YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

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After American Express shares began to tumble we made a small stake and have added little by little as it’s shares have declined, and we’ve been eyeing it much more lately – especially at $11/share. AmEx is much more transparent than some of the larger banks such as Citigroup, Bank of America, and JPM. It’s a much more straightforward financial company – their financial assets are much easier to analyze.

It’s also very different than the other credit card companies in three major ways. First off, it’s a closed loop credit card network, meaning AmEx processes the credit card transactions and also maintains the relationship with its customers, so profits aren’t shared with any bank – which has been a much more profitable business model.

Second, cardholders tend to be among the more affluent. Although, this business model started to slip over the past few years, and management admitted to this yesterday and explained they plan to return to their traditional strategy of issuing cards to those who pay off their balances. Fortunately, they did not stray even further from their strategy into subprime customers and the mortgage industry. In fact, AmEx was actually still profitable in the 4th quarter while the banking industry recorded billions of dollars of losses.

Third, a very significant difference is that AmEx makes the majority of their profits via merchant fees, rather than making money on high interest payments through revolving consumer lending. And because it’s such a widespread card, and used frequently among the more creditworthy, merchants are willing to swallow a much larger fee so as not to alienate any customers. In fact, more than half of AmEx’s annual revenue comes from these merchant fees which average about 2.5%! (Which helps explain why they were still profitable last quarter). However, since they depend on volume and size of transactions, this means revenue will decline from sluggish consumer spending (spending on their cards dropped 10% last quarter). We would argue, though, that even if consumer spending continues to fall, in this day and age, cash is becoming obsolete and more and more transactions are done via credit cards. In 2003, credit card usage exceeded cash and checks, and we believe credit cards will continue to be the major form of payment over time. In fact, I heard a growing number of people are paying their credit card bills before (or instead of) their mortgages because that’s their main source of cash flow. (Another bill consumers continue to pay is their auto loan because you can’t drive your home to work! We’ll have to discuss our investment in AmeriCredit another day). With such a strong franchise name and a different business model, we believe that if any credit card company is going to make it through this tornado, it will be AmEx.

However, while we have an investment here, we’re not plowing into AmEx shares. We still admit we have some legitimate concerns if defaults were to rise too quickly – after housing, the next shoe to drop is certainly credit cards. From January 2006 to present, defaults have already soared four times from 2% to 8%. For a very leveraged company (due to their closed-loop network), this is no small thing. But we do take solace in one person – Warren Buffet. With a significant portion of Berkshire Hathaway invested in AmEx, we don’t see him allowing AmEx to fail. Instead, he’d probably inject billions of dollars into the company, if needed. In fact, we wouldn’t be surprised if Buffet decides to take the entire company private as he does many of his investments. But we’re also cognizant of the possibility he’d decide to inject capital through preferred stock which would severely dilute shareholders (Much like the Goldman Sachs deal. And even though he’s a current shareholder, he’d likely work a deal to keep the company afloat where he would on the net help the Berkshire shareholders while steamrolling the rest of us).

We don’t see credit cards becoming obsolete anytime soon, and if the same remains true for the company American Express, at $11/share, regardless where this stock trades in the short run, this will turn out to be a fantastic investment in the long-run.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | March 02, 2009 | Permalink

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