Buffett, American Express, Visa and MasterCard

Rupert 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) is a true old age behemoth of investing. The company is one of Warren Buffett’s favorites and is one if the Dow 30. However, how does the company stack up to its newer rivals – Visa (NYSE: V) and MasterCard (NYSE: MA)

One of the main draws of investing in a company like American Express is the fact that the company can run itself. There is no need for complicated management decisions like industrial companies or basic material companies. In addition, both Visa and MasterCard have the same kind of business and they could effectively both run themselves.

American Express has one major difference between Visa and MasterCard. American Express lends money to customers and derives the vast majority of its income from customer interest on credit card loans. Both Visa and MasterCard only offer a payment network, skimming revenue off of each transaction and neither of them has any loan exposure or potential customer default risk.

So, who presents a better investment opportunity right now based on Warren Buffett’s investing criteria?

Buffett’s Berkshire already owns all three of these card providers, but what about the average Foolish investor who does not have as much cash as Buffett and was not savvy enough to open a position in American Express all those years ago?

So the criteria I will be reviewing the companies on are:

  1. Value – A basic ratio comparison of each firm. It’s well-known that Buffett likes to buy stocks that are going cheap and undervalued vs. their peers. This will help put together a quick overview.
  2. Company Performance For Investors - What is the ROE for each firm and who is generating the best and continually improving return on equity for equity holders.
  3. Cash Flow And Profitability – A good free cash flow can be the key for future shareholder returns. A decent cash flow usually stems from a decent profit margin.
  4. Debt And Balance Sheet Strength – does the company have and debt? Can it repay/service interest on current debts?
  5. Do The Company’s Products Rely On A Commodity? – Companies that have products based on commodities do not have pricing power, therefore margins can become unpredictable.
  6. Is The Stock Selling At A 25% Discount To Its Real Value – The deal clincher for Buffett, even if all of the other points are positive, if the stock is not a buy.

1. Value

 

American Express

Visa

MasterCard

Group Average

Forward P/E ratio

12.4

18.2

19.5

16.7

Price to Sales (TTM)

1.9

11.8

8.6

7.4

Price to Book (MRQ)

3.3

3.7

9

5.3

Price to Free Cash Flow (TTM)

5

30.6

24.5

20

American Express is obviously the slowest grower of the group with the lowest forward earnings multiple. This low multiple for AXP however, brings down the group average making the other two look expensive. On a price to sales basis American Express exhibits the same trend with the lowest ratio in the group and the group average significantly above the multiple placed on AXP. The price to book ratio is low again for American express whilst it is high for MasterCard. Free cash flow is a fundament that Buffett finds the most important, with AXP trading at the lowest multiple to its free cash flow I believe Buffett would still American Express as the most undervalued stock in the group.

2. Company Performance for Investors.

 

Return on Equity, is a measurement of how quickly a firm has improved shareholder funds over the period and is a decent measurement of how shareholders can expect the company to perform in the future increasing the shareholder capital base.

Over the past five years, the best and most consistent shareholder return has been from American Express. Both Visa and MasterCard have been able to increase shareholder return on average; however, there has been significantly more volatility in the ROE over time. This could be an indication that American Express will continue to sustain a constant level of just under 30% return on shareholder equity over the next few years. This presents a much better prospective investment than the erratic Visa and MasterCard.

3. Cash Flow and Profitability

 

Operating Margin

Profit Margin

MasterCard

42%

30.5%

Visa

21%

20%

American Express

28.5%

15.1%

 

In this section American Express does start to fall down. Visa and MasterCard both produce significantly larger margins than American Express. There are two main reasons for this;

1. AXP has significant financial liability and exposure to consumer loans, forcing the company to have a provision for bad loans:

In Q3 2012 AXP made a provision for financial losses of just under $500 million, or 7% of total Q3 revenue. However, if we look back to Q1 2009, AXP provisioned for losses of about $1,500 million, or 31% of total Q1 2009 revenue.

2. AXP has a significantly smaller exposure to highly lucrative card transaction network.

 

 

Q3 Total Cards

(Millions)

Q3 Total Transactions

(Millions)

Q3 Gross Dollar volume (Billions)

Worldwide

US

Visa

2032

20,532

$487

$521

MasterCard

1859

8679

$628

$290

American Express

101.4

-

$146.9

$73.2

 

The winner of this round has to be MasterCard, with Visa coming in second.

4. Debt and Balance Sheet Strength

 

American Express

MasterCard

Visa

Total Assets

152.9B

9B

40B

Cash & Short Term Investments

26.4B

6.5B

7.25B

Inventories

0B

0B

0B

Total Liabilities

133.4B

5.2B

12.4B

Long-Term Debt

56.3B

0B

0B

ST Debt & Current Portion LT Debt

4B

0B

0B

Current Ratio

-

2

1.5

Quick Ratio

-

2

1.5

Risk-Based Capital Tier 1

12.7%

-

-

 

Reviewing the companies under this critera does prove to be a struggle, while MasterCard and Visa have a solid balance sheets and no debt, American Express does have debt and, due to its lending division it only has a capital ratio of 12.7%. This makes American Express significantly less appealing than its competitors, who currently have no debt and large cash balances.

This round once again goes to MasterCard, with fewer liabilities and a higher portion of Cash and short term investments compared to its total asset pool.

5. Do the company’s products rely on a commodity?

In this case none of the companies products rely on commodity.

6. Is The Stock Selling At A 25% Discount To Its Real Value?

This is the deal maker. Unfortunately there is no definitive method to calculate Buffett’s perception of a discount to real value. If there was then his style would be very easy to replicate.

 

There is one way of working out a guess however that is through the Graham Number.

Company

P/B

P/E

EPS

Book Value Per Share

Graham Value

Current Discount/Premium To Graham Value

AXP

3.3

12.1

$4.73

$17.4

$57

-5%

V

3.7

18.2

$8.36

$41

$87

-71%

MA

9

19.5

$25.5

$55.7

$176

-175%

 

Currently none of the candidates offer a significant ‘value’ opportunity. In fact both Visa and MasterCard present a significant prospective downside in the view of the Graham value.

Conclusion

Currently, none of the candidates present a value buying opportunity, however, American Express still seems to be the most undervalued stock of the group. Currently the stock provides a decent discount to its two peers, a constant, predictable return on shareholder equity and has a current price that is closest to becoming undervalued compared to its Graham value. On the other hand American Express does generate the lowest free cash flow and operating margin in the group as well as having the worst looking balance sheet.

Despite these negative factors, I believe American Express still presents a decent investment opportunity over both MasterCard and Visa, this is based on its historic shareholder equity returns and possibility of maintain these returns over future years providing a more sustainable return for shareholders.

 

 


RupertHargreav has no position in any stocks mentioned. The Motley Fool recommends American Express Company and Visa. 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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