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Morningstar | American Express' Renewal of Delta Is a Positive, but It Comes at a Price

Wide-moat American Express began its 2019 growing net revenue by 6.6% from the previous year to $10.4 billion. Unfortunately, the company’s expenses continue to grow at faster rates leading to negative growth in GAAP earnings. During the quarter, the company earned $1.80 per diluted share, a 2.6% year-over-year decrease. The company highlighted a one-time merchant litigation charge that provided a $0.21 per share hit to earnings. On a non-GAAP basis, American Express earned $2.01 per share, an 8% annual increase. Worldwide billed business grew by 4.2%. Though this is a meaningful deceleration from recent quarters, management was quick to point out that some of this is being caused by currency headwinds and tougher comps. Within the U.S., American Express achieved 7.1% year-over-year growth in billed business while realizing negative growth abroad, demonstrating the impact foreign exchange has had on billed business. Overall, we think this quarter supports our thesis that American Express can continue to grow revenue at mid-single-digit rates, but doing so will be increasingly expensive. In the first quarter, total marketing spend was 44.1% of revenue, a nearly 200-basis-point increase from the previous year. For now, we see no reason to change our fair value estimate of $110 per share and consider the company fairly valued.

As mentioned during the quarter, American Express added back $0.21 per share to GAAP earnings to get its non-GAAP EPS of $2.01 per share due to merchant litigation. We’ll need to dig deeper into the company’s forthcoming 10-Q to conclude whether this charge is non-recurring, but we think it’s worth observing that American Express’ Global Merchant segment saw a 22% year-over-year decrease in compensation and other expenses while taking this charge, lifting the merchant segment’s pretax margins by nearly 700 basis points to 51.4%. Given the noticeably large drop in the segment’s operating expenses, it may suggest some of the firm’s expenses were shifted to its corporate segment and could recur. However, we’ll caution this may just be a coincidence, but it does give us some worry that American Express is facing lower margins.

The renewal of its partnership with Delta contributes to our worries American Express will continue to see margin pressure. It’s important to note that investors should be happy Delta will continue to use American Express as its card partner. Delta and American Express' shared lounge access is a great benefit beloved by cardholders. Without Delta, American Express will have a lot harder time attracting and retaining cardholders. That said, this deal was renewed four years before the existing partnership was due to expire. Now, management expects marketing expenses to increase by $200 million for the remainder of 2019. Throughout our research of private label card issuers, we have become increasingly worried that healthy retailers and airlines will be able to extract better terms from issuers. This is the clearest example we have that credit card issuers have a weakening hand in negotiations and will be forced to share more revenue with private label partners.

Finally, American Express is experiencing higher charge-offs on loans--seeing net write-offs increase 30 basis points sequentially to 2.7%. Given delinquencies are up only modestly, this doesn’t give us too much concern, yet. However, American Express' loan growth is elevated, increasing 11% from a year ago. This will likely provide some pressure to the company’s credit losses but shouldn’t yet be interpreted as a sign of consumer weakness or a turn in the credit cycle. Until we see significant increases in delinquencies and slower loan growth, we’re inclined to consider increasing the firm's charge-offs as benign.