American Express Earnings Preview: Upside Surprise in 4Q?

American Express Company (NYSE: AXP), the biggest credit-card issuer by purchases, is expected to beat Wall Street's consensus profit estimates, with earnings gains driven by stronger consumer spending and a diversified business model. This is sharp change from prior quarters when the company grew profits by dipping deeper into the company's reserve funds that were set aside to cushion against future losses.

Analysts surveyed by Thomson Reuters expect fourth-quarter results, which the New York-based company plans to announce Thursday after the market closes, to show a revenue of $7.92 billion, or 98 cents a share. In the same period a year earlier, profit was 88 cents a share on $7.32 billion in revenue.

Keefe, Bruyette and Woods analyst Sanjay Sakhrani told the International Business Times that American Express "haven't really put out specific guidance for the fourth quarter, but it's quite plausible that they can do better than the street consensus."

He assigned the stock an "Outperform" rating with at target price of $66.

Those analysts who expect American Express to beat the consensus estimates point to the relatively wealthy status of the company's cardholders.

"Their client base is a segment of the population that has been very resilient throughout the recession," David Darst, analyst at Guggenheim Partners LLC, told the International Business Times. "American Express has had a more robust recovery in spending than its peers."

According to Sakhrani, the average annual spending per card in 2010 for American Express was about $9,700, which is way above its rivals. Customers of JPMorgan & Chase Co. (JPM) spent $3,700 per card in 2010, Bank of America Corp. (BAC) customers spent $4,000 per card and Citigroup Inc. (C) customers spent on average $2,000 per card. Historically, American Express customers spent four times the average that Visa Inc. (V) and MasterCard Inc. (MA) customers did.

Another sign that indicates American Express has a wealthier cardholder base is the improvement in charge-off rate. Card companies typically write off loans after they are six months past due. American Express hit its peak charge-off rate in April 2009 at 10.4 percent, but recovered faster than any of its rivals. In December, American Express' default rate dropped to 2.3 percent, while Discover's default rate rose to 3.15 percent - though it has improved from its peak of 10.5 percent reached in the first quarter of 2010.

The biggest chunk of the firm's revenue comes from fees charged to retailers each time the card is used by a customer. That's a contrast to Visa and MasterCard, who are more dependent on interest paid on cardholder balances.

Spending-Focused

Unlike most credit-card lenders who make the bulk of their money by charging interest on revolving loan balances, American Express receives as high as 85 percent of its revenue from fee income, while Discover Financial Services (DFS) only makes 31 percent of its revenue from this channel.

American Express operates a closed loop network, meaning that the company acquires both cardholders and merchants into its network. In terms of revenue, the company collects a portion of every transaction charged to its cards from merchants, while also charging cardholders fees on items such as annual membership fees, foreign exchange conversion fees, etc.

This closed loop merchant network gives American Express a competitive edge over its rivals, making it possible for the company to make four to eight times as much on each transaction compared to either Visa or MasterCard, according to corporate filings.

"Those fees come from a variety of sources that spread across many different demographic profiles," Sakhrani said.

Interest earned on balances is particularly important for American Express' rivals. However, such income is inherently, on a risk adjusted basis, lower return compared to fee income, Sakhrani said.

"So having more exposure to fee income allows American Express to have a stronger economic return model relative to its peers," Sakhrani added, explaining why American Express hasn't been impacted as much by the low interest rate environment and consumers' declining appetite for debt, as its competitors have.

The Commerce Department reported continuous growth in consumer spending during the period of American Express' upcoming earnings release. At the same time, Moody's said average combined balances at the six largest card issuers fell by more than 5 percent to $488 billion in 2011. The last time balances rose year over year was in 2008.

Those six issuers are American Express, Discover, Bank of America, JPMorgan, Citigroup and Capital One Financial Corp. (COF)

Reserve Release

At the end of 2010, American Express had $4.03 billion loss provision outstanding. However, by the end of the third quarter of 2011, this figure dropped to $2.53 billion, which gave the company's top line a $1.5 billion boost that wasn't earned through fundamental business lines. American express has been releasing its reserve funds since 2008.

"I expect them to release $35 million in loan reserves in the fourth quarter. They released $421 million in the third quarter," Sakhrani said.

According to Sakhrani, companies like American Express usually keep about 12 months of losses on their balance sheets. And where American Express is right now is about 17 months.

With the rate its customers were late with payments or defaulted on their cards declining in the last quarter of 2011, American Express still has a long runway to bring down its loan reserve levels.

However, the company is not expected to "bleed" too much in the fourth quarter.

The affluent consumer has spent quite a bit of money and they came back much sooner than the rest of the U.S. population. So at some point, they won't be able to keep up growing their spending at that same level. The recent announcement from Tiffany & Co. could serve as an indicator. The jewelry retailer cut its full-year earnings forecast earlier this month on weak holiday sales.

Therefore, it will be tougher to produce the same type of revenue growth in 2012 that American Express has produced last year because the comparison on volume just gets tougher.

"To the extent that they can't produce the same type of revenue growth that they did in 2011, American Express probably need some of the benefits of reserve release more in 2012 than they do in 2011," Sakhrani said.

Expense Level

When the results come out after market closes, investors should keep an eye on whether American Express' revenue trends will remain sustainable in the low double-digit range and whether expense growth will be slow enough to provide future earnings catalyst for 2012.

In the fourth quarter, American Express is going to get its last installment of the Visa settlement, which is expected to keep the company's expenses level relatively elevated for another quarter. American Express has been taking that cash flow and investing it in their business to support future growth.

When the payment ends, revenues are going to decline as a result of that and analysts want to look for an offsetting decline in expenses.

"The bear case is they can't cut expenses and they need to be spending as much as they are to drive the kind of growth on the top line that they've been producing," Sakhrani said.

Visa agreed to pay a total of $2.1 billion to American Express to settle damages relating to a 2004 antitrust lawsuit in 2007, after the Supreme Court ruled that Visa and MasterCard had violated antitrust rules by barring their member banks from offering their customers credit cards that could be used on rival payment networks. The last payment from MasterCard came through in the second quarter of 2011.

On a pre-tax basis, American Express will get about $70 million from Visa in the fourth quarter.

Digital Space

American Express has been expanding its digital payment platform through strategic alliances, which will not only expand the company's card membership base but also help it penetrate the unexplored market and tap the upcoming opportunities in the field of ecommerce.

The company has announced a partnership with foursquare, which allows customers to link their foursquare profiles to their card to load and redeem merchant specials without coupons, codes, or the need to present a mobile phone. Additionally, it announced a partnership with Facebook that allows cardholders to redeem membership rewards for Facebook ads. American Express has also partnered with Zynga, allowing its customers to exchange their 'membership rewards' points for virtual goods or 'game cards' that can be redeemed for Zynga's in-game currency.

The closed loop network is American Express' primary competitive advantage. This business model places the American Express closer to data that others are trying to get but don't have.

"This specific benefit within their model that differentiates them from others should allow American Express to capture some incremental revenues in the form of marketing dollars," Sakhrani said.

A lot of spending that American Express is incurring today has been "positioning the company very favorably when the growth in that area becomes meaningful," Sakhrani noted.

"It's probably going to take some time to play out."

Shares rose 18 cents to $50.74 in midday trading. Year to date, the stock has gained seven percent.