Why Did Buffett Buy American Express?

Warren Buffett’s Berkshire Hathaway has become one of the world’s most valuable companies by investing in successful businesses.

 

Out of Berkshire’s large portfolio, though, a handful of stocks stand out as being even better than the rest. One such stock is American Express (NYSE:AXP). It has stood the test of time. While companies like IBM made the cut for a period of time in Berkshire’s portfolio, they didn’t last. American Express is one of the exceptions, it’s a Buffett favorite.So, why did Buffett buy American Express?

In Q2, American Express’s revenue increased 34 percent year-over-year to $13.4 billion. In large part, this was driven by increased consumer spending across the company’s payment network.

 

Despite this strong revenue growth, earnings per share did drop 8 percent from $2.80 to $2.57. Given the challenges of the past year, however, this modest interruption in earnings growth is far from a crisis for the company.

One important factor for American Express’s future is its success with younger consumers.

 

According to the most recent quarterly report, Millennial and Generation Z cardholders increased their spending by 48 percent year-over-year. This suggests that these younger consumers are making extensive use of their American Express cards and will likely continue to use the company’s payment services going forward.

 

In addition to taking advantage of rising customer spending, American Express also added a large number of new customers to its network. The company issued 3.2 million new cards last quarter.

 

Giving the rising spending among existing cardholders, it’s likely that these new customers will also add considerably to the company’s revenues.

 

As the most famous value investor in history, Warren Buffett’s strategy has involved identifying companies that trade at steep discounts to their intrinsic values.

 

At the moment, American Express appears to be priced attractively. The stock trades at 15.06 times forward earnings and 2.31 times sales. When we ran the numbers, American Express had 34.1% upside to fair value of $191.86 using a discounted cash flow forecast analysis.

 

Buffett’s cost basis, however, is only about $8.50 per share. Given that the stock currently trades at over $140, it’s safe to say that Buffett has gotten his money’s worth from American Express.

 

American Express also has a strong history of generating free cash flow, another well-known point in a company’s favor for Buffett. In 2021, the company produced over $13 billion in FCF.

 

Even in 2020, when the effects of the COVID-19 pandemic were at their peak, American Express generated $4.1 billion in free cash flow. As such, the company appears to be extremely resilient and capable of generating free cash under nearly any market condition.

 

American Express’s dividend yield is also worth taking into consideration. As with most of Buffett’s best stocks, American Express pays a reasonably high dividend that pads out its overall returns. The stock currently yields 1.36 percent, paying out $2.08 per share annually.

 

Far more impressive than American Express’s dividend yield, though, is its rate of dividend growth. Over the last 10 years, management has increased the payout at an average annual rate of 9.6 percent.

 

Even during the last three years, which include the years of pandemic-related disruption to the credit industry, this rate averaged 6.85 percent. With the company’s payout ratio standing at just 21.33 percent, there should be ample room for the distribution to keep growing.

 

Today, American Express is an attractively valued company that’s performing well and appears to be succeeding with a new generation of American consumers.

 

As such, it should come as no surprise that analysts are generally bullish about the stock’s future. On the 12-month time horizon, the median analyst price target is $175. This would reflect a return of 22.4 percent from the current price of $143.03.

 

Over the next five years, American Express is expected to grow at an annual rate of about 14 percent. Assuming the stock keeps pace with this growth and the company doesn’t encounter any obstacles that would seriously inhibit growth beyond the 5-year horizon, it’s likely that American Express could be a strong performer for several years to come. This is especially true if future returns build on the 20 or more percent expected this year.

 

In its 2021 annual report, American Express’s management identified geopolitical and macroeconomic conditions as among the company’s top risk factors.

 

During the COVID-19 pandemic, payment processors and credit providers saw huge disruptions to their businesses. The market, however, is now beginning to normalize and is unlikely to face such large and sudden risks in the immediate future.

 

Increasing competition in the payment services industry could also put pressure on American Express. Visa and MasterCard are among the legacy payment companies that are competing with American Express for global market share.

Fintech companies, such as PayPal, could also begin taking market share away from these established providers.

 

Another risk that American Express shares with other credit card companies is that of rising default rates as consumers take on more and more debt. Earlier this month, American credit card debt reached a record high of $930 billion.

 

Rising inflation has forced consumers to increase their balances and, in many cases, put day-to-day necessities on credit cards. While higher balances are a net positive for credit card companies while defaults remain low, they could be a major risk if more consumers default on their loans.

 

While today’s investors certainly can’t get anywhere near Warren Buffett’s cost basis on American Express, there’s still a strong argument for buying the stock at current prices.

 

Given the growth that is expected from the company over the next five years and the recent rate of dividend growth, American Express looks far from overpriced. The company’s risks are moderate and are largely shared with the rest of its industry.

 

As of now, American Express does not see any weaknesses in consumer spending on the horizon. If those weaknesses develop, however, the company has more than proven that it can ride out business cycle disruptions.

 

In the event of an economic downturn, American Express’s stable dividend will likely also be helpful for bolstering investors’ overall returns.

 

American Express may not be Warren Buffett’s best stock, but it typifies the kind of investments that have made the Oracle of Omaha one of the world’s wealthiest men.

 

The company has an existing moat in the form of its large cardholder network, produces generous cash flows and has a consistent path toward future growth. Add these factors to a reasonable valuation, and American Express becomes both a classic Buffett stock and a seemingly appealing buy.

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