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Memo to Warren: AmEx Preferred at 15%, Warrants at $12

by: Rakesh Saxena November 16, 2008 | about stocks: AMX / BRK.A / BRK.B / C / GE / GS

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Barron's is suggesting that Warren Buffett might come to the rescue of American Express (AXP). Since Berkshire Hathaway (BRK.A) already owns 13% of the troubled credit card issuer, a rescue might make sense. If, that is, Mr. Buffett can price his entry in line with the new reality governing yields and valuations.

On Monday, Fed officials announced that an application to transform American Express into a bank holding company had been approved. Two days later, the company confirmed that it was seeking $3.8 billion in government aid. But that is only part of the story. Besides needing $4 billion from the commercial paper market, American Express must raise nearly $7 billion in longer-dated debt within six months, and another $15 billion within the next year. Quite clearly, Chief Executive Ken Chenault’s strategic decision to rapidly expand the domestic credit card portfolio from $38 billion, in 2004, to $70 billion failed to incorporate the prospects of a serious economic downturn.

American Express shares are down 60%-plus so far this year. So the challenge facing Warren Buffett, or any other investor with deep pockets, is to determine whether (a) the inevitable increase in credit card delinquency rates, domestically and globally, has been factored in at current price levels and (b) the 10% yield on Goldman Sachs (GS) and General Electric (GE) preferred stock investments adequately reflects the reality in this instance, on a company-specific and comparative basis, of today’s fluid bond pricing environment.

If American Express and Berkshire Hathaway longer-dated CDS spread trends are any guide, Mr. Buffett should provide around 850 basis points for default risk alone. Then, given the nature of the yield curve, a more prudent fixed rate benchmark is about 5%. After adding execution costs, a rationally priced preferred should yield 15%.

Of course, as Barron's pointed out, the 5% preferred-with-warrants proposition from the Treasury appears, at first glance, to be a decidedly better alternative for American Express, particularly when the credit card company could also access the FDIC guarantee programme for near-term and medium-term debt issues. But the finer print of the FDIC’s Interim Rule has received serious objections relating to fees, maturity restrictions, guarantee quality and even capital adequacy guidelines. When, if and at what cost the FDIC programme begins is still an open question. In the interim, there is certainly room for Berkshire Hathaway to increase its stake in American Express.

Which brings us to the task of establishing a strike price for the warrants. When Moody’s cut its rating on American Express last month, from “A2” from “A1”, it placed the company on negative watch. And for good reason. Moody’s statement warned that since American Express derived much of its income from fees, as opposed to interest from revolving credit balances though “its lending exposures have increased significantly over time.” Note the important shift in key value drivers.

The statement went to on to point out that “with this shift, eroding economic conditions across the US will likely pose a higher burden on Amex’s asset quality and profitability. In its latest disclosure documents, Citigroup (C) conceded that it is virtually impossible, at this point in time, to assess how the fate of the global economy will influence the quantum of credit card default provisions required during 2009. Note the uncertainty.

This writer’s bearishness on American Express shares (Friday close: $19.90) is firmly rooted in the belief that unless Washington can resolve the crisis in jobs (including job quality) and housing on a high-priority basis, consumer delinquencies must rise exponentially in forthcoming weeks and months. Believe the optimists, who invariably talk of 5-year and 10-year time horizons, if you must. For the record, if this is any comfort to AXP bulls, Barron's is of the view that the market is presently over-reacting, and that American Express has ample liquidity to ride out whatever tough economic conditions lie ahead.

Disclosure: Author holds short positions in AXP, C, GE, GS

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This article has 24 comments:

Nov 16 06:56 AM
Gee, it's good to know we have super computers to make enough zeros to calculate the millions, billion, trillions we are giving away. I hardly can wait until the next spend and don't tax President that also thinks money is free.

Well after AIG I'm sure Amex and everyone else will we asking for a handout. The game seems to be hold the US as an economic hostage. If I go bankrupt let me explain why I will make the US suffer. The auto industry is sick. They had over 20 years to catch up to the Japanese who get paid more and have higher labor costs and environmental requirements. What did they do? Nothing? Why should the US bail out the execs? If they go into bankruptcy they will be reoganized without the execs. So the real issue is keeping the execs entitled.

