Good Hands Tied Behind Back? (ALL)

Allstate (ALL) just announced results from the third quarter of 2008. Management seemed nervous as concern over the potential for a "perfect storm." Three factors were at work: 1) a significant number of hurricanes, 2) investment portfolio declines, and 3) the potential of rating downgrades.

When I analyze ALL, my primary concern is the combined loss ratio in the property and casualty area, excluding catastrophes. Day in and day out, this ratio measures the profitability of the ALL franchise. This chart describes the loss ratio quarterly since the beginning of 2003:


The two lines drawn horizontally depict 86% and 88% combined ratios. For reference, a combined loss ratio lower than 94% is outstanding. When I evaluate ALL, I assume that the average combined loss ratio will average 97%. But the market analysts ignored this quarter's impressive 86% combined ratio. Why is this so?

Right now the urgent is superceding the important. The current environment has triggered significant liquidity and capital crises. The liquidity issue has been caused by the inability to sell anything. The capital issue is related as the lack of liquidity has caused depressed valuations which have caused capital to disappear.

Despite ALL's outstanding combined ratio performance, investors are selling out of ALL. This would be an ideal opportunity for ALL to repurchase shares as well as purchase other financial services companies. Unfortunately, the ratings environment is forcing ALL to stop the repurchase of shares, disinvest financial services company securities and not pursue acquisitions - tying their "good hands" behind their back.

Discount Revenue at AXP

American Express's (AXP) core competitive advantage is the higher spending level of its customers compared to those of Visa and MasterCard; it's four times higher. AXP attracts these "big spenders" by better rewards and benefits than its competitors. AXP can afford to provide these rewards because AXP extracts more money from the merchants in the form of discount revenue.

"Discount revenue" is collected by AXP in the form of a discount in purchasing goods and services from the merchant which are then effectively sold at full price to the consumer of goods and services. Discount revenue forms roughly 50% of the AXP's total revenue. An indicator of AXP's competitive strength is its relative discount rate depicted here:

If discount revenue is the primary profit center for AXP, then it is important to understand how it works. The calculation of discount revenue is based on billed business; the more goods and services purchased, the greater the charge for the services. But discount revenue and billed business are not always in lock-step.

For 2007, worldwide billed service grew 15% over 2006. At the same time, discount revenue grew 12% over 2006. This pattern continues in 2008 with billed service growing at 8%, while discount revenue grows at 5%. AXP explains that the slower comparative growth in discount revenue was caused by sharing with third party card issuers, higher cash-back rewards and corporate incentives. These various marketing costs are reported against revenue (contra-revenue) rather than as an expense for a more accurate discount rate.

Unfortunately, AXP does not provide much clarity on the discount rate for each of its business segments. AXP has four: U.S. Card Services, International Card Services, Global Commercial Services, and Global Network Services. AXP prefers to roll discount revenues, card fees and the ubiquitous "other" into one revenue line. This makes analysis more difficult. In addition, the discount rate will decrease over time because the higher growth segments, such as Global Network Services, have much lower pricing.

The Color Of American Express (AXP)

Last night American Express (AXP) released earnings information and provided "color" on its earnings call. The targets of the analysts' questions points to a lack of focus on the business model.

AXP began as a company in 1850 to transport money and other valuables safely. In a sense, AXP's focus has not changed. Today, AXP is a payments company, safely moving money on behalf of consumers and businesses.

AXP is compensated for its work in the form of "discount revenue." Discount revenue is the fee which facilitates a transaction between the merchant and the consumer. In a reversal of the old days when AXP got paid for moving money by the customers who had the money, now AXP gets paid for moving money by the merchants who receive the money.

For example, when I go to a restaurant, I pay with my American Express card (I carry no others). If my bill is $100, the restaurant receives $97.44, typically within one business day. (AXP reports a fee of 2.56%).

If all goes well, that little $2.56 is wonderfully profitable for AXP. AXP simply put a piece of IOU plastic in my pocket to run through a machine and took $2.56 from the merchant. No meals to serve; no dishes to wash. The merchant would prefer to have $100 in cash, but settles for $97.44 in "plastic" that might not otherwise have come.

To get this $2.56 from the merchant, AXP has two costs: financing and bonding. AXP sends $97.44 to the merchant and does not receive my $100 for about 30 days. This is "reverse float," that is, money that is not held that costs interest. If AXP is paying 5% annually, then the month's cost is $97.44*(.05/12) = $0.41. This is the financing cost associated with the generation of discount revenue.

The other cost is that the consumer won't be good for the money. One way to think of AXP is as a bonding company. When I am to "pay my dues" for my meal, AXP posts bond. If I pay AXP, then all is well and AXP received a fee for the work. If I don't pay AXP, then AXP is on the hook and will be looking for me. This is the major potential expense for AXP.

The "failure to show" bonding cost dwarfs the financing cost, but all of the questions of Wall Street's finest were slow pitches focused on financing costs. What's the color of American Express? Yellow, at least on that call.

Managing U.K. Bank Crisis

Gordon Brown, the U.K. prime minister, has been urging other countries to follow the U.K.'s $1 trillion bailout package. This package provides for government financial support to the banking system. However, Brown is experiencing some backlash domestically as senior executive bonuses continue to be paid - based partially on rising bank stock prices. If the banking sector experiences such financial windfalls while the rest of the economy moves into recession, domestic support for the bailout is likely to wane.

Nationalizing Banks

The current crisis is grounded in a lack of confidence in our banking system. During the past years, many of us wondered where all the money was coming from, not only to fund the coast-to-coast building program but also to buy all the completed projects. Now it turns out that the banks were assuming it was someone else's problem. Not so.

As the various securities failed to meet expectations, the supposedly safe components of these securities also dropped in value. This decline in value affected the equity strength of the inherently levered banks and this lack of equity strength hammered confidence.

Sweden and Japan are both countries that have had similar experiences as a result of real estate booms. Sweden effectively nationalized the banks with privatization following the government take over. Japan simply propped up the banks. The results were different. There was a sharp recovery for Sweden, while Japan was sluggish at best. So far, the U.S. has been helping the banks along a Japanese style prop-up, but something alot like nationalization is arising now.

U.S. authorities are now considering radical new measures to shore up ailing financial markets, including guaranteeing billions in bank debt and insuring all U.S. bank deposits for a temporary period. To do so requires multiple government agencies agreeing that a "systemic risk" exists, thereby invoking a rarely used legal power. If such a measure is implemented, then concerns over enrichment of equity shareholders cannot be far behind.