American Express Sliding Off the Rails

The American Express AXP looks to be running out of steam.

The financial giant Monday reported second-quarter earnings that exceeded estimates, but the company also sounded an unnerving note of caution on full-year 2002 profits.

New York-based American Express said it might not exceed the Wall Street consensus earnings estimate, which is currently $2.01 per share. In explaining the forecast, the company didn't cite any specific business deterioration. Instead, it said it's planning to take money generated through cost savings and restructuring efforts and reinvest it, rather than letting those benefits boost profits now. The outlook incorporates the impact from the recent stock market meltdown, Amex CFO Gary Crittenden said on a conference call after the close of regular trading Monday.

The market, perhaps reacting to Amex's lackluster guidance and the quarter's results, drove the stock down $2.68, or 8.5%, to $28.97 Monday. The Keefe Bruyette banks index closed 4.3% down for the day.

Expect Amex to slide still further. The main reason: Second-quarter earnings are going to be hard to repeat. The slumping stock market will slam Amex's already damaged wealth management business. The current financial stress is likely to slow the economy, which will reduce card activity, worsen bad loan numbers and possibly lead to more bond losses in Amex's investment portfolio. And, going forward, the company is going to get less earnings benefit from the steep drop in interest rates that has taken place over the last 18 months.

As a result, Detox believes Amex should trade around $20, more than 30% below current levels.

Solid Bounceback

Amex made 51 cents per share in the second quarter, way up from 13 cents in the year-ago period, which was hurt by hefty bond losses. Analysts expected Amex to make 50 cents in 2002's second quarter.

There was nothing terrible about second-quarter numbers. In fact, there was much to be impressed with. Certain credit-quality indicators showed improvements. Loans more than 30 days past due fell to 3.1% of the total loan portfolio from 3.4% in the previous quarter. The Amex salesforce did an admirable job of selling mutual funds, annuities and investment certificates in the quarter, offsetting a huge drop in the institutional business.

But things are a lot nastier now than they were in the second quarter, and the second half could prove tough. Amex likely will have to bolster its bad loan reserve, which will increase costs. At the moment, the company's reserving policy indicates that it believes the credit quality of its borrowers is going to improve slightly over the next few quarters -- a difficult propostion to go along with. The bad loan reserve dropped to 3.5% of total loans in the second quarter, from 3.7% in the first. If the reserve had been kept at 3.7% of loans, it would've made the bad loan provision $34 million larger. That would've caused net earnings to be 2 cents lower than reported.

CFO Crittenden defended the reserve level on the call. When asked if credit losses have peaked, the executive said one of the main factors that drives credit losses is unemployment claims, which he said were moderating. "The data [on unemployment] is mixed enough for us to feel comfortable with the reserve levels," Crittenden said.

And the card business's top line will get hit. As the market drop saps consumer confidence, people are likely to use their credit and charge cards less -- and this could happen at a time when Amex is trying to woo customers with lower-rate offerings. In addition, vacation spending, already depressed, is also likely to suffer still more from any additional pullback by consumers, which will whack Amex's travel-related income.

Outflows

American Express Financial Advisors, the wealth management division, experienced net outflows of $6 billion in the second quarter, and a $20 billion drop in asset value due to market depreciation -- both ugly numbers. The impact of this was softened by an eye-popping increase in sales of investment products to individuals.

Annuity sales totaled $2 billion in the quarter, up from $1.4 billion in the year-ago period. The AEFA division took a $78 million pretax loss on its WorldCom bonds in the second quarter. As the corporate credit bust continues, there could be more such losses, but maybe not as much from a single issuer. In fact, Crittenden said on the call that there would be "some amount of ongoing losses associated with the high yield portfolio," though he didn't give a specific number.

The other disturbing feature in the second quarter was the absence of strong cost control in some areas. What's more, on its earnings conference call, Amex management said it was planning to increase marketing expenses as it pursues growth. Swelling a loan portfolio in the midst of economic stagnation is hardly a confidence inspiring plan.

The remainder of this year will be tough for Amex, and full-year earnings could come in 10 cents to 15 cents below the consensus estimate of $2.01. Over the coming months, it will be no surprise if investors start to erase the premium price-to-earnings multiple that Amex trades at over its peers.

The company currently has a P/E of 14 times based on the 2002 estimate. By contrast, comparable credit card issuers trade at nine times, while asset managers have 2002 P/Es around 14. Amex's business is heavily slanted toward the card business, so a P/E of 11 would bring it into line with competitors.

Applying that multiple to $1.85 of projected earnings gets to a price of $20 -- the next stop for the American Express.