Anyway, that's for letting us know Amex's card game of hiding losses until they get on the government's short list of zombie companies. They must have learned it from AIG.
Reply | Link to Comment
Nov 16 08:02 AM
Here's my memo to Warren:

Hey Mr. Bigshot,
If you had just not been such a wise guy 1 year ago and had just invested in Ambac and MBIA without some absurd limits, maybe just maybe, this entire financial mess could have been prevented.
Think about it!
Reply | Link to Comment
Nov 16 08:42 AM
American Express has a terrific brand that will be a huge asset when the recession ends. Thus they will be one of the better performers in the financial sector when the market recovers. As for timing an entry, no one knows where the bottom is. I prefer to buy weakness and buy small over a period of many weeks thus hopefully achieving an average price close to the lows. This has worked well for me in other down cycles.
Reply | Link to Comment
Nov 16 02:26 PM
Interesting...
Reply | Link to Comment
Nov 16 04:02 PM
Apppro - why should Buffet bail you out? He has a fiduciary obligation on behalf of his shareholders in Berkshire not to make the same stupid mistakes as the rest of corporate america.

While I am not a shareholder in BRK, I wonder why everyone thinks he will come to the rescue of everyone. He's the ultimate capitalist, and as GE and GS know, he drives a hard bargain.

I am also humble enough to know that I shouldn't be writing him any memos nor making any recommendations. I can only watch, marvel at his patience, and try to learn a thing or two so that I can improve my own performance down the road.
Reply | Link to Comment
Nov 16 05:12 PM
Utterly vacuous.

On Nov 16 08:02 AM apppro wrote:

> Here's my memo to Warren:
>
> Hey Mr. Bigshot,
> If you had just not been such a wise guy 1 year ago and had just
> invested in Ambac and MBIA without some absurd limits, maybe just
> maybe, this entire financial mess could have been prevented.
> Think about it!
Reply | Link to Comment
Nov 16 05:57 PM
Maybe so, but if he's going to use his pulpit through political leaders he financed into office, then he should have been more willing to be a promoter of the greater good and not it's destroyer.
I hope his practice of having surrogates put companies into financial trouble so he can pick up the pieces, is not utilized by the innocents he just help get elected.

On Nov 16 04:02 PM Canuckify wrote:

> Apppro - why should Buffet bail you out? He has a fiduciary obligation
> on behalf of his shareholders in Berkshire not to make the same stupid
> mistakes as the rest of corporate america.
>
> While I am not a shareholder in BRK, I wonder why everyone thinks
> he will come to the rescue of everyone. He's the ultimate capitalist,
> and as GE and GS know, he drives a hard bargain.
>
> I am also humble enough to know that I shouldn't be writing him any
> memos nor making any recommendations. I can only watch, marvel at
> his patience, and try to learn a thing or two so that I can improve
> my own performance down the road.
Reply | Link to Comment
Nov 16 09:04 PM
As a long time reader of Barron's I have found most of their writings on investments a less than top notch. As permabulls they see very little or no evil. Only Alan Ableson seems willing to call a spade a spade, but his voice is smothered by the other writers. If I ran Barron's most of their analysts would be out looking for jobs.
Reply | Link to Comment
Nov 16 10:49 PM
At the risk of stating the obvious, the common stock of a credit card company has proven an excellent way to lose money during this accelerating recession. The fact that Amex has converted the company into a bank so that they can receive Federal emergency funds makes me wonder.

Oracle Warren is big into brand names with sustainable competitive advantages with good management. Does a credit card company have a sustainable competitive advantage during a credit bust?
Reply | Link to Comment
Nov 17 01:05 AM
I have believe Buffett buys mostly stocks that pay dividends but he sure doesn't pay any.
Reply | Link to Comment
Nov 17 02:22 AM
He's only human.
Just a bit older now.
Reply | Link to Comment
Nov 17 07:27 AM
I think the long term perspective is that Amex has done some stupid things in the past (purchasing EF Hutton) and overcome them. Warren tends to see things in the industry from when he purchased Salomon Brothers. Both BRK and AMX got out of that situation when the opportunity presented itself and survived. AMX is like a financial cockroach and that's the kind of company that appeals to him. Its a long term play designed to shake out the weak hands and from the comments above, weak hands have been shaken out.
Reply | Link to Comment
Nov 17 08:55 AM
Of course if meantime AXP buys a nice $20B domesic bank with a nice set of stable Liabilities...... One or two may naturally become available...
Reply | Link to Comment
Nov 17 12:40 PM
I believe I should expand on my comments and also ask the question:
What event would make the writer close out their short position in AXP? This considering that AXP will be profitable in 2008 and is expected to be profitable in 2009, even if delinquencies reach a high of near 9%... Bearing in mid the stock is down near 70% from its high. i.e. how much more play is there, realistically, on the downside? Needless to say the the short play has been terrifically profitable to-date. But can it continue far?

