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2019-10-22 11:16:46

Dividend growth investing is a popular and largely successful approach to generating wealth over long periods of time. Investors typically do well focusing on companies with long streaks of dividend increases, in part because of the positive qualities a business needs in order to be able to continually afford what is ultimately a cash layout to shareholders. However, many of the companies known as Dividend Champions - those with 25 consecutive years (or more) of dividend growth - are mature companies. By identifying strong companies earlier in their lifecycle, we can benefit from strong total returns while these companies build their dividend growth reputation. We will be spotlighting numerous dividend up-and-comers to identify the best dividend growth stocks of tomorrow.

Overview

American Express Company (AXP) is a financial services company that provides a wide range of payment cards, as well as lending, payment processing, and merchant services to its customer base. American Express operates its own payment network, which is essentially a toll road for consumer/commercial transactions to take place. When you swipe your charge card, the merchant pays a small fee for the service of connecting that transaction to the customer's financial institution.

In other words, the company generates revenue whenever you use an American Express card or American Express-branded card such as those shown below:

(Source: American Express Company)

While some of its peers in this category such as Visa (V) and Mastercard (MA) stop there, American Express engages in various lending services. So, in addition to the payment network generating revenues, it is a lender that generates revenues through interest spreads. The business is broken up into three segments: Global Consumer Services Group, Global Commercial Services, and Global Network & Merchant Services. Altogether, the company generates more than $30 billion in total revenues. American Express is also famous as one of the pet investments of all-time great investor Warren Buffett.

(Source: YCharts)

Over the past decade, revenues have grown at a CAGR of 7.75%, while net income has grown at a 15.64% clip over the same time period.

Fundamentals

In order to gain insight into the inner workings of American Express, we need to look at a few key operating metrics. The bank operates a little differently than most traditional businesses. Part of its business is based on lending money, so that will be reflected in our evaluation. You wouldn't evaluate a lender in the same way that you evaluate a dog food manufacturer, for example.

So, we will look at return on equity (ROE) to gauge how profitable the collective business is. We also want to invest in companies with strong cash flow streams, so we look at the conversion rate of revenue to free cash flow. Lastly, we want to see that management is effectively deploying the company's financial resources, so we review the cash rate of return on invested capital (CROCI). This is similar to the above ROE metric, but is more cash-centric. In other words, it measures cash returned on cash invested . We will do all of these using three benchmarks:

ROE - Consistent/expanding rates over timeFCF Conversion - Convert at least 10% of sales into FCFCROCI - Generate at least 11-12% rate of return on invested capital

(Source: YCharts)

While the results here shouldn't be overly surprising, it's still great to see that metrics are above benchmarks. Lending is one of the world's oldest business models, and there is a reason that it's still thriving today. It's a very asset-light and profitable enterprise (the payment processing network business model is also very high-margin). Management is doing a good job realizing strong returns on equity, both in ROE and on a cash basis with CROCI. American Express is a very strong cash flow generator as well, converting more than $0.26 of every dollar into free cash flow.

The other major aspect of a company such as American Express is the balance sheet. The financial crisis a decade ago is a reminder of how important the balance sheet is to any company involved in lending.

(Source: YCharts)

While increasing consumer spending following the recession has pushed total loans to near peak levels, the company's debt-to-equity levels remain near multi-year lows. Additionally, the major credit rating bureaus have all assigned upper-medium grades to American Express with stable outlooks.

(Source: American Express Company)

Dividend and Buybacks

American Express has frozen its dividend in extreme recessionary environments, and the financial crisis a decade ago was no exception. Since resuming growth of its payout, the dividend has been increased in each of the past eight years. Today, the dividend totals an annual sum of $1.72 and yields 1.47% on shares. Trailing the yield offered by 10-year US treasuries, American Express isn't going to attract a ton of investors seeking income generation.

(Source: YCharts)

While the yield is lacking, dividend growth has been solid. Over the past five years, the dividend has grown at a CAGR of 10.9%, and if you go back 10 years (which includes two years of zero growth), that CAGR still comes in at 7.2%. This shows that despite the occasional freeze, the dividend will still outpace inflation rates.

