Using ROIC To Value American Express AXP

Welcome everyone to our webinar on how to boost American Express's value by $50 billion. This webinar builds on a series of webinars and reports that we've written on the power and benefit of return on invested capital. I'm David Trainer, CEO of New Constructs, and return on invested capital is our single most important metric at New Constructs. There are many important metrics, but the most important one is return on invested capital. And to see our webinar on return on invested capital, click here on our handout. This handout will be available in any webinar. If you're watching this as a replay, it will be available. We will send it out to all attendees, and it will also be available on our blog. But the takeaway is that return on invested capital is the single best measure of profitability. It is the one version of the truth When it comes to profitability, the concept is very straightforward. What are the cash flows the company generates relative to the capital in the business? Simple concept, simple calculation, very difficult to get the data, very difficult to get the data right for lots of companies. But when it comes to American Express, what we show is that as American Express looks to innovate its business, and this is a different situation than Oracle in some ways, in some ways not. But the takeaway is that for management to act in the best interest of shareholders, they need to focus on return on invested capital. If management does focus on the return on invested capital, they can boost the market value of American Express by $17 to $50 billion. Now, aligning the firm's strategy around around invested capital also means aligning their performance compensation around return on invested capital. I think Valeant is an excellent example of where paying executives on performance benchmarks or metrics that are not aligned with shareholder value creates a misalignment of interest that over time only grows worse. And when you're paying people for things that don't create shareholder value, you're attracting people that don't care about shareholder value. So it should come as no big surprise that that executive team turned out to be a little less than what one might desire in terms of looking out for shareholders and instead looking out for themselves. We live in a capitalist world. If you make it easy for people to make money while you lose money, don't be surprised when that's what they do. And the one way to make sure that management teams aren't going to make money, when investors don't make money, is to focus on return on invested capital. Now, our thesis and our belief in return on invested capital is predicated on the idea that real cash flow matters and superior profitability is ultimately rewarded by the market. There may be times in the market when stocks are valued incorrectly. But I can tell you, and our track record can speak to the fact that while the market's appetite for irrationality might be limitless, investors' appetite for risk is not limitless. If you care about risk, you care about the kind of work we do. And ultimately, the market will come back to you because our market cannot be successful or survive if it allocates capital to businesses that don't make money. It is successful and does survive if it allocates capital to those businesses that do make money. So the crux of a lot of our analysis is this regression analysis where we show ROIC and how much— what its effect on valuation is. Return on invested capital regressed against enterprise value divided by invested capital. What is enterprise value divided by invested capital? It's a fancy, much more sophisticated, cleaner price-to-book. The big takeaway here is 72%. 72% of the changes in valuation for American Express and its peers can be explained by changes in return on invested capital. That's a really high number. It's just about as high for the entire S&P 500. Here it's 56%. For large-cap financials, It's 69%. The purpose of these slides is to show you that we don't do this work just in isolation. We don't do it for just a few companies. We do it for thousands of companies. Currently 3,000. We're gonna be probably at 6,000, 7,000, 10,000 by the end of the year. The point is we're providing our clients a framework and a platform for understanding the true value and true profitability of businesses. We're able to allow you to fulfill fiduciary responsibilities and make more informed decisions with less risk. In other words, we help you transcend the noise. Most sophisticated investors know that sell-side recommendations, that entertainers such as the one we see on the screen here, Mr. Cramer, are not necessarily in the business of informing people The truth. They're in the business of making themselves money. And we've got plenty of webinars as well as articles that point out that sell-side recommendations, sell-side analysis of earnings are not reliable. Where does all this come from? The purpose of the capital markets is to allocate capital to its most efficient use. What does that mean? All right, that means that we believe that markets are efficient when they help investors identify which companies are the best to put capital in, right? And we believe that when markets are efficient, standards of living are better. So when we stand up for our beliefs, that means that we focus entirely on understanding cash flow. We focus on the relationship between Return on invested capital and stock valuation because we think it's intuitive. We think this regression analysis makes sense. The market should reward with valuation those businesses that make the most money relative to the capital put into them. American Express can focus on that, then that's what management drives toward. They can see returns on capital or at least minimize the decline in return on capital that's already baked into the stock price and drive big improvements in valuation. That's what we focus on. Now, to get details on our report on American Express, just go to our website. This is published and available to the public. Gold members get to see the full report. Basically what we say is that we look at, we look at 5 different scenarios. If the current return on invested capital for American Express can be maintained at 20%, the implied stock price is $94 or a 60% gain, which is about $33.6 billion in market cap. If they can keep ROIC at 17%, it's a $17.7 billion gain. 22, 21, and 15 are the other scenarios. Let's talk about those scenarios. So here's the regression analysis we looked at before. So what does that mean? How do you interpret that, right? The stock is worth $94 a share if we assume that American Express can maintain its current ROIC of 20%. That means if it goes from below the