I don't mean to describe the AXP managers as in ANY way "faultless". They are "marketing" orientated and "do" that well and run a reasonable tight expense base (much more in line after their new 10% culling this Quarter). What they have NEVER been is good Liability managers and for decades they refused to accept that there was anything better than funding largely via the cheap and prior readilly available commercial paper(CP) market. Now that "mistake" has been realised () and they have become a BHC all of a sudden (should have heppend decaes ago), This gives them an immediate alternative to very expensive CP markets i.e. Fed windows.....
As a newly annointed BHC and recipient of $3.5B in TARP they are in what appears to be OK financial health (well compared with all those other financial service BHCs which have been making depressingly consistent Quarterly losses and writing down assets by the many 10s of billions). We will likely see some more domestic bank failures, closed by the FDIC and poor asserts removed. What better BHC to sweep in and takeover such failed BHC deposit base? And what better use of such money to fund still profitable AXP card receivable business with relatively inexpensive, stable funding. The Fed and the FDIC would surely be happy as it would remove AXP as a future heavy user of "window liquidity" and create a combined MUCH stronger business. Paradoxically by a poor (AXP) management decision, not to become a BHC much sooner (read decades ago) AXP might well "luck out" by sometime soon helping the Fed Gvt takeover such a BHC cheaply. Of course current shareholders probably don't think themselves lucky and one has to ask why management and directors only belatedly saw the light (BHC light). Hint get better stronger independent thinkers as directors. But that's an industry wide problem! It was also a reulatory failure in alllowing non bank companies to flourish, largely outside of Fed supervision for decades, yet morp into bank like lending.

A Liability based bank takeover would be long term good for AXP's business and surely erode much more downside risk to the AXP stock and raise investor and analysts confidence in the future prospects?

I wonder why, therefore, the writer and shorter of AXP stock continues to like take the shorting risk in AXP? They have done tremendously well thus far. When is time for a rethink?

I would also like to see a new generation of AXP management hired, from the outside, to counterbalance their existing marketing heavyweights at the Executive Management levels. Preferably person(s) with Liability management background and excellent dynamic risk management skills. This could place AXP back as a TOP financial services(BHC kind) leader for years to come. A much quicker potential fix, IMHO, than at many other financial services companies.

Disclosure : Long AXP
Reply | Link to Comment
Nov 17 02:33 PM
So the Amex wide moat has a huge leak?
Reply | Link to Comment
Nov 17 06:56 PM
Warren is buying. He added to Conoco and Eaton last quarter. Conoco is his 4th largest holding now.

warrenbuffettstocks.bl.../

Reply | Link to Comment
Nov 17 07:15 PM
First of all, Does anybody know why Seeking Alpha now requires two Google Corporation scripts to be run in your browser in order to post on Seeking Alpha?

Both of the scripts being run by the Google Corporation on Seeking Alpha have been flags as unsafe by my computer security software.

There is another script that is also being run by Seeking Alpha from nuconomy.com that is flagged by security protection software as a privacy concern. Now I have to use a computer at an Internet cafe to post on their computers. Crazy!

Is Seeking Alpha now violating privacy of posters, or reporting back to Paulson, Pelosi and Frank who is posting what against them? LOL!

Anyhow...

MESSAGE TO WARREN:

No cuts in the soup line!

Don't lie on your Food Stamp application!
Reply | Link to Comment
Nov 18 01:35 AM
On Nov 16 10:49 PM Dr. O.. wrote:
...
> Does a credit card company have
> a sustainable competitive advantage during a credit bust?

Yes. Not necessarily enough of an advantage to "survive". But, theoretically, they are issuing to lower-risk card holders. They should outlast Discover.
Reply | Link to Comment
Nov 18 12:07 PM
You are the type of person that has me investing in building a very tall, secure fence around my property along with ammunition for me and my two sons. The ignorant mob will want it's vengeance and is too stupid to know whom to eradicate.

