Don't Leave Home Without This Stock

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

American Express (NYSE: AXP) saw a 6.5% pullback last week, which was driven by a downgrade at Barclays due to valuation concerns. Barclays believes the recent run up by the stock, which is up more than 28% in the last 12 months, is a result of multiples expansion rather than fundamental growth. However, given the credit card company's market-leading position, I think there is long-term growth buried in the company.

American Express is expected to grow EPS at an annualized 13% over the next five years, which puts its PEG ratio at an enticing 1.3. What's more is that at only a 23% payout of earnings, American Express has room to up its 1.3% dividend yield in the future. The stock is trading at 18.7 times earnings, and Barclays admits this is a the low end of its historical average of 16 times to 18 times. Its 18.7 times P/E is also below the 20.8 times industry average.

Its merchant-services business has seen spending on cards grow at an annualized rate of nearly 25% from 1999 to 2010, then 28% in 2010, 15% in 2011 and 10% in 2012. American Express already has a strong position in the U.S. card-spending business and is also reaching out to international markets for growth.

Other tailwinds for the company include its strong management of credit. Delinquency rates improved nicely in 2011, 2012 and 1Q 2013. American Express also set record-low default rates in 2011, and this trend has continued so far in 2013. 

A couple of notable credit-card competitors include Discover Financial Services (NYSE: DFS) and Capital One. In the same research note that had Barclays downgrading American Express, the bank upgraded Discover, citing margin expansion as the catalyst. Barclays believes that Discover deserves a P/E multiple that is closer to American Express, given the credit-card company has similar return on equity and growth metrics.

The thing about Discover is that it has managed to limp along for the past few years, presenting low-to-modest revenue growth. However, revenue is expected to increase 5% in both 2013 and 2014, as the credit-card company looks to emphasize a greater focus on higher quality credit. Discover has already managed to work losses down to only 2.1% of average loans as of 1Q, compared to 8.5% in 2010. 

One initiative that Discover is undertaking includes expanding its direct consumer finance and banking businesses, allowing it to move toward a full-service banking provider, which includes offering home equity loans and deposit accounts. These will come in addition to the student loan and mortgages it already offers.

Capital One has been on an acquisition spree of late, snatching up ING Direct in 2012, which boosted its deposits by some 75%. Then later on in 2012, Capital One bought HSBC's U.S. credit-card portfolio, boosting its presence in the credit- card sector.

With its ING Direct acquisition, Capital One has leveled its portfolio between spenders and borrowers, which comes as a positive given consumers are looking to limit debt loads. However, with the rebounding economy, I believe it will be the credit-card operators that perform best, as opposed to deposit takers. 

Pure purchasing play

One of the big competitors for credit cards has been the rise in debit card usage. Part of this is due to the credit crunch, where the availability of credit has decreased and customers look to de-leverage, leading to more debit purchases versus credit purchases. Two of the big benefactors of this transition have been MasterCard (NYSE: MA) and Visa. As seen below, over the past five years the purchase volume for debit cards has risen 61% versus the 17% increase for credit cards. 

<img alt="" src="http://g.fool.com/editorial/images/50835/nilson_purch_vol_2013may_large.jpg" />

Some of what MasterCard and Visa hope to use to drive future growth is payment processing opportunities in emerging markets. For MasterCard this includes its Mobile Money Partnership, which is seeking out opportunities in under-banked regions for completing secure transactions via mobile. 

As well, both MasterCard and Visa are looking to break into e-commerce, mobile payments and prepaid cards. For MasterCard specifically, the company is focusing on China. MasterCard has a partnership with China UnionPay to enter the personal consumption market, which is estimated to be a $450 billion market. 

Earlier this year MasterCard introduced MasterPass, its digital wallet, which will also break into the funds-transfer market for mobile phones. Juniper believes the mobile funds-transfer market will grow rapidly, estimating that more than 85% of payment terminals will accept cashless payments by 2016. 

Although Visa also still owns the U.S. purchase-volume market for credit customers, its encouraging that American Express has overtaken MasterCard during the past two years to move into second. As seen below, for 2012, American Express now owns 15.6% of the U.S. purchase-volume market compared to MasterCard's 14.1%. Discover appears to present little competition, given it owns less than one-fifth of the market share that American Express does, at only 3.2%. 

<img alt="" src="http://g.fool.com/editorial/images/50835/nilson_purcvh_vol_market_shares_2013february_large.jpg" />

The hedge fund move 

Capital One has some of the most robust hedge fund interest with 58 hedge funds long the stock at the end of 1Q. This was a 6% fall from the previous quarter, but includes Andreas Halvorsen's Viking Global as having the largest position among hedge funds, at $595 million (see Viking's newest picks).

Meanwhile, Discover had 46 hedge funds long the stock after an 18% increase from the end of 2012. Donald Chiboucis' Columbus Circle Investors had the largest position in the stock at $273 million, or 3.1% of the fund's 13F portfolio (check out Columbus Circle's top stocks).

Heading into Q2, a total of 47 hedge funds were long American Express, with notable billionaire Warren Buffett's Berkshire Hathaway having one of the largest positions in the stock at $10.2 billion, making up 12% of Berkshire's 13F portfolio (see Buffett's top stock).

Bottom line

As credit markets begin to loosen up, I believe there will be a return to credit card spending, where American Express has a stronghold in the market. With a forward P/E ratio of 14 times, the valuation is also compelling. American Express should continue to reward shareholders with its dividend and price appreciation on the back of a rebounding economy.  

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends American Express and MasterCard. The Motley Fool owns shares of MasterCard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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