This Blue-Chip Dow Stock Is Now A Bargain

Tim Begany's picture

Thursday, April 30, 2015 - 10:45am

by Tim Begany

Wall Street tends to take a binary view of even well-seasoned companies: Love 'em or hate 'em.

Right now, the Street is overreacting to some snags at one of the world's leading financial services firms, American Express Co. (NYSE: AXP)

In 2015, American Express is the Dow Jones Industrial Average's worst performer, falling more than 16%. 

 

Shares have weakened due to the company's susceptibility to the strong dollar. Like other large multinationals, AXP generates substantial profits in foreign currencies. With the greenback at an 11-year high, those profits lose significant value when exchanged back to dollars.

The market reacted very harshly to an announcement in February regarding the loss of an exclusive 16-year co-branding agreement with Costco Wholesale Corp. (Nasdaq: COST), a relationship that accounts for 10% of all American Express cards in use. 

American Express decided to walk away from the agreement, which ends next April, because the two companies couldn't negotiate a mutually satisfactory fee arrangement. Costco plans to replace AXP with Citigroup, Inc. (NYSE: C) and Visa, Inc. (NYSE: V).

The recent loss of a similar, though much smaller, relationship with budget airliner JetBlue Airways Corp. (Nasdaq: JBLU) hasn't helped investor sentiment either. Adding insult, American Express delivered mixed first-quarter results and issued tepid full-year revenue and profit forecasts.

However, the market's reaction to these events might give the impression American Express is in serious trouble. It's not.

The key takeaway: American Express remains an industry leader, with a large base of affluent customers, a superior business model and a solid balance sheet. And management is taking decisive action to re-establish forward momentum.
 
For one thing, management is bolstering the core high-end credit card business with additional rewards on gold cards, a key growth segment that boosted membership by 10% last year. Starting in June, premier rewards and regular gold card holders will receive personalized travel services and a $100 annual credit for certain air travel costs, like baggage surcharges. 

Foreign transaction fees will be eliminated. American Express plans to increase annual membership fees by as much as 30%, depending on the type of card, to help offset the costs of new perks. 

Last month, the firm launched Plenti, a loyalty rewards program enabling cardholders to pay for products and services with points earned through purchases from participating companies. Points can be redeemed at retailers such as Macy's, Inc. (NYSE: M), Exxon Mobil Corp. (NYSE: XOM), AT&T, Inc. (NYSE: T) and McDonald's Corp. (NYSE: MCD), among others. American Express plans to continue adding participants, which pay a fee to be in the program.

Plenti reflects a broader "downmarket" strategy, where American Express seeks to augment its core high-end operations with services aimed at mass markets. Recent downmarket moves include the 2012 introduction of debit card and checking services (known as "Bluebird") in tandem with Wal-Mart Stores, Inc. (NYSE: WMT). In 2014, American Express and Apple, Inc. (Nasdaq: AAPL) announced the creation of a digital wallet application for use with mobile devices.

In March 2015, American Express inked a long-term, exclusive deal for two co-branded credit cards with low-cost brokerage and financial services firm Charles Schwab Corp. (NYSE: SCHW). The new cards are scheduled to roll out in early 2016. American Express already has a similar co-branding deal with Fidelity Investments.

As it seeks other partnerships to negate the loss of Costco, American Express will continue to leverage a crucial competitive advantage: its unique "closed loop" business model.

In this model, American Express issues credit cards and administers a network of merchants who accept those cards. Key rivals Visa and MasterCard, Inc. (NYSE: MA), on the other hand, operate under an "open loop" model, which simply means that they are only merchant network administrators. Their cards are actually issued by independent third parties, typically banks.

For American Express, this provides a big head start on revenue generation because, as an issuer, it collects the entire 2%-to-3% fee merchants are usually charged for accepting credit (and debit) cards. Visa and Mastercard forfeit the bulk of these fees to their issuers. 

As an issuer, American Express is also in a position to collect large amounts of data on the demographics and spending habits of its customers. This, too, should give the company a leg up in formulating growth strategies that will help to put recent setbacks in the rearview mirror.

Risks To Consider: American Express took a legal hit recently when a federal judge ruled that the firm was violating antitrust laws by prohibiting those in its merchant network from encouraging consumers to use lower-cost alternatives. American Express plans to appeal. But if the decision stands, the company could soon be facing a tougher competitive landscape.

Action To Take --> American Express is out of favor on Wall Street. But for long-term investors, the firm's recovery potential makes its stock a bargain. The price-to-earnings ratio of 14 -- roughly a 15% discount to the historic average and the typical rival -- presents an attractive entry point. 

Though performance may remain sluggish a while longer, American Express should be able to boost profit growth in the coming years. I see approximately 50% upside potential through 2019. With a strong balance sheet, the firm should be able to deliver substantial dividend raises along the way, as well.

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Tim Begany 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.