A value proposition for AMEX to the market could be lending to small businesses and innovators as loans guaranteed by the U.S. government, not much different then the SBA but with a very talented captain guiding the ship.

On Nov 16 05:12 PM James Cullen wrote:

> Utterly vacuous.
Reply | Link to Comment
Nov 18 12:12 PM
I can't speak for SA but I am in the digital media space. Many companies use Google tracking for redundancy. For SA: Check out the product Open X. It is a tad sophisticated to learn because it does everything soup to nuts when most sites only need simplicity, but the product is wonderful and stable. Of course, being freeware is also nice.

On Nov 17 07:15 PM curbs-in wrote:

> First of all, Does anybody know why Seeking Alpha now requires two
> Google Corporation scripts to be run in your browser in order to
> post on Seeking Alpha?
>
> Both of the scripts being run by the Google Corporation on Seeking
> Alpha have been flags as unsafe by my computer security software.
>
>
> There is another script that is also being run by Seeking Alpha from
> nuconomy.com that is flagged by security protection software as a
> privacy concern. Now I have to use a computer at an Internet cafe
> to post on their computers. Crazy!
>
> Is Seeking Alpha now violating privacy of posters, or reporting back
> to Paulson, Pelosi and Frank who is posting what against them? LOL!
>
>
> Anyhow...
>
>
> MESSAGE TO WARREN:
>
> No cuts in the soup line!
>
> Don't lie on your Food Stamp application!
Reply | Link to Comment
Nov 18 12:14 PM
That comment was directed to APPRO.

On Nov 18 12:07 PM iThinkBig wrote:

> You are the type of person that has me investing in building a very
> tall, secure fence around my property along with ammunition for me
> and my two sons. The ignorant mob will want it's vengeance and is
> too stupid to know whom to eradicate.
>
> A value proposition for AMEX to the market could be lending to small
> businesses and innovators as loans guaranteed by the U.S. government,
> not much different then the SBA but with a very talented captain
> guiding the ship.
Reply | Link to Comment
Nov 18 01:46 PM
AMEX will be offering CDs now and selling commercial paper to the Fed.
That big sucking sound you hear is from depositors buying CDs from AMEX, GE, C, etc instead of main street banks, or buying money market funds. As others have pointed out, the victims will be small banks first as the FDIC and the Fed support the larger banks and keep a lid on the CP rates for the both banks and non banks. Banks deposited another 90 billion in the Fed last week keeping the conduit full. What will be interesting is when if ever the banks pull their deposits from the Fed.
Reply | Link to Comment
Nov 18 03:06 PM
Note to editor:

AMX is the stock symbol for American Movil, a Latin American telecom. The typo is under the heading.

DOH!
Reply | Link to Comment
Nov 18 08:35 PM
A few weeks back I wrote an email to some friends after I realized that Buffett may be sitting on a house of cards with B/H. I would love feedback on what I wrote-mainly is Buffett "all in" i.e. with his own money with his own funds? Or when we talk about Buffett are we talking about 1 Buffett who has in own wealth and investments or another Buffett whose wealth is tied up in BH. If it is the latter he and is shareholders could end up holding a house of cards---

"I always assumed that Berkkshire Hathaway stock has gone up exponentially over the years which is not the case. Look here from 1998 to today- from 8000 to 11,000 in change. I do not believe any dividends have been paid although I may be wrong. It is like having bought an $8 stock in 1998 and her 10 years later it is $11?? Where is the genius in that? That has to be less than a money market fund.

finance.yahoo.com/echa...;range=my;indicator=vo...

On top of that the balance sheet of B/H is strange. It is loaded with debt and when the baloney "goodwill" is taken out the net tangible assets are $85 billion while the market cap is $175 Billion. Investors are paying over 100% premium for this rather poorly run mutual fund?? That is quite a load fee.

finance.yahoo.com/q/bs...

I know he is one of the richest men in the world but he didn't get there from holding this dog. In fact I would say that any net worth he reports that is from his holdings in Berkshire "A" are 100% inflated due to the debt. Show me the beef Buffet. What happens if this company can't refinance it's debt in the future? RDG

ps- Yes I know that the fund did incredibly from 82-98 but there is an old saying "never confuse brains with a bull market"

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