The dividend payout ratio is very conservative at just 10% of cash flow and 15% of net income. This is partially due to the company's need for financial flexibility, but also due to its desire to buy back its stock. American Express spends billions each year retiring shares to help boost EPS growth. Over the past decade, the float has been reduced from approximately 1.2 billion shares to 821 million.

(Source: YCharts)

Growth Opportunities and Risks

We touched on the historical success of the lending business model, and there is good reason to count on continued growth at American Express over the years to come. Consumer spending is an ever-increasing metric that will only continue to rise as population growth and inflation carry it higher. If we look at the below historical chart on consumer spending in the US, we see that even the financial crisis was but a blip on the curve.

(Source: Trading Economics)

This benefits both of American Express' businesses. Its payments network charges as a percentage of each transaction, so revenues generated will correlate higher with the total number of dollars spent. On the lending side, credit card balances are currently at all-time highs in the United States. Consumption is a cultural staple of Western societies, so we don't anticipate these behavioral patterns to reverse anytime soon, with the exception of a recessionary environment. The same holds true for the commercial side. While also economically sensitive, the increased globalization and emergence of worldwide business only brings increased spending along with it. For many businesses (especially smaller businesses), the easy liquidity of a business credit card is a very valuable tool.

Additionally, American Express just recently received permission from the Chinese government to begin building a payments network in China. This makes it the first US credit card company to penetrate China at this level. Peers such as Visa and Mastercard currently sell co-branded cards into China, but they utilize UnionPay rather than their own networks. Once American Express has established a payments network, it will be able to process payments in China. This is potentially a large growth driver over the long term. China is one of the most lucrative consumer markets in the world, often isolated from western companies by the Chinese government.

As a lender, American Express is influenced by interest rates as well. This can growth or threaten the company's earnings potential. This plays out in the company's net interest spread/yield. In its simplest terms, a lender makes profit by lending money at a higher yield than what the lender paid for that capital. The difference in these rates is called the net interest spread. We can see below, the spread (displayed as a yield percentage) that American Express has generated on its lending over the past several quarters.

(Source: American Express Company)

Lower interest rates are a headwind for American Express because the low rates put pressure on these spreads. While rates have been increased in recent years thanks to a strong economy, they remain low from a historical perspective. Investors should keep an eye/ear out for movements in interest rates. They have a direct impact on how companies like American Express make money.

Recessionary events also pose a threat to the company. During recessionary events, risks increase for defaults on loans because people lose their jobs, etc. When times are tough, people will obviously pay rent/feed families versus pay their credit card statement.

Valuation

At just over $118 per share, American Express stock currently trades near the higher end of its 52-week range ($89-129).

(Source: YCharts)

Based on analyst estimates, American Express is poised to earn approximately $7.97 per share for the full fiscal year. The resulting earnings multiple of 14.80X is right in line with its 10-year median P/E ratio of 14.48X.

If we look at valuation from a cash flow standpoint, we see that the company's current FCF yield of 13.81% is also somewhat in the middle of its 10-year range.

(Source: YCharts)

Lastly, we look at American Express' price-to-book value to get a third perspective on value. The book value gives us some perspective on the non-operational aspects of the company's value. Again, we come in at the middle of its 10-year range - although if you remove spikes from the chart, we are closer to the higher end of the range.

(Source: YCharts)

Collectively, shares appear to be trading near the higher end of fair value. Because of the stock's financial exposure as a lender and our place in the tail end of an economic up-cycle, investors may want a margin of safety to protect themselves from the event of a recession, or disruption in the financial markets. We would like to see a 20% discount to fair value , which would place the stock at an earnings multiple of around 11.5X earnings, or $92 per share.

Wrapping Up

When you look at the big picture, it's easy to see why Warren Buffett has been such a fan of American Express over the years. The company is a cumulation of lucrative business models, woven into an entity that produces strong cash flows for investors. The lending aspect of American Express presents a bit of risk into the equation, and investors should keep this in mind when considering the stock. If acquired at the right valuation, American Express is a solid financial stock for investors to consider.

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Disclosure: I am/we are long V. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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