks have a significant exposure outside the U.S., such as Coca-Cola (NYSE:KO), Priceline (NASDAQ:PCLN), and McDonalds (NYSE:MCD), but all these companies have substantially higher valuations than American Express. If the Dollar were to break down from here, American Express ticks all the boxes because of its low valuation, strong fundamentals, cash flows and strong international exposure. Just look at the 'global network and merchant services' division. This division's revenue net of interest expense may have fallen to $1.4 billion in the last quarter (see chart) but on a constant Dollar basis, revenues rose by 1% and business expanded by 14%. This division is growing strongly and makes up 17% of the company's revenues. 'International card services' is also growing on a constant dollar basis and is a further 15% of revenues. Revenue from these divisions should automatically rise in Dollar terms is the Fed moves towards negative interest rates or intermittent easing, which will boost EPS.
In terms of analysts' earnings predictions going forward, they continue to be bearish especially for 2017. Only 30 days ago analysts were predicting over $6 a share in earnings, but fourth quarter earnings decreased this projection meaningfully.
There is no doubt that the impending Costco breakup (happening in March 2016) has been the main instigator of the decline in the American Express stock price, but the credit card company was right in pulling away from this deal. Why? Well, it has been mentioned that American Express was making less than 0.8% in merchant fees at Costco, which is well below the company's average of 2.5%. Costco wanted its rate lowered which Amex would not agree to. Furthermore, the Canadian fallout which happened in January 2015 was not all that bad and I believe the impending U.S. termination won't be all that bad either. Yes, top line growth will be adversely affected in the near term but this was a good economic decision by American Express. It hasn't achieved the stellar return on equity percentages down through the years by bowing to merchants regarding lower fees.
To sum up, I still firmly believe that American Express has sound fundamentals, but a cheaper share price may be on the horizon in the near term. Triggers to go long this stock would be movement from the Fed or substantial lower earnings projections. Too much negativity has been priced into the American Express stock at this stage. If the S&P500 its 2007 highs, this would be bullish for the credit card company as I foresee the Fed renewing its easing measures which should tank the dollar.