line to the line, Right? That enterprise value to invested capital ratio would imply a $94 stock price or $93.50, right? So right now it's trading below the line. It's below the trend line. It's undervalued. Goes up to the line, it's properly valued. The other way to interpret Figure 2 is that American Express is going to move this way or have a lower ROIC. And our model says it will meet the, meet the, it will meet the trend line With a 14% return on invested capital. You can interpret the model here showing us that the market expectation is that American Express's return on invested capital will permanently decline to 14%. The bigger takeaway here is that the strong correlation between return on invested capital and market valuation shows that there is big upside for shareholders if management can convince the market it is focused on boosting ROIC. Now we point out that this switch in focus is not necessarily easy. Same thing we said about Oracle. There's a lot of pressure in the marketplace to listen to the crazies, right? And I mean Jim Cramer mainly, right? To listen to the noise, to focus on growing earnings. And anyone who watched our Oracle webinar on the same topic, we show you quite specifically, quite specifically We show you that Oracle was focused on growing earnings per share, and they did grow earnings per share, but return on invested capital went down. And guess which way the valuation went? The valuation went down. The valuation follows ROIC, not earnings per share. And we see a similar thing with American Express. Here's their enterprise value invested capital. You can see it's fairly well correlated as well. With return on capital, except here recently where the valuation has dipped quite below, below the correlation. And what's that telling you is that we— it seems like the markets no longer believe in the sustainability of American Express's ROIC. So a lot of reasons to be concerned. Loss of the Costco account, JetBlue as well, right? Uh, some of the non-discrimination provisions. In contracts with merchants, right? American Express charges the merchants extra. They don't like that. So if management does follow ROIC, what do they need to do to convince the market that this is— that what they're doing is going to stick? Well, it has to start with leadership, right? The focus on ROIC needs to start and stop with the CEO. If the boss doesn't back the plan, then it's hard to believe that everyone else will. It has to be tied to capital budgeting. Every capital allocation decision needs to pass the NPV test, which measures whether or not return on capital is greater than the cost of capital. You also got to tie it to compensation, right? As I said with Vale, and as I say with a lot of our danger zone stocks, if management's getting paid based on non-GAAP earnings, well, guess what they're going to grow? Non-GAAP earnings. And guess what non-GAAP earnings does not do for you? Growth. Mr. and Mrs. Investor. It does not create shareholder value. Valiant's a perfect example of that, and as are a lot of the danger zone stocks that we pointed out and have since blown up. And then communication is the last part. They got to be able to communicate this. Why do you think we gave— we published this openly? Why do you think we made this an open letter to Larry Ellison? All he could do is take this letter with him to— on his road shows. Ken Chenault, the same thing. Take this report with him on road shows. Put it in front of investors and say, this is what we're doing. We're going to improve our return on invested capital, and that's going to lead to a higher valuation because we're going to be putting more money in your pocket, Mr. and Mrs. Investor. So targeted proposals. These proposals— any proposal on any strategy needs to be thought of in, in, in really through 3 things. Is it going to increase the return on capital of the business? Is it going to extend our growth appreciation period or widen our moat, right? Is it going to allow us to maintain high returns on capital for longer, right? So either you're increasing return on capital, you're maintaining your return on capital at a higher level for longer, or you're going to grow revenue. Now, revenue growth is last. And I got this question earlier, you know, why is revenue growth bad? I'm not saying revenue growth is bad. I'm saying revenue growth is bad if the company's ROIC is not above WACC. What I'm saying is that not all revenue growth is made the same. Not all revenue growth is good. Revenue growth is only good if it results in return on capital that is greater than the cost of capital. All right? So we talk about the specific proposals. We speak about them in general, but then we get to the specifics here. So Scenario 1, American Express is priced for such a significant decline in profitability that it can deliver significant value by declining less than the market expects. So how about we assume a 14% drop in revenue with no change in return on capital— I'm sorry, margins or invested capital. That would give American Express a 17% return on capital and increase its value by $18 billion for an implied share price of $78. Scenario 2: The current $1 billion cost-cutting plan would increase the NOPAT margin to 19%. Capital turnover remains the same at 1.18, or the same level as fiscal year 2015. That would imply a 22% return on capital. That 200 basis point improvement in ROIC would increase American Express's market value by $47 billion and give it an implied value share price of $109 a share. Scenario 3. An innovation strategy. Let's assume American Express invested $5 billion funded by debt in innovation that results in 10% revenue growth and an overall NOPAT margin improvement of 200 basis points. Capital turnover rises to 1.1. NOPAT margins would go to 19%, ROIC to 21%. These improvements drive an implied stock price of $113 a share or a $51 billion increase in market cap. Now, innovation is a general term. And we're not here to really do a real consultant's job of helping companies figure out all the ways they might innovate or how— all the ways they might execute a drop or a decrease in costs. That's not the point. The point is that we give consultants, investors, managers, everybody, everyone, the framework for understanding exactly what the impact of the strategic consulting offering or the strategic decision makes on valuation. Whatever it is they need to do to achieve cost cutting or to achieve the success in investment, as implied by Scenario 3. We leave that to other folks to figure out. We could write a white paper on that by itself. We don't want to do that. Scenario 4, we analyze the impact of innovation efforts that are not guided by ROIC and shareholder value. To isolate the impact of the misguided