Dan Loeb’s 3Q18 Letter: Market Outlook and American Express

Smart Money

Review and Outlook

  • In January, fueled by tax cuts and synchronized global expansion, PMIs rose, economic growth estimates were revised upwards along with corporate earnings, and stocks surged across the board, especially growth stocks
  • In February, volatility spiked to record levels and stocks dropped precipitously after a series of technical dominoes fell into place
  • After October’s market rout, it seems that the environment this year ought to have been dubbed the “Bad Place Market”
  • We will explain why we think the sell-off happened, what we missed, and what we think comes next in the markets and for our portfolio
  • While the S&P is up slightly for the year, this statistic belies the extremity of the moves at the sector and global levels. YTD retail is up 30%, tech hardware is up 20%, and healthcare equipment is up 20%. By contrast, autos is down 18%, materials is down 8%, and capital goods is down 7%. At the lows, 63% of global stocks had entered into a bear market, which is almost equivalent to the 70% level reached at the 2011 and 2016 index lows
  • We believe the initial sell-off was caused by a backup in interest rates that saw 10-year yields rise from 2.8% at the end of August to 3.2% by the beginning of October. Rates were driven higher by Fed Chair Powell’s commentary that spooked the market into quickly projecting the worst-case scenario, i.e. that a tightening overshoot would drive an otherwise buoyant economy into recession. These fears manifested themselves initially in the delivering of growth stocks, causing volatility to rise and the market to breach levels to the downside, driving systematic and quantitative strategies to accelerate selling in a window of time where corporates were not participating in buyback programs due to the blackout period
  • Weakening earnings plus trade war escalation plus a potentially overzealous Fed was a toxic combination, particularly for cyclicals
  • While current US growth remains above-trend, helped by fiscal stimulus, this positive impulse is peaking now, and will combine with an increasing drag from tightening financial conditions. This means that current above-trend growth will slow over the next year
  • Growth outside the US is tepid, driven by Chinese tightening still percolating through the system as markets wait for the country’s recent stimulus to take effect
  • Given lack of financial imbalances and limited signs of an outbreak in inflation despite low unemployment, we still do not see any signs of an impending recession
  • The market has just been through its sharpest P/E multiple de-rating since 2011 sovereign debt crisis. While the current 10% consensus EPS growth forecast for 2019 is probably too high, the current multiple of 16x is already discounting cuts to the 2019 consensus
  • On the upside, delivery on 2019 consensus EPS and a return to the pre-sell-off multiple, which would still be below the peak 18x multiple in January, would imply ~8% upside
  • We have delevered our portfolio, reduced our tech exposure meaningfully, and grown our short book. We expect to be net sellers over the next few months if markets rally but, while we recognize that we are far along in the cycle, late-cycle and end-cycle are not the same
  • At ~16x one year forward P/E for the S&P 500, valuations are not overly demanding, especially when considered relative to real rates of 1%, which imply an above-average equity risk premium

American Express

  • 115 million cards-in-force and $1.2 trillion of billed business, making it the fourth largest payment network globally
  • From 2014-2017, Amex lost co-brand relationships with JetBlue and CostCo and saw increased competition from Chase’s Sapphire Card; EPS growth halved; and shares underperformed the S&P 500 by ~40%
  • New CEO Stephen Squeri is re-energizing Amex by focusing on topline growth and underappreciated structural opportunities in Commercial and International – efforts we think will lead to more sustainable double-digit EPS growth going forward
  • Amex has significant opportunity to sustain higher revenue growth as it prioritizes investments that drive customer acquisition, card acceptance, and higher average spend. This is a long runway where Amex is just beginning to inflect after years of under-investing
  • Proprietary card acquisitions hit 3 million last quarter and total cards rose 7% y/y
  • Merchant acceptance is growing at a high single-digit pace, twice that of Visa/MasterCard, and Amex aims to reach virtual parity with the latter networks by year end of 2019
  • Management has re-prioritized share, scale, and relevance – a formula that is driving billed business and net revenue growth of >8% the past 5 quarters, nearly twice the average pace of the past two decades
  • Amex also re-aligned operating segments earlier this year to better execute on the structural growth in Commercial and International payments. Today, Global Commercial Services (GCS) is Amex’s fastest-growing segment, with billed business up 12% Y/Y, and a close #2 in scale and profitability to Global Consumer
  • In large corporate, Amex has relationships with >60% of the Global Fortune 500; in SME, Amex is larger than the next five players in the US combined (by spend)
  • While Wall Street tries to find the next high-multiple stock to monetize the shift in B2B payments – an area with ~$20 trillion of addressable spend and ~10% penetration – they are missing a more obvious beneficiary in Amex, where B2B already makes up 2/3 of commercial spend
  • Amex also has a structural growth opportunity as it presses its unparalleled value proposition in less competitive international markets
  • In International SME, Amex is just scratching the surface, with <5% market share in each of its eight core markets – seven of which are now growing double-digits
  • Growth is less about cyclical tailwinds than greater operating focus: both Commercial and International are growing proprietary cards-in-force at more consistent levels and at higher average spend per card than has been seen before
  • Greater scale – in users and acceptance, across commercial payments and international markets – has the power to drive operating leverage and more sustainable EPS growth over the long-term. Critical to this equation is Amex’s spend-centric model, where fees are 80% of revenue, about 3-4x the level of a “traditional” card company, and credit costs are just 1/5 the cost of total customer engagement spend with the latter providing an important lever to throttle back and help sustain earnings in tougher times
  • With shares trading at just 12.5x our 2019E EPS, and 11x 2020E EPS we think markets under-appreciate the strategic pivot occurring at Amex and see shares trading above $135 over the next 18 months for a total return of 30% upside

Third Point 3Q18 Letter, November 9, 2018

Third Point is a New York-based long/short, event-driven, and activist hedge fund founded in 1995 by Dan Loeb. As of 2014, Third Point had an estimated AUM of $17.5 billion.

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