innovation efforts, we assume that the company can maintain a 20% ROIC in its existing business. So we are giving them credit for saying, you know what, we are not going to see that drop from 20% to 14% ROIC. The current business stays the same. And they invest $10 billion in debt-funded innovation that increases revenue by 5%. The NOPAT margin stays the same, but the capital turns are lowered from 1.18 to 0.91. RYC falls to 50%, though NOPAT rises by $275 million. That $275 million in incremental NOPAT, or profit, divided by the $10 billion investment yields a return on capital of just 3%. This means the— on the margin, American Express's overall return on capital would decline by 450 basis points. And as shown in Figure 4, even though profits grow, shareholder value would be less. And here's the summary again. Sustain current level, scenarios 1, 2, 3, and 4. Notice in scenario 4, you got less value creation than if you just sustain the current level of the business. Because you're making an investment and you're growing revenue, but you're lowering the efficiency of the business. You're lowering the return on capital for American Express by making an investment that focuses on the top line and not the real bottom line. And that's kind of the big takeaway here. More details in the rest of the report. I'm going to take some questions now, and then we'll be done very quickly. First question, can this analysis be performed on any company under coverage at New Constructs? Yes. We're going to continue to roll out more of these. We're working on another large financial services firm as we speak, and that will probably be done next week. Why don't we see return on invested capital more widely used in financial media and company releases? 2 reasons. One, it's difficult to do, right? It takes a lot of work. And we have actually a paper on this. If ROIC is so great, why don't more people use it, right? So take— check that out. It goes through a lot of reasons. But the main reason is that it's difficult to do. And at the end of the day, Wall Street analysts and Wall Street analysts— or all analysts in general, they don't really want there to be one version of the truth because that would greatly simplify what it means to be— what it means to do research. So it's really not in Cramer or or any of the sort of insiders' best interests for all investors to know return on invested capital and be able to focus. Because this framework, I think, is pretty obvious and intuitive, and it really cuts out a lot of the noise that tends to drive the dialogue on Wall Street too often. Are there any companies currently focusing on ROIC as we propose American Express should do? There are a few, and we've written them up. AutoZone is one we've written up as a long idea for a long time, done very well. There are others, and we will be publishing on those in the foreseeable future. Can you think of the delta between 20% and 14% ROIC as a margin of safety? Yeah, you could possibly think about that, right? Because that's what the current stock price already implies. So if they do anything better than that, you can see the stock go up. Unfortunately, you really want— you still want management— you know, the margin of safety is not that great because if ROIC is headed down, It may be difficult to rise it— to get it back up because I think the issue with American Express is they are in many ways in a business that is increasingly commoditized. They're going to have to do something. They're going to have to do something to maintain profitability. Do we see— do we foresee a large adoption of ROIC or will it remain a lesser-used metric by most investors? That's a great question. You know, we don't know. We have sort of in many ways unlocked the accessibility of ROIC because of our work in making it more readily available to people and making it available with scale. You know, the fact that we can do this analysis on the S&P 500, if you've seen my other webinars, I can do it on the fly on my website pretty quickly. Yeah. So it really depends. You know, I think that we're in a world where investors care more about the truth, they care more about risk, and it's in their best interest to understand ROIC. But predicting when and if that's actually going to happen en masse is difficult. I thought it was going to happen a long time ago and I've been wrong, so I'm not going to guess again. I got one last question and then we will move on. Is goodwill removed from income and retained as invested capital? Yes and no. If you want to know exactly how we calculate return on invested capital, go to the education page on our site. So go to New Constructs, click on Education, and you can see the definition for return on invested capital. You can see the definition for NOPAT and invested capital that make up return on invested capital. You can see all the adjustments we make to get NOPAT and invested capital in our discounted cash flow model right. These are all free. We like to be very transparent at New Constructs because we know how much work we do and we want you to know how much work we do for you. I'm not worried about somebody copying my formula for return on invested capital. You're welcome to copy it. Use it as much as you can. Just make sure you understand that you need the right data to drive that formula. But I know one thing is for sure, you're not going to be able to do it at the scale we do it because we've invested a decade and millions of dollars in technology to do this with integrity and with scale. And that's what makes New Constructs better. We're better at collecting data because we use data. We're better at modeling data because we collect the data. Our competitors on the data collection side are typically using data entry specialists in third-world countries that don't know the difference between the correct line item and a right line item. They're just collecting data. They've never seen a model, never built a model, they never will. Our research competitors are using data from those data collection specialists, and our research competitors, many of which probably have not looked at an actual 10-K or an annual report And who knows, ever, 10 to 20 years. We look at the 10-Ks and we look at the models. We think that makes us special. We focus on being the best in the business at return on invested capital. Thank you for your time. Please feel free to contact us at Twitter, @NewConstructs, on Facebook, look under New Constructs. You're welcome to email me. research@newconstructs.com. Feel free to watch more webinars. We've got a whole bunch of webinars here on the site as well. Again, we're very transparent. We want you to understand how much work we do for you, and we thank you for joining us today